Top investor says excessive state support to select sectors may limit VC play in China

Jeffrey Lee, co-founder and managing director at Northern Light Venture Capital (NLVC)

As China’s venture capital market continues its rapid growth riding on Beijing’s endeavours to achieve technological self-reliance, an investment veteran said that excessive government funding could squeeze room for venture investors looking to cash in on the country’s technology advancements.

“Broad [government] support has been the most valuable gift that we’ve received as investors,” Jeffrey Lee, co-founder and managing director at Northern Light Venture Capital (NLVC), told DealStreetAsia in an online interview. “Where we found regret, as sometimes bad side effects, is when a regional- or local-level government overly promotes specific industries by giving too much capital.”

An example of that, said Lee, would be the growth of China’s photovoltaic solar industry.

The sector saw the Chinese government’s direct investment, subsidies, and easy access to bank credit over the past 20 years create what is now the world’s biggest producer of solar energy, led by domestic giants including LONGi, Suntech Power, and Trina Solar.

“China’s solar panel sector was a big success story,” said Lee. “But from an investment perspective, the sheer amount of capital that the government offered to industry players made it very hard for us as investors to benefit.”

Coupled with its capital market reforms, massive government funding is expected to continue amid China’s ambitions to become a global leader in the scientific field.

In a wide-ranging interview, Lee touches upon multiple themes including the overall investment landscape as China shifts to a consumption-led and innovation-driven economy, the increased regulatory oversight on consumer-facing sectors, and NLVC’s deal momentum and focus sectors.

Founded in 2005 and now with over $4.5 billion in total assets under management, NLVC backs early-stage startups in China and the US. The firm has by far invested in over 400 companies through six US dollar funds and four Chinese yuan funds with a focus on the fields of TMT, advanced technology, and healthcare.

The firm was looking to officially close its USD Fund VI and RMB Fund IV with $700 million in total capital commitments in the recent two months.

Edited excerpts of the interview:-

Do you think that LPs continue to see China as the biggest venture market outside the US?

Even though China, with 1.4 billion people, is in many ways a developing country, it is the single largest consumer market in the world. That will continue to drive the government to shift [China] from a fixed asset investment and export-led economy to a consumption and service-led economy. That rotation has been going on for almost 10 years. We’re only seeing it accelerate.

We are incredibly excited with two big groups – the post-90s generation and the post-2000 generation. These generations are fundamentally different in consumption patterns.

The second megatrend that excites international investors is China going global. Unfortunately, we are not an investor in this firm, but you probably know the most exciting example of that is Shein. China going global, not only to the developed world but also to the developing world, is very exciting.

Another pillar, which is a little bit more controversial and touchier, is the technological advancements, especially in IT and healthcare where China is leapfrogging from a developing country status to cutting-edge technology aided by strong national support, domestic capital market reforms, and VC funding.

There are a lot of storm clouds on the horizon. There is the rapid aging of the population, the low birth rate, and obviously, the different styles of governance with regards to most of the West. But these megatrends are the reasons why I think that institutional investors, especially those in the US and Europe, find China to be an attractive investment destination.

How did your journey with NLVC start? Given that NLVC invests in both China and the US, is the team sort of using the playbook of successful US technology companies to envision the potential of Chinese players?

I am employee No. 1 of NLVC. My partner and NLVC’s co-founder, Feng Deng, and I were both entrepreneurs in Silicon Valley. He was formerly an Intel chip designer before he quit to start NetScreen Technologies in 1997. [NetScreen went public on the Nasdaq and was later acquired by Juniper Networks in 2004 for $4.2 billion]. The company was famous in Silicon Valley because it was the [creation of] the first generation of Chinese returnees, or “sea turtles,” which refer to people who grew up in mainland China but went to the US to study or to work in technology.

Before NLVC, I was working at a chip startup that is now part of the US semiconductor firm Broadcom. Back then, we were both technology entrepreneurs on weekdays and students at the Wharton School’s MBA programme on the West Coast during weekends.

