Here’s one of the reasons why Donald Trump is limiting Chinese investment in the U.S.

Much of the U.S. government’s stance can be traced back to a report prepared by the U.S. Department of Defense, which warns of Chinese venture investors accessing “the crown jewels of U.S. innovation.”

Although the U.S. Administration is pushing to protects national security interests by blocking Chinese investments in the field of artificial intelligence, machine learning, drones, and cyber security, for some reason it has left investments in startups untouched.

Venture capital firm, Danhua Capital, has invested in some of Silicon Valley’s most promising startups including in areas such as those mentioned above.

Danhua Capital, based based just outside Stanford University, the epicenter of U.S. technology entrepreneurship, was established and funded by the Chinese government.

The hard line taken by the administration against Chinese acquisitions of U.S. public companies, has largely left investments in startups, even when backed by the Chinese state, untouched so far.

This could however change since the U.S. Congress is finalizing on a legislation that significantly expands the government’s reach to block foreign investment in U.S. companies, including venture capital investments.

The new law aims to empower the government’s Committee on Foreign Investment in the United States (CFIUS) with wide latitude to decide what sorts of deals to examine, eliminating certain ownership thresholds, with a particular focus on so-called “critical” technologies.

“The perception is that a lot of the tech transfer of worry to the U.S. security establishment is happening in the startup world,” said Stephen Heifetz, a former member of CFIUS and now a lawyer representing companies going through CFIUS review.

Although the latest version of the bill exempts “passive” investors which essentially covers many of the limited partners that back venture firms, limited partners that have some control over the business whose managing partner is a “foreign person”, can now be subject to scrutiny.

Chinese entities that have many times taken a passive role in big venture funds will now be in CFIUS’ crosshairs.

This possibility of a regulatory crackdown has sent down shivers in the startup world.

As per a source familiar with the knowledge at hand, Andreessen Horowitz, a venture capitalist firm , has begun counseling startups that if they raise money from a China-backed investor, they put themselves at risk of government scrutiny.

“The window for some startups to raise money from China may be closing,” said Chris Nicholson, co-founder of AI company Skymind, which has raised money from China’s Tencent Holdings Ltd and from a Hong Kong family office.

Scrutiny on funds of funds

Previously, the original sources of funds for venture capital firms have not been an issue in Silicon Valley. Since venture firms are not obliged to disclose who their investors are and since entrepreneurs rarely question them on this issue, a few deal makers are wondering how CFIUS could keep tabs on startup investments.

Investments made by Danhua Capital have been in areas deemed as most sensitive, including data management. The firm has also invested in Cohesity, a security company which counts the U.S. Department of Energy and U.S. Air Force among its customers.

Flirtey, a drone startup, which earlier this year in May 2018 was selected by the U.S. Department of Transportation to participate in projects to help the agency integrate drones safely into U.S. air space, is also a firm in which Danhua has invested.

According to Danhua’s founder, Shoucheng Zhang, who is a professor of physics at Stanford University, “Most of our (limited partners) are publicly listed companies in New York or Hong Kong stock exchanges. We will of course fully comply with any legislations and regulations.”

Cohesity declined to comment.

Flirtey’s spokeswoman stated, “We would not knowingly accept money from the Chinese government; we take investment from Delaware-registered, Silicon Valley-based venture capital firms”.

She went on to add, Flirtey would support any new “mandate that investors must disclose if they have any form of backing from government entities, to help ensure there is never a question in the future.”

Although capital controls have to some extent slowed down the flow of Chinese capital flowing into the United States since 2016, venture capitalist firms have been more resilient than other sectors, including the real estate, in part due to the Chinese government’s focus on improving its domestic high-tech industry.

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