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China-US Investment and How it Evolved – with Howard Chao, Founding Partner of Doon Capital

· The Boss Interview,Doon Capital,ZTE,CFIUS,Cross Border
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Today we have the pleasure of interviewing Howard Chao, an active cross-border investor and advisor to entrepreneurs. Howard began his career as a corporate lawyer with O’Melveny & Myers, helped found the firm’s offices in Tokyo, Shanghai, Hong Kong, and Beijing, practiced law for many years as a cross-border investment specialist, and was chair of O’Melveny & Myers’ Asia practice. In the past six years, Howard has moved to the principal side of investing, and now makes angel and other VC investments in earlier stage companies through his personal vehicle, Doon Capital. Howard invests primarily in startups located in the US and China, including fintech, mobility, agtech, foodtech, and other verticals.

Howard shares his perspective on a number of topics, including: the development of Chinese trade and investment flows since the 1990s, the progression of VC investment into China beginning in the mid-2000s, Chinese outbound capital, the role of CFIUS in monitoring Chinese investment into US companies, and the beginnings of not only a trade war, but potentially an economic cold war between China and the US, and what this can mean for investors and founders.

Edited by Juzhi Zheng and Xinyi Huang

Link to SoundCloud (here), also available via Apple Podcasts, Google Play, etc.

[Editor's note: this interview has been edited and condensed for clarity. The opinions expressed in this article are Howard’s own and do not reflect the views of Doon Capital or O’Melveny Myers]

Initial Interest in China

Hi Howard, let’s start with your story. Could you tell us a bit more about what the past 30 years have been like for you in China?

Howard: Sure thing. As you know I was a young immigrant. I came to the US when I was four years old from Taiwan. For many years I was pretty much Chinese American. It’s only when I got into law school, which was in my adult years, that I started to get really interested in China. It was at a time when there was a thaw in relationship between the US and China: Nixon was going to China, Kissinger was going to China. So there was a lot of excitement about that. That was during the mid-1970s.

This all happened when I went to law school starting in 1976. During those years when everyone was talking about how this was going to be game-changer for the world, I started to get back into Chinese language and studies. I knew I had to figure out how to do something related to China with my career.

I started practicing law in LA in 1980, with a LA law firm called O’Melveny & Myers, and soon after I started looking for opportunities to get in China. In 1984 I traveled for the first time to mainland China, and gave some lectures on legal matters. Then I pursued it along with a few other opportunities, until in 1985 I took a year off from practicing law in China and taught law at two universities, one in Shanghai and another in Beijing for a year. I spent a lot of time studying Chinese law, getting to know people. From that time on I was just hooked. Even though I didn’t have a chance to actually move to China and practice law in China until later, I became more and more active in China-related matters. Even after June 4th 1989, I continued to pursue the China angle until finally I persuaded my law firm to open offices in China in 1994. I moved my family to Shanghai in 1994, and helped set up offices in Shanghai and Hong Kong.

In 1994, it was still the early days of US-China business and trade development. To give you some perspective: back in the Nixon years when China was first opening up, US-China’s total trade was about a billion dollars per year. Fast forward to today, I don’t remember the last number, but it’s something in the range from 500 to 600 billion dollars a year. This is pre-trade war, of course, but gives you a sense of the scale of the change. I feel privileged to have seen all of the changes from pretty much the very beginning until the recent past, where basically everything exploded, whether it was two-way trade or investments: first international investments into China, US investments into China, and then later Chinese capital outflows back into the US.

When things started, China was an extremely capital-poor country. It was a very poor country to begin with, so it was willing to make all kinds of concessions to attract foreign capital. And over the years, we all know that China accumulated more and more of a capital base, until it reached the point where it was one of the most capital-rich countries in the world, other than, for example, the United States. As you know, the US is a big debtor country, and China at this point is a big exporter of capital. This transformation has been just stunning. It’s the most rapid and largest economic transformation that any country has gone through in such a short period of time in world history. It’s just a stunning ride.

Growth in Capital In and Out-Flows

Clearly, there has been a lot of growth in China, a lot of trade between China and the US, China and the rest of the world. You mentioned the importance of capital inflows and the importance of capital in general. Can you tell us a bit more about how it has developed? What did it look like from the early days to today – where was the capital coming from, was it mostly the US, Hong Kong, or other countries? We’d love to get some details there.

Howard: In the early days, first of all there were the money that did not come from VCs or PE funds or financial institutions. It was coming from multinationals… smaller deals. A lot of the money was coming from overseas Chinese, i.e. from Hong Kong, from Taiwan, and from other resources of Chinese money. Also, much of this money was nominally labeled as coming from Hong Kong, even though the ultimate source may not have been Hong Kong. So it was a little bit harder to actually characterize the source, but in general it is fair to say that a lot of money came from those two sources – multinationals and overseas Chinese.

