Michael Yao, a partner at ZWC Partners, discusses valuations, exit obstacles, and artificial intelligence in China, as well as the scope for applying China knowledge in Southeast Asia
Q: How would you describe ZWC’s strategy?
A: We are a technology-oriented investor covering China and Southeast Asia. Technology brings huge value to fast-growing markets, and we believe there are strong synergies between these two markets. Our Chinese portfolio companies are slightly more developed than those in Southeast Asia. However, Southeast Asia is developing rapidly, and you must be localised to capture that opportunity. We have offices and personnel in Singapore and Jakarta to understand the local ecosystem and source deals.
Q: Has the pace of investment among Chinese GPs slowed this year?
A: Some GPs invested too quickly at high valuations last year, they haven’t raised new funds, so they are preserving what dry powder remains and helping existing portfolios secure new funding. Others are worried about exits, especially later-stage players, given public market valuations are now below private market valuations. As a typical Series B investor, we haven’t been impacted so much. We pay more attention to changes driven by underlying technology evolution, which has its own rhythm, independent of capital markets. In this sense, we are optimistic. We still see exciting technology adoption in different industries, and we invest based on long-term theses and whether a company’s performance justifies the valuation. ZWC made two investments in the first quarter of 2022.
Q: What is happening with valuations?
A: They are in the process of adjusting, but many companies have yet to accept this, and so investors are waiting until they do. Only the strongest survive, but good investment opportunities do come out of difficult times. The market went through difficulties in 2007-2008, yet some VC funds of that vintage are among the top performers from the last decade.
Q: Could you elaborate on those concerns about exits?
A: There are regulatory issues that need to be addressed regarding US exits. In Hong Kong, it’s not so much a matter of regulation as general market confidence and overall macro conditions. Traditionally, Hong Kong has been more friendly to large-cap stocks – if your market capitalisation is below HKD 10bn (USD 1.25bn) you will have no liquidity. It doesn’t necessarily favour story-telling companies, which means many start-ups backed by US dollar-denominated funds aren’t suitable for Hong Kong exits. Tech investing is often about generating a high multiple on the back of a compelling growth story. During a downturn, investors are risk-averse and they tend to focus more on cash flow. Another issue is many early-stage investors don’t really consider the link between private and public markets. Now, though, you must start thinking about exit routes much earlier and which capital market is most likely to be receptive to the equity story.
Q: Is it fair to say that US dollar investors think more about the future and renminbi investors prioritise current financial performance?
A: Not anymore – it is converging. With uncertainty over traditional exit paths for US dollar investors, the A-share market has become increasingly important as an exit route, but can you list there? Local regulators are unlikely to welcome companies making huge losses or with unproven monetisation capability. Everyone must make certain trade-offs in their investment preferences.
Q: There has been a lot of investment in software-as-a-service (SaaS) in China by US dollar funds. What are the exit prospects?
A: There is a huge gap between US and China SaaS companies in terms of maturity. Only a handful of Chinese players are generating annual recurring revenue of more than CNY 500m (USD 75m), so what kind of valuation are they likely to get in Hong Kong? Just look at Weimob – its revenue was CNY 2.6bn last year, but it’s market capitalisation is just HKD 1.2bn.
Q: Are we going to see more GPs specialising in certain sectors or verticals?
A: In China, the sectors develop and rotate quickly – the investment opportunity in one area might only last 3-5 years. Take artificial intelligence (AI) investment, for example. In each segment, the window closes after a few years. When that happens, do you switch strategy or quit the industry? If you want to build an organisation that lasts for 30-50 years, you cannot limit yourself to one segment. Strong organisations are constantly evolving. They may start in one area, but then expand naturally into three or four, which diversifies risk.
Q: How is the opportunity set changing in AI?
A: Financial services AI was the first to emerge and the first to reach maturity. This happened because Chinese banks had strong IT and data infrastructure and they were willing to invest in technology. There are three main use cases: customer acquisition, credit scoring in risk management, and voice and text interaction in customer service. The leading players established themselves five or six years ago, and now there is no space for new entrants without a fundamental technological breakthrough. Security AI has evolved in the same way. There are four so-called little dragons: SenseTime, CloudWalk, Megvii, and Yitu Technology.
Q: What do you find interesting in the space now?
A: ZWC looks at different AI application scenarios. We think manufacturing AI and logistics AI are on the brink of a breakthrough. We see AI-enabled visual recognition systems replacing inspection workers on production lines, advanced robotics, and driverless vehicles such as forklifts. Unmanned production lines, which integrate hardware and software, are a huge opportunity. Healthcare AI has been popular for the past two years, some Series B and C rounds are happening, but we don’t yet see a clear differentiation between the players. Autonomous driving is a long-distance race because it relies on data accumulation and policy support, and then the financing needs are relatively large. The industry is at an early stage and valuations are already high, but companies are yet to deliver compelling use cases in China.
Q: How has ZWC reorganised itself to handle the shift from consumer internet to deep-tech that is visible in VC more generally?
A: In consumer internet, a product manager can become a good investor. Today, technology needs to be deeply rooted in industries. Our approach is to form groups of two or three members, combining industry expertise and technical know-how. Then we encourage interdisciplinary cooperation between groups. In AI, for example, we shared knowledge and resources in port-related businesses with Trunk, an autonomous driving technology provider that focuses on port and dock applications. Also, it’s important to note that consumer internet is winner-takes-all and subsidies are critical to winning customers. But when you apply technology to different industry verticals, there will be champions within each one, and subsidies usually don’t work on business customers. Making sound assessments as to how industries, technologies, and competitive landscapes will evolve is very important when making investment decisions.
Q: What key trends do you see in cross-border investment?
A: There will always be new opportunities. It is wave after wave, depending on where China is competitive globally and well-positioned to export. The first wave was consumer internet, where teams would leverage the traffic, technology, and talent they had developed locally. I think that opportunity has now largely passed. The second wave is supply chain capabilities with integrated hardware and software. ZWC has made quite a few investments based on this thesis. Maybe AI or enterprise services will come next. We haven’t seen a large-scale Chinese enterprise software company go overseas yet; that industry is still at an early stage.