By Shelly Banjo, Lulu Yilun Chen, Janet Lorin and Adrian Leung
The growing tension between China and the U.S. over trade and technological dominance is shining a spotlight on the billions of dollars that U.S. pension funds and college endowments have channeled into Chinese technology companies in search of investment returns.
China has become a rising power in technologies like artificial intelligence and facial-recognition software, helping fuel a trade dispute with the U.S. that escalated again over the past week with tit-for-tat measures from Washington and Beijing. Yet a large chunk of the capital behind China’s success can be traced back to U.S. funds that manage money for Texas teachers, San Francisco firefighters, Minnesota policemen and Louisiana judges.
It works like this: Pension funds from California to New Jersey and college endowments pour money into venture capital and private equity firms, which scour the globe for the best investment opportunities. In recent years, many of these firms have turned to China, helping fuel the success of global giants such as Alibaba Group Holding Ltd. and rising stars like drone-maker DJI and artificial-intelligence pioneer SenseTime Group Ltd. Pension and endowment fund managers may recognize such investments could become politically unacceptable, but they also have a fiduciary responsibility to pursue lucrative returns for their clients.
“Whether teacher unions and college endowments should be helping to fund the rise of China’s technological skills is a completely valid question,” said Paul Gillis, a professor at Peking University’s Guanghua School of Management in Beijing. “We’re not there yet, but we could get there quite quickly.”
The strategy is starting to come under attack, notably in June from U.S. Senator Marco Rubio. The Republican warned the U.S. needs to become much more careful about providing money to a country that is increasingly contending for global leadership. “We can no longer allow China’s authoritarian government to reap the rewards of American and international capital markets,” he said.
He also wrote to MSCI Inc., asking the global index provider why it added hundreds of Chinese stocks to its benchmark emerging markets index last year, causing billions of passive investment dollars to flow to Chinese companies. The MSCI emerging markets index is tracked by more than $1.8 trillion.
“Firms like MSCI have an obligation to make sure investors know whether their investment dollars are unwittingly aiding Chinese state-owned and state-directed companies linked to China’s efforts to steal American innovation, undermine fair competition, increase threats to U.S. national security and economic security, and support China’s systemic and egregious human rights abuses,” Rubio wrote.
In a later interview with Bloomberg, Rubio said he’s not advocating an all-out ban on U.S. investment in China. He suggested there should be a regulatory body charged with examining investments, modeled on the Committee on Foreign Investment in the U.S., which was recently granted greater power to restrict Chinese acquisitions of U.S. technology.
Rubio’s comments come during a sustained effort by President Donald Trump and his administration to scrutinize ties between the U.S. and Chinese technology companies such as Huawei Technologies Co. The U.S. blacklisted the telecom equipment giant this year as a threat to national security, cutting it off from American suppliers.
A spokeswoman for MSCI said it has informed Rubio that the company is preparing a reply to his questions.
Billionaire investor and Trump supporter Peter Thiel added fuel to the debate in a speech this July in Washington, criticizing U.S. tech companies that agreed to work closely with China. Thiel, who has mostly avoided investing in China, branded Google’s efforts to get its search engine back into China as “seemingly treasonous.”
Pension funds and endowments have been funding the country’s tech upstarts for years. DJI became the world’s leading drone maker with funding from a venture firm whose backers include the Delaware Public Employees Retirement System and the State of Michigan Retirement System. This year, the U.S. Department of Homeland Security warned that DJI drones present a security risk, a characterization that DJI disputes.
SenseTime, the world’s most valuable AI startup, has raised money from venture firms including those backed by the California Public Employees’ Retirement System, Washington State Investment Board, and the Teacher Retirement System of Texas. ByteDance Ltd., a leading developer of AI apps, has benefited from the backing of funds that raised money from New York State Teachers’ Retirement System, Oregon Public Employees Retirement System and the Minnesota State Board of Investment.
These investments have paid off. The Washington State Investment Board posted an internal rate of return of 24% from its investment in the Warburg Pincus China Fund between early 2017 and 2018. By comparison, the fund’s private equity portfolio returned 15.3% in 2018.
That will make it difficult for funds to change course on their China investments.
“This is the second biggest economy in the world and probably the only legitimate rival to the Silicon Valley tech ecosystem,” said Ashby Monk, executive director of the Global Projects Center at Stanford University who researches governance at institutional investors. “To shut off that market for soft political reasons would probably come close to a breach of fiduciary duty.”
More than 90% of U.S. foundations and endowments have some exposure to China, mostly through a broad emerging markets strategy, according to a 2018 survey of 47 respondents by consultant NEPC. That makes it harder to separate out China investments made through vehicles such as index-linked funds that allocate part of the money to China. Only about a tenth of the U.S. institutions have a dedicated China private equity or private debt strategy, NEPC said.
