China's venture capital industry is dying

Two weeks ago, I wrote an article on my WeChat blog which set off a heated discussion in China about the fate of the venture capital industry. The article has hit some major nerve. To date, the article, along with its sequel, has been viewed by more than 130,000 people and shared more than 10,000 times. This may well suggest that almost anyone who has anything to do with venture capital in China has viewed and/or shared this.

Today, I am translating my own articles for you to help you gain a clear understanding of the huge existential soul-searching in that industry right now. The main article is free, while the sequel article is behind the paywall.

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The Chinese Venture Capital Industry Should Be Rebuilt from Scratch 中国创投行业是该推倒重来了

First, I'll state a basic fact: Today, China's PE/VC (venture capital) industry is no longer the same industry as venture capital in the US.

In the US, venture capital is a product of the highest stage of capitalist development. The biggest feature of venture capital is it involves extremely high risk and extremely long investment cycles. Only when a capital market has developed over a century, spanning many generations and market cycles can there be enough "patient capital" willing to support startups.

But what about China? China's venture capital market was once absolutely dominated by US dollars, and at that time, the differences between the Chinese and US venture capital industries were not large. The only difference was the composition of the investment teams. Because the US capital market is highly developed, there are a large number of successful entrepreneurs who, after achieving success and fame, go on to support the development of more entrepreneurs through the venture capital industry. This "pass-on传帮带" spirit is very strong. A typical example is a16z, where the fund founders themselves are successful serial entrepreneurs, including the author of the book "The Hard Thing About Hard Things", Ben Horowitz.

What about China's venture capital? China's venture capital industry's core competitiveness used to be securing US investors, telling stories to foreigners, and gaining their trust. Therefore, the educational background and experience of the team was very important. So you'll find that the industry is dominated by Ivy League or Tsinghua/Peking University graduates, but there are very few investment managers with actual entrepreneurial experience. After all, "truly understanding entrepreneurship" was not a core competency for them, and when the whole industry is in an upward cycle, you can invest in good projects with your eyes closed. You could say that the past glory of China's venture capital industry was a case of seizing the opportune time, place, and personnel. If China hadn't had rapid development since the reform and opening up, and if it hadn't caught up with the rapid global development of the internet industry during this fast-paced growth, US dollars would not have been willing to support it. Without US dollars, China's venture capital market would not have had a logical starting point. This was a growth story driven by the industry's super-strong beta.

But today, everything has changed. US dollar funds have withdrawn from China and are unlikely to return in the foreseeable future. As the tide recedes, the industry has suddenly realized how little "patient capital" our society has. Ask yourself sincerely, how many Chinese people are willing to give money to startups without caring about the risks? This actually makes sense. China's market economy has only been running for a few years, through only a few generations, and experienced a few cycles. Long-term, patient capital is naturally scarce.

Today, “long-term capital” in China is basically only left with state-owned capital, especially local government-owned capital. If venture capital funds want to survive, they have to find a way to get money from local governments. But the core demand of local governments is to develop the local economy, so they will definitely require venture capital funds to invest the money back into the local area, what the industry calls "return investment". This is also a very reasonable arrangement. Therefore, many venture capital funds find that what they are doing is no longer investment, but helping the government with investment promotion.

These underlying changes have brought profound changes to the venture capital industry and all startup companies.

First, state-owned capital cannot make mistakes or lose money. However, more than 90% of venture capital investments are destined to lose money, which creates an internal contradiction. To ensure that state-owned assets are not lost, funds now generally require startup founders to provide unlimited personal liability for the investment. Venture capital has become distorted, turning into banking, or even high-interest loans. I know that more and more entrepreneurs are choosing to refuse this kind of financing, feeling that it's not worth taking such an "expensive" investment, and they might as well just close the business.

Second, local fiscal conditions are not good, and state-owned limited partners (LPs) themselves are also in difficulty. There was an article by Investment Sector投资界 recently that talked about this, with the title "Sorry, we're still waiting for the capital call", which was very true. The result is that the industry's investors are extremely singular, and the investors' funds are also very tight, leading to a chain of defaults from top to bottom in the entire industry.

Finally, the question that needs to be soul-searching is, who are venture capital funds actually serving? According to my most superficial understanding, venture capitalists should serve startups. Startups are the real clients of VC funds. They are the funds' source of sustenance. Only when startups do well can the funds succeed and have the capital to raise more funds. From the perspective of the whole society, this is also reasonable: the core driving force of the economy is enterprises, and when enterprises develop well, the economy can be good, and everyone can make money, not the other way around.

But now, the venture capital ecosystem with investment promotion as the core demand and financing as the main purpose has precisely reversed this logic. I believe that many funds now feel that their clients are state-owned limited partners, and they have to do their utmost to meet the requirements of the LPs, even if the LPs have no money, they have to beg on their knees. Conversely, they will also become more and more demanding of the invested companies. The commercial logic no longer matters, and whether the companies are good or not no longer matters. The industry's logic has been completely subverted.

What dire consequences will this industry ecosystem bring?

I'll share two recent cases I've heard about to illustrate this problem. These cases themselves are not big deals, but precisely because they are not big deals, that they are so common, they deeply reflect the widespread crisis in China's venture capital industry. I'm not responsible for the authenticity of these cases.