It was only in the late 1990s and early 2000s that financial capital started to come into China. And that was still a trickle in the beginning. The venture capital and PE wave didn’t really start to accelerate until the mid-2000s. These were foreign until, of course, China developed its own growing stock of capital – a lot would be invested into tech and other start-ups as China accumulated more and more savings.

You mentioned that VC and PE money came a little bit later. Based on what I have seen, there were some of these global VCs coming into China: Sequoia, Matrix Partners, etc. They got in and did relatively well for themselves in the early days. But it seems that now, after the 2010s, there are a number of local Chinese funds. Could you tell us more about how that has developed since the mid-2000s?

Howard: In the very beginning, international VCs were wary going into China, first because they were worried that China was a very risky market, the “Wild West.” They didn’t trust the legal system, didn’t understand the market. Plus, they didn’t know what the legal structure was for them to set up an investment in China. They certainly wouldn’t want to invest at that time in a Chinese-incorporated company. Today, the typical structure is the Cayman-Islands-based structure, but in those days, the mainstream VCs were not comfortable investing in the Cayman Islands companies, even though the Cayman Islands is a British jurisdiction with common law. But still, they just weren’t comfortable with it, so a lot of VCs would just not invest for these multiple reasons.

Over the time, however, a lot of the mainstream VCs including those on Sand Hill started to get comfortable: they got on an airplane and started traveling to China frequently. That was a time when people did not have very strong, or any offices in China, so the Sand Hill VCs were basically taking the “airplane bus” to China twelve times per year just to look at deals or do deals. That was in the mid-2000s. And that quickly evolved to having offices, hiring partners and making some bigger bets in China, some of which turned into real successes. It just snowballed.

When we look at the landscape of VCs here in China, many of the top funds are still US names essentially. They use quite an interesting structure, since the Chinese variant of that US fund is usually quite localized and set up as an independent entity. If I recall properly, these two sub-entities, let’s say Sequoia Capital US versus Sequoia Capital China, they’ll share carried interest and returns via a separate SPV. Those guys have done extremely well. These days, perhaps there are still opportunities for US funds to enter, but fewer low-hanging fruit. And of course, we are talking about not only foreign capital invested in China, but also Chinese money going abroad. Can you tell us a bit more about those trends?

Howard: Sure. It’s has been a two-way stream as you said. Some of the US VC funds have been extremely successful in China. The structures they use vary fund to fund. Some of them have split up and have separate China funds, while some are still global funds. Some of them invest out of their global fund into China and the US using the same fund. So it depends on the firm. But American and international capital has been a huge player in Chinese tech and startup investment, although, as you’ve mentioned, Alibaba, Tencent, and others in China have now become massive players and are overtaking the former, as we know.

But the other direction, as you’ve said, has also been very important. Chinese capital has been exported, and part of that export has been VC and PE money. In any case, they have been making investments in many startups and technology companies in the US and elsewhere, part of which is to acquire new technologies, particularly deep tech, and also to lay the groundwork for access to international markets. But, as we all know, this whole strategy is now at risk because of the ongoing political tensions and trade war – I think what some people have correctly called the economic cold war that’s now developing between the US and China. The future of PE and VC investments out of China into the US and also Western countries is going to be heavily impacted and changed, not necessarily stopped but heavily impacted.

Economic Cold War?

Yes, and we see that reflecting in the numbers as well. 2016 was a peak year, with the Chinese investing about 50 billion dollars into the US. In 2017, this dropped down to under 30 billion USD. Then, in the first half of this year, I think it was as low as about two billion dollars. It generally reflects the trend that you’ve mentioned. How might this trend develop over time?

Howard: I think we are in for a long-term chill in the relation between the US and China, and the West and China. I don’t think that this is just a US issue, but that the US and many Western countries all share the same change of attitude toward China, which is reflected in actual legislation and changes in regulation in the US and other places. As we all know, the US has in place CFIUS and regulations that have been recently amended to be more strict with China, and the so-called FIRRMA legislation. Other countries around the world have been doing similar things. I think it arises out of a sheer fear that China will not be just a strategic competitor but a potential military competitor, so anything that might feed or help the development of Chinese capabilities is something that people fear.

By the way, this is not just Trump’s issue. This is currently a bipartisan issue in the US, a DOD and US government issue. This is something that would happen under Hillary Clinton, if she’d been elected. And this is something that was developing even under Obama during his last couple of years. So I think we are in for a less pleasant time between the two countries. Chinese investors investing in the US know this and they are much more cautious about what they are going to invest in.

