The iron curtain of venture capital investment has finally fallen.
Author | Shi Jiaxiang
Editor | Liu Jing
On August 9, 2023, US President Joe Biden signed an executive order requiring the establishment of an "Investment Review System for China" (hereinafter referred to as the "new regulation"). After more than 500 days of gaming, it will come into effect today.
In short, the new regulation restricts "Americans" from investing in sensitive areas (such as semiconductors, quantum information, and artificial intelligence) that are closely related to entities in China. It is worth noting that the definition of "Americans" in the new regulation is relatively broad. In addition to US citizens, it also includes green card holders (regardless of their location), entities established in the US and their foreign branches, and any individual or entity in the US (regardless of nationality).
Previously, a spokesperson from the Ministry of Commerce responded that this move restricts US companies' investment in China, suppresses the normal development of China's industries, is a typical generalization of national security practices, goes against the consensus reached by the two heads of state at the San Francisco meeting, affects the normal economic and trade cooperation between Chinese and US enterprises, disrupts the international economic and trade order, and disturbs the security and stability of the global industrial chain and supply chain. China expresses serious concern and firm opposition to this and reserves the right to take corresponding measures.
The new regulation is undoubtedly another strengthening for the already sluggish venture capital industry.
The first to be affected are naturally the US dollar funds that have been influential in China over the past two decades and have the highest risk tolerance. Over the past year or so, many multinational investment institutions, such as Sequoia, GGV, and Matrix Partners, have split one after another.
The second are these AI entrepreneurs who have been thinking globally from DAY1 - the already harsh financing environment has added another cloud. They need to make a more clear-cut choice earlier. A lawyer told us that due to the new regulation, a batch of AI application projects were rushed to be completed before the new regulation came into effect.
According to the new regulation, restricted investments are further divided into "prohibited categories" and "categories that require declaration". The Gao Rui Law Firm tells us that the scope of prohibited transactions is much smaller than that of "categories that require declaration". However, the new regulation does not have an exemption clause for complying with foreign laws and regulations. That is to say, strictly providing all project information to the US government in accordance with the new regulation may also simultaneously violate the information confidentiality obligations applicable under Chinese law.
The specific implementation method of the "categories that require declaration" will determine the specific strategies of US dollar funds in AI investment.
The shoe has already dropped. Whether it is GPs or AI entrepreneurs, in an unpredictable new environment, it is always essential to understand the new game.
In the past two weeks, we have successively interviewed Huang Minda, a partner at Qinglv's New York branch, Liu Zhen, the China managing partner of the US Gao Rui Law Firm, and Zhang Ruiyuan, a partner. Under the gaming, today's Chinese entrepreneurs and funds cannot have it both ways and have to "choose a side".
The following is the main text of the conversation, edited by 「DarkTide Waves」:
The Strictest Venture Capital Iron Curtain in History
「DarkTide」: Can we first summarize a specific profile affected by the new regulation?
Huang Minda: To understand the content of the new regulation, three key points need to be grasped: The new regulation prohibits or restricts (1) Americans (2) investing in equity or similar methods (3) sensitive industries in countries of concern. The final rules target three major areas: semiconductors and microelectronics, quantum computing, and artificial intelligence. At the same time, the US investment in these three areas in countries of concern is divided into prohibited categories and categories that require declaration. For the former, no Americans are allowed to invest, while for the latter, a declaration to the Ministry of Finance is required.
US citizens and permanent residents, US companies, foreign entities controlled by US entities, etc., are all subject to the restrictions of this new regulation.
「DarkTide」: In the field of artificial intelligence, how are the prohibited and declaration-required categories regulated in terms of the training computing power threshold under the new regulation?
Zhang Ruiyuan: According to the new regulation, AI systems with a training computing power reaching the 10^25 threshold, or those with a training computing power reaching the 10^24 threshold and mainly using biological sequence data for training, are classified as prohibited. The Ministry of Finance has chosen to use 10^25, which is also the standard currently used in the 《EU AI Act》 to determine whether a large model has a "systemic risk". Currently, most of the world's top models (such as GPT-4 and Gemini) have already been able to reach or exceed this 10^25 standard.
For the AI business categories that require post-event declaration, AI systems with a training computing power reaching the 10^23 threshold are stipulated. According to our interviews with industry technical experts, this computing power standard is very low and can basically cover the vast majority of current mainstream AI large models.
「DarkTide」: What is the attitude of all parties towards the new regulation at present?
Liu Zhen: In fact, before the draft was promulgated, at least the vast majority of US dollar funds in the market had already been contracting their investments, and their behavior had changed due to macro factors.
