How Trump's Trade War With China Will Affect U.S. Investment Markets

Breaking down how these changes will hit venture capital, private equity and M&A.
 
 
This story originally ran on PitchBook.


President Donald Trump's aggressive economic nationalism is resulting in a deepening trade rift with China. The impacts are reverberating into the capital markets, with cross-border investment flows and dealmaking looking vulnerable.

Trump laid into China in late July, accusing them and others of "manipulating their currencies and interest rates lower" in an effort to get a competitive edge over the United States. He added that the US should be allowed to recapture what was lost due to the "illegal currency manipulation and BAD Trade Deals."

Less than a week later, US Treasury Secretary Steven Mnuchin said his department was closely monitoring China's currency for signs of manipulation. Around the same time, Goldman Sachs warned clients that the current "trade war is evolving into a currency war." The Republican-led Congress is getting in on the action, too, recently passing legislation to tighten procedures for reviewing foreign investment deals in an effort to protect national security interests.

Overall, Trump has said he is ready, if necessary, to raise tariffs on all US imports from China—a total of more $500 billion worth of goods—in order to narrow the US trade deficit with China, which totaled $375.6 billion last year.

Trump has already rolled out a 25% tariff on $50 billion worth of Chinese imports in retaliation for a "Section 301" finding by the US Trade Representative that China has repeatedly engaged in practices to steal American intellectual property. Trump has asked the USTR for higher tariffs on a further $200 billion worth of Chinese goods after a public comment period in August, with the tariff rate now being jacked up to 25% from the 10% previously.

The US exported less than $130 billion in goods to China last year, so Beijing can't react in kind. But it's still fighting back, with the Chinese government warning it could increase the tariff rate on $60 billion of US goods to 25% from 5%.

According to the latest reporting, high-level trade talks between the two countries have stalled.

Thus, concern Beijing could look to alternatives, such as crackdowns on US technology firms or a conscious weakening of their currency, to strike back. 

According to the Rhodium Group, an independent research provider, these developments are already having a chilling effect on US-China investment activity: In the first half of 2018, Chinese foreign direct investment into the United States totaled only $1.8 billion, down 90% from the comparable period last year and the lowest level in seven years. And money is being rapidly pulled out, with nearly $10 billion in US asset divestiture by Chinese investors in the first five months of 2018.

The turnaround comes at a time when China's private markets were beginning to blossom. Per a Wall Street Journal analysis, Silicon Valley's dominance in VC investment is being challenged by China: Last year, 44% of global venture finance was led by US-based investors versus 24% for China-based investors. In 1992, US investors enjoyed a 97% share.

Amid all these crosscurrents, here are the top-of-mind impacts PitchBook's news team sees on the VC, PE and M&A spaces.

Venture Capital

While China's domestic VC industry has been growing rapidly over the last few years, cross-border investment flows have been relatively modest. Per the aforementioned WSJ analysis, US VC industry deal flow totaled $67 billion in 2017, of which $52 billion stayed at home and $5.5 billion flowed into China. China's VC industry saw $38 billion funneled into its tech ecosystem, of which $30 billion stayed at home and $3.1 billion flowed into the US.

According to Rhodium, US investment into Chinese tech companies has taken off in recent years, as has Chinese investment in foreign startups, particularly in American companies. Since the beginning of 2010, Chinese venture capitalists have completed more than 1,000 deals for American companies worth some $36 billion; most of which occurred between 2014 to 2017.

We expect startups headquartered in the US that are expecting capital from Chinese investors to be hit hardest because of increased regulatory red tape. Chinese investors, for their part, won’t have the same access to deals amid new restrictions on deals with US companies involving emerging technologies working through the legislative process in Congress (specifically, the Export Control Reform Act of 2018). According to reports published earlier this summer, the administration was specifically concerned about Chinese investment in robotics, aerospace, AI and more.

US investors, on the other hand, may not be up against the same level of scrutiny. China has taken a different approach as the trade war has heated up, opting to play nice with foreign investors, approving large financings and "portraying itself as a champion of openness," per Reuters. The most active US investors in China, additionally, are well-established in China, for the most part, with offices in China and dedicated funds.

SOSV, for example, is headquartered in New Jersey, but the firm also has an office in Shenzhen, where Chinaccelerator, its mentorship-driven, seed accelerator, is based.

Sequoia, of course, has an established Chinese subsidiary and fundraising vehicles with offices in Beijing, Shanghai and Hong Kong. So far this year, Sequoia has participated in the round for multiple companies headquartered in China, including bitcoin mining hardware startup Bitmain, edtech company VIPKid (which is also backed by Sequoia China) and apartment rental service Ziroom.
 
