China VC: Early birds

Bluerun Venture established a China presence in 2005, but it wasn't until two years ago that the US-based firm carved out its early-stage investment platform into a separate fund. The China team subsequently raised $200 million for the strategy in early 2015. A successor vehicle recently closed with more than twice as much in aggregate commitments.

The $500 million corpus comprises US dollar and renminbi-denominated tranches - BlueRun claimed at the final close in October that it was the largest dual-currency early-stage VC fund ever raised in China - and will focuses on seed and Series A rounds. "Some industry peers might find it hard to believe that we can deploy $500 million into early-stage start-ups, but that's our mission. We want to support the best entrepreneurs, providing more capital to help them learn and grow from their mistakes," says Weiguang Chen, a partner at BlueRun.

The fundraise coincided with Redpoint Ventures - which used to invest in China via its global funds - announcing the separation of its China team and the launch of $180 million debut country-focused vehicle. A few weeks later, Long Hill Capital, a China spin-out from New Enterprise Associates (NEA) closed its first US dollar fund at $135 million.

These GPs appear to have identified a new sweet spot between the late angel stage and Series A rounds in an otherwise inflated VC environment, but it remains to be seen how many others follow suit. Fundraising is tougher than before, particularly for US dollar funds, and the market is compressing. Growth investments, once a prime target for many investors, are now perceived as high-risk, forcing firms to seek value on either side of this middle ground. Going earlier has proved to be a popular option.

"We've seen a few new entrants, which have traditionally invested at the Series C stage or later, coming into Series A and B rounds. Investors in these mid-stages recognize they have to go either earlier or go later. There is a bifurcation in China's venture capital market," says David Yuan, head of Redpoint China.

A dissipating trend

According to AVCJ Research, a total of $6.4 billion has been committed to 26 China-focused venture capital funds so far this year. This follows two bumper years for the industry, with $7.8 billion and $8.6 billion raised - over the full 12 months - in 2014 and 2015, respectively.

The bulk of the 2016 commitments went to Sino-US player GGV Capital, which raised $1.2 billion across three vehicles targeting early and growth stage investments. Qiming Venture Partners also posted a sizeable final close, securing $648 million for its fifth China fund, while DCM closed a Sino-US vehicle at $500 million. Lightspeed China Partners also raised $260 million to invest in early-stage companies.

GGV's early-stage vehicle - the $250 million GGV Discovery I - is the product of a strategic move to capture a changing market dynamic in the early space. Another component is a $225 million top-up vehicle, intended to make follow-on investments in companies backed by the main fund. It is arguably an extension of the VC fundraising craze, which saw a number of GPs secure additional capital enabling them to extend their reach into later funding rounds.

"The period between 2010 and 2015 was a golden time for venture investing in China, in particular for early investing in e-commerce companies," says Haide Lui, a principal at HarbourVest Partners. "In the past three years, a wave of new GPs have been formed - spinning out from experienced managers or launched by industry practitioners at leading internet companies and team members exiting successful start-ups."

Banyan Capital Partners and Source Code, spin-outs from IDG Capital Partners and Sequoia Capital, respectively, are classic examples. Both GPs quickly managed to scale up their fund sizes beyond pre-Series A and Series A rounds. Within two years of coming into existence, Banyan now has three US dollar fund and two renminbi funds, with around $700 million and RMB1 billion ($156 million) in assets under management.

"Other people tried to copy that. Even junior managers, they left established firms and wanted to raise their own funds. I was a bit worried at that time because the early-stage space suddenly became so competitive. It was a phenomenon in 2014, but less so in 2015, and definitely not in 2016," says James Mi, co-founder and managing director at Lightspeed China.

New firms are still being formed - for example, Genesis Capital and Xianghe Capital, which were set up by former executives from Tencent Holdings and Baidu, respectively - but it is harder to achieve momentum. China's slowing economy and overvalued VC market have made global LPs more cautious. With IPO exits uncertain, some expect markdowns and down rounds to become more prevalent over the next two years as the later-stage growth space stalls.

"China is coming off a peak in valuations in the VC cycle, providing a moderating environment for new investments. While the number of investments may not match the past few years in terms of volume, there will continue to be high quality start-ups," adds HarbourVest's Lui. "The very best managers will continue to make outstanding returns, but it will be more challenging for the others. We expect to see increased variance in performance, especially in the early stage."

Overpopulated areas

One of the reasons for the anticipated diverging fortunes among early-stage investors is the sheer number of participants at certain levels of this market segment. Uncertainty regarding growth-stage rounds has seen investors push lower down the spectrum. But the angel and seed spaces are already awash with capital from cash-rich entrepreneurs and individuals seeking portfolio diversification.

"Probably three to five years ago, most early-stage projects we looked at had no prior investors. But today, I would say more than 50% of the companies looking to raise Series A rounds have already received angel or seed investments. There are a lot of investors, primarily renminbi investors, are involved. The competition is much more intense," says Redpoint's Yuan.

