The Death of Risk Capital: How Hefei’s Government Fund Is Rewriting the Rules of Tech Dominance

Why Silicon Valley’s ‘fail fast’ era is over. and why states now engineer industries into existence (with 600% returns to prove it)

Hefei City: Hefei City

Am about to wrap up my week of learning more about HEFEI and all of a sudden I realised something I hadn't panned out to find. The Fact That The City Government is now the Venture Capitalist and is now literally engineering Industries into existence. I feel this is too important for it to be left in my heart as I believe we are about to Witness a seismic Shift we have never seen before. Earlier today I responded to an article by

The Startup Guy

on Industries that had the Kodak Moment, my comment here. I said that Silicon Valley will soon become obsolete. I said this off my head because of what I had seen as i learnt more about HEFEI. I kept thinking about it and then when I did a search I bumped into this defining article from Caixin Titled: Venture Capital in China Flounders as State Takes Over.

I just said let me come here and share my thoughts, that soon Venture Capital as we know it shall be obsolete. If, (as the article mentions) traditional Venture Capitalists in China are struggling because they can't compete with State Backed Funds, Provincial and City Government Funds not only bring Capital but ensure the ecosystem that makes companies thrive exist. Since I only have information from HEFEI, and HEFEI as noted in the Caixin 2023 article is China’s top VC. The best term to use for this kind of Financing isn’t Venture Capital but maybe Industrial Investment as it basically propels the whole industry.

Beyond Venture Capital: The Industrial Capital

The difference between Hefei and traditional VCs is the focus, whilst the other focuses on would be winners, Hefei Engineers industrial Ecosystems. They did this through 3 strategic Decisions

1. Pre-build Infrastructure before market existed

Hefei Local appliance manufacturers like Midea (5M Unit Appliances/yr plant), Gree (8M AC/yr Factory), Hisense (10 million unit TV Factory) were mandated to source their LCD/OLED panels from BOE under the 合肥市新型显示产业配套采购指导目录 (Hefei New Display Industry Local Procurement Guidelines). This created instant demand for a Factory that had not yet produced a single screen. This captive market strategy de-risked the investment and ensured 70% utilisation from day one.

Key Terms for this investment ($4.2B Gen 10.5 LCD Factory): 2015 to 2018¹

1. State Banks (50% at 0% interest)

2. Hefei Government (30% stake)²

3. BOE 20%

By 2020, BOE was the #1 Global producer of LCD panels surpassing Samsung.

The Government invested even more to BOE: Phase 2 (2020 TO 2023) | OLED Expansion $1.8B and Phase 3 (2024 -) | $1.3B | Micro-LED Joint Venture

The main difference here is that in Traditional VC scenario, the VC will fund innovation, BUT this State fund lays foundation for monopoly.

2. Mandate Demand

i. How Anhui Built an EV Empire overnight

When NIO was facing Collapse in Shanghai, the Anhui Government offered a Bailout that essentially propelled the EV Industry in that Province.

The State funds (Hefei City Construction Investment and Anhui Provincial Emerging Industry Fund) provided a $1B Bailout (for a 24% stake) to the floundering EV maker. The deal also included land to set up the Factory and this birthed the NEO park that not only houses NIO but also component suppliers.

This deal had two main condition,

• NIO had to source at least 40% of inputs from within Anhui province.

Pre-Bailout (2019) Anhui only had 12 EV Suppliers with an annual output of 48,000 units a year. By 2023 there were now 1200 EV Suppliers (incl component suppliers - electric motors / Jee, batteries / CALB, automotive glass / Fuyao etc) with an annual output of 520,000 EVs.

The results of these decisions are outstanding as NIO’s market cap grew from $3B in 2020 to 30B in 2023. The Auto sector now accounts for 18% of the provinces GDP. In 2022 Volkswagen shifted its EV R&D Department to Hefei.³

• NIO Had to relocate its Main Headquarters to Hefei

Hefei moved its main Headquartes to Hefei as part of the Bail out conditions. By anchoring NIO in Hefei, suppliers were forced to follow (finding receptive conditions at the NEO park). This turned a corporate rescue into an Industrial Revolution.

ii. How Hefei Forced a Quantum Leap

In 2017, The Government (Through Hefei Industrial investment Fund) seeded Origin Quantum with $110M⁴ with only one condition that they commercialise the University of Science and Technology of China (USTC) quantum patents within 5 years. 11 USTC Professors were ordered (State Council Directive #2017:09) to spin out research, whilst salaries were more than doubled matching the US Post Doc Offers.

