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  • Greater China

China semiconductor: Casualties of war

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  • Larissa Ku
  • 21 September 2022
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Private equity investment in China’s semiconductor industry continues unabated despite intensifying US regulatory action. While start-ups are not explicitly targeted, many are feeling the heat

All is not well in China’s semiconductor industry. Why else would a chip developer at the pre-Series A stage – that has yet to complete the tape-out process for its debut product ahead of manufacturing – be invited to acquire a rival of longer standing with accumulated revenue of CNY 20m (USD 3m)?

The Shenzhen-based company seeking a white knight is a consumer electronics chip designer. It has big-name customers like Vivo but its profit margin is less than CNY 1 per unit. In the second half of 2021, with consumer spending waning, revenue fell by 80%. This compares to a 25% retraction industry-wide, according to the founder of the pre-Series A start-up. Lower-end products were the most heavily hit.

Locked into fixed supply agreements with fabrication plants, inventory will continue to pile up on the Shenzhen company’s factory floor. The founders knew they weren’t in a strong bargaining position. They asked for CNY 2m in cash plus guarantees of continued roles for themselves under the new owner.

“We turned them down,” said the founder of the pre-Series A start-up. “The only reason for us to consider the acquisition is to get access to their customer base, but their product type and price range are very different to ours. Given the market situation, we can’t spend even one dollar unnecessarily.”

It remains to be seen whether the Shenzhen-based company survives. Plenty of others have not. In the first eight months of the year, 3,470 semiconductor-related companies – defined as those with the Chinese character for “chip” in their registered names – have gone bust, according to Qichachai, a local business data provider. There were 3,420 closures across the whole of 2021 and 1,397 in 2020.

These challenges are playing out against a backdrop of an increasingly antagonistic China-US chip war and scandals linked to debt-laden Tsinghua Unigroup, the one-time pioneer of China’s semiconductor self-sufficiency drive. Nevertheless, private equity investment in the industry is not fading.

Indeed, the investment boom was triggered by an acceleration in the chip war in 2019, specifically US regulators placing Huawei Technologies and several other Chinese technology companies on a blacklist that prevents US companies from doing business with them. Suddenly, finding locally made replacements for imported components became a priority for all Chinese technology manufacturers.

By 2020, PE and VC players were looking for ways to leverage this trend. Investment in the semiconductor industry hit USD 7.16bn, up from USD 230m in 2019. It held steady at USD 6.7bn last year, although this doesn’t include USD 9.4bn committed to the restructuring of Unigroup, and it has since kicked on. Nearly USD 9.5bn was put to work in the first eight months of 2022.

Investors aren’t necessarily disheartened by the wave of bankruptcies. Rather, they believe consolidation could lead to a period of more rational industry development, with clear leaders emerging in each segment and greater emphasis on product quality.

“The semiconductor boom that started in 2019 attracted investors with no domain expertise, and this drove up valuations, but now that phase of high valuations has ended. This year and next year will be vintage years for semiconductor investment,” said Raymond Yang, founding and managing partner of deep tech-focused WestSummit Capital.

He added that leading companies in the space are now raising capital at around half their targeted valuations; meanwhile, second-tier players are raising down rounds, if they can secure capital at all.

Sanctions to substitution

China’s semiconductor demand dynamics are well-known. The country consumes more than 60% of global supply, and last year, imports of integrated circuits (IC) reached USD 432bn, up 23.6% year-on-year. They were responsible for 16% of national import value, according to customs statistics. China’s State Council wants the semiconductor self-sufficiency rate to rise from 30% in 2019 to 70% in 2025.

Industry research firm IC Insights believes those calculations of optimistic. It found that local suppliers addressed just 16.7% of local demand in 2021, up from 12.7% in 2011. It expects the self-sufficiency rate to reach 21.2% by 2026. However, if China-based manufacturing by foreign companies such TSMC, SK Hynix, Samsung, Intel is excluded, the 2021 figure slumps to 6.6%.

“Domestic substitution is a very clear and certain investment theme. It creates opportunities for every segmented track. This is a space in which hundreds of start-ups can thrive, and it’s not just for the next 3-5 years. Semiconductors will be a sunrise industry in China for the next two to three decades,” said Alex Banh, a managing partner of specialist semiconductor investor IPV Capital.

3535-cover-pe-investment-in-china-s-semiconductor-industrySeveral LPs with US-dollar denominated assets, including family offices and fund-of-funds in Greater China, told AVCJ that semiconductor-focused managers are an essential component of their portfolios. But they are comfortable taking a “wait-and-see” approach.

On one hand, market conditions mean patience will not be penalised – there is no obvious advantage to committing early. On the other hand, it was reported earlier this month that the Biden administration is mulling restrictions on US investment in Chinese technology companies. It is deemed wise to put decisions on hold until the policy situation becomes clearer.

