\n<\/p>\n
On a weekday<\/span> afternoon at Red Rock Coffee, the cafe known for spotting venture capitalists in Silicon Valley, one is likely to overhear a few conversations in Mandarin. Since China reopened its border this spring after three years of COVID-19 restrictions, managers of U.S. funds in the country have been flocking to the Bay Area. These trips weren\u2019t unusual before the pandemic, but they now serve a new purpose.<\/p>\n USD-denominated funds in China have long been drawing inspiration from Silicon Valley startups, using them as benchmarks for investment targets back home. They would seek out the equivalents of Facebook, Amazon and Uber on the other side of the Pacific Ocean and hope they become winners in the country\u2019s largely untapped internet market.<\/p>\n This dealmaking strategy of American funds in China has become less effective in the face of shifting global and domestic landscapes. Driven by a confluence of factors, from China\u2019s crackdown on the tech industry to escalating U.S.-China tensions, these investors are now turning their gaze to opportunities abroad, tracing the footsteps of a new generation of Chinese-founded startups that are expanding overseas.<\/p>\n Since their entry into China in the late 1990s, American venture capital firms, led by powerhouses like Sequoia Capital, IDG Capital and GGV, have played a major role in funding high-risk, high-reward startups in the country\u2019s consumer internet sector. This two-decade-long mutually beneficial relationship, however, now hangs in the balance as changes at home and abroad diminish the pool of investment opportunities for outside investors.<\/p>\n In recent years, Beijing\u2019s sweeping tech crackdowns have introduced a new level of uncertainty to investors. VCs fear that their portfolio companies might encounter a similar fate as Ant Group, whose colossal initial public offering was called off<\/a>, and Didi, which weathered an extensive data security probe<\/a> that eventually led to its delisting from New York.<\/a> As China tightened its grip on overseas IPOs<\/a>, investors who once relied on taking Chinese firms public in the U.S. are no longer assured of an exit channel.<\/p>\n In the meantime, Washington has stepped up restrictions on the flow of U.S. money into China amid an escalating tech war between the two superpowers. In August, President Joe Biden signed an executive order barring U.S. investments in three strategically sensitive sectors in China<\/a> \u2014 artificial intelligence, quantum computing and semiconductors.<\/p>\n As USD funds in China await further clarity on the scope of the ban, they resort to practicing more discretion than ever before. They\u2019ve slowed down deployment even amidst a global AI fervor that has given rise to a parallel AI universe in China<\/a>. At the same time, domestic RMB funds play an increasingly larger role in funding critical tech sectors. Zhipu AI, one of China\u2019s most ambitious challengers to OpenAI<\/a>, for instance, raised financing in RMB instead.<\/p>\n Even having the Chinese branches of famed American VCs listed on the cap table might deter U.S. investors from funding Chinese founders in their backyard. Local investors are now shunning Chinese \u201clinks\u201d, of which definition is ever evolving and narrowing, at all costs.<\/p>\n<\/blockquote>\n These changing currents, coupled with a slowing economy, have resulted in a pronounced decline in American VC funding activity in China. The year 2022 saw just $14.5 billion invested in Chinese companies by U.S.-headquartered VCs, compared to $45.4 billion the year before, according to a report from research firm Pitchbook<\/a>. The number of deals nearly halved to 595, and the share of deals with U.S. investor participation dropped to 18.2% in 2022 after hovering above 30% for half a decade.<\/p>\n The scaleback is most notable in prolific investors like Sequoia Capital China, which recently changed its name to HongShan after splitting off its China operation<\/a>. Despite its proactive move to decouple, Sequoia still faces scrutiny from the U.S. government<\/a> over its decades of investments in China. For the first three quarters this year, HongShan completed just 47 deals, compared to 99 deals in the same period of 2022, according to Crunchbase<\/a> data.<\/p>\n As China\u2019s investment appeal wanes, investors start to look for opportunities beyond its borders. Rather than a complete departure, many are merely following the footsteps of Chinese talent who has already embarked on global expansion (a topic we\u2019ve covered extensively here<\/a> and here<\/a>).<\/p>\n Chinese startups have a long history of going abroad, and every wave has assumed its own approach. Previously, many companies would venture out only after succeeding in China. These days, more are eyeing global expansion from day one, sometimes even skipping their home market.<\/p>\n Many in the current generation of globalizing Chinese founders have studied or worked overseas. Captivated by the Chinese internet\u2019s rapid growth, they returned in the late 2010s to join the likes of Tencent, Baidu, Alibaba and ByteDance. Having gained an insider\u2019s look into Chinese tech giants, they embarked on their own entrepreneurial journey with the hope of becoming the next Jack Ma, the founder of Alibaba.<\/p>\n In China, they are called haigui<\/em>, meaning those who \u201creturn from overseas,\u201d a homophone of \u201csea turtles.\u201d Their dreams started to crumple following the fall from the grace of Ma, whose Ant Group and Alibaba became targets of China\u2019s crackdown on Big Tech. They soon realized that China had entered a new era, where the regulatory hurdles for running a startup have significantly heightened.