China is “too big to ignore,” said Doug Phillips, chief investment officer at the University of Rochester‘s $2.5 billion endowment, adding that he doesn’t plan to scale back investments in the country because of a potential trade war.
Still, some venture capitalists in China are already drawing up contingency plans.
“We have some worries about raising money from U.S. endowments and pension funds amidst the current trade tensions,” said Zhou Wei, who runs the two-year-old China Creation Ventures fund. More than a decade ago, Zhou helped Kleiner Perkins Caufield & Byers set up in China, when U.S. endowments and pension funds were looking to profit from China’s rapid internet growth. ”It’s now politically incorrect in the U.S. to be pro-China,” he said.
Zhou said he’s expanding his investor base to institutions in Europe and the Middle East in case U.S. pensions and endowments delay plans to increase allocations to China or choose not to direct funds to newer VC firms like his.
Anna Xu, co-founder of Hike Capital, which is in the process of raising a new fund of $300 million to $400 million, is also trying to expand its investor base beyond China and the U.S. “It’s much more difficult now to raise money,” compared with the firm’s launch in 2015, she said.
Attempts to stifle the flow of U.S. money into Chinese startups may also backfire.
“The model of raising U.S. money to fund Chinese startups that capture the world’s biggest internet market has worked successfully for two decades,” said Will Cai, a partner at Cooley LLP, who worked on some of the biggest Chinese tech IPOs. Private equity and venture capital firms “want this model to keep working, but they also have to seriously consider whether times are changing.”
Chinese tech companies secured a record amount of funding in 2018, just before the trade war went into full swing. Some of the largest venture and private equity firms–including Hillhouse Capital, Warburg Pincus and Sequoia Capital–also raised billions of dollars from a clutch of high-profile U.S. pension funds.
For example, Sequoia’s Global Growth Fund III, which includes investments in China, raised $6 billion, three times the amount of its previous batch, including money from the Washington State Investment Board. Hillhouse attracted more than $10 billion to its Pan-Asia buyout fund. It got support from endowments and pension funds, including the University of Texas Investment Management Co., whose board until recently included noted China bear Kyle Bass.
Warburg Pincus’s Global Growth fund raised more than $14 billion, with backing from state pension funds in Michigan, Louisiana and Washington. Sequoia, Hillhouse and Warburg Pincus declined to comment on their investors, known as limited partners, or LPs.
When contacted about their investments, the venture capital and private equity firms and most of the pension funds and endowments either declined to comment or did not respond to requests for more information beyond that available from public records.
The State of Michigan Retirement System said China investments represent a small part of its portfolio, while the University of Texas’ endowment said it aims to maximize long-term performance and has a policy of not discussing its underlying investments. Pennsylvania’s Public School Employees’ Retirement System said it would continue to evaluate future investments in China as it sees opportunities.
Last year’s fundraising frenzy coincided with a flurry of 435 IPOs from companies based in China that bolstered war chests before the trade war began to take its toll.
As the Chinese economy weakened and the conflict intensified, Chinese VCs have experienced a precipitous drop this year. Venture deals are down 77% in the second quarter from a year earlier, according to the market research firm Preqin.
That doesn’t worry Liu Yuan, managing director of Beijing-based ZhenFund, which has invested in more than 600 companies in China. “Chinese VCs are being preemptively cautious when they think they need to come up with a plan B,” Liu said. “If the day really comes where U.S. pension funding gets cut, we can easily look for money in Europe.”
That cross investment between China and the U.S. evolved over years, showing some of the difficulties the Trump administration faces in trying to untangle ties with China.
“You really haven’t seen the Trump administration get into the weeds telling U.S. bodies where they can and can’t invest,” said Mitchell Green, managing partner of Lead Edge Capital, which is an investor in Alibaba and has about 20% of the $2 billion in assets it manages exposed to China tech. “That would just crash the market.”
Meanwhile, many U.S. endowments and pensions continue to invest in China. Two large pension funds recently committed to Warburg Pincus’ China-Southeast Asia II fund, which has raised $4.3 billion.
New Jersey’s Division of Investment, with $76 billion in assets, committed up to $100 million in the fund. The Washington State Investment Board, with $135 billion under management, in June approved a new commitment of up to $300 million and will continue to invest significantly in China, said spokesman Chris Phillips.
“Our investment teams are tracking current developments and the potential and real impacts of the ongoing tariff tensions,” Phillips said. “To date, these near-term developments are not materially changing our strategies as a long-term global investor.”
Jim Dunn, chief investment officer at Verger Capital Management, made the firm’s first investment in China about 10 months ago, putting less than $10 million into a American venture firm with a team working in China. The draw is simple.
“It’s betting on the consumer,” said Dunn, whose North Carolina firm oversees $1.7 billion including the Wake Forest University endowment. “I’m more bullish on the consumer marketplace in China than the U.S. for sure.”