So when we discuss the impact of the new regulation with our clients now, it is generally believed that it is better than the worst-case scenario expected. Different from the requirements of CFIUS (foreign investment in the US), this new regulation is for post-event reporting, rather than obtaining approval before the transaction is completed. From the perspective of industry insiders, having a clear rule as a practical guideline is better than speculating whether one will cross the line without a rule.
「DarkTide」: Before the introduction of the new regulation, were there any similar restrictive regulations issued?
Huang Minda: Almost none. In the past, the US has taken measures such as export controls, embargoes, and economic sanctions against specific countries or industries, but none of them have had as great an impact as this new regulation.
The characteristic of the US dollar is free entry and exit and exchange. The logic behind it is simple. The US dollar is valuable because it can be exchanged for money and used to buy things anywhere. Therefore, any regulations that restrict the flow of the US dollar will reduce the competitiveness of the US dollar in the market, only to varying degrees.
「DarkTide」: Some people believe that the new regulation is just a slogan and may not be fully implemented, so the actual impact may not be so great.
Huang Minda: Judging from the enforcement of similar policies in the past, the number of cases investigated and dealt with by the US federal government departments is not large, which is a fact. However, whether there are investment institutions willing to continue investing while taking the risk of being investigated, or how much profit can make them take such a risk, may be questionable in the current environment.
Liu Zhen: These new regulations all rely on the restricted transaction parties to actively comply or complete the reporting. Then, how much manpower and other resources the government departments will use to investigate the investment transactions that they believe should have been reported but were not, or should have been avoided but were not, depends entirely on the law enforcement focus of these government departments at the relevant time points.
From this perspective, the enforcement intensity of the new regulation is inevitably related to the political environment. CFIUS, as a set of legal norms restricting foreign individuals from investing in US projects, has existed for a long time. However, US officials, some of whom are facing the end of their terms, have suddenly made the review of US projects with Chinese investors participating more frequent, in-depth, and continuous in the past few years.
This new regulation is similar. On the one hand, everyone is watching to see who will be the first to be the "guinea pig" (to make this reporting) after January 2 and how much content will be disclosed; on the other hand, due to the change in the direction after the Trump administration took office, unsurprisingly, we will also see the Ministry of Finance's enforcement of the new regulation being sometimes strict and sometimes loose.
The Various Images of Funds under the New Regulation
「DarkTide」: After the implementation of the new regulation, which type of US dollar fund is most affected?
Liu Zhen: For the new funds covered by the new regulation, in the context of the new regulation, there are two types: The fund itself is a US entity (US person) (for example, there are Americans in the GP), and it has a direct compliance obligation; and the fund itself is a non-US entity, but due to the compliance requirements of the US LP, the GP has been "transferred" a certain compliance obligation. The investment behavior of the former is directly restricted and there is almost no safe haven, while the latter has some space to agree on a compliance framework with the LP.
For the latter, for blind-pool funds, only funds raised after January 2, 2025, are directly affected by the new regulation. The capital call for the investment of the existing stock funds is exempt for US LPs, and they cannot refuse to contribute.
When we help many fund clients design response plans for the new regulation, we find that the scales of different funds are different.
Some funds have relatively strict and conservative risk control, believing that reporting transactions involves the disclosure of too much sensitive information about China. US LPs, especially university endowment funds, are also unwilling to be exposed to the records of government departments voluntarily, so such transactions cannot be touched.
This means that the fund manager needs to make a written commitment to the LP that the fund will not participate in prohibited or declaration-required projects, especially in the currently popular ones. For example, the space for investing in the AI track has been greatly reduced.
However, some other funds believe that reporting is also compliance. Since there is such a legal channel for investment, why not use it to participate in some promising projects. For example, set a frequency limit of investing in X declaration-required projects within one year to avoid the situation where the LP questions why the fund could have invested but missed it when a star project appears in the future.
「DarkTide」: Has any GP encountered difficulties directly in the recent fundraising due to the new regulation?
Liu Zhen: Encountering difficulties will not be because of the new regulation. Capital is always very sensitive to the macro political and economic environment. In fact, in the past few years, fundraising and investment in US dollars have not been easy under the attack of multiple factors.
But at the same time, it should also be realized that the essence of capital is to make money. In the golden decade of China's venture capital in the past, the Chinese market is the market where investors outside the US mainland have made the most money, without exception. US LPs are intimidated by many objective factors including the new regulation, but they are still watching.