To ensure its success, the Government forced demand with Pre-Commit purchases that led to the State Grid purchasing $29M worth of unproven quantum Cloud Services in 2021. Origin’s Quantum encryption was to be used on the Belt and Road Projects with the Pakistan’s Gwadar Port being one of them. There was also Academic Capture as USTC papers had to cite Origin IP.

By 2023, Origin had 128 Quantum Volume compared to the IBM at 64. Its cost per Qubit was way lower ($8,200) compared to IBM at $27,000. Their Key advantage was that the Municipal Fab 9 (Hefei Advanced Semiconductor Manufacturing) supplies the customised chips. This gives a 48 Hour urn around whilst its competitors have to import (TSMC).

OriginQ’s 72 Qubit ‘Wukong’ was a resounding success as it became China’s first super conducting quantum processor to achieve industrial scale applications. They secured $130M pre orders mainly from state owned enterprises before completion of its prototype⁵.

3. Capture Talent

Hefei has a Coercive retention model that ensures over 70% of its graduates⁶ remain in Hefei’s Quantum / Tech Sectors (vs. <30% at MIT or ETH Zurich). This is achieved through many embedded systems BUT the ascendance of HEFEI into a Tech Industry giant is an attraction by itself for most. This captive talent pipeline is actieved through Patriotic mandates⁷, subsidized housing (up to $750,000 BUT stay for at least 10 years) and 5+ year contractual obligations for state funded PHDs.

PROFIT RE-INVESTMENTS

One condition that Hefei set to ensure the ecosystems thrive was to lock the profits of the Industry Champions it financed (BOE, NIO etc) into investing in local R&D, startups, and infrastructure. In the case of BOE, its 2020 agreement was such that 30% of its profits should be invested in Local R&D, in this case the Hefei BOE Display Technology Research Institute⁸. As for NIO, through the 2022 Amendment, 20% of its Anhui sourced Revenue⁹ was to go towards the NeoPark supplier incubator.

The City of Hefei holds Golden Shares (1% stake) in both companies, it has veto power over profit use. In 2023, the City blocked BOE’s planned SOuth East Asia expansion and forced investment in the Micro LED R&D in Hefei.

This has created a closed loop industrial engine where success is mandatory and every yuan is availed for the next technological battle. This instantly creates an industrial base in the city such that downstream industries are attracted to the city. By 2023, BOE’s investment in R&D led to 14 new Display patents and for NIO, it had invested in 23 local battery firms.

Firms comply for many reasons BUT the 50% Tax rebates are a major factor and if you don’t comply you lose the Factory sites.

Contrast this with Apple’s $110B stock buybacks in 2023, Hefei’s model prioritizes industrial expansion over shareholder returns.

The Governance Paradox

This system shouldn’t work under normal circumstances given the thin line between power and resources, which usually leads to cronyism (pushing investements to related firms), overreach (propping up firms for numbers just to score political points) and Resource Hoarding (Protectionism stifling competition). Despite all this the system seems to strive mainly through the dual track system in China.

The Central Commission for Discipline Inspection¹⁰ (CCDI) plays a critical role and has seen Hefei officials jailed. The 2023 case of Hefei’s former science Bureau who was jailed for favouring his nephew’s EV startup. Officials also face personal liabilities for losses above 15%…. Beijing might also rotate officials every 3-5 years if they so wish so as to reduce the cases of fiefdoms. The Quantum Capital’s founding CEO was reassigned to Shanxi in 2022.

STATE OF VENTURE CAPITAL

How Hefei’s Playbook Killed Private Financing.

As per the Venture Capital in China Flounders as State Takes Over 2 Part Article on Caixin, Venture Capital is now floundering in China mainly because the other Provinces are learning from Anhui and the city of Hefei. By 2023, state funds led rounds greater than $100M, and Private VC deals were down 82% and 76% in AI.

This model is now being replicated at scale and given the fact that there are Universities in each province that can replicate USTC, this can be pulled off. There are now clear examples like the Xi’an case where XJTU Graduates are now locked in using 5 year Patriot clauses and in Suzhou, the city owned Bio Tech labs are providing the stabilising base, whilst in Wuhan there was a mandate to purchase local EV Batteries.