Our passion was to take what we saw as the best traditions in Silicon Valley such as disruption, innovation, and models that benefit society and bring them to China. That’s our fundamental investment thesis.

Are you seeing that investment thesis changing these days, as many believe that China is transforming from a copycat into a nation where entrepreneurs are innovating new technologies and business models?

There’s no more exciting time to invest in China than today. In the first five years of NLVC, it was probably easy to find inspired entrepreneurs but really challenging to find an entire team. The concept of things like product management was foreign to the country, so we had to help educate the market. A lot of it was catch-up and trying to benchmark what was happening in other markets.

Nowadays, a lot of innovations are happening first in China and growing first in China. One of our most proud investments is Meituan (a food delivery firm in China). The future is where companies have deep, sometimes difficult-to-understand technical innovations.

From Sina and Sohu to Baidu, Alibaba, Tencent, JD.com, and Meituan, there are several generations of big tech companies. The Chinese government and regulations are much more friendly to entrepreneurship today.

What is the proportion of NLVC’s capital deployment to China, versus that to the US?

In the recent five years, I would say we are about 70% allocated to China or China-concept opportunities.

Five or six years ago, I would be telling you about a lot of hybrid companies, which are companies probably with a headquarters or a development arm in Silicon Valley and another one in China. This is no longer that easy to do. That’s why we now see what is a China-focused investment and what is a US-focused investment.

Due to our natural network and Silicon Valley being a place with a high prevalence of people with ties to China, a lot of the companies that we invested in the US are backed or co-founded by Chinese Americans or Chinese immigrants. But they are decidedly US companies.

I don’t think the proportion is going to change that much down the road. The bigger question is the jurisdiction and structure of these companies. We’ve seen, in the early days, how all our companies had to be offshore VIE [variable interest entity] structures. And then, we had a wave in the late 2000s of companies moving to create onshore structures with CJVs [cooperative joint ventures] and EJVs [equity joint ventures]. With the recent reforms of China’s stock market, companies are going back to creating onshore infrastructure again.

We have seen some startups moving their headquarters from Silicon Valley to China, including companies like Alibaba-backed autonomous vehicle startup AutoX and medtech firm Insilico Medicine. Do you think it is a growing trend given China-US geopolitical uncertainties?

Yes, definitely in areas where technology can be viewed by governments as being an issue of national security or having mixed-use applications. For those areas, investors must be very clear about how the deal can be an attractive investment opportunity, but also respectful to the country in which the firm operates.

Self-driving technology is one of those things – personally, and I share the belief of many GPs in the VC industry – that we can’t imagine why it would be threatening. But we understand that many governments believe that it is a technology that can potentially have different applications, so they want to be careful.

We’ve been involved in investments in that value chain that have had to make those tough decisions. Some of them have opted to go all-in to the American ecosystem while others have decided from day one to be part of the China ecosystem.

Do you see any adverse impact from that on VC investments?   

China and the US have different models and business environments. Autonomous driving is a key example. In China, it is letting a thousand flowers bloom as an ecosystem where different stakeholders are collaborating to come up with solutions. Examples include the cooperation between Baidu and Geely, Huawei [which joined hands with Chinese state-owned Chongqing Changan Automobile], and Alibaba [in partnership with SAIC Motor], among others.

In America, industrial and business opportunities are totally different. Autonomous driving is a vertical play, where companies like Waymo are trying to create a whole package of integrated, vertical solutions touching customers.

That’s much more important to note than some national barriers. China’s opportunities allow venture investors to add more angles and have a good investment outcome, without having to create a whole vertical solution.

Do you think the geopolitical tensions between the world’s two largest economies are pushing global technological infrastructures around 5G, semiconductors, autonomous driving, AI, and others into two different directions and ecosystems?

