(Bloomberg) — Sequoia Capital and its Beijing affiliate have spent over a decade scattering more than $10 billion across China's multitude of startups, backing the likes of ByteDance Ltd. and JD.com Inc. while becoming a powerhouse brand among the venture firms aiming to strike it rich there.

Now, the prospects for investments in that country are mired in uncertainty, as regulatory actions on both sides of the Pacific squeeze China’s technology industry and create unpredictability for its financial backers.

Sequoia remains optimistic about China over the long term, according to people familiar with the matter, and continues to be highly profitable there. It helps that the health-care industry, which has not yet been a focus of Beijing’s recent crackdowns, represents about a third of Sequoia Capital China’s roughly 600 portfolio companies and around half of its initial public offerings for the first six months of this year. But the cascade of policy changes makes for delicate strategic maneuvering in a region that offered Sequoia and its rivals seemingly unbound financial promise not long ago.

A key issue for Sequoia in China is a July overhaul of rules for education-technology companies, which now ban some of these businesses from taking foreign capital and require them to become nonprofits. Sequoia has some of the biggest exposure to China's education-technology sector among venture firms, according to researcher Preqin. It has invested in Huohua Siwei, which was valued at $1.5 billion this year, according to local media, and Zuoyebang, which fetched a $3 billion valuation in 2018.

Sequoia China, which operates largely separately from Silicon Valley-based Sequoia Capital, is still weighing what to do with those investments, according to a person familiar with the matter. Both Huohua Siwei and Zuoyebang might have to spin off units that include out-of-school tutoring classes for younger students, a potentially drastic change to their business models. Another portfolio company, VIPKid, said recently it would stop selling classes in China that are led by instructors based outside the country.

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Foreign investment within the education sector has been no secret. So Beijing’s move on that industry “fits the overall more confrontational stance of the government to take on the U.S. and assert its dominance as the global superpower,” said Ayako Yasuda, a professor of finance at the University of California, Davis. That, in turn, “puts U.S. VCs active in China, like Sequoia, in a complicated position.”

New Business Terrain

While the education-technology rules present the most immediate challenge, they are just one component of a multi-step crackdown in China as the government aims to tighten its grip on some of its splashiest businesses. Officials have moved to investigate everything from monopolistic practices to data security and user privacy protection. Ride-hailing giant Didi Global Inc., for example, is undergoing a security review during which it is unavailable for download in China. Sequoia only holds a small stake in Didi, but some other companies in which it is a larger shareholder have had their own problems. JD.com's financial affiliate is undergoing overhauls per demands from regulators. TikTok parent ByteDance is working to ensure it complies with data-security requirements before going public, an undertaking that comes after meetings with Chinese government officials over the issue earlier this year, people familiar with the matter have said.

Meanwhile, the U.S. has stepped up scrutiny of Chinese companies that want to list on New York exchanges, including a new requirement for them to disclose whether they received permission from Chinese authorities to do so. That decision was made after Didi was put under review by Chinese regulators and after it emerged that Didi was advised by China’s cyberspace authority not to go public in the U.S.

Sequoia is just one of many investment firms navigating new business terrain in China. Coatue Management, SoftBank Group, Lightspeed China Partners and DST Global are among the entities with stakes in some of the same Chinese companies as Sequoia. Still, Sequoia China stands apart. It started investing in the country years before most and still invests at very early stages. The strategy has led to it owning large stakes in high-profile Chinese IPOs.

This positioning makes for an unenviable task for Neil Shen, the investment guru who has run Sequoia’s China presence since 2005. While many rival firms have committees outside China that approve or nix investments there, Sequoia China is one of the few with its partners making their own on-the-ground decisions. Shen has overseen a series of China-focused funds, including the recently raised Sequoia Capital China Growth Fund VI and Sequoia Capital China Venture Fund VIII. Together, those two funds raised more than $4 billion, according to a person familiar with the matter.

Shen has adeptly managed relationships with startup founders, Chinese officials and a global investor base. Now, as even the most successful Sequoia portfolio companies are getting caught up in the crackdown, investors are wondering whether his connections with government bureaucrats will provide much value and how much protection from investigations and draconian rule changes, if any, Sequoia China’s portfolio companies might receive.

Shen, along with U.S.-based Roelof Botha, has been considered a contender to become the de facto leader of the firm, taking the mantle from Doug Leone. If he is unable to successfully manage the portfolio through this moment of tumult, it could hurt Shen’s chances. The firm has made no announcements or decisions on its succession plans, and for now, Shen is in good standing, with the China funds showing solid returns, according to a person familiar with the situation. Sequoia China and Sequoia Capital declined to comment for this story.

A ‘Complicated Dance’

Sequoia’s China portfolio is important to the company’s wider business ecosystem. Sequoia is an umbrella brand for three different venture entities: one focused on China, another on the U.S. and Europe, and a third for India and Southeast Asia.

The China portfolio companies account for a sizable chunk of the venture capital behemoth’s global growth funds — for one such fund, more than half. Generally, money from that pool of capital is used to provide large follow-on investments into existing Sequoia-backed companies. The firm raised its third global growth fund, of $8 billion, three years ago.

Limited-partner investors typically commit to multiple Sequoia funds. Yasuda, the UC-Davis professor, said the latest regulatory changes may nudge Sequoia to make less effort to jointly market its funds, as some U.S.-based investors reconsider how much they want to back Chinese companies. At the same time, Yasuda suspects others will see China’s distancing from the U.S. as a reason to invest there more, as a hedge against any relative U.S. weakness.

“There is a tension between the two ways of thinking, and that again adds to the [venture firms’] complicated dance,” she said.

For now, investors worry about whether China’s crackdown will end up engulfing an even wider swath of consumer-oriented companies, and that it won’t matter how carefully CEOs cultivated government officials and endorsed Communist Party rhetoric in the past. Tencent Holdings Ltd., a company known for being compliant with government demands, was still fined for anti-monopoly practices and accused by state media of inducing gaming addiction.

The government’s latest moves have been enough to give at least one prominent investor cold feet. On a recent earnings conference call, SoftBank CEO Masayoshi Son told analysts, “We don't have any doubt about future potential of China, but again new rules and new regulations are beginning to be implemented. So until things get settled, we want to wait and see.”

Lines of communication between big-name firms and top government officials are still open, people familiar with the situation said. Still, many officials not directly authorized to talk with investors and entrepreneurs have stopped responding to overtures and phone calls, a change from the past when many bureaucrats would help smooth startup paths.

Yet another fresh hurdle for the venture firms could come from China’s entrepreneurs, some of whom are starting to say quietly that taking money from top players like Sequoia will hurt more than it helps, because those firms are so high-profile that their investment attracts intense scrutiny from regulators.

About one-third of China deals by value include U.S. investor participation, according to PitchBook, a percentage that has held fairly steady over the past five years. In 2020, some $25 billion in venture-capital fundings in China included participation by U.S. investors, according to PitchBook. This year through Aug. 2, some $20 billion in deals have included U.S. participation, with almost five months left in the year.

Investors in venture funds with China exposure said the funds largely have not publicly criticized the regulatory moves, perhaps mindful that any letter or email might be read by Chinese officials and could lead to negative repercussions. The firms are often trying to put a good spin on the situation, telling investors, for example, they anticipate pressure will ease over time.

“Those who know aren’t talking,” said one investor in several affected funds, who declined to be identified because the situation is sensitive. “And those talking have no clue.”

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