Economy, Talking Point

Taught a tough lesson

Edtechs exit our Top 50 China Unicorns ranking after regulatory storm

Unicorns w

Start-ups that reach $1 billion in value were once regarded as a rare breed. Today the unicorn story is much more commonplace. Indeed, unicorns are seemingly everywhere. Counts often vary but the upper-level estimate is there are at least 900 of them, with new ones arriving all the time.

Another feature of the herd is how many unicorns have been created this year amid a surge in venture capital investment. At least 316 companies reached unicorn status between January 1 and August 20, says CB Insights. The United States was home to the highest number at 402, followed by China (158), India (40) and the UK (31).

Since the start of this year WiC has copiously tracked China’s contribution to unicorn numbers with a ranking of its own that concentrates on the top 50 firms.

What’s revealing is that the number of Chinese additions to 2021’s new cohort of unicorns has tailed off significantly – trailing the Americans by some distance. There are clues to why in the latest iteration of our Top China Unicorns 50 ranking, which we review here as part of our quarterly update of the list.

What’s new in WiC’s Top 50?

The major change in our third quarter update is the evisceration of the edtech platforms, which have suffered a shocking reversal in fortunes. Back in 2020 their revenues surged as the Covid-19 pandemic forced millions of Chinese students to study from home. At least $10.5 billion of new capital poured into edtech unicorns on our list like Zuoyebang and Yuanfudao in the period.

Yet these formerly hot prospects were chilled to the bone by comments in March from Chinese leader Xi Jinping that after-school training for the K-12 market (kindergarten to the 12th grade) was a “social problem” that needed to be fixed. By the summer the campaign against the edtechs had taken fuller form with directives that they couldn’t charge to teach subjects in the core curriculum to school kids (see WiC551 for more). Late-stage start-ups such as Yuanfudao, valued at $17 billion last year, effectively became non-profits overnight.

Like their listed peers such as Tal Education, which have lost more than $100 billion in market value because of the changes demanded by the government, the edtech unicorns have been trying to pivot into non-curriculum subjects and courses in adult education. Their prospects still look bleak, with no obvious route back to their former high-growth glories. Tencent-backed VIPKid, Zuoyebang and Yuanfudao have all been dropped from our ranking as a result, owing to their precipitous drops in valuation (mirroring the listed edtechs: Tal dropped around 93% in New York over the course of 2021).

What else has changed in the ranking?

Turnover in our Top 50 has been limited. Yes, three new unicorns have been added as replacements for the departing edtechs. However, over the last three months none of the other constituent firms have been able to ‘graduate’ from the ranking by going public and thus shedding their unicorn status (though that will change when NetEase Music – currently placed at 16th spot in our table – lists in Hong Kong on December 2).

Government discouragement of IPO applications in certain sectors has clearly been a factor, but there has also been reluctance from the later-stage unicorns to test market appetite, with fears of a lukewarm fund manager response.

Still remaining atop our ranking, Bytedance was said to have held back from an IPO earlier this year because of the newly intense regulatory scrutiny of many of the companies in China’s internet sector. Its valuation of $400 billion may be revised down when we do our fourth quarter update, with its shares said in recent weeks to be changing hands at a lower assumed value in the private market. Last month one of its largest investors failed to sell stock at a valuation of more than $400 billion, Bloomberg reported, while another was believed to be divesting at a similar time at a valuation of $360-370 billion. A few days later Reuters reported another round of private trades had valued Bytedance at a much lower figure of about $300 billion.

Declines like these wouldn’t be too surprising for the world’s most valuable unicorn, whose core business includes social media and gaming, two areas that have been at the centre of Beijing’s crackdown – as well as education, a division it shuttered a few months ago amid the edtech fallout. The speculation in the Chinese media this month is that advertising sales at its short-video platform Douyin (the local version of TikTok) have been slowing as well.

Two of the other valuations for firms near the top of our table are open to question as well. SHEIN’s $47 billion price tag was predicated on talk of a record-breaking IPO last June, when excitement about the fast-fashion retailer was effervescent (see WiC542), while Reuters reported this week that US private equity firm Warburg Pincus had cut the valuation of fintech giant Ant Group by 15% to below $200 billion.

In fact, new oversight of the internet sector by government agencies has brought cloudier skies for China’s unicorn cohort as a whole, with fewer reports of surging values across WiC’s Top 50.

Most of the group has been treading water in valuation terms, with a couple of notable exceptions.

