From TikTok to the Two Sessions: How should investors think about regulation in China?

Over the last few years, China has tightened its grip on Big Tech. Since late 2020, the government has issued billions of dollars in fines to companies such as Alibaba, Meituan, and Didi Global for offenses ranging from antitrust violations to data misuse.

At the recent Two Sessions, the annual meeting of the National People’s Congress and the Chinese People’s Political Consultative Conference, lawmakers didn’t give any clues about whether its crackdown on tech companies was over.

Meanwhile, members of Congress in the US are considering whether to ban TikTok or force a sale of the company’s American unit. Some of them have also spoken out against the possibility of SHEIN listing in the US.

Boyu Hu, partner and founder of XVC, explains what all of this means for investing in Chinese companies.

(Q) Let’s start with TikTok. Do you think the US will try to split up any Chinese company of a certain size operating in the American market?

Boyu Hu: Relations between the US and China are at a low point. There’s a lot of suspicion against Beijing on Capitol Hill, which means Chinese companies that do well in the US will get attention from lawmakers. I’m sure TikTok and Shein won’t be the last.

That’s annoying for investors in those companies, but it comes with the territory. If your Chinese portfolio company is big enough that it’s attracting the gaze of US regulators, you’ve probably already made a good return whether you got in at the early or growth stage. TikTok’s parent company ByteDance did $25 billion of EBITDA in 2022, while Shein reported $2 billion of profit on $45 billion of gross merchandise value.

(Q) What about China’s approach to regulation – is it possible to anticipate what policy makers might do in the future?

BH: China has been tough on private companies over the last few years, and not just the tech sector. If you don’t follow Chinese politics, it’s easy to think that regulators will take action against any company that reaches a certain size, but their approach is more rational than that. New laws are logical and generally telegraphed far in advance, which makes it easier for VCs to factor them into their investment decisions.

For example, in 2021, China banned tutoring companies that teach the school curriculum from making a profit. The move was one of the biggest education reforms in a long time, and led to the collapse of long-standing tutoring businesses such as Wall Street English China and Juren Education.

But it wasn’t a total surprise. President Xi Jingping first started talking about the issue in 2015, and a year later the government banned for-profit private schools from the compulsory education system. It was another half a decade before it went further and legislated against private tutoring.

There was also clear thinking behind the decision. More than 70% of families in Beijing, Shanghai, and Shenzhen put their children in some kind of private education, costing them at least 12% of a parent's salary. By legislating against private tutoring companies, the government was trying to avoid the fate of South Korea, which failed to tackle its tutoring problem and saw skyrocketing childcare costs and low birth rates as a result.

(Q) Can you predict antitrust action in the same way?

BH: This is another area where we’ve seen China issue some big fines, which can be scary for investors. The way to think about it is that China is becoming much more like the US and the EU in its approach to antitrust.

Western governments have never been shy about calling out tech giants. Think about the €497 million ($614 million) fine the EU issued to Microsoft in 2004 for bundling Windows Media Player with Windows, or the 2013 US ruling that found Apple conspired to raise the price of ebooks. Even now there’s talk of break-up orders against Apple and Google.

In China, antitrust is relatively new, but the principles are the same. Companies mustn’t use their position to compete unfairly. This was the case with Alibaba, which said it would split into six units in 2023 after facing pressure from Beijing. It was later fined 1 billion yuan ($140 million) for abusing its market dominance to damage JD.COM.

The silver lining is that China’s alignment with the US and EU on antitrust creates a helpful parallel for Western investors, making it easier to anticipate when authorities might take action. It also gives an indication of how companies might perform in the years after a regulatory crackdown. For example, Microsoft’s share price is about 17 times higher today than when it was fined by the EU in 2004.

(Q) China has also stepped up scrutiny of IPOs. How does that factor into your investment decisions?

BH: This is something we think about a lot because a significant number of XVC’s 37 portfolio companies are profitable, generating nearly $40 million in monthly net profit between them. That means many are at a scale where they could go public.

The market is bearish, so regulators are trying to boost investor confidence by making sure only quality companies can go public and those that do list don’t raise too much. This trend doesn’t seem to be going away in the short term, but good businesses don’t need to worry. The IPO window won’t stay narrow forever, and companies that are growing, profitable, and generating free cash flow can afford to wait.

There’s also the option to go public overseas. The Chinese government has encouraged this, issuing a notice in late 2023 to say businesses should “make the most of the markets and resources at home and abroad”.

Foreign listings are becoming a well-trodden path. Chinese companies accounted for 21% of US IPOs in 2023, excluding deals under $5 million, raising a combined $528 million. Some of the biggest names like Tencent and Meituan trade in Hong Kong, and they’re still getting a fair valuation in the long term. Sure, liquidity has been low in the Hong Kong market over the last few quarters, but it’ll eventually normalize and won’t negatively impact long-term returns.

(Q) Do all these risks change your view that China is the best place in the world to invest right now?

BH: No, we still stand by that. Of course, regulatory risk should be factored into investment decisions, but it shouldn't necessarily be a reason to veto an opportunity.

The most exciting thing about China isn’t its economic growth. It’s the potential for long-term alpha –– backing companies that consistently outperform. This is because the market is very big and inefficient, which makes it a perfect environment to spot outliers.

Some of the best-known investors in the West have reaped huge gains from investing in China. Bridgewater founder Ray Dalio recently said he finds high-quality Chinese assets “very attractively priced”, adding that he’s done “very well” investing in the country and remains committed to doing so.

Hunting for long-term alpha requires a research-driven approach, and part of that involves assessing regulatory uncertainty. At the end of the day, venture capital is about taking calculated risks and getting high returns. But our gross IRR of 32% at year-end 2023 shows that the value to be unlocked in China outweighs any regulatory risk involved.