The Role of CFIUS and FIRRMA

Right. It seems that it is not just Trump, but rather a bipartisan movement. So from a Chinese investor’s perspective, we’ve seen capital investments into the US decrease. Is it because the investors are cautious? You’ve mentioned that there is CFIUS, and the FIRRMA (Foreign Investment Risk Review Modernization Act of 2018). What are some of the specific criteria and stipulations in those acts and in that committee? What are the specific constraints for Chinese investors?  

Howard: The CFIUS has already been very restrictive on Chinese investments. You could argue that they went beyond their actual black letter law legislative authority by being so restrictive. Basically anytime CFIUS and the US government feel like there is a transaction which threatens US national security, then they can delay or block it. But the definition of national security is being interpreted in a very expansive way, much more expansive than I think it used to be. It extends to many different sectors and technologies, which previously would not have been covered. For example, you might not think that genomics is something key to national security, but it may have become sensitive because it could give rise to a shorter path to biological weapons. Or if you were investing in some kind of critical infrastructure in the US – and a critical infrastructure is something that can be interpreted in many ways, even real estate, power generation and management, and fintech where you are dealing with too-big-to-fail banking institutions – many of these could be interpreted to be key to US national security.

The basis for Trump’s tariffs is supposedly national security. It has never been interpreted this way before, but now he is using this as a justification for imposing these tariffs. In the case of China, what it means is that there are a lot of transactions, not only in terms of industries – we’ve talking about technology, for example – but also the percentage of equity that may be viewed as threatening to US national security. For example in the past if you had a very small percentage of equity in a company, then that might not be viewed as potentially threatening. If you didn’t have a board seat, didn’t have more than ten percent of equity or didn’t have access to the information reporting, then people probably wouldn’t worry about you that much. Even with that kind of profile you might have to worry about it, if the technologies were sensitive these days. So I think another target of the legislation is metrics on investment, where Chinese investors are taking relatively smaller stakes in companies that might be deemed to be sensitive.

What I’m hearing is that certain fences run around certain tech sectors such as genomics, perhaps fintech, AI, as you’ve mentioned. It’s still a bit ambiguous, a bit of navigating the grey. I imagined this would be relevant only in the case of very large-profile acquisitions, but now you are saying that even minority investments by VCs could be on the radar.

Howard: Just to be fair, in the past even minority investments were scrutinized, but I think they’re going down to a much smaller, lower level and a smaller type of deals, where in the past people probably didn’t worry so much about them in the sensitive sector.

So how broad reaching is the CFIUS? How much resource… how many people are part of this CFIUS committee? I wonder how much it can cover.

Howard: That’s the tricky thing. They don’t have enormous manpower since they are an interagency committee, but what they can do is that they can overturn closed transactions. For example, if you don’t report a deal and just close the deal, thinking that its okay, CFIUS might decide later that this is a deal that you should have reported. They could unwind it at that point.

Implications for Investors

On the topic of fences around certain sectors, how do companies navigate around that?

Howard: It’s going to be very tricky. What’s going to happen eventually or is happening very quickly, is that in certain sectors of business, companies will be forced to choose sides, or they will be put on one side or the other involuntarily by the way that markets or governments work, and they will not be permitted to serve both sides of the fence. That’s already happened, for example, in social media. If you are Facebook or Twitter, you are not permitted to engage in social media in China. Similarly, if you are a search engine, then you are outside of the fence, which is why we have Baidu. But this is now spreading to many other sectors. If you are ZTE, or Huawei, there are a lot of things that you are just not permitted to do in the US. The US doesn’t have legal machinery to completely take them out of the US, but for all intensive purposes, I think US government see ZTE and Huawei as spy organizations. So they are doing everything they can to prevent them from doing much business, for example, in 5G and various other areas, such as telecom equipment.

So what’s the Chinese government going to do? Are they going to allow Western, especially US telecom equipment companies to have free rein in Chinese market? Maybe it hasn’t stopped them yet, but over the long run, I am not optimistic about reciprocity. I think there is going to be a tit-for-tat, as China reacts to the US position. So when that tit-for-tat takes hold, companies will need to be on the US side of the fence or Western side of the fence, and Chinese side of the fence in many different sectors–not every sector or every kind of companies, but in some growing number of sectors. On which side of fence you fall is going to depend in part on who owns you and controls you. That’s going to be probably the most important factor.

Given some of these constraints to cross-border investment, and you mentioned some of the fences that are drawn, what is still open for business? What are some areas that Chinese investors are still excited to getting involved in?

