Michel Brekelmans, at L.E.K. Consulting breaks down investment trends and troubles in Chinese tech, media and telecom.
Last September Alibaba shattered global records with a US$25 billion initial public offering in New York, capping a year in which 50% of venture capital investment in China was focused on Internet industries and technology, media, and telecom, or TMT.
That’s only natural: Since 2010, investors in China have been increasingly focused on the tech sector, driven by the ongoing digitization of the economy and rapid consumer adoption of new technology. China is the largest smartphone market in the world with more than one billion users, an install base that has not only created the largest market for mobile applications globally, but also signalled to businesses that Chinese consumers are ready to go mobile-first for many goods and services.
But rising valuations don’t always translate to market-shaking innovations, and some start-ups clearly aren’t worth their implied sticker price. To better understand what is driving overblown investments, and whether they could blow up in investors’ faces, it is necessary to peek beneath the hood of China’s tech sector to understand who is investing in what—and how.
A TMT boom
Over the last six years, the number of tech deals in China has grown approximately 36% on average, with deals doubling from 2013 to 2014. The recent increase in volume and valuation of deals has industry participants increasingly whispering of a bubble. We see four key drivers that explain the boom in venture capital and private equity deals (see above chart).
First, there has been a massive increase in available capital from both domestic and foreign sources. In addition to the number of deals doubling, the amount of funds raised targeting venture capital investments in China almost doubled from US$7 billion in 2013 to US$13 billion in 2014.
Second, investors have been drawn to the sector by the success of China’s now-established tech giants. Tencent and Baidu laid the foundation over a decade ago, followed by a second generation led by JD and Alibaba, and who arrived just as innovations in online payments had taken off. Now tech start-ups-turned-heavyweights such as Xiaomi and Dianping are making headlines by demonstrating how private equity and venture capital technology investments can be more than just futile grasps after the global tech leadership crown of Silicon Valley. That has attracted still more foreign investors eager to partake in the growth. In 2014, the Carlyle Group made one of its first Chinese Internet investments (US$100 million) in Ganji, an online classifieds company, during its series F round.
Third, successful entrepreneurs are becoming investors, creating a disproportionate number of specialized tech-focused funds. Banyan Capital, founded in 2013 with more than US$700 million under management, focuses exclusively on investments in the TMT space. Investors include founders and managers of Tencent, Alibaba, Baidu, JD and Xiaomi; founding fund managers all have experience and success in tech industry investment.
Finally, thriving communities of tech entrepreneurs are creating more investment opportunities. Cities such as Beijing, Shenzhen, and Hangzhou are becoming technology hubs that attract engineers, investors and other industry professionals. Of the 30 Chinese Internet and software start-ups that achieved billion-dollar valuations in the last decade, 20 were in Beijing, making it the second most prominent tech hub globally behind Silicon Valley.
As investment funds have become more widely available, so has the competition over investment opportunities.
Many traditional international players, most notably the Silicon Valley firms, have been well-grounded in the Chinese market for several years and have successfully adapted to it. We increasingly see senior deal makers spinning out from these groups to set up their own shops, often backed by Chinese institutional investors.
Several local firms that often apply a less ‘rigid’ decision making process have emerged in recent years, resulting in very aggressive timelines. Their shared strategy is to deploy capital as quickly as possible, and they typically avoid applying traditional investment metrics. Thanks to the rise of intermediaries, few good deals are proprietary anymore, and in such a competitive environment there will likely always be some players in the mix who feel they can justify the highest valuation in an attempt to win the bid.
Besides these players, funds from a range of non-traditional sources – including sovereign wealth funds, super angels and tech millionaires – are hungry for a slice of the China tech sector. Even many private equity (PE) firms and institutions that normally only participate in later-stage investment are delving into relatively untested pre-revenue assets.
Some sovereign wealth funds are no longer serving as passive asset investors, opting instead to act as lead partners in early-stage tech company fundraising. In 2013 Temasek – Singapore’s state-owned investment fund with investments in Xiaomi, Alibaba, Cloudary, and Dididache – established the Enterprise Development Group (EDG), which specializes in funding new businesses and helping them grow with coaching from Temasek’s private equity fund.
With more funds targeting a necessarily limited supply of promising investment opportunities, valuations are growing markedly. Average deal sizes for the TMT/Internet segment almost doubled from US$6.5 million in 2013 to US$11.6 million last year. While that average is skewed by some high-profile deals, median deal size also nearly doubled for the same period. The business fundamentals often don’t justify these levels, but valuations can take on a momentum of their own, driven by a scarcity of deals and the fear of being left out.
This valuation momentum is further exacerbated by a lack of traditional, disciplined commercial due diligence among early stage companies: Abandoning traditional metrics means that start-ups are pitching themselves more on the basis of a sexy business plan, a gut feeling and the track record of their management team than any detailed model of the market. After all, many argue, how would one even model a ground-breaking, disruptive innovation?
The risk is that this mentality, suitable when placing bets of $5-10 million, is being carried over into much larger and later rounds of funding for companies that are still in their early days, but whose valuations have ballooned due to momentum and intensified competition among investors for deals.
When this bubble eventually bursts it will be the late and repeat entrants who are most likely to get burned, whether from stepping in at the wrong time or due to having failed to
cash in on huge returns from investments completed three to four years prior. It is true that firms like Temasek, Sequoia, and Shenzhen Capital have all enjoyed fantastic returns from the tech industry and are not afraid to continue making hundred-million-dollar bets wherever they please. But while such established investors should be able to weather the storm with full coffers, more recent investors will likely go under.
In order to make intelligent investments in China’s potentially tumultuous tech sector, investors must be willing to take on more risk than is the norm in Silicon Valley. The current self-fulfilling momentum of deal volume and value in particular must be given appropriate consideration before making a first foray into the mainland tech sector.
As deal sizes creep up from the $5-10 million range into the tens or even hundreds of millions of dollars, investors will need to start taking a different, more rigorous approach to ensure the value and risk are justified. Many of the traditional commercial due diligence techniques used in evaluating commercial risks associated with established companies can still be applied, albeit in a somewhat modified way, including consumer testing, benchmarking comparable business models and stress testing market and financial projections.
Indeed, it is in this context of slipping standards and ballooning valuations that we think due diligence is more important than ever—and that in TMT, as elsewhere, tailoring one’s entry plan to take local conditions into account is the hallmark of a smart China investment strategy. While it might look from a distance like funding rounds for mainland tech start-ups will maintain their stratospheric trajectory for the foreseeable future, the stock market’s nosedive this summer should serve as a fresh reminder that investor exuberance can only take one so far off the ground before gravity takes hold. ♦
Michel Brekelmans is a Partner at L.E.K. and Managing Director and co-head of L.E.K.’s China practice based in Shanghai since 2006. L.E.K is a global consulting firm that supports clients in evaluating investments and in developing strategies and organizational capabilities that have significant impact on performance. L.E.K has been operating in China since 1998 through offices in Shanghai and Beijing.
Editor: Hudson Lockett (@KangHexin)