Amid the ongoing trade war between China and the U.S., on August 13, President Trump signed a law which may substantially curtail Chinese investment in the U.S.; especially the tech sector. The Foreign Investment Risk Review Modernization Act (FIRRMA) expands the role of a key government body to screen acquisitions of U.S. tech companies and other investment transactions by foreign companies for national security implications. Make no mistake, the law was designed with Chinese investors principally in mind. We know from our clients’ experience in the semiconductor and advanced automotive sectors, however, that Chinese investors have seen the writing on the wall for some time now and were already starting to prepare.
First, some context. The new rules are meant to strengthen the Committee on Foreign Investment in the United States (CFIUS), a federal inter-agency group which has the authority to review these kinds of transactions. CFIUS has historically applied a narrow interpretation of national security and only reviewed full acquisitions of American companies, not minority ownership investments such as venture capital. But that has started to change in the last couple of years, and in many ways, the new legislation simply acknowledges what CFIUS was starting to do on its own anyway: stretch the limits of its old mandate.
In the last two years as pressure from Congress has built, including from the primary proponent of the new law, Senator John Cornyn of Texas, CFIUS has increasingly been taking the position that ownership of technologies in areas such as artificial intelligence, robotics, and semiconductors now also has national security implications. It has therefore rejected or threatened to reject certain foreign acquisitions on these grounds. Even data privacy has been used as a stated rationale for rejecting an Alibaba affiliate’s acquisition of Moneygram earlier this year. The new legislation captures these growing areas of concern by including “emerging and foundational technology” in CFIUS’ official scope of review.
The impetus for these new rules is clearly China. Despite its breathtaking speed of economic development, China still lags far behind companies in Europe and the U.S. in certain core industrial technologies. This has created a sense of vulnerability in Chinese policy and industrial circles, heightened most recently by a threat by the U.S. government to cut-off ZTE, a major Chinese telecommunications company, from licensing U.S. technology following violations of U.S. sanctions on Iran. The ban, which ultimately was removed (although hefty fines were levied), would have fatally crippled one of China’s champions in the all-important development of 5G technology.
To address its dependency on foreign technology, China had until recently been vocally pushing the “Made in China 2025” plan, which sets forth certain domestic industrial targets for core industrial technology to be developed and used locally. The audacious ambition of the plan has caused alarm in the halls of governments and the boardrooms of major companies in the U.S. and Europe. Until recently, the plan had been frequently cited in official Chinese publications and other media outlets. But that has changed in recent months as the trade tensions have heated up. Despite a directive at the national level to minimize reference to the policy, local officials we talk to at the local commerce department and economic development zones are still citing it with regularity in offline conversations. Even if the rhetoric on Made in China 2025 slows down, few people think the plan itself will actually change.
“The trade turmoil that has unfolded under the Trump Administration has only hardened China’s belief that it is a national security threat to be dependent on technology from the U.S. China will forge ahead, but with less transparency and more roundabout ways of getting what they need,” James McGregor, Chairman, Greater China at APCO Worldwide, told me. He is an author, journalist, and businessman who has lived in China for 25 years.
While the drive to achieve the goals of Made in China 2025 will stay strong, we have seen a marked slowdown in Chinese outbound M&A in the past 18 months. This slowdown was first driven out of Beijing in an effort to halt a precipitous drop in Chinese government foreign currency reserves, which Beijing uses as a policy tool to help manage the official RMB-forex exchange rates. Then, just as Beijing gave the clear green light again for Chinese companies to pursue foreign acquisitions which were in line with the policy aims of Made in China 2025, potential buyers suddenly found the world of potential targets was shrinking rapidly due to hardening attitudes in the U.S. and Europe. There is a palpable sense of frustration in China of having money to spend but nowhere to spend it.
Chinese venture capital has also been more inwardly focused of late, though mostly by its own volition. In recent months, we have witnessed a fever pitch of investment in domestic rather than overseas opportunities – so it does not surprise us that Chinese VC investment is on pace to surpass that of the U.S. in 2018.
We do know several investors who also simply felt burned by Silicon Valley in the past, with VC funding seemingly peaking with valuations for companies like Uber. Chinese funds, the new kids on the block, have typically had to buy their way in to rounds by paying a higher price for U.S. startups than U.S. funds. To the extent U.S. startups remain open to Chinese venture capital, those valuations will now only rise as the better startups can afford to be choosy. Unless winter is coming soon for Silicon Valley startups (a distinct possibility) and funding becomes scarce, we expect times to be difficult for many Chinese funds operating there.