When you think of venture capitalists, you usually think of a familiar list of names from Silicon Valley—yet the one you would least expect to find on it might be Xi Jinping. On July 27th, China’s biggest modern chip-producing company, CXMT, went public at 8.66 yuan per share and raised 57.9 billion yuan (8.6 billion USD).
The shares closed +466% on debut, valuing CXMT at 3.3 trillion yuan, and placing it as China’s most valuable publicly listed firm. This development is particularly favourable for the Chinese government, which is the company’s largest equity owner and earliest investor. It is estimated that the government has seen a 40-fold return on its capital invested.
Xi Jinping, venture capitalist. This is not out of the ordinary for the CCP. Xi Jinping has become the country’s greatest venture capitalist, as he increasingly uses government funds to invest in transforming China into a high-tech powerhouse. The government’s investments stretch across green energy, electric vehicles, semiconductors, batteries, drones and even flying cars.
- By the end of 2024, the government had pledged 12 trillion yuan across 2,000 state-backed funds, with the money pouring into China’s tech sector and redefining the Chinese economy. CXMT was Xi’s most successful investment yet, for three reasons. This investment and CXMT’s success bolster state efforts to erode foreign dominance in high tech and make China more self-reliant.
- It also brings a major return to the state’s treasury, and importantly, preserves a good degree of state control over the company. 15 state investors own 36% of the firm directly (a position worth about 1.1 trillion yuan), but the government’s exposure is even higher if we factor in public stakes in private funds that own CXMT.
This specific investment strategy has been dubbed the Hefei model, after the name of the city where it was first implemented in 2008. The playbook is simple. The government, instead of providing a loan or a subsidy to a strategically important firm, acquires an equity stake in the company.
- This gives much-needed capital to the firm, allowing it to expand, whilst leaving room for big upsides and profits for the CCP, as seen in the case of CXMT. An important aspect of this strategy is its industrial dimension. In exchange for capital, firms are made to ground either their HQ or their supply chain in the city providing the funds.
- This approach has helped the city of Hefei to create a massive supply cluster that generates over 200 billion yuan per year. Therefore, the state becomes both an industrial investor and a venture capitalist. This is exactly how Xi has modernized and bolstered Chinese industry whilst also essentially building up a portfolio of stakes in promising firms.
The limits of the Hefei model. Nonetheless, this approach is not without its caveats. Economists acknowledge that the Chinese government also holds far less profitable investments as it became one of the most important sources of funds in the tech sector following a political crackdown in the field starting in 2020.
- As a consequence, this has led to government investors supplying 90% of the capital committed to private equity markets. This leads to fears of crowding out private capital, misallocation of funds and the concentration of losses of taxpayer money. This concentration of losses is seemingly already observable, as reports suggest the party will need more “wins” such as the one brought by CXMT to cover its failed investments elsewhere.
- This high concentration of state capital has also led to corruption scandals, such as a significant one in 2022 in the semiconductor industry. It has also led honest officials to fear corruption accusations if reasonable investments stall or go bad. This often leads them to impose a lot of restrictive provisions on the startup founders, which often counterproductively stifles growth rather than stimulating it.
What Europe can learn. What can Europe learn from the Chinese model, despite its imperfections? Should Ursula von der Leyen also become a venture capitalist, and begin building up a portfolio of EU-held shares of promising startups? Not exactly. Europe, unlike China, is structurally restricted by the Treaty on the Functioning of the European Union. Article 107 of said treaty states:
- “Save as otherwise provided in the Treaties, any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market.”
Whilst this doesn’t make EU spending in the economy impossible, it does force Europe into subsidy logic rather than equity logic. This can be seen currently, for example, with the €2 billion grant given by the Italian Ministry of Enterprises and Made in Italy to STMicroelectronics to build an integrated chip manufacturing plant in Catania.
- The state carries execution risk and reputational risk but essentially captures none of the direct reward. Jobs and tax revenue will be created, but Italy misses out on equity appreciation. That being said, the EU does not directly ban state equity investment. In fact, the European Innovation Council (EIC) Fund already takes direct stakes in startups.
- The reason why this is not common and is constrained is that the Union abides by the market economy investor principle, which stipulates that a state can invest as equity only if it does so on the same terms a private investor would, meaning it does so expecting a clear market return. Whilst this undeniably sounds reasonable, it runs counter to the Hefei logic used by China. The value of this approach for the state was that it would become the investor of last resort.
This is exactly what happened in 2020 when Hefei bailed out NIO after 18 cities and every VC had already passed. The EU thus can never be this investor of last resort, and thus is missing out on potential opportunities that its unique nature as a state investor would allow it to profit off of even if private capital would not.