The investment restriction would be the latest in a string of measures targeting China’s technology sector, especially the semiconductor space.

For example, the CHIPS & Science Act, which was signed into law last month, includes USD 52bn in subsidies for semiconductor manufacturers that set up factories in the US. In what amounts to an attack on China’s longstanding manufacturing bottleneck, companies that receive funding must agree not to scale up their production of advanced chips in China.

Some industry participants challenge the economic rationale of the policy. Morris Chang, founder of TSMC, denounced the subsidies as “a very expensive exercise in futility” in an interview in April, noting it costs twice as much to operate a semiconductor plant in the US as it does in East Asia.

While the US controls core technology and software, as well as key manufacturing tools, Taiwan-headquartered TSMC produces 92% of advanced semiconductor chips required for smart phones, laptops and ballistic missiles. US players like Nvidia, Qualcomm and Apple outsource almost all their manufacturing to Taiwan.

“This is the result of natural economic development. The US economy has developed to such a stage that chip manufacturing doesn’t really fit it,” said Jie Yuan, an associate professor at Hong Kong University of Science & Technology (HKUST), who leads the mixed-signal and sensory IC lab.

“It is still in charge of technology innovation for the chip industry, but manufacturing should take place somewhere that is more cost-effective. An artificial move against economic reality is not wise.”

Decoupling, still flourishing

The situation underscores how the chip war is more about politics than economics. China is often described domestically as the “country with no heart,” which plays on the fact that chip and heart are pronounced the same way in Chinese. This captures how keenly the paucity of semiconductor manufacturing capabilities is felt as well as the government’s resolve to address the issue.

At the same time, an emerging narrative in the US aligns the chip war with cross-Strait tensions and US national security concerns. Graham Allison, a professor of government at Harvard University, and Eric Schmidt, former CEO of Google, noted in a co-authored article that if Taiwan’s chipmakers went offline or came under mainland China’s control, the consequences for the US tech sector would be devastating.

“America is on the verge of losing the chip competition. Unless the US government mobilises a national effort similar to the one that created the technologies that won World War II, China could soon dominate semiconductors and the frontier technologies they will power,” they wrote.

3535-covertable-largest-china-semiconductor-dealsThe polarising and politicised nature of the debate, on both sides, has already contributed to the destruction of global supply chains and may effectively split the world in two, Dylan Patel, chief analyst at SemiAnalysis, a boutique semiconductor research and consulting firm, told AVCJ.

“There will be more and more Chinese-only companies serving China and countries favourable to them and more companies that serve the US and its allies,” he said. “The world of technology may falter into two spheres of influence as the two countries escalate on actions against each other.”

Despite the moves to curtail chip development in China – with restrictions on exports of advanced chipmaking equipment and design software to the country among the most keenly felt – the domestic industry continues to grow steadily.

Authorities in Shanghai announced earlier this month that 14-nanometre chips are now being mass produced in the city. While global leader TSMC is still several generations ahead, having begun mass production of 3-nanometre chips, 14-nanometre chips are typically used in new energy vehicles, an emerging pillar industry in China and one in which the country is globally competitive.

Corporate performance is robust. Semiconductor Manufacturing International (SMIC), China’s top fabricator, reported a 67% year-on-year surge in its most recent quarterly sales. Other listed industry participants, from video chip designer Shanghai Fullhan Microelectronics to smart card chipmaker Shanghai Fudan Microelectronics, are experiencing similar upswings.

According to Bloomberg, China is home to 19 of the world’s 20 fastest-growing semiconductor industry companies, based on average performance over the past four quarters.

More importantly, the country’s flash chips have rapidly achieved international recognition. Yangtze Memory Technologies (YMTC) has been shortlisted as a potential supplier of Nand flash memory chips used in Apple’s iPhones. Facing widespread criticism in the US, Apple clarified that YMTC’s chips would only feature in products sold in China.

YMTC recently unveiled its fourth-generation 3D Nand chip used in solid-state drives (SSD) – a top-of-value-chain product. In July, global leader Micron Technology released a chip with 232 layers of memory cells, up from 176, promising 50% faster data transfer speeds and 100% higher write bandwidth. YMTC skipped the 192-layer setup detailed in its original roadmap and went straight to 232, intent on matching Micron.

“YMTC is running ahead of other players in Nand with homegrown innovation. In a couple of years, we have no doubt that they will be cost competitive with even the best in the industry. They will structurally change the Nand industry,” said Patel of SemiAnalysis. “Companies without a durable advantage in technology or large subsidies will face an apocalypse regarding their future business viability.”