Howard: This is a time when I think Chinese investors are just rethinking. I don’t think that Chinese investors are plunging into most cases right now. They are putting things on hold until they get more clarity on how the rules will work. Many of the ones that I know are looking elsewhere. They are looking at other countries and opportunities because they feel the US just will be too difficult. Let’s start to say that if you try to buy a shoe factory somewhere in Georgia and guessing that’s probably be okay, unless the shoe factory is next to a naval defense installation. I am sure there are businesses which are okay. If you buy buildings–residential compounds somewhere not located near a military installation, then it’s probably okay. There are certain other businesses that are probably okay, but just the scope of what is going to be understood is going to be much larger now than before.

The other implication of all these is that when there has been a lot of people who talk about how there will be a compromise reached between the US and China on this trade war, it’s obviously not just the trade war, but things that are investor-related restrictions. So again, I call it an economic cold war. But it has been talked about how the two governments will get together, to negotiate and compromise, how you can’t drag this out for too long, and how the two leading economies in the world are hurting each other, etc. I am not just optimistic about that. I think in particular, the Trump administration is frankly not interested in a compromise because it serves their goals to have US companies move out of China. So if there is no compromise, the Chinese government, sooner or later, will feel that they need to retaliate on the investment side not just the trade side, because on the trade side, US doesn’t export that much to China anyways, compared with the other way round.

Furthermore, if the US is restricting Chinese investment in a fairly serious way, then sooner or later, instead of opening up more, which China has talked about a way to try to placate the US, what China may do at some point is to crack down on US investment in China. That may just make the Trump administration very happy, because they want the Apple and other US multinationals to move out of China so that they could quote on quote bring their jobs back to the US. Now we know that many of them have been moving back to US, or to Thailand, to Malaysia or to wherever. But I think this administration will be able to claim some kind of victory for what they’ve moved out of China.

Potential Opportunities for Investors

There are a number of these risks and quite a bit of apprehension and geopolitical tension. But at the end of the day, these are still the two largest economies in the world that are going to see growth. From your perspective as an investor… what kind of opportunities do you find cropping up, given this backdrop?

Howard: It’s a tough question. I think everybody is scratching their heads right now, because the consequences and impacts of all of these conflicts between the US and China are hard to figure out. There are some obvious consequences, but the second-order consequences – the global consequences are still unfolding. As you know, I am an early-stage tech investor at this point, and I don’t practice law anymore. Most of my investments are in the US, and I look at several sectors: some of the sectors I look at are actually going to be less affected by this economic cold war. They will be affected, but less so. For example, I look at agricultural and food tech. I can’t say they won’t be affected, obviously, for example, exports of US agricultural products are definitely impacted. But in general, agriculture and food tech are less sensitive.

Another area I look at is automobile and mobility tech. Again, those are areas which may be a little bit less sensitive – I can’t say there is zero sensitivity, but they are a little bit less sensitive. Furthermore, as we know, the automobile industry is global, and some of the biggest profits of the global automobile companies come out of China. And of course, the Chinese domestic auto industry has not developed as smoothly, quickly and independently as a lot of other sectors, perhaps in part because China’s insistence on JVs and the fact that the foreign companies chose to invest their technology. I think there will be greater collaboration at least in the foreseeable future, in these kind of sectors, but I can’t say that they won’t be hurt or affected.

The World’s Supply Chain

We have been talking quite a bit about China wanting to acquire advanced technologies and its need to catch up. But China’s supply chain and what’s offered in Shenzhen is unparalleled comparing with anywhere else in the world, in terms of not just cheap labor but also experience and know-how and infrastructure. Lots of the parts and products globally are actually still made in China, and you did mention earlier that Trump wants to repatriate certain businesses or parts of these businesses back to the US. So how feasible is it for the US to rebuild the supply chain out of China? How might this play out over the next period?

Howard: That’s a very good question that I don’t have an answer to. You are right that China is the center of the supply chains for tons of different kinds of industries and products. I am afraid that disengaging on that is very difficult. It can happen over time, but is virtually impossible at least in the short term. But that seems to be what the Trump administration wants to happen at least in certain areas. So how is it going to happen? I don’t know, and it is not going to be easy.

There is Always Upside

There are clearly certain tensions, but this is also an interesting period of our lives. There are always opportunities when the environment is dynamic. So I would love to see how these things play out.

Howard: I think you are right about that. Despite the fact that overall this is going to be bad for many kinds of business – probably the majority of them, there will be many situations where they would be an upside because there are winners and losers. Whenever there is a big change, economically or politically, there are winners and losers. So I suppose that if you are an investor, you will want to think longer and harder about where the winners are.