Xiaohongshu, an e-commerce platform with a focus on fashion and beauty brands for young women, completed an investment round this autumn that brought a jump to $20 billion, double the valuation levels of earlier this year. Although it dropped plans for a listing in the US earlier this year, Xiaohongshu is expected to file for an initial public offering in Hong Kong within the next few months.

Yuanqi Senlin (or Genki Forest to use its English name) is another of the better performers in the Top 50, following a fundraising this month that values the firm at $15 billion, up from $6 billion in the previous round in April. The company is a prime example of a new breed of domestic consumer brands with business models based on rapidly evolving local tastes and swiftly adapted products (in bottled beverages like teas and sugar-free drinks in Genki Forest’s case) and a focus on online marketing and sales. Its revenues more than tripled last year to Rmb2.4 billion ($375 million), according to an investor presentation that found its way into the media (we first wrote about the company last September; see WiC511).

What chances of a turnaround in sentiment?

The clampdown on the internet sector has cast a dark shadow, with little clarity on where the review may be heading next. Last month there was new anxiety about risks for the group-buying companies following rumours that regulators disapproved of their discounted deals on everyday staples to squeeze out smaller ‘mom and pop’ vendors.

Of course the regulatory shake-up has spilled over even more spectacularly into the public markets, where Tencent, Alibaba, Kuaishou and Meituan gave up more than a $1 trillion in value between them in the eight months to September.

Despite a partial recovery in recent weeks, the Hang Seng Tech Index was still more than 40% down on its February peak as of the middle of this month and the shares of the leading tech companies came under selling pressure again on Monday after a slew of new fines was announced over the weekend as part of ongoing antitrust investigations. The news was enough to force Alibaba’s shares to record lows, following declines of more than 15% last week on anxiety about slowing quarterly growth.

The sombre mood reflects other headwinds in the sector, including the implementation of the Personal Information Protection Law, which came into effect this month. The new legislation strengthens data protections for consumers but makes it significantly more costly for tech firms to store, process and share their customer information. On Wednesday, the Ministry of Industry and Information Technology (MIIT) announced that Tencent was banned from launching new apps or updating existing apps (such as WeChat) as part of a “temporary administrative guidance” to help China’s most valuable internet firm to sort out certain of the government’s data protection concerns.

Another area of focus is uncompetitive behaviour, where the State Administration for Market Supervision (SAMR) has been publishing new guidelines on the country’s anti-monopoly law since the start of the year, fining a cluster of internet giants in the process (which as a result are being forced to open up their erstwhile closely guarded ecosystems to competitors).

Other abuses in the spotlight: M&A activity that didn’t receive formal approvals in advance; and tech platforms exploitating their dominant positions in the market to coerce merchants into opting out of competitors’ services.

The shake-up raises questions about how the competitive landscape could change for the unicorn breed. Some of these changes could be positive. Beijing’s efforts to erode the ‘walled gardens’ of titans like Alibaba and Tencent might allow more breathing space for newcomers to grow and attain unicorn status. The antitrust investigations could herald an end to some of the more imperious behaviour of the two giants too, which have been accused of choking the lifeblood out of up-and-coming rivals or forcing their way onto their shareholder registers at knockdown rates as the price of admission to their lucrative ecosystems.

The new determination of ministerial-level agencies like the SAMR and MIIT to counter market abuses also casts doubt on certain unicorn business models, especially the companies with high-volume, low-margin approach that was geared towards winning sectoral supremacy. Sectors like bike-sharing, video-streaming and ride-hailing are littered with rival contenders that have been prepared to endure years of losses in a bid to build ultimately dominant positions. But why burn billions of yuan in sectors like these if the end goal is going to be denied by regulators?

How have investors responded?

Shifts in the landscape have brought uncertain times for the venture capitalists, including Son Masayoshi, the founder of Softbank, one of the leading backers of the Chinese unicorns. He acknowledged in August that Softbank was rethinking its approach because of the regulatory crackdown, and predicted it could take as long as two years before the picture became clearer.

Marcelo Claure, Softbank’s chief operating officer, has made similar comments about taking a more conservative stance. “By no means are we going to abandon China,” he reassured. “We’re just going to be more cautious.”

Reactions like these may be playing in favour of unicorn hopefuls in other markets as investors turn their attention to a wider range of opportunities.

