Investors have long prepared for a crackdown on technology investments in China.
President Biden on Wednesday signed an executive order banning new American investments in certain technology sectors critical to national security, part of steadily escalating tensions between the two countries. The executive order will prohibit VC and PE firms from making additional investments in Chinese semiconductors, quantum information technologies, and certain AI systems, and require other US investors to notify the Treasury about particular transactions located in China.
VC and PE firms have anticipated the changes for years, building models that incorporate China as a risky investment area that they have discounted heavily, said Scott Jones, managing director at Alvarez & Marsal, a consulting firm.
“We’ve seen our clients and investors treating China as more of a risk area and not an opportunity as far as how they approach potential investment companies they’re looking at,” Jones said.
This is a stark contrast to the pre-2018 environment, when investors wanted exposure to China and saw potential for growth opportunities. In fact, the number of unique US-based investors participating in China-based VC deals fell from 262 in 2018 to 179 by 2022, according to PitchBook data.
In 2018, former President Donald Trump imposed tariffs on $200 billion of Chinese imports and placed restrictions on China’s access to US technology and intellectual property.
“My own view is that it has escalated steadily through the Trump and Biden administrations and will continue to escalate. There’s no end in sight to it,” said J. Scott Maberry, partner at law firm Sheppard Mullin.
Since 2018, Maberry said his firm has been preparing clients for pending related regulation.
The networking effect
The main impact of the administration’s most recent move is an attempt to block what Jones calls the “networking effect,” in which smaller, privately held Chinese technology companies gain access to capital, resources and industry experts through PE and VC backing.
Maberry agreed. “The whole idea is that we’re in this global struggle for technological dominance with China, and China is a strategic adversary in that struggle,” he said. “The logical extension of that theory is that certain technologies become strategic national assets of the two countries.”
In a strategic struggle, parties take certain policy-driven steps to gain dominance, including denying an adversary access to technologies and the ability to develop those assets. In this situation, this looks like the US decelerating China’s development of key technologies outlined in the executive order by, for instance, crippling their access to PE and VC capital and the “intangible” benefits of US investor dollars, Maberry said.
As more areas of this political race are identified, Maberry said he expects additional export bans, increased investment in US-based technologies, and continued denial of outbound investments in those areas.
Compliance implications
For PE and VC buyers, this potential for a wider casting of the regulatory net has implications for compliance with US law and due diligence processes as well.
“What we’ve been telling clients is that even if you’re not investing in the high-tech semiconductor industry, you need to make sure that you’re complying,” said Doreen Edelman, partner at law firm Lowenstein Sandler.
A failure to comply with US regulations and sanctions could result in legal and reputational damage to investors, Edelman said.
“Unfortunately, there’s no knowledge requirement. If you break US sanctions, you break US sanctions, even if you didn’t know about it,” she said
Compliance precautions include, for example, being aware of other investors in a portfolio company or fund; having an exit strategy for investments that may not comply with federal regulations; and ensuring security across the supply chains of portfolio companies.
“The bottom line is that firms need to focus on diligence and compliance requirements no matter where they’re doing business, and now they’re going to have to look at these rules about China,” said Edelman. “It’s just one more item.”
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