Fund focus: Unicorn prepares for turbulence in China's VC space

Chinese VC managers raised a record $10.8 billion for US dollar-denominated funds in 2018, according to AVCJ Research. However, more than two-thirds of this capital went to eight firms, dominated by blue-chip names such as GGV Capital, Qiming Venture Partners and Matrix Partners China as well as former local upstarts like Shunwei Capital Partners and Gaorong Capital.

Tommy Yip, managing partner of venture capital fund-of-funds Unicorn Capital Partners, believes this flight to brand names – if not necessarily to quality – is largely a function of low liquidity from previous vintages. The same was true of 2019 and he expects the effect to become more extreme in 2020 as numerous larger managers return to market. These funds will absorb most of the already limited capital available from US institutional investors, leaving smaller players high and dry.

"There are a handful of managers – typically those on Fund I or Fund III – who have been raising capital for two years or more. They aren't going to close their funds," he says. "If you look at what has happened over the past five years, fundraising cycles were compressed. Some of these firms deployed their first two funds within two years and now they are back with Fund III, but they don't have outstanding track records. And Fund III is the one where you must show some returns, or LPs won't continue re-upping every couple of years. We are going to see some consolidation."

Lacking liquidity

The liquidity issue is as follows. A US endowment would have a $20 million annual allocation to China, which would be spread across four funds. As distributions from existing funds failed to come through, this annual budget shrank to $10 million – and rather than take a risk on a couple of unproven managers, the endowment put it all with one big name.

This dynamic will remain until paper gains turn into actual gains, which doesn't just mean mega IPOs for the likes of ByteDance Technology and Didi Chuxing but also sell-downs in already listed companies such as Pinduoduo, Meituan Dianping and Xiaomi. "Given the large positions some VC firms have in these companies, it's going to take them a while to exit. We are talking about 12-18 months, if not longer," says Yip.

Unicorn welcomes the development for two reasons. First, the firm hopes that a thinned out emerging manager space will underline its ability to pick winners. Second, a market correction could ease the frenetic pace of fundraising, allowing for greater vintage diversification.

Against this uncertain backdrop, Unicorn recently closed its third fund at the institutional hard cap of $350 million. The vehicle launched last April with a target of $300 million and the fundraising process was largely completed by August. A final close was delayed until December 31 because a few investors needed more time for internal procedures. The LP base primarily comprises US endowments and foundations, many of them re-ups and many of them relationships that Yip established during his decade with Asian fund-of-funds Emerald Hill.

Unicorn was set up in 2015 and accumulated a small corpus of around $60 million before closing its first official vehicle at the end of the year at $210 million. Fund II closed at $250 million in mid-2018, having launched with a target of $200 million. Yip credits the increase in size and the speed of the fundraise – it is Unicorn's shortest process to date – to strong performance of that initial $60 million corpus and the gradual validation of the firm's early-stage investment thesis.

As such, there is no change in strategy for Fund III. Unicorn will continue to deploy the largest portion of capital with emerging managers, including spinouts, with smaller allocations for top-tier VCs, micro VC, healthcare specialists, and direct co-investments. The firm put 15-20% of Fund II into co-investments, typically Series B and C rounds. The goal is to enter when a business is about to reach an inflection point, allowing for 3-5x of upside. It is all in the timing: once early-stage risk is mitigated but before the likes of Hillhouse Capital and Tiger Global arrive.

Young guns

There are no standardized criteria for defining an emerging manager or assessing whether they should graduate to the top tier. Unicorn often backs teams that have investment or operational experience from previous roles, but no history of working together. For Yip, individual reputations and networks really matter because deal flow tends to follow people in venture capital.

"Everybody has money, it's almost becoming a commodity," he says. "One question we ask all the time about managers is why a particular entrepreneur is taking their money over groups like Sequoia or Matrix. There must be value that they bring beyond capital. The market gets excited about certain firms because of their ecosystems – they can bring different resources to the table, in sourcing and post-investment management, and this is valuable to entrepreneurs."

There has been some evolution in where these emerging managers are coming from. To begin with, backgrounds were somewhat homogenous: people would spend five to 10 years with brand name firms, building out their networks, and then strike out on their own. The emergence of large Chinese technology companies – the BAT (Baidu, Alibaba Group, Tencent Holdings) and the TMD (ByteDance-owned Toutiao, Meituan, Didi) has brought a different kind of talent into the market as executives with strong operating and product experience spin out.

Meanwhile, the slowdown in fundraising by those outside the top tier has led to reduced competition for deals, which in turn means entrepreneurs are less aggressive on valuations and terms and conditions. China VC investment came to $13.3 billion in 2019, down by only 13% on the previous year, and the third consecutive annual decline. More startling, growth-stage investment in the technology space fell by more than half on 2018.

"We are not in a winter environment – every year VCs say winter is coming – but it is definitely cold," Yip observes. "We haven't seen a lot of down rounds yet, but companies are taking longer to close their Series B and C rounds, including some of the better names. VCs that have been able to raise capital are taking their time in deploying it, and that's a good thing. Our underlying capital calls have slowed over the past six months and we expect that to continue. The market is normalizing."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Greater China
• Fundraising
• Fund-of-funds
• Venture
• Technology
• LPs
• China
• Unicorn Capital Partners
• TMT