By: Ashley Kindergan From The Financialist

The headline data out of China hasn’t exactly been comforting of late. The country is grappling with the challenges of slowing GDP growth, rising debt levels, and volatile stock markets, to name just a few. But if the macroeconomic statistics seem bleak, the picture is brighter among the country’s entrepreneurial class. The quality of Chinese innovation is increasing, the funding environment is improving, particularly for early-stage companies, and the Chinese government is doing everything it can to make China Inc. a force to be reckoned with.

It should come as no surprise that a large portion of recent Chinese startups is aimed squarely at the country’s rapidly expanding middle class. The number of middle-class adults in China has grown by more than half since 2000, to a total of 109 million, more than the 105 million in all of North America, according to Credit Suisse’s 2015 Global Wealth Report. And their spending power has increased even more: Middle-class wealth jumped more than seven-fold during that time, from $1.7 billion to $7.3 billion. What Chinese people eat, drink, and wear, where they travel, and what they do for entertainment “will be the driving force of consumption in the next decade,” Michelle Leung, founder and CEO of Xingtai Capital Management, said at Credit Suisse’s 2016 Asian Investment Conference (AIC) in April.

Internet giants Baidu, Alibaba, and Tencent were at the head of the first generation of Chinese startups to successfully target the country’s burgeoning middle class. All three continue to build their businesses by rolling out new e-commerce, social media, and mobile payment products and services to middle-class consumers. While their size and momentum make them formidable adversaries to any startup seeking to compete with them, their collective success has also made it easier for startups when it comes to one key variable: capital. Whereas the Internet pioneers had to go overseas to scrounge up funding, today’s Chinese entrepreneurs are awash in both foreign and domestic capital. That kind of change brings its own challenges, including rising concern about high valuations and liquidity risk, but those are high-class problems when compared to no capital whatsoever.

Early-stage funding has never been anywhere near as plentiful in China as it has been in the U.S. or Europe. A decade ago, it was positively scarce. Ramakrishna Velamuri, professor of entrepreneurship at the China Europe International Business School in Shanghai, says that when he first came to China in 2007, many so-called venture capital firms acted more like private equity firms, buying out companies instead of taking minority stakes. But that’s changing. While there is still more capital seeking to fund later-stage companies, a slew of domestic and foreign investors at the seed and angel stages has begun to emerge. “It’s been like a gold rush,” says Velamuri. “Lots of people who made money in real estate investments or in businesses have decided to become investors.”

Wu Yibing, head of the Singaporean sovereign wealth fund Temasek’s China business, says the fund believes strongly in Chinese innovation and has begun investing more aggressively in the country’s startups as a result. “Increasingly, to capture the China innovation theme, we are moving to earlier stages,” he says. By investing earlier on, he said, “you will be there with them when they become Didi Chuxing (a ride-sharing service) or Alibaba – and when that happens, they’ll be very expensive.”

The Chinese government has played an important role in the changes in the funding environment. Some 780 state-backed venture capital funds raised $231 billion in 2015, tripling the amount of assets under management in just a single year, to a total of $338 billion. While that money is also available for later-stage financings, such as a $4.5 billion fundraising round for Ant Financial, Alibaba’s financial services spinoff, the funds are squarely aimed at shoring up seed-stage and angel investing in China. And there’s even help before the money comes: Since it began its campaign to support entrepreneurship in 2014, the government has also opened 1,600 high-tech incubators for startups.

The flood of investor interest in Chinese startups has pushed up valuations to a degree that has begun to concern some investors, however. At the Credit Suisse 2016 Asian Investment Conference (AIC) in April, Wu compared China’s frothiness to that of Silicon Valley. At the same time, he noted a concurrent consolidation trend that has helped justify at least some of those valuations. The 2015 merger of ride-sharing apps Didi Dache and Kuaidi Dache into Didi Chuxing, for example, positioned the company to receive a $1 billion investment from Apple in May.

If the funding environment has improved dramatically, the same cannot yet be said for its flipside: liquidity. Stock markets have been volatile over the last 12 months, and the Chinese government has repeatedly banned IPOs for extended periods. December 2013 marked the end of a 15-month freeze, while 2015 saw a five-month shutdown between July and early November. Zhang Yichen, Chairman and CEO of China-focused private equity fund CITIC Capital Holdings, said at the AIC that his company focuses on buyouts primarily to control the exit strategy. When firms the company invests in do go public, Zhang said, CITIC typically tries to sell enough stock to pre-IPO funds before the offering to make back their money – just in case. Velamuri also points out that liquidity has been helped by China’s hot M&A market. In 2015, the Internet conglomerates Baidu, Alibaba, and Tencent invested $29 billion between them to acquire or take minority stakes in 134 firms.

For public-market equities investors seeking a piece of the startup action in China, the primary and secondary markets each present their own challenges. In the primary market, the number of promising startups is growing, but it’s still exceedingly difficult to pick winners and losers in a market as brutally competitive as China’s. And in the secondary market, it’s the usual story—too much money chasing too few success stories. Vincent Chan, Credit Suisse’s Head of China Research, notes that traditional industries such as banks and commodities companies still dominate Chinese public markets, while newer, high-growth sectors such as technology, communications, and media are tiny by comparison. “You end up with people paying a very high multiple for companies with a relatively small earnings base,” he says.

When the amount of capital available to fund promising startups shifts from not enough to more than enough, the challenges shift too. Today, liquidity and valuation risks are increasing for entrepreneurs and investors alike in China. But that’s also better than the alternative, which is no money available at all. For the time being, money is flowing, the Chinese government has committed to innovation as a national policy, M&A provides a viable exit route, and Chinese consumers are eager for the next, new thing. Whether this will prove another golden era for entrepreneurialism in China, only time will tell, but in the meantime, China’s startups are too busy figuring out new ways to cater to a fast-growing consumer base to worry about it.

To find out more about China’s increasingly innovative startups, read our companion story here: http://thefinancialist.devsjr.com/chinese-innovation-takes-flight/

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