Trouble at home

The success of YMTC wouldn’t have been possible without Unigroup, which established and seeded the company through the National Integrated Circuit Industry Investment Fund, also known as the IC Fund or Big Fund. The first of these vehicles – managed by Sino IC Capital – closed on CNY 138bn in 2014 and a second launched in 2019 with initial capital of CNY 200bn.

Unigroup and Sino IC achieved international prominence following attempts to buy assets overseas, including a bid for Micron in 2015. Most of these were either rejected or blocked by US regulators. They were prodigious investors domestically as well, and the weight of debt-fuelled acquisitions at home and overseas eventually pushed Unigroup into court-ordered bankruptcy restructuring last year.

Since then, the leadership of Unigroup and the Big Fund have been placed under investigation for suspected legal violations. Seven Big Fund executives have been implicated, including Jun Lu, the former head of Sino IC, Wenwu Ding, a general manager of the Big Fund, and Weiguo Zhao, who previously led Unigroup.

“The investigations into the leadership at the Big Fund suggests that the fund is deeply politicised in ways that are unlikely to produce effective investments,” said Chris Miller, an associate professor at The Fletcher School at Tufts University.

“When the Big Fund was first created, some analysts saw this as adopting the best features of a private sector ‘venture capital’ model. The investigations at the top of the Big Fund are evidence not of a venture capital mentality, but of political intrigue. The more China's semiconductor investments are politicized, the less likely they are to produce viable companies.”

An Alibaba Group-led consortium was poised to bail out Unigroup, but the bid reportedly faltered amid concerns about the e-commerce giant’s US listing and heightened disclosure requirements tied to closer regulatory oversight of Chinese companies trading on US exchanges.

In the end, an investor group led by state-owned Jianguang Asset Management (JAC Capital) and Wise Road Capital – described as an international Asian growth capital investor – secured the restructuring mandate. Zhao immediately objected to the deal, arguing that it would contribute to losses of CNY 73.4bn, but the restructuring was completed in July.

The Big Fund was widely regarded as a “gold finger” investor: whatever it touched would see a spike in valuation. Holdings in key industry players like SMIC and YMTC have delivered strong returns. However, compensation was structured like a state-owned enterprise rather than a VC firm – fixed salaries with no incentives – and there were reports of executives making personal investments on the side.

“What we lack is a proper repair system. We rectify an industry by rectifying individuals, and this means those in leading positions are no longer willing to take responsibility. They just play safe,” said a Beijing-based tech investor.

He added that investments by the second Big Fund overlap considerably with those of its predecessor. Moreover, the portfolio companies, including Shenzhen-listed Naura Technology Group and Advanced Micro-Fabrication Equipment (AMEC), don’t really need external liquidity.

Know your risks

As the politicisation of China’s semiconductor industry ramps up, private equity investors looking to back new domestic champions that benefit from domestic substitution face an array of risks. Chief among them is the widely-held assumption that US dollar-denominated funds cannot back local chip start-ups.

Both WestSummit Capital and IPV Capital stated that, to date, they have experienced no problems making investments in the industry through US dollar pools of capital. Exits are also smooth. While listing on Shanghai’s Star Market can be a protracted process because of the backlog of applicants, the criteria and credentials remain the same, WestSummit’s Yang noted.

In recent years, private capital has gravitated towards artificial intelligence (AI) chips, also known as GPU or CPU chips. The targets are often young start-ups with products years away from commercialisation, yet helmed by founders or teams that previously worked for established technology companies.

Cix Technology, a CPU chip designer, is a case in point. The start-up has raised USD 100m since across three rounds since its establishment in October 2021, including a pre-Series A in July led by Nio Capital and Qiming Venture Partners. Led by a CEO who previously served as system-on-chip (SoC) director at AMD, Cix aims to create ARM-compatible CPU SoC designs.

Biren, which was founded by a former president of AI specialist SenseTime, is further along a similar path. It has raised CNY 4.7bn since 2019, most recently securing USD 410m in Series B funding in March 2021 from US dollar and renminbi funds. Ping An Insurance, Country Garden Venture Capital, and New World Development took the lead, with the likes of Source Code Capital and BAI also participating.

One investor in the round told AVCJ that Biren is now valued at around USD 2bn, up from USD 800m a year ago. This in part acknowledges the company finally launching its first GPU chip. The product surpasses Nvidia’s high-end A100 series on certain specifications, but the investor noted that Biren cannot match Nvidia’s key asset – the Cuda platform, which serves as an ecosystem for gathering users.

Regardless, the company can count on plentiful support from domestic customers in need of alternatives to overseas products. But there are still risks - specifically, that only TSMC can produce these chips. The US has already blocked TSMC from supplying Huawei. A second investor suggests it may do the same to Biren, should the chip war escalate.

“This would be a sword always hanging over your head,” the investor added.

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