On the other side of the table, Chinese companies, including some of the world's most valuable, have garnered significant backing from American investors. Ant Financial, for example, has raised substantial capital from Sequoia and private equity funds such as The Carlyle Group and General Atlantic. Similarly, Didi Chuxingis backed by US firms including 2020 VenturesMatrix Partners and several others.

Across the Pacific, leading US companies, including those among the most valuable VC-backed companies in the world, are securing large financings from Chinese investors. Uber, for example, is backed by prominent Chinese VCs like Hillhouse Capital GroupHony Capital and Legend Holdings are WeWork investors. And Airbnb has landed investments from China Broadband Capital Partners and Hillhouse, among others.

  Private Equity

US private equity interest in Asia has been active lately, with both Carlyle and Blackstone holding final closes on Asia-focused funds in June: Carlyle Asia Partners V ($6.6 billion out of Hong Kong) and Blackstone Capital Partners Asia ($2.3 billion out of Beijing). This caps a heady two years for North American PE shops raising funds in Asia, with more than $8 billion raised in each of the last two years (full-year 2017 and 2018 year-to-date). Compare that to $3.1 billion in 2016 and $4.2 billion in 2015. 

Ostensibly, the focus is on China: According to Private Equity International, China-focused capital represented 20% of total fundraising for the region in the first half of the year, outpacing the "Pan-Asia"-focused capital raised by more than 70%.

But trade tensions are starting to bite into allocations, with capital raised by China-focused and headquartered private equity firms falling to just $3.6 billion through the first half of this year, a decline of nearly 50% compared with the same period in 2017. GPs are still trying, however, with Primavera Capital Group targeting $2.8 billion for its third fund and CDH Investments looking for $2.5 billion for its sixth fund.

US LPs may look to circumvent any dampening effect that increased regulatory scrutiny could have on cross-border deal flow by gaining exposure to Chinese investments via non-US-based GPs. For example, CVC Capital Partners is expected to launch its fifth Asia buyout fund later this year with a $4 billion target.

For existing PE portfolio companies, especially those in China, valuations are likely to be negatively impacted by higher tariffs, since China's economy has a higher sensitivity to export growth.

  M&A/Big Tech
There's little new in the prospects of a trade war with China for those who have been tracking dealmaking between the countries over the last few years. The best example of this is the nightmare faced by Qualcomm, which waited nearly two years after striking its $44 billion deal for NXP Semiconductors, only to see that transaction quashed by the Chinese government.

But two can play at that game. And no other situation stateside has better illustrated the thorny intersection of access, oversight, taxes and approval processes than the hokey pokey currently being played with ZTE and China Mobile, companies that have had had their right to do business in the United States held captive to the winds of geopolitics.

In early July, on a recommendation from the US Commerce Department over increased security risks, the Federal Communications Commission blocked wireless carrier China Mobile from operating in the US. Commerce has run this playbook before on Chinese tech companies, including smartphone behemoth Huawei: In April, the department banned ZTE over breaking a 2017 agreement to pay a fine for violations against sanctions on Iran and North Korea. Then Trump overturned the ban in May.

US multinationals, on the other hand, are attempting to proactively circumvent possible regulatory ire.

For example, Apple has announced plans to connect suppliers with renewable energy sources through a new investment fund that's meant to combat climate change. The tech giant, along with several suppliers, will invest nearly $300 million over the next four years into the China Clean Energy Fund.

Earlier this month, in a bid to boost its presence in China, Facebook established a separate unit to serve as an "innovation hub" in Hangzhou with registered capital of some $30 million and a focus on training. Trouble is, the Chinese pulled the plug on the project the day after news of its approval hit.

For executives working on big splashy deals, the bureaucratic apathy is likely to get even worse.

What's next?

At this point, there are more questions than answers. But one thing is clear: Escalation is in play and the situation looks set to get worse before it gets better. Trump has pointed to the relative strength of US equity markets versus China as real-time evidence that his aggressive tactics are working. (The S&P 500 is up more than 31% vs. the Shanghai Composite since the beginning of the year.)

For its part, China threatened on Tuesday to use Apple as a "bargaining chip" in state-backed media and warned it could be the target of "anger and nationalist sentiment" if the company didn't share more of its profits with the Chinese people.

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Nationally, the number of deals worth more than $1 billion were down 75 percent last year compared to 2016.