After going around India, Southeast Asia, Africa, Latin America... US LPs also realize that China's innovation market and investment environment are relatively more mature. They will say "Let's take a look again", but rarely say "We will never invest in the Chinese market from now on".
For GPs, the more direct impact of the new regulation is how to tell my fundraising story: If AI is the hottest track that everyone is betting on, and we cannot use investing in AI in China as the core of fundraising due to the new regulation, then what is the investment logic of my new fund and how to build the team.
「DarkTide」: What are the main concerns of US LPs now?
Liu Zhen: There are actually quite a number of US LPs coming to China this year. Although they have made fewer investments, they have been watching curiously. So I don't think they have more concerns, but rather want to know where the opportunities are and when the window of opportunity is.
Investors who shouted that China is "uninvestable" two years ago are not so loud now. After all, as "born global" Chinese entrepreneurs seize the market around the world, it is unwise to completely exclude China from any investment logic.
In the final analysis, the demands of US LPs have never changed. In short, it is "both and", that is, they want to not step on the government's red line and make money, and Chinese or Chinese-origin enterprises can make investors make money.
「DarkTide」: If a US dollar fund has only one GP who is an American, is it also affected by the new regulation?
Huang Minda: (1) Assuming this US dollar fund is established in the US, regardless of the nationality of its partners, it will be subject to the new regulation.
(2) Assuming this US dollar fund is established in a third country (such as the Cayman Islands), if it is considered to be controlled by this general partner, for example, the fund is also subject to the new regulation.
The word "control" also has a lot of room for interpretation and is not limited to 50% of the equity. Affecting the fund's decision-making through various methods may constitute control. From a cautious perspective, US dollar funds with an American general partner should consider complying with the new regulation.
(3) Even if the fund is not regarded as a controlled entity of this American partner, this American partner should take reasonable measures and must not instruct the fund to violate the provisions of the new regulation knowingly.
「DarkTide」: Can a Singapore-licensed US dollar fund effectively avoid the impact of the new regulation?
Huang Minda: For funds established outside the US, the core also depends on whether the fund is controlled by an individual or company in the US. For funds that intend to invest in the Chinese market, it becomes very delicate if an individual of US nationality holds a management position or enjoys major financial rights.
「DarkTide」: For example, if a startup is a non-restricted category when it is financing, but later its computing power increases to a prohibited category. In this case, is the GP responsible?
Zhang Ruiyuan: At the time of the investment, did the GP know that this would happen in the future? If you have no reason to "know", there is no problem. When measuring whether "knowing", the US Department of the Treasury considers in general what information Americans obtained at that time, or what information could have been obtained through reasonable and diligent investigation. For example:
Whether the fund has made efforts to obtain some relevant non-public information;
Whether the fund deliberately does nothing to avoid obtaining relevant information that may prove that the target is restricted;
Whether the target company has any warning-sign behaviors such as deliberately avoiding, evading, or remaining silent and not providing information on relevant issues;
Whether the fund reasonably uses public information and available commercial database and other resources to verify the situation of the target.
If the US Department of the Treasury obtains information about the target company engaging in restricted businesses through media, think tanks, and other channels, it is untenable for the fund to claim that it knew nothing about it when investing.
「DarkTide」: How to view the survival environment of US dollar funds in the future? What specific predictions are there for them?
Liu Zhen: Those who stay at the table are definitely optimistic, and those who are pessimistic have already left. They think there is no hope, which is understandable, but the market development must rely on those who are willing to take risks.
US dollar LPs have made more profits in the past decade. They cannot find a substitute for China in other markets. Therefore, as a part of the venture capital market, US dollar funds will exist for a long time.
Thinking about this problem in reverse, basically, the largest high-tech enterprises in the Chinese market today have developed with the continuous support of US dollar funds.
US dollar funds need the Chinese market, and the Chinese market also needs US dollar funds. Like any curve, it has troughs in its micro development, but it will rebound sooner or later. The key is who can persist until that day.
N Possibilities for Entrepreneurs
「DarkTide」: How much impact will this new regulation have on the company side, especially companies in the AI field?
Zhang Ruiyuan: The impact on the model is very clear, and the application is indeed a bit tricky. The new regulation has a lot of content explaining its legislative background and why it needs to be reported. It may want to understand to what extent the development of sensitive industries in China has reached through all cases.
Moreover, the US Department of the Treasury does not divide company types by "LLM" and "non-LLM". On the contrary, the "development (develop)" of "developing an AI system" in the new regulation encompasses any stage of activities before the mass production of the product, and also includes "substantial modification" of the third-party large model used