No. I’m a realist about the unassailable forces of capitalism. Most businesses in the US and Europe have been pushing very hard to prevent what you’ve just described from happening. [Such endeavours are made by] companies like Intel, Qualcomm, Nvidia, Google, as well as General Motors, to which China is still one of their biggest markets.

A lot of the most emerging standards for 5G, 6G, AI, and RISC-V [risk-five, an open-source computing architecture that defines what kind of software can run on the chips] are being thoughtfully placed in Switzerland or other third-party regions, so they won’t be embroiled in a technological Cold War which may or may not happen.

What’s clear is that people want peace and prosperity. We need to fix misunderstandings. We are optimistic that our rational heads are on the table, and we understand that there are benefits from the common good. I still want my iPhone to be working when I turn it on in China.

Beijing has lately been stepping up antitrust probes into the country’s tech giants. How will this play out in the next one to two years? 

We believe that the founders and management teams of these tech giants would agree that some form of regulations to create a balanced growth and a balanced economy was a long time coming. We don’t think that this is a surprise. It is healthy. Obviously, as an investor, we’re not unhappy that we could have some control over the sectors of BAT [an acronym for Baidu, Alibaba, and Tencent] or [sectors where] these big companies always come in.

These companies will not be broken apart. Beijing’s probes are natural in the development of modern society.

NLVC is an investor in Dianrong, which used to be one of China’s biggest peer-to-peer lenders until Beijing’s multi-year crackdown on the sector led to a wave of P2P company collapses. We also saw similar stringent regulations in the fields of cryptocurrency and e-cigarette, and increasingly, in the online education sector. What are your thoughts?

We’ve never invested in e-cigarette firms. We cover blockchain very carefully. And yes, we invested in Dianrong.

I believe in balanced, harmonious growth. When certain innovations can be harmful to social stability, it needs to be reflected upon. Even though we are a prolific investor in online education, and we are excited about the advantages given to people, especially those in third- and fourth-tier cities and countryside to access education is amazing, we also agree with the concern to make sure the level playing field.

We’re very proud of the management team of Dianrong and that they tried to operate from day one in a business model that we felt was upstanding. That is verified by the caliber of investors that we invested alongside. The company is struggling, for sure. We understand that it’s very hard for the government to regulate the industry. But at the time, we were excited about their ability to allow small businesses, like restaurants and small shops in China, to get access to credit and to grow their businesses.

We think that blockchain and decentralised finance is exciting as the world’s smartest technology talents are in that space. But strictly from an environmental perspective, people using huge amounts of energy – some of it from coal generation – to create Bitcoin mining farms in China is probably not a good practice.

For VC investments in China, how influential are the government’s policy changes, or potential policy changes, to your consideration in making an investment or staying away from it?

Most of our investees, probably 60-70%, are based on technology innovations. It’s broadly clear that the government is a big supporter of it. We haven’t found regulations inhibiting the growth of those businesses. Whether those businesses succeed or fail has been due to their own decisions or mistakes. But it’s never been because of the government’s involvement.

There are definitely a lot of consumer-facing businesses that would see the government step in. But we don’t think that is anything different than what would happen in the US or in Europe. At NLVC, we do try to stay away from consumer-facing businesses that we think further down the line would have a social impact that could require the government to step in, such as e-cigarette.

On the flip side, how are Beijing’s favourable policies in developing sectors like 5G, AI, carbon neutralisation influencing the focus of VC investments?

Broad support has been the most valuable gift that we’ve received as investors. The support includes a more attractive IPO market, a registration-based IPO system, a system that allows pre-profit companies to go public, as well as tax benefits for startups and venture investors.

Where we found regret, as sometimes bad side effects, is when a regional- or local-level government overly promotes specific industries by giving too much capital. An example of that in the early 2000s would be the PV solar industry. China’s solar panel sector was a big success story. But from an investment perspective, the sheer amount of capital that the government offered to industry players made it very hard for us as investors to benefit. The same thing also happened during the country’s huge transformation to LEDs.