For some it has become too intense. Sinovation Ventures, formerly Innovation Works, started out with an incubation-plus-investment model: the incubator backed companies with potential and those seen as likely home runs received capital from the VC fund. However, the incubation business was spun out and Sinovation now focuses on Series A and B rounds, as well as the odd seed investment.

At the same time, the Chinese government has become a more prominent actor in the VC space, announcing a slew of policies to encourage domestic start-ups. It has backed two dedicated venture funds, with target sizes of RMB40 billion ($6.5 billion) and RMB200 billion, respectively, and permitted insurance companies to invest in VC funds. These efforts have helped the renminbi space evolve, with more institutional capital entering the system.

"It is encouraging that the government is becoming a bit more instructional. There are a lot of government-backed funds looking into the venture space - we are talking about a huge amount of capital, but a large portion of it is managed by professionals such as fund of funds, VC or PE funds. The government is starting to work closely with institutions and as a result market discipline and professionalism are improving," says an investment manager of a Shenzhen-based renminbi fund-of-funds.

Peng Cheng, managing director at Tsinghua Holdings' venture arm THG Ventures, echoes this view. His firm recently received an investment mandate from Ministry of Finance, which provided a quarter of the capital for its latest RMB4.5 billion fund. Other recipients include Shenzhen Venture Group and Jiangsu Addor Capital, as well as China International Capital Corp's fund-of-funds unit. THG typically invests in post-Series A start-ups with proven concepts and basic operational infrastructure.

Traditional US dollar venture investors have also raised renminbi vehicles to have the flexibility to back start-ups in areas where foreign capital is unwelcome or an onshore listing is desired. Indeed, local capital dwarfs US dollar commitments. Of Sinovation's latest $674 million dual-currency fund, over half of the corpus is from renminibi investors including government-backed VC funds. The RMB2.5 billion renminbi portion is five times larger than its predecessor.

However, Kai-Fu Lee, founder of Sinovation, says this development may not be evidence of greater maturity in the domestic LP base. "For many of our LPs, this is the first time they have invested in a venture capital fund. It will probably take another five years before we see widespread institutional interest in VC," he explains.

Renminbi LPs tend to have a lower risk tolerance and a stronger demand for liquidity. As a result, when a US dollar manager raises a renminbi vehicle, the latter targets lower risk, lower return-type deals, while the former makes investments that might take longer to monetize.

For example, about 20-30% of BlueRun's renminbi vehicle - which is approximately equates to $250 million - will go into pre-IPO deals. In particular, the GP will deploy capital into some of its existing US dollar portfolio companies where the variable interest entity (VIE) structure needs to be dismantled, and the foreign investor redeemed, ahead of a domestic listing.

A time for focus

However, the mismatch between renminbi and US dollars is also a function of the difficult international fundraising environment. Ten years ago, with China's VC market in its nascent stages, almost every investor targeted broadly-defined technology, media and telecom (TMT) opportunities. Now, though, winning over LPs requires a more thoughtful and often more niche approach from fund managers in terms of segment and stage focus. This in part explains the relatively narrow strategies of BlueRun, Redpoint and Long Hill.

"The numbers of VC funds and VC fundraising volume have each jumped 10-fold over the last five years. In such a competitive market, we need to differentiate. Why should LPs choose you? How can you generate fruitful returns over the next 5-10 years despite a slowing economy?" says Bo Jiang, a partner at Long Hill. "We believe there are more new business models emerging from two robust sectors - consumer and healthcare services."

And within healthcare there are two areas of interest: new technology and service delivery. Long Hill has chosen the latter as its focus, aiming to support technology-enabled start-ups that can address the shortage of quality doctors and structural inefficiency of the current healthcare delivery system.

If soft services represents Long Hill's differentiation, Sino-US specialist WI Harper has chosen data analytics and blockchain, although healthcare is of interest as well. Edward Liu, a partner at WI Harper, observes that this strategic evolution is a function of the greater emphasis on consumption in China's economy. While the trend has taken many GPs into consumable technology areas like the internet-of-things (IoT), he has no desire to follow the mass market.

"Everyone talks about robotics, IoT, augmented reality (AR), drones, but do they really understand it?" Liu asks. "We target TMT and healthcare services. We have recently done more technology deals overseas, and fewer in China, because valuations are crazily high, while overseas companies have better corporate governance and sometimes better technology."

Indeed, the application of technologies such as artificial intelligence and machine learning - which are expected to be widely used in online education, healthcare and internet finance - is said to be at least two years away. But valuations of start-ups in these areas are rising simply due to a lack of choice: there aren't many qualified founders with overseas business experience who can roll out solutions of such complexity.

"Everything has become more expensive - it's all relative. The risk at Series A today will be much higher than five years ago. But I still think there is a pocket of opportunity if you have the right team to look at the right deals," says the renminbi fund-of-funds manager.

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• Topics
• Greater China
• GPs
• Venture
• Fundraising
• China
• BlueRun Ventures
• HarbourVest Partners
• Lightspeed Venture Partners
• Long Hill Capital
• WI Harper Group