- The solution is thus to allow the EU to invest patiently and countercyclically without being disqualified by its own financial rules. It is ridiculous for Brussels to penalise states for not acting and investing like hedge funds.
Building patient European capital. The EU is also constricted in regard to big investments by the rules that accompany Important Projects of Common European Interest (IPCEI) investments. Before a single euro is moved, 14 member states need to jointly notify and get the Commission to sign off on the investment. This is complicated by the fact that leaders are often severely hindered in this regard by domestic electoral cycles.
- Both of these pressures and constraints do not exist in China’s one-party state, and Xi can thus invest at will given the opportunity to do so. It is not as if Europe lacks the infrastructure for patient investment.
- As highlighted by Mario Draghi in his competitiveness report, the NextGenerationEU (NGEU) fund is the perfect precedent for a deeper European capital instrument, as it is proof Brussels can build multi-year, election-insulated financial structures.
- It is only natural, therefore, that the Union should apply the institutional technology more efficiently by extending it to venture-style equity bets as Xi has done in China.
Europe is also specifically suited to avoid the major pitfalls of this system. The IPCEI’s leverage design is specifically designed to avoid strong state capital concentration as is the case in China, where it reaches such extremes as 90% of all credit in private equity.
- This is exemplified by the IPCEI on Microelectronics and Communication Technologies, which uses approximately 8 billion euros in public funds to support nearly 14 billion euros in investments from the private sector.
- Additionally, Europe’s multi-state notification and Commission scrutiny are precisely designed to avoid opacity and corruption, two issues with the Hefei model in China.
The missing exit strategy. A venture capitalist nonetheless does not merely write checks. They provide capital but need an exit for it, so they can recycle it for their next bets. China struggles with this despite having built a captive venue for it, the STAR Market, a tech-focused equities exchange hosted by the Shanghai Stock Exchange and launched in 2019.
- It was designed on purpose to allow both the state and private capital to eventually cash out of domestic tech bets. Nonetheless, this solution is only effective to a limited extent, as it is held back by a 3-year lock-up period for newly acquired shares and a limited pool of buyers.
- This can be seen by the fact that the STAR 50 Index dropped 16% in the month before CXMT’s IPO as investors pulled cash to fund their purchase.
The exit problem Europe cannot ignore. Despite all of this, Europe’s version of this dilemma of an exit strategy is decidedly worse, as fragmentation plagues the Union. As highlighted by Draghi in his infamous competitiveness report, no EU company built from scratch in 50 years has crossed 100 billion euros in market cap, compared to 6 US companies above 1 trillion euros in the same window.
- European scale-ups that need growth capital or a real IPO venue go to the US because there is a lack of a single deep European pool to sell into. If Brussels implements the above-discussed solutions for more equity-style patient capital investments without fixing this exit strategy issue, it will solely recreate China’s illiquid stake problem through a different mechanism. China’s state currently holds a growing pile of positions it cannot exit because of capital controls and thin buyer pools.
- A Europe that embraces the Hefei model without a capital markets union would end up holding a diverse portfolio of positions it cannot exit, as this pile of positions and stakes would be trapped in 27 separate sub-scale national markets.
- This is why a true capital markets union, as advocated by the Draghi report, would be the precondition for a “Hefei-style” Europe that can finance its startups and thus drive its own innovation in tech rather than just borrowing Washington’s.
This is why Europe does not need a single-style VC that acts as Xi does in China currently. That would be neither feasible nor desirable for the Union. No one wants Ursula von der Leyen or any other official sitting at the top of a portfolio worth trillions. Rather, instead of one VC-in-chief, Europe should aim to develop a vast multitude of “Hefeis.”
- The candidates already exist. Between Catania with STM, the regional investments of the Cassa Depositi e Prestiti, France’s Bpifrance-backed clusters and Germany’s Länder-level industrial funds, Europe has more than enough resources to create a multitude of innovative clusters just like Hefei.
The bottom line: What must now be built is the connective tissue between them that can truly allow these to flourish, expand and multiply.
- This is the main role of the Capital Markets Union, to pool all of these small individual and regional bets, which alone are too small and illiquid to matter, into a larger pool that acts in practice as Xi’s portfolio does, decentralized in location but united in where the capital eventually exits and is recycled.
- A pure copy of the Hefei model in our Union would be counterproductive. What Europe needs is a European solution to our European problem. Beijing has found its venture capitalist in a single man. Brussels will have to find ours among twenty-seven countries.
