ChinaTech #11 A Trillion Yuan Guidance Fund
... and venture capital with Chinese characteristics
This new segment by Shobhankita Reddy is your go-to newsletter for updates and perspectives on China’s tech ecosystem.
Zheng Shanjie, Chairman of the National Development and Reform Commission, announced last week that China would set up a government-backed fund - the National Venture Capital Guidance Fund - to mobilize a trillion yuan to invest in early, long-term and "hard" technologies.
The fund would have a lifespan of 20 years, significantly longer than private market equity investments, which typically have a 7—to 10-year timespan with an additional cushion of 2-3 years.
Guidance funds - a way to channel private and public capital into the government's strategic and priority sectors while generating financial returns for their investors - are a key financing and policy instrument in China. As of 2021, China had 1800+ such funds.
Similar to private market funds, guidance funds have a thesis and may be restricted to investing in specific technology sectors or geographical areas.
As this 2021 CSET report says -
… a guidance fund might be meant to promote a strategic industry, such as semiconductors or photonics; support a particular type of business activity, such as startup formation or modernizing production capacity; or attract industry to a particular city or region.
The fund itself is an entity formed by or at the behest of a central, provincial, or local government agency.
Typically, the governmental sponsor creates the fund, sets a fundraising target, allocates capital to part of that target directly from budget outlays, and tries to raise the rest from other investors, whose contributions are called "social capital".
About 70-80% of the fund target comes from "social capital".
Many commentators implicitly or explicitly equate "social capital" with private capital – that is, capital raised from profit-motivated investors with no connection to the government. In practice, though, many limited partners in guidance funds are state-funded entities, such as state-owned enterprises (SOEs) and state-run banks.
Yet again, the heavy presence of the state. This is venture capital with Chinese characteristics, folks. In fact, in many of these funds, fund managers are bureaucrats who might not have specialized market acumen or financial expertise to make some of the investment decisions.
Also,
To entice social capital investors, guidance funds' government sponsors may forgo their own interest payments, assume other investors' losses, or provide other incentives.
The first guidance funds in China emerged in the early to mid-2000s, and their numbers gradually increased into the 2010s. There was a heavy uptick between 2015 and 2018, thanks to a central push (coupled with loose regulation) for more guidance funds and increased investment in emerging technologies.
The authors conclude with observations about the challenges these funds face -
Firstly, massive capital inflows from the government mean that there are too many guidance funds. Think redundancy, overcapacity, oversupply and inefficiency. However, an economy can only absorb a certain amount of capital, leading these funds to sit on their raised capital. Coupled with corruption and misuse, being poorly managed, much of this money also gets diverted to nonstrategic, illicit activities and even to operate as "government subsidy funds".
Some of the quoted references in the article make for an illuminating read -
"when the central government proposed the seven strategic industries, it did not expect each province to invest in all seven at once. . . . [However,] in the eyes of local governments, adding a new area of investment means receiving more funding from the central government."
"A biotech and pharmaceutical industry cannot be developed in every province, but every province is blindly trying to create such an industry through [guidance] funds. Investment is cyclical. In the beginning, everybody wants in. It's 'national strategic industry' this, 'emerging industry' that. However, if every province is investing in [these industries], we will have excess capacity within three years. . . . Government guidance funds have entered an era of wild growth and we must get to the root of the problem."
"The investments made by some industrial funds do not comply with regulations. For example, the 90,785,800 RMB [13,429,900 USD] Kaihua County Government Industry sub-fund was used by the fund manager to acquire equity in listed companies on the New Over-the-Counter (OTC) Market. This is far from the original intention behind industrial funds."
For example, one of his peers applied for [funding from] a local guidance fund, but the repayment period was only two years, and his business would have been hard-pressed to repay the loan in that narrow window of time.
Despite these shortcomings and several regulations implemented since to tighten regulatory oversight, the authors posit that guidance funds in China are important. They bring a profit motive and market discipline to China's industrial policy, and some of the best-managed funds with private expertise have been seeing promising returns.
At a time of decreasing FDI in the country and the government’s heavy handed regulation on private technology players, the Chinese government's doubling down on this financial instrument with a huge target of 1 trillion yuan (whether or not they are able to meet it) is understandable. Most privately run and foreign-owned funds are likely to follow the investment strategies and sector focuses as the guidance funds, seeing the latter as the Chinese State's priority areas for the economy (and hence safer investments to pursue).