The first story is about Company C, which just received a new round of financing from Fund Y. Fund Y is a standard RMB fund. Like many companies, the founder of Company C has taken on personal unlimited liability to Fund Y. Company C's previous investors were US dollar institutions, who had never heard of "unlimited liability", so this was the first time Company C had encountered this with an RMB investor, and it was a huge cultural shock at the beginning. But in order to save the company, the founder gritted his teeth and accepted this term. Originally, they thought that with this backstop guarantee, the investors should be reassured. But the opposite is true. Those US dollar institutions, in their daily operations, basically don't interfere with the company, and when the company needs help, they will do their best to help. But Fund Y is different, they keep asking for this analysis and filling out that form, every time they ask, it's all about "compliance requirements", "middle office requirements", and "post-investment management requirements". Company C is tired of it, a company's thoughts should be focused on doing its business well, but it still has to keep diverting scarce manpower to deal with Fund Y's chores. Company C has more than ten investors, but 90% of the shareholder relations work is spent on Fund Y. The irony is that Fund Y is precisely the investor that is best protected by the terms!

The last straw that broke the camel's back in the relationship between Company C and Fund Y was when Fund Y sent a junior person to demand that Company C provide personal credit reports for the entire founding team, hinting that they had encountered related issues in other projects. This is just too much. So what is Fund Y, a venture capital fund or a bank? If it's a bank, shouldn't they lower the buyback interest rate from 12% to the bank loan prime rate level? Shouldn't they give up the right to enjoy the excess returns of equity? Company C later just ignored Fund Y, focusing on making the company better, and then finding new money to buy out Fund Y. In this way, the relationship between investors and invested companies has changed from business partners to counterparties.

The second story: Company A started fundraising in 2022 and talked to Fund W for half a year before signing. Fund W only invested a very small amount of money, but imposed various harsh conditions, making the founder of Company A exhausted. Finally, they signed, but after half a year, Fund W only paid half of the money, because one of the local government LPs did not contribute the funds. This is a euphemistic way of saying that the local government LP breached the contract, and Fund W breached the contract along with them, but Company A couldn't do anything about it, they can't sue the local government for default, right? And what can Fund W do, sue the local government for default? Just when customer payment delays were serious, and banks were due for repayment, with tight cash flow, Company A asked Fund W for money, but they simply didn't have it. The founder of Company A almost went crazy, and in the end, they found a group of brother companies, including other companies invested by Fund W, to borrow from each other to solve the short-term cash flow pressure. This is the current state of China's venture capital industry, startups can no longer rely on investors, they can only be their own investors. It's quite a helpless situation.

Even a child can see that if this continues, the Chinese "venture capital" industry will soon perish. Not only will it fail to provide financing for startups, it will actually create more conflicts for society and bring difficulties for economic development.

A glimmer of hope

After sharing two frustrating cases, let me share a case that can bring some hope. Somehow, I feel this case also points to a certain future for this industry.

Mr. S used to work for a top-tier dollar-denominated institution. But he always dreamed of setting up his own fund. Even in 2023 when the venture capital industry hit rock bottom, he resolutely gave up his multi-million dollar salary and embarked on his own fund "startup". After analysis and a period of setbacks, he found that fundraising for new funds in this market had become very difficult, so he decided to adjust his strategy. First, he invested the funds he had barely managed to raise, along with his own savings, into a batch of companies he truly believed in. Then, he selected the most promising ones, rolled up his sleeves, and helped the companies with financing, bringing in key clients, recruiting key hires, and even going overseas to Asia, Africa, and Latin America to help them acquire customers. In fact, Mr. S is no longer a traditional investor, but a true partner of the companies.

Is Mr. S stupid? I think Mr. S is very smart. You have to fight to win. By immersing himself fully, and giving his utmost effort, even if he fails, he can start over. But if one day the companies succeed, Mr. S will reap not only the investment returns but more importantly, the deep trust built between him and the companies. Such a good story will be inspiring to all entrepreneurs, and I believe the day will come when all entrepreneurs will line up to get Mr. S's investment.

The greatest dream of every investor is to invest in a company that gives a hundred-fold return, and then have that company become their own investor. In this era, if such good opportunities are not given to people like Mr. S, who else will they go to? In this cold industry, it is actually the opportunity for the next generation of industry leaders to grow and emerge.

Let's believe that we will see the day when entrepreneurs, China's own a16z, become the core force in the venture capital industry!

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Sequel: Responding to criticisms

I didn't expect the venting article I posted yesterday about the Chinese venture capital industry to need to be rebuilt from scratch to generate so much attention. The article was written on a flight from Shanghai to Shenzhen - it was written in one go, all from the heart, which is why I was able to complete it in just an hour at cruising altitude.

I have been an investor for 7 years, and an entrepreneur for the past 5 years. You could say I can understand both sides' way of speaking, which is why I dared to express these views. I don't have any personal agenda, I just hope the industry can improve, I hope all entrepreneurs can achieve great development, and I hope the relationship between entrepreneurs and investment institutions can be mutually beneficial. If we can straighten out the capital flows and relationships, won't that lead to a "financial superpower"?

I've also seen some critical voices, mainly from some investment institutions. I'll pick two typical ones to respond to, as a supplement to the previous article, and also to speak up again for the entrepreneurs. After this, I don't want to discuss this topic anymore. After all, for us who are getting things done, the endless theoretical debates aren't that interesting - in the end, it's the results that matter.

Criticism 1: "Good companies in such an environment don't need to be obligated to local governments’ goal for “attracting investment”. If there are problems, it means the company is not good enough, or the actual value doesn't match the valuation."