We look at the entrepreneurs, as well as the businesses and technologies that they want to develop. If it makes sense for their businesses as to where they set up shops, factories, and offices, we won’t deny it [from going to a particular province or city with favourable government policies]. As a result, most of our technology businesses are in Suzhou, Hangzhou, or Beijing. Similarly in biotech, we find Shanghai, Beijing, Suzhou, and Guangzhou to be good places because of the local industrial cluster, talent, and ecosystem.

The biggest obstacle for our companies is usually searching for technical talent. If it is simply a province offering a huge government grant for setting up a fab for semiconductors, it alone would not make us attracted to find a business that fits that offer.

As a private-sector venture capitalist, how do you feel if one of your portfolio companies raising capital from a government-linked fund?

It can be value-added. There can be benefits that help the company set up shops faster with access to resources and facilities. Traditionally, facility expansion has been the biggest benefit that venture-backed companies have received in China at the government level.

But the challenge is typically technically and business-wise. The government support doesn’t really change that fundamental premise.

How many deals does the team aim to complete in 2021? 

We tend to invest our capital on a cycle of about three years, compared to many VCs in China and Silicon Valley that are investing as aggressively as on a one-and-a-half-year cycle. We will probably close six to eight deals this year, but I don’t think we’re investing as actively as we were at the peak before the COVID because the market is not perfectly back to normal yet.

But several investors feel it has been a year of accelerated technology adoption and a great time to source deals, especially among startups offering digital solutions. What do you think?

It depends on who are the beneficiaries of this secular change in consumer behaviours. We love it when it’s happening with companies that we’ve invested in like Meituan, and others including JD.com, Amazon, and Taobao. But as a venture investor, we need to understand where’s the attractive investment underwriting prospect.

Particularly for B2B, enterprise-oriented businesses, and SaaS companies, I think many Chinese corporates are still relatively cautious. Having said that, the rising labour cost has become an incredible opportunity for us to invest in enterprise software. So has the desire for factories and offices to increase their level of automation and use of technology. But those aren’t going to be as fast because they need to go through the retooling process. The enterprise cycle just takes longer.

What SaaS applications do you think are taking off in China?

The first difference that we have [from other VCs] is that we don’t think that SaaS, like many things in China’s economic development, will just copy what happened in the US. We don’t think that there is a stack of apps that companies in China will pay $20 a month for each offer.

What we do think is attractive is automation in factories. The tens of thousands of small manufacturers in China still need to get on the bandwagon for things like VRP [vehicle routing problem] and CRM [customer relationship management] solutions.

The biggest challenge for us is how to invest in a business that is driving adoption from the private sector. We find companies having a bottom-up type of growth to be more attractive than [those] trying to sell to big state-owned enterprises. We also like products that are not going to become a free feature from Alibaba or Tencent.

NLVC also invested in consumer-facing businesses like online grocery app Missfresh, as well as edtech companies VIPKid and Spark Education. What is your view on the cash-burning business model?

For the consumer-facing businesses, we believe that many of these companies, particularly online education firms, have fundamentally strong unit economics. We have good confidence that they will become profitable businesses, although I can’t give you a specific timing.

You brought up a good point for the land grabbing model as competition emerges across various sectors. The commonality of these companies is that they’re trying to solve difficult problems. Missfresh, for example, is tackling difficulties in cold-chain fresh produce deliveries – a very complicated challenge in China. If the firm can solve that problem at scale, they will end up having a moat that makes all their work worthwhile.

Within NLVC’s focused areas of TMT, advanced technology, and healthcare, do you think any segments could outshine this year?

Relatively speaking, we found the healthcare sector to be the most exciting. We saw opportunities around advances in biotech, applied research for therapeutic solutions like mRNA, and vaccines for COVID-19, immunotherapy, as well as treatment for cancers and chronic diseases including diabetes.

What about healthtech startups, for example, those that use technologies like AI to develop medical equipment and rehabilitation robotics?

