ANEW - U.S. Tightens Noose On Outbound Investment In Cutting-Edge China Tech

2023-08-10 22:45:00 ET

Summary

• Joe Biden has signed an executive order restricting U.S. private equity and venture capital investment in Chinese companies from sensitive sectors like microchips and AI.
• The move, along with similar steps over the last year, is increasingly scaring off big U.S. asset managers and limited partnerships that used to be one of China tech’s biggest funding sources.
• Within the chip sector, the order targets companies involved in chip-manufacturing technology, rather than chip design companies.

A new executive order by U.S. President Joe Biden could hit Chinese tech firms where it hurts the most by cutting off the funds they need to grow in their early stages.

And while stock market reaction was relatively muted, perhaps because the latest move was targeted at just a few sectors, the action could have a much bigger effect than early reactions might suggest.

Biden’s order signed on Wednesday seeks to stop the flow of U.S. investment dollars into a small number of cutting-edge high-tech fields in China, including semiconductors, quantum information technologies, and artificial intelligence, according to media reports . Details are still thin, probably because many are still being worked out.

The restrictions apply to venture capital and private equity companies, showing this particular measure is aimed at stifling the development of certain types of early-stage Chinese tech startups, particularly those making products with potential military applications.

Within the chip sector, the order targets companies involved in chip-manufacturing technology, rather than chip design companies. That means that Chinese makers of chip-manufacturing equipment and software used for chip design, products now dominated by western firms like Applied Materials ( AMAT ) and Synopsys ( SNPS ), would become off-limits for U.S. private equity and venture capital firms. But such funding sources might still be able to invest in actual chip designers, which are far more numerous.

The situation could be similar with AI, with only developers of technologies with potential military applications affected. Thus, makers of facial recognition AI might become off-limits, while investments in more benign forms of AI like chatbots could still be permitted. The ambiguity could lead many U.S. investors to simply avoid entire sectors for fear of getting in trouble.

Stock investors didn’t seem too alarmed by the latest order, which has been rumored for at least the last few days. The two benchmarks we follow, the U.S.-listed MSCI China ETF and the Hong Kong-based China Enterprises Index, both actually rose by small amounts on Thursday, and were roughly flat in the first four trading days of this week.

The lack of concern probably owes at least partly to the new order’s focus on pre-IPO companies, and thus currently listed companies shouldn’t be affected. But the move could ultimately kill some of the many of the Chinese startups that typically depended on western funding in the past in their early stages.

That would eventually trickle down to the IPO market, since such companies were traditionally some of the most attractive IPO candidates that listed in the U.S., though many are increasingly going to Hong Kong and mainland China’s two domestic A-share markets.

But stock buyers – especially big institutional buyers – might think twice about their lack of concern. That’s because last week separate reports said a committee from the U.S. House of Representatives had begun investigating how major asset managers like BlackRock were using channels like index-based funds to facilitate investments into Chinese companies that were banned for U.S. investors.

The bottom line is that the U.S., first under former President Donald Trump and now under Biden, is determined to choke off funding for Chinese tech firms at all stages of development in sectors that could pose a national security risk.

Why worry?

Truth be told, these latest steps shouldn’t be too troubling for smaller retail investors who have plenty of stocks to choose from and often move in and out of companies quite easily and rapidly.

But it could prove far more problematic for major institutional stock buyers that typically plow millions, and even tens of millions, of dollars into their individual investments.

One high profile example of the shifting landscape appeared in June, when U.S. venture capital giant Sequoia announced a plan to spin off its China and India units into standalone companies no longer tied to the parent company in California.

Many interpreted the move, at least partly, as Sequoia’s attempt to distance itself from its Chinese unit to avoid getting in trouble for investing in sensitive areas, even though Sequoia China was already steering clear of some areas like AI.

Another example of the potential for trouble came in December of 2021, when Chinese AI startup SenseTime ( SNTMF ) was forced to delay its Hong Kong IPO at the 11 ^th hour after its name suddenly appeared on a U.S. blacklist barring American investors from buying its stock.

The company managed to make its IPO after a slight delay. But its stock has performed poorly since then – losing more than half its value – mostly due to its big losses, but also probably at least partly because of lower liquidity from the absence of U.S. investors banned from buying its shares.

A number of other Chinese companies like iFlytek and Hikvision have been blacklisted by the U.S. as well, and the latest U.S. House investigation shows that any U.S. investors who try to find workarounds to still invest in those companies could end up in trouble.

Then, there’s a far less visible issue involving limited partnerships that supply the actual money to big venture capital and private equity companies. Many of those are U.S.-based, and typically encompass a wide range of companies, from insurers, to pension funds and universities.

Those limited partnerships provide money not only to U.S.-based private equity and venture capital, but also to many non-American firms like China’s own Hillhouse Capital.

But those American funding sources are increasingly avoiding investors with a China focus, preferring to steer clear of any potential risk that could arise with future Washington actions.

The growing wariness by U.S. investors is quite visible in the numbers. U.S. venture capital investment in Chinese companies totaled just $9.7 billion last year, less than a third of the $32.9 billion from 2021, according to PitchBook data cited by Reuters. What’s more, U.S. venture capital has invested only $1.2 billion in Chinese tech companies this year, Reuters said.

While other funding sources, notably from within China and also other places like the Middle East, will inevitably fill in some of the funding gap, there’s no way they can replace the huge hole being created by retreating Western investors.

That will ultimately cascade down the food chain, resulting in a shriveling number of the types of hot investment choices for stock buyers who once flocked to the China growth story.

Disclosure: None

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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