Watching the Chinese technology sector over the last week has been a fascinating exercise. The Chinese government took on entire industries like edtech while also coming down on individual companies (Tencent, Meituan) in a broad effort to change the country’s technology landscape.
The sum of the financial damage is easy to understand. The NASDAQ Golden Dragon China Index, for example, which tracks U.S.-listed companies that do their business in China, fell from a 52-week high set earlier this year of 20,893.02 to 10,672.37 yesterday. You can also track the decline in value of various Chinese technology companies both on shore and on foreign exchanges if you want to get an even fuller picture of the financial carnage.
It’s common among commentators and analysts to draw a direct line between the blocked Ant Group IPO last year, the ensuing fall from grace of Chinese entrepreneur Jack Ma and the latest news out of the Chinese Communist Party’s (CCP) regulatory bodies. That’s reasonable. Things are changing in China, and the regulatory landscape of tech work in the country won’t be the same from here on out.
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We’ve explored the moment a little, noting last week that edtech investment could slow in the country provided that the government went through with its plan to force tutoring companies to go nonprofit. The government then did so, and more, also blocking tutoring companies from being formed, going public, raising external capital from foreign sources and more. It was comprehensive. Natasha Mascarenhas has a great read on the matter here.
So, bad news for startups? After all, if edtech investment could slow in the face of regulatory changes, what about other technology-influenced areas of business?
The negative case is somewhat easy to make. The positive case is more interesting. Some market watchers are making the argument that by taking on some of China’s largest technology companies, more room could be cleared in the country for smaller companies to snag a piece of business.
The seeking of rents
One way to reduce rent-seeking is to trust-bust, or diminish powerful incumbents unfairly preying on markets they do business in. An example of this is the recent news concerning Tencent Music. The company, caught up in the current regulatory wave, has been told that it has to surrender exclusive music streaming rights. This move by the CCP could lead to a more competitive music streaming industry in China, which would likely lower consumer prices thanks to rising competition.
That’s bad news for Tencent, because it won’t be able to continue leveraging its heft to control a market; market control is the inverse of market competition, and the latter is better for economies and consumers alike. In this particular example, we can see how some of China’s recent regulatory changes could lead to a more competitive marketplace.
Making the same case more broadly is KPMG. In its Q2 2021 venture capital digest, the professional services company wrote the following regarding China’s startup market:
Given the increasing government concern and scrutiny of big tech companies in China, there has been a growing opportunity for second- and third-tier tech companies focused on areas such as e-commerce, the sharing economy and logistics to attract more attention from VC investors. While many of these players are still working to scale and grow sufficient volume to become profitable, it could be the beginning of a transition to less concentrated market participation.
This cuts both ways. On one hand, more competition should lead to better consumer outcomes, as noted above. But venture capitalists don’t want to invest in second- and third-tier companies. Indeed, venture investors tend to do very well when their investments build a market-dominant position in an industry (Google and search, for example), or build a company that is a clear market leader (Amazon and e-commerce, for example). No venture capitalist wants to invest in a company that they expect will merely do fine amid a sea of rivals. Why? Because that would be a recipe for pedestrian returns, not the outsized wins that power venture economics.
How the CCP treats the next generation of emerging tech giants in China will be key. Will new giants be allowed to form? Or will they be kept small and, therefore, both easier to control and smaller in value? From a venture perspective, the question points to an uptick in investment risk. Which is not conducive to rising investment totals, even if some opportunities do open up thanks to shrinking incumbents.
Yeah, but what sort of tech are we talking about?
Not all technology sectors in China are being taken on in the same fashion. Bloomberg columnist and Substacker Noah Smith discussed the point earlier this week in an essay. Here’s Smith:
[T]he crackdown on China’s internet industry seems to be part of the country’s emerging national industrial policy. Instead of simply letting local governments throw resources at whatever they think will produce rapid growth (the strategy in the ’90s and early ’00s), China’s top leaders are now trying to direct the country’s industrial mix toward what they think will serve the nation as a whole.
And what might serve China as a whole? Smith cites Gavekal Dragonomics and Bloomberg’s Dan Wang’s 2020 letter discussing China, in which Wang cites “hard tech” as where the country is pivoting its focus.
This is a clarifying perspective.
We’ve seen that the CCP is content to kneecap sectors that it thinks don’t align with its current priorities (edtech). And that it is willing to bring to heel major consumer-facing tech companies that it previously allowed to command markets in an anti-competitive manner (Tencent and its music business). But we’re not hearing that AI-focused companies are up next. Or that semiconductor manufacturing is at risk.
So, the CCP crackdown on tech won’t suffocate the whole sector, but rather limit certain parts of tech. This brings us back to our venture capital discussion. It appears that the venture capital market in China is not suffering an extinction-level event, but that certain areas of investment (consumer tech, thinking loosely) will prove less attractive over time while others (hard tech, anything that aligns with stated CCP national industrial goals) may prove viable for investment.
The result may be concentrated effort and capital in sectors that Beijing favors and reduced capital and focus from entrepreneurs in sectors that have been deemed fit for strict control. Simply: Central planning is going to tilt business more toward centrally planned goals.
Does the situation add up to a net positive? I don’t think so. It feels more like a new reality, and one that may freeze billions of capital invested in companies in the wrong industries. But the picture is not all negative, at least from a consumer choice perspective.
Obviously, we’re thinking out loud together this morning, and the situation is fluid. But it really does seem that the Chinese venture capital market, famous for taking on U.S. venture capital totals back in 2017-2018, is now in a new era of its own.