I recently traveled to China to meet with a number of local investors in the internet finance space to better understand opportunities in the sector as well as general investment dynamics in China.
For early-stage foreign investors who are looking to enter the space, here are our key takeaways:
Seed-stage investing is difficult for U.S. funds without a local presence
The challenges for U.S. funds come from a number of areas, including regulation on foreign investment, deal-sourcing and portfolio engagement:
Regulation on foreign investment
Internet finance companies are often registered as value-added telecommunications companies in China, which is a “restricted” industry for direct foreign investment, as stipulated by China’s foreign investment law. A number of startups have attempted to circumvent that law by using a Variable Interest Entity (“VIE”) structure. However, given the amount of money (approximately $100,000) and time (usually 3 months) required to establish a VIE, Chinese startups much prefer accepting RMB funding, particularly when they are early-stage and have a high demand for financing very quickly.
There are a number of reasons for their preference for local investors: local capital in China is abundant and can act quickly – individual angel investors can usually invest the RMB equivalent of approximately $500,000 much faster than foreign investors can. Regulations for the incorporation of local funds are different as well: hundreds of venture capital funds are raised each year. Because of both Chinese regulations and startups’ preferences, U.S. funds face inherently more difficulty investing in China’s internet finance space; instead, they typically invest in Series A or later.
Deal-sourcing and portfolio engagement
Similar to investing in other markets, deal-sourcing for early-stage investment opportunities in China requires a large and strong local network. Although the emergence of early-stage Technology, Media, and Telecommunications financial advisory firms help consolidate potential investment opportunities for investors, top local investors still source deals mainly within their established networks. As these investors have already built strong reputations in China, promising entrepreneurs tend to also directly reach out to them for investments.
Without a local presence, network-building can be very difficult and slow, which in turn affects a fund’s ability to source deals in the market. For portfolio engagement post-investment, the lack of local presence will also deter the investor’s ability to provide quality portfolio support.
Innovation is limited in the market
Startups in China usually compete on speed instead of innovation, as many of them have very similar business models to start with, let alone the numerous copycats that will come online after seeing a promising startup get funding from reputable investors — this is also why some Chinese startups have initially started as the Chinese version of existing U.S. startups.
The lack of proper regulation also helps fuel the competition in speed. With an enormous market to serve, Chinese startups don’t necessarily “need” to be innovative, and local capital is definitely willing to bet on different startups with similar models, and sometimes even similar geographic coverage areas (i.e. taxi-hailing apps Didi Taxi and Kuaidi Taxi, student micro-loan startups Qufenqi and Fenqile).
Investments in Series A rounds are more feasible for foreign investors
As mentioned previously, startups that have grown to the Series A stage are likely to be more ready and willing to receive foreign funding. In addition, with the number of startups that are established every day in China and how commonplace fraud is, angel- and seed-stage investing is likely too risky, particularly for impact investors like us.
We are also unlikely to act fast enough as compared to local investors in the angel/seed stage round to invest in the better deals. By the time of Series A, many of the noncompetitive startups will have been culled, and investors would also have more time (albeit maybe only slightly more) to make investment decisions.
Due to the economic slowdown in China, as well as the poor performance of Chinese stocks on both domestic and overseas exchanges, local investors have become less aggressive, which also allows investors like us to have a bit more time to review opportunities, and has given us a better chance of completing investments.
Huge opportunities exist in agricultural finance and financing to targeted businesses and populations
Given their significant market potential, agricultural finance, consumer finance and wealth management are likely the key growth markets within China’s internet finance industry. As an impact investor, we will be paying special attention to opportunities in the agricultural finance space; we’ll also track specific sub-segments within the consumer finance sector, such as financial education and services for thin-file clients, including blue-collar workers and self-employed individuals.
Potential opportunities also exist in the less crowded supply chain finance space, where startups target specific subsets of micro, small, and medium enterprises (MSMEs), either by location or by industry. Deep understanding of the specific industry and an established network are very important to build a strong supply chain finance business.
Although many challenges remain as we consider potential investment opportunities in China, we are still very excited to see that many impactful opportunities exist and remain largely unexplored.