Inside China's Historic $338 Billion Tech Startup Experiment

(Bloomberg) -- China is getting into the venture capital business in a big way. A really, really big way.

The country’s government-backed venture funds raised about 1.5 trillion yuan ($231 billion) in 2015, tripling the amount under management in a single year to 2.2 trillion yuan, according to data compiled by the consultancy Zero2IPO Group. That’s the biggest pot of money for startups in the world and almost five times the sum raised by other venture firms last year globally, according to London-based consultancy Preqin Ltd.

The money’s in what are known as government guidance funds, where local and central agencies play some role. With 780 such funds nationwide and a lot of experimentation, there’s no set model for how they’re managed or funded. The bulk of their capital comes from tax revenue or state-backed loans.

The money is part of Premier Li Keqiang’s effort to bolster the slowing Chinese economy through innovation and reducing its dependence on heavy industry. The country began a campaignto support entrepreneurship in 2014 and has since opened 1,600 high-tech incubators for startups.

The huge influx of cash raises the possibility of a boom- and-bust cycle like the government-led investment in China’s solar and wind power sectors, said Gary Rieschel, founder of Qiming Venture Partners.

“They have a fantasy that if they give everyone money they’ll create entrepreneurs,” he said. But inexperienced or corrupt managers are likely to invest in dozens of regional copycats unable to get big enough to be profitable, he said. “What it will result in is catastrophic losses for the government.”

It’s unclear how quickly the funds will be deployed. Regulations and market practices remain to be finalized, Zero2IPO said in its report.

But it’s clear that governments are marshaling their resources. Central China’s Wuhan, the capital of Hubei Province, is leading the push with a 200 billion yuan fund, the country’s biggest, with a mix of local and central government financing. The government there says it wants to grow that eventually to 1 trillion yuan, including private money.

Hubei’s government hasn’t granted Bloomberg News requests for an interview.

Build it

“The idea is to attract limited partners to set up funds in that area with a central China investment focus,” said Ken Xu, a partner at Shanghai-based Gobi Partners. A Shanghai government guidance fund contributed 25 percent to one of their own local funds. “That’s good leverage for the government.”

Local fund managers told Xu the real goal is to attract 2 trillion yuan, he said. That could just be too much to handle because there aren’t enough experienced managers or quality startups to invest in, Xu said. Venture capitalists typically fund a fraction of pitches they receive, yet Xu said investment managers who don’t deploy their money will risk getting a smaller allocation the following year.

Zero2IPO said the cash pools are modeled after government- backed programs in Israel and the U.S. China’s government guidance funds emerged more than a decade ago in the Beijing district of Zhongguancun, but really took off last year with Li’s endorsement. They were mentioned in his work report Saturday at the annual meeting of China’s legislature, the National People’s Congress.

Li’s Support

Banned from offering subsidies or tax breaks, provincial and city governments poured money into newly created funds, usually putting their management out to bid. Though officially run as non-profits, managers and government split gains on investments.

The cash is meant to “overcome the failure of pure market- oriented allocation of venture capital,” by steering investment into seed and early stages, according to Zero2IPO. The government wants to attract money to riskier startups shunned by private investors who chase quicker and surer returns in late- stage bets, Wu Qing, a researcher for the State Council Development and Research Center, told the China Youth Daily.

Surging Investment

Yet the sheer size of the policy funds dwarfs venture capital in the private sector. The growth is part of an explosion of private equity in China, where there are now some 15,857 limited partners that have disclosed investments in PE and VC funds totaling 6.1 trillion yuan, the consultancy said.

Fan Bao, China’s most prolific Internet dealmaker, recently issued a stern warning about the dangers facing investors in “lawless” venture capital and startup markets, urging regulators to step in and curb irrational investment and asset bubbles.

Rieschel said it’s wrong to assume more money will drive innovation. Instead, the government should work on offering greater freedom of information and better education to promote entrepreneurship.

“It’s hard to see how this doesn’t end poorly,” he said.

To contact the reporters on this story: Shai Oster in Hong Kong at soster@bloomberg.net; Lulu Yilun Chen in Hong Kong at ychen447@bloomberg.net To contact the editors responsible for this story: Peter Elstrom at pelstrom@bloomberg.net Edwin Chan, Robert Fenner