The main issue is that for State Financing, its very silent capital looking at, at least 15 years of waiting whilst VC is around 7 years. With State Financing the startups are sure of off take demand through mandates and VCs can’t provide this¹¹.

The VCs who will survive are those who take a gamble and finance startups way before the state notices them.

Impact on Silicon Valley and Global Start Ups

The three Lock system Hefei perfected Mandating demand, talent lock up and Patient capital poses existential risk to Silicon Valley as whats possible in China can’t be (talent lockup is illegal) done or takes forever (CHIPS Act took over 2 years). So for heavy tech in AI, Quantum and Chips, they have to think so much about their location as they will always be out competed by the Chinese startup that have all three.

Over time, i foresee Startups in Key Areas that can enjoy Financing and Propelling in China choosing to settle in China, like the German Biotech Startups relocating to Suzhou to access the pre-funded labs or the Israeli AI Firms in Shenzhen. In Reality the $1B checks in Hefei dwarfs Seuqoia’s $50M Series financing. Startups in Areas that China doesn’t care about like Consumer Tech or Protected like Data Sensitive won’t be moving to China as there are no benefits at all for that. Silicon Valley might lobby the State BUT we all can foresee the outcome as USA doesnt work on mandates the way China does.

With this Silicon Valley might end up being a place to finance light Consumer Apps and SAAS in none strategic Sectors. This will lead China creating Deep Tech Monopolies; State backed Giants in Hardware, Quantum, AI, Bio Tech and Energy. For investors the best is to Avoid any startup thats in the radar of China state financing and they might flounder as they fail to out-compete their Chinese competitors. Alternatively they bet on Areas China has no interest in like Crypto, Privacy Tech etc.

Hefei isn’s out competing Silicon Valley of Private Financing in general, its just proved that in strategic industries state funded Capitalism out competes venture funding.

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Conclusion

There is a silent Paradigm Shift happening in the Financing Sector that has seen a major entrant who is too big not to force a collapse on what we had assumed is here to stay. By Merging Finance, Policy and Academia, China is rewriting the rules of Tech dominance and has shifted the attention from the West to the East.

For Deep Tech, Venture Capital is now obsolete as it doesn’t have what it take to fund long as they can’t just pre-fund, pre-sell, pre-scale the critical industry the way China Government can. Talent is no longer free market, as the state now controls housing, research grants and the issuance of the very degree. Without these Cohesive tools, the US, EU and other Western entities can not counter, leading to a structural disadvantage in Quantum, AI and advanced Manufacturing.

With time, we shall see China winning in areas where Capital Intensity in in the radar of State priorities, thus Hardware, Energy and BioTech. On the other end Silicon Valley will slowly retreat to Software (even this is under danger of some Chinese Provinces that cant compete in areas of major state interest picking this. This is already happening with Hangzhou creating a SaaS, Gaming incubators in Chengdu, leaving Silicon Valley with crypto and other niche B2B that are actively suppressed by China.

China’s second tier cities are focusing on Apps, in 2023 the Hangzhou Government mandated that local firms use made in Zhejiang CRM tools. Chengdu offers a 5 year tax holiday for Game developers who stay. State Funds have begun letting VC act as scouts and they take over Series B.

The Defining battle of our era, is who controls the stacks, from chips to talent. Hefei has written the playbook, other cities in China are replicating at ruthless scale and speed and the West can only watch, paralysed as a whole industry goes through its own Kodak Moment. The irony? Kodak’s collapse took decades; this disruption will hit before most VCs finish their next fundraise.

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SOURCES

1. Hefei Govt 2015 Announcement:《合肥市新型显示产业基地建设实施方案》

2. BOE 2016 Annual Report Pg 8

3. Hefei’s Rise to Tech Hub

4. Origin Quantum 2023 Annual Report: (Page 4: Govt funding breakdown)

5. Origin Quantum 2023 press release

6. USTC 2023 employment report

7. Hefei "Talent War" policy docs

8. BOE 2020 Annual Report, Page 23

9. NIO China 2022 Financials Note 12: "Reinvestment Commitments"

10. CCDI Annual Report 2023: Case Studies in Tech Fund Oversight

11. PwC China VC Report 2024: 73% of VCs say “policy risk now outweighs market risk