<\/p>\n The year 2022 saw just $14.5 billion invested in Chinese companies by U.S.-headquartered VCs, compared to $45.4 billion the year before.<\/p>\n<\/blockquote>\n To launch an AI service in China, for example, a company needs to navigate a multitude of complications, which can include obtaining a license for its large language model<\/a>, seeking regulatory approval for its algorithms<\/a>, and implementing a costly censorship mechanism to comply with censorship requirements.<\/p>\n \u201cYou need to pick sides. You either focus on China or go overseas, otherwise, you end up doing double the workload but with a lot less funding secured from the last two years,\u201d said one of the five China-based VCs we interviewed for the story. We also spoke to six diaspora Chinese entrepreneurs. Due to the sensitivity of the topic, all of them have asked to stay anonymous.<\/p>\n Some well-funded AI startups want to target both sides. To that end, they have created two entities that are each tailored to the Chinese and non-Chinese markets as well as raising capital in USD and RMB separately.<\/p>\n Not every startup has the resources for a dual-market strategy, so many \u201csea turtles\u201d end up leaving China again. While foreign markets present their own sets of challenges \u2014 competition and skepticism towards outsiders \u2014 the entrepreneurs perceive a broader, more predictable opportunity in AI by venturing abroad. This reversal of their trajectory has earned them the moniker, guihai<\/em>, or those who \u201creturn overseas.\u201d<\/p>\n At home, the Western-educated and -trained Chinese entrepreneurs are darlings of local VCs. In Silicon Valley, they are little known to investors. Media reports that stress their Chinese background further erodes trust in potential investors and customers at a time when concerns about national security already run high.<\/p>\n Even having the Chinese branches of famed American VCs listed on the cap table might deter U.S. investors from funding Chinese founders in their backyard, three founders said. Local investors are now shunning Chinese \u201clinks\u201d, of which definition is ever evolving and narrowing, at all costs.<\/p>\n \u201cIf you speak like a local, know how to pitch like a confident Silicon Valley founder, have not taken any money from Chinese VCs, have all your staff in the U.S., have generated good traction in the local market, and are working on getting a green card, you might get a chance to raise local money,\u201d said a Chinese founder based in San Francisco. \u201cDon\u2019t even think about it if you still run your R&D out of China.\u201d<\/p>\n This funding gap presents an opportunity for the USD fund managers who are hunting beyond China\u2019s territory. \u201cIt\u2019s just a lot easier to raise their first round from China\u2019s USD funds,\u201d said a former investor at one of China\u2019s top VC firms. \u201cIn some sense, the entrepreneurs are taking these investors on an international expedition.\u201d<\/p>\n VC activity with U.S. participation in China during 2023 will hit a nine-year low, followed by a decade low in 2024.<\/p>\n<\/blockquote>\n Aside from picking the low-hanging fruit of the diaspora community, Chinese VCs flying in from Beijing and Shanghai have limited avenues to source deals in the U.S. American startups already have a plethora of local investors to choose from, let alone the geopolitical risks of accepting Chinese-managed money. These parachuting investors also encounter competition from local investors already tailored to U.S.-China cross-border opportunities, most famously UpHonest Capital.<\/p>\n \u201cVCs thrive on information arbitrage. In the U.S., we don\u2019t really have that same extensive network as at home,\u201d said an investor from the China arm of a global VC firm.<\/p>\n Venturing out of China is not a \u201cpivot\u201d for the USD fund managers, said one of the investors. Rather, the partners and their associates are mostly looking for something to get their hands on in the midst of a cooling market. Some are contemplating a career change, but it\u2019s difficult to find any job that can match their current pay.<\/p>\n \u201cThe Chinese VCs are most anxious about the U.S. building cars behind closed doors. They don\u2019t want to fall behind, especially given the speed AI is evolving, so they want to visit the Bay Area to figure it out themselves,\u201d the investor added.<\/p>\n The recent influx of Chinese investors into the Bay Area should also be viewed in a broader context. Many of these investors, who have family ties in the U.S., have been traveling regularly to the U.S. for years. COVID-19, which shut down trans-Pacific flights and introduced costly and harsh quarantines, created a pent-up demand for travel. Naturally, many investors rushed to the Bay Area as soon as the borders reopened, but the surge in activity might soon start to subside, said a partner who spent the past summer in California.<\/p>\n There are no signs that USD funds\u2019 venture dealmaking in China will bounce back in the foreseeable future. The Pitchbook report predicts that VC activity with U.S. participation in China during 2023 will hit a nine-year low, followed by a decade low in 2024. Many Chinese general partners have already been sourcing capital from the Middle East, which might eventually limit the impact of U.S. investors\u2019 pullback. But many question whether Chinese tech firms, now under a new stringent regulatory regime, can deliver the same level of strong growth and returns they experienced in the previous laissez-faire era.<\/p>\n<\/p><\/div>\nBetween a rock and a hard place<\/h3>\n
\n
The reversing turtles<\/h3>\n
\n
Following the turtles<\/h3>\n
\n
A transitory phase<\/h3>\n