Recent events in China and the US signify that the world has entered into a new phase of contentious relations between two global superpowers, as China shows its rising power through major international policy initiatives such as Made in China 2025 and One Belt One Road, and the US takes protectionist measures to preserve its leadership in key industrial sectors.
One person and one party rule
In 2018, China made the biggest change to its governance in 30 years by appointing President Xi Jinping for life and rewriting the Chinese constitution to affirm one party rule. National economic levers have also been brought under state control through break-ups of the country’s largest private companies such as HNA Group, Anbang Insurance and Wanda Group, and the government takeover of the largest “shadow banks” that adds to the ruling party’s existing control of the traditional banking system.
In short, the industrial and financial system of the world’s second largest economy is effectively under the management of one person and one party, with a clearly defined set of strategic priorities and the levers to execute with authority. This is a truly momentous development in world history.
US measures against China
As China moves strongly forward to engage the global economy, the US is going in the opposite direction. Instead of implementing countermeasures to China’s policies like developing a NAFTA-style free trade zone with its allies through the Trans-Pacific Partnership, the US has instead turned sharply towards protectionism, led by a president who seeks to close off the US from the world while somehow keeping America’s influence in it. The list of US measures against China are extensive:
- Multiple rounds of tariffs against Chinese goods;
- A seven-year ban on Chinese telecom equipment giant ZTE from buying US components;
- A provocative report by the US Department of Defense titled, “How Chinese Investments in Emerging Technology Enable A Strategic Competitor to Access the Crown Jewels of U.S. Innovation”;
- A blistering 200-page Section 301 Report from the Executive Office of the President arguing that China uses unfair trade practices, M&A and investments to access, replicate and ultimately replace US technology;
- A new law sailing through the US Congress called the Foreign Investment Risk Review Modernization Act (FIRRMA) that further expands the scope of the Committee on Foreign Investment in the US (CFIUS), which is a US governmental entity already empowered to block cross-border M&A by presidential decree; and
- The unprecedented proposal to use the International Emergency Economic Powers Act (IEEPA), which was created 40 years ago during the Iran hostage crisis to impose emergency sanctions on foreign governments, to declare a “national emergency” targeting China that would extend the CFIUS mandate to block Chinese minority investments in the US.
The implications for investors
There’s a lot to unpack here with major implications for LPs and GPs doing cross-border business in China. Here are several key takeaways:
1. China has massive capital resources and a huge appetite to invest in global innovation
China has a tremendous amount of capital that wants to fund, acquire, partner and consume products from US and European technology companies in sectors such as semiconductors, artificial intelligence, biotech, and advanced manufacturing. Sovereign capital such as the $300Bn Made in China 2025 Fund, the $21Bn National Integrated Circuit (IC) Fund, and provincial IC funds in Anhui, Hubei and Fujian are charged with connecting the best global technologies to China.
In addition, privately run state-backed funds and large Chinese multinationals are active investors in the global technology industry, actively seeking cross-border business partners, investments and M&A. It’s worth pointing out that these Chinese programs are similar those of the US and numerous European governments that utilize investment capital to advance strategic objectives; for instance, the mission statement of the US-backed Overseas Private Investment Corporation (OPIC) includes “advanc[ing] U.S. foreign policy and national security priorities.”
2. China’s capital controls on outbound investments will remain in place for the foreseeable future, but will open up for strategic priorities
While Chinese capital wants to invest overseas, the country’s strict currency controls aim to balance global strategic goals with state control of the economy. The government seems likely to continue permitting acquisitions under $300 million and investments of any size that support national policies, but not much else due to concerns that a broad opening of currency controls would unleash a flood of capital out of China and destabilize the financial system. Unfortunately, most US and European VCPE fund investments are not permitted despite some recent encouraging news.
3. China’s stock market will remain high for a while
The Chinese stock market will remain highly valued, fueling domestic technology R&D and cross-border M&A and investments in permitted sectors. The combination of capital controls, state control of private lending, laws against real estate investments and crackdowns on cryptocurrency speculation, the stock market is one of the only games in town for retail investors to achieve alpha. Valuations do not appear sustainable over the long term, but domestic exchanges won’t see much downward pressure while these policies remain in place.
4. The US will increasingly and aggressively block Chinese technology investments and M&A
Despite strong demand for US technology in China, the US government will take the measures listed above to restrict Chinese investments, M&A and commercial relationships with US technology companies. CFIUS already has the power to reverse any transaction at any time with no statute of limitations, based on a national security concern that may not be known to the US company (or even CFIUS) at the time of investment.
A recent study of CFIUS applications showed that the about half of the technology transactions presented to the Committee during the Trump Administration thus far have been blocked. FIRRMA makes this situation more challenging by expanding the scope of CFIUS to include minority investments and adding a financial penalty on the US company for any completed Chinese investments that are later reversed. Caught in the crossfire are financial returns-driven VCPE firms that are unfairly labelled “State-Backed Actors” by the US government simply because their funds are majority-backed by Chinese LPs, subjecting those firms and their portfolio companies to intense scrutiny from CFIUS.
5. China’s market is too large, and the global technology supply chain is too interdependent to stop cross-border commerce, investment and value creation
China’s massive and growing market of 270 million increasingly affluent middle class have been and will continue to be consumers of the best brands, products and technologies from the US, ranging from Apple iPhones to Starbucks coffee, and Chinese multinationals have depended for decades upon US software technologies such as Oracle databases and Microsoft Windows.
Chinese companies are also going global by establishing overseas offices, investment programs and partnerships to enter new markets. Finally, China’s role as a global technology manufacturing hub will not change anytime soon, as almost every technology product in the world is built in China using a mix of local and foreign components. No matter the tensions between China and the US, our global economy is interconnected and there is no turning back.
6. If Chinese capital cannot flow directly to the US, it should flow indirectly to the US and to friendlier destinations such as Europe
In prior years, Chinese investors seeking to fund innovation in the US would often invest directly and through VCPE firms that are majority-backed by themselves or a collection of Chinese LPs. Unfortunately, current US policy towards China is aimed at severely curtailing these investment strategies. While these programs should continue despite increase friction, a viable alternative for Chinese LPs is to invest as minority LPs into western VCPE funds. This strategy maintains information flow and portfolio company access while steering clear of CFIUS since Chinese investors have invested as minority LPs for over a decade – without issue – into funds run by Blackstone, Carlyle and TPG, among others.
Investors should also consider allocating capital to technology hubs in regions where trade relations with China are more favorable. In particular, Europe’s burgeoning technology industry has entered a renaissance of sorts, with domestic innovation rivaling the US in artificial intelligence, semiconductors, robotics and advanced manufacturing. Europe is also home to the world’s second largest market behind China for technologies driven by Industry 4.0 initiatives.
While Europe has its own rumblings of protectionism towards China, the European Union is a diverse governing body where no single member country can unilaterally apply trade restrictions on others without their consent, and countries such as Ireland have been outspoken opponents of anti-competitive trade restrictions.
Navigate through the changes and capture value
The China cross-border opportunity in technology remains highly attractive, and the macroeconomic forces at work are just too strong to keep innovation out of China or to prohibit Chinese capital from coming to the US.
However, geopolitics poses a real and present danger to returns, and LPs and GPs alike need to adjust their strategies to factor in today’s volatile state of US-China relations. Global investors would be wise to develop familiarity with CFIUS, Made in China 2025 and One Belt One Road so that they can navigate these new developments and make the proper adjustments in their portfolios to capture value from a global, interdependent and rapidly growing technology industry.