Southeast Asia has been getting acclaim for announcing 15 new unicorns in the first 10 months of this year – an impressive haul given that just 19 unicorns had emerged over the previous eight years in the region. Commentators have cited a fast-growing middle-class and a step-change in internet usage as spurring the surge, although China’s crackdown on its internet sector has freed up more capital to flow into Southeast Asian deals.

Similar trends have been celebrated raucously in the Indian market, where the domestic media has been championing the fastest increases in venture investment on record. These advances are portrayed as being at Chinese expense, with a growth rate in both deal value and volume that has exceeded China’s in each of the first three quarters of the calendar year.

Capital inflows reached an all-time high of $19.5 billion in India in the first nine months of this year, a rise of 150% on the same period last year, according to analytics platform CB Insights. “When China tightens the screw, markets like India benefit,” Shivakumar Ramaswami, a director at Indigoedge, an investment bank, told Nikkei Asia.

Despite the euphoria within the Indian media about the increased unicorn activity, a reality check needs to be called at this juncture: that’s because deal value in China hit the much higher total of $67 billion in the period, according to estimates from CB Insights (i.e. the absolute dollar amounts raised by Chinese unicorns remain easily the biggest in the region even if Indian percentage ‘rates’ of growth are higher).

In fact, if anything studies from other research houses paint an even starker contrast when it comes to sheer volumes of funds raised (with the caveat that accurate data is hard to obtain, especially for financings in China). For instance Zero2IPO, a China-based advisory firm, claims that venture capital (VC) and private equity investment (a broader category of investment activity, admittedly) in Chinese start-ups for the first three quarters rose 75% from a year earlier to $165 billion (i.e. well over double the CB Insights estimate).

Zero2IPO says the value of this year’s VC deals is already higher than for the entirety of 2020’s, when Covid-19 was at its height. More significantly, this year’s totals are on track to beat China’s peak numbers in 2017, it adds.

In this kind of context, VC investors are more likely to be changing strategy in China than giving up on the market completely. Rather than swim against the tide, VCs have also been searching for positions in the slipstream of government policy in the hope that they will bring better chances to profit.

There was a glimpse of that tactic in the $5.4 billion of new venture funding in technology hardware start-ups during the first half, more than the total investment into firms of that type in the whole of the previous year, according to PitchBook, a Seattle-based data provider.

The funding was a clear response to some of the priorities in China’s 14th Five-Year Plan, where the government wants to see more effort in areas such as renewable energy, quantum computing, biotechnology and semiconductors.

PitchBook’s report also makes the point that VC firms can’t take the risk of giving up on new opportunities in China completely, because of the potential profits on offer. “For many VCs, investing in Chinese start-ups represents both a paradigm shift from Western companies, given the sheer operational scale and speed of the region’s innovation economy, as well as an opportunity to invest in first-in-class start-ups in a rapidly growing market,” the study concluded.

Venture capital firms tend to take the long view and many of them will be betting that the Chinese government still wants the digital economy to soar over the longer term, because of its contribution of almost 39% of China’s GDP last year (an estimate from the MIIT, which includes electronics manufacturing and telecommunications, alongside internet and software services).

Savvy VCs, of course, also filter which sectors currently enjoy official favour by assiduously tracking the queue of IPO approvals in China’s A-share market – where companies in breakthrough technologies look better positioned to get the green light for public offerings. Artificial Intelligence (AI) is one such area: major players SenseTime (number 11 on our Top 50) and Cloudwalk (number 34) have already filed for market debuts in Hong Kong and Shanghai respectively, and Megvii (number 32) also has a Shanghai IPO plan in the pipeline, according to media reports. YITU Technology (number 46) is said to be considering an IPO in Hong Kong at a projected valuation of $4 billion too.

Companies like these are perhaps safer picks too because they are important providers of government services. SenseTime, a leader in facial recognition, derived nearly 48% of its revenues in the first six months of this year from its Smart City business, primarily in applications like surveillance systems and traffic management technology for municipal authorities.

Looking ahead…

As we cast forward to 2022 and how our ranking will get reshaped, it is a good bet that fewer consumer-focused internet platform plays will be joining the top 50 (the big investment trend of the past, but now less in favour with Beijing) and instead that those making the grade will be masters of core technologies.

The next crop of Chinese unicorns may also reach that status with more VC backing from state-linked entities and less from the ‘Big Four’ investors that dominated our earliest ranking (see WiC530) namely Sequoia China, Hillhouse Capital, Tencent and Alibaba.

Click here to visit our dedicated Top 50 China Unicorns site for more background and insights on the companies in the list.

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