At NLVC, we broadly look at robotics in two areas. The first one is factory automation. We’re one of the biggest players in core components and Topologies for factory automation.

For healthcare, we look at solutions for China’s rapidly aging population and for geriatric care. We have some investments in companies developing surgical use devices, as well as external and implanted devices.

Do you think the buoyant valuation level around technology startups will sustain themselves in a post-virus world?

There is going to be some form of regression to the mean. That’s unavoidable. There are two factors that we think are worth considering. First, there is a global macroeconomic situation with ultra-low interest rates. With central banks issuing loads of currency into the system, it has led to a huge asset inflation across all asset classes including the stock markets. If anything, the Chinese domestic market is probably more insulated than the US market.

Second, it’s acceptable to give companies like Alibaba and Meituan the premium valuation because they are market leaders. But for a nascent business in the same space, the question is: Do they deserve that premium valuation? Some of these companies will make it with huge amounts of capital and resources. But many will fail to prove that they deserve the premium valuation.

How large is the NLVC team?

We have 45 people, including about 25 people on the investment team. Most of the NLVC team is based in Beijing, alongside other members across our offices in Shanghai and Shenzhen. We also have a significant legal and operational team in Hong Kong.

I am the only investment team member outside of Greater China. We have an office in Silicon Valley, where I’ve been based for about six years till now. VC firms New Enterprise Associates and Greylock Partners have been our founding and strategic partners. They are special limited partners in all of our US dollar funds. They also serve on our advisory board.

What is your biggest miss – the company that you should have invested in but you didn’t?

We passed on Kuaishou three times, I believe. The founder of Kuaishou is a close personal friend of one of my partners. We’re still kicking ourselves as to why we didn’t do that deal. But we still have decades to go to find the next one.

Singapore Reporter/s

In Singapore, we are looking to double our reporting team by this year-end to comprehensively cover the fast-moving world of funded startups and VC, PE & M&A deals. We want reporters who can tell our readers what is really happening in these sectors and why it matters to markets, companies and consumers. The ability to write precisely and urgently is crucial for these roles. Ideal candidates must have to ability to work in a collaborative, dynamic, and fast-changing environment. We want our new hires to be digitally savvy and ready to experiment with new forms of storytelling. Most importantly, we are looking for hard-hitting reporters who work well in a team. Collaboration and collegiality are a must.

Following vacancies can be applied for (only in Singapore).

Following vacancies can be applied for (only in Singapore).   

  • A reporter to track companies/startups that have raised private capital, and have the potential to become unicorns. SEA currently has over 40 companies with a valuation of over $100 million and under $1 billion.
  • A reporter who can get behind the scenes and reveal how funding rounds are put together, or why they’ve failed to materialise. She/he in this role will largely focus on long-format stories. 
  • A journalist to track special situations funds, distressed debt and private credit (from the PE angle) across Asia.

Singapore Reporter/s

In Singapore, we are looking to double our reporting team by this year-end to comprehensively cover the fast-moving world of funded startups and VC, PE & M&A deals. We want reporters who can tell our readers what is really happening in these sectors and why it matters to markets, companies and consumers. The ability to write precisely and urgently is crucial for these roles. Ideal candidates must have to ability to work in a collaborative, dynamic, and fast-changing environment. We want our new hires to be digitally savvy and ready to experiment with new forms of storytelling. Most importantly, we are looking for hard-hitting reporters who work well in a team. Collaboration and collegiality are a must.

Following vacancies can be applied for (only in Singapore).

Following vacancies can be applied for (only in Singapore).   

  • A reporter to track companies/startups that have raised private capital, and have the potential to become unicorns. SEA currently has over 40 companies with a valuation of over $100 million and under $1 billion.
  • A reporter who can get behind the scenes and reveal how funding rounds are put together, or why they’ve failed to materialise. She/he in this role will largely focus on long-format stories. 
  • A journalist to track special situations funds, distressed debt and private credit (from the PE angle) across Asia.