China’s venture capital (VC) market has undergone tremendous growth in recent years and has emerged as one of the most important in the world. Despite being a nascent industry in China, it has made enormous contributions to innovation and entrepreneurship in the country, while successfully providing Chinese entrepreneurs with access to global capital markets.
Although entrepreneurship and private ownership are an integral part of Chinese history, developments from the 1950s to the early 1970s shifted attention toward state ownership and collectivism. It was not until the late 1970s, when Deng Xiaoping began to transform China’s planned economy into a market-driven economy, that private ownership and entrepreneurship were reinvigorated. Some academics believe that the birth of the Chinese VC industry can be traced back to the mid-1980s, when the Chinese government created numerous VC agencies to support the technology sector. However, during this period access to capital was limited, and most entrepreneurs relied heavily on family and friends for funds. As a managing director of a successful Beijing-based venture capital firm concludes, the concept of “equity ownership and capital investment needed time to take off.”
It was not until the late 1990s that the Chinese VC industry began to take shape. The initial wave of investments into China took place in sectors that closely mimicked successful initial public offerings (IPOs) in the U.S. Following Yahoo and the like, early VC activities in China focused on web directory ventures including Sohu.com andNetease.com, both of which listed on NASDAQ. The attention of Chinese VC firms then turned to Internet service providers and eventually to business-to-business companies, such as Alibaba. During these early days, prominent active VC firms in China included IDGVC, Softbank and Walden International.
Between 2001 and 2004, the VC industry was still small and activity was limited. There were no public listing exits and only three major foreign-led acquisition exits: 3721 Internet Assistant (a browser helper object technology acquired by Yahoo), Joyo (a web retailer acquired by Amazon) and Each Net (an e-commerce company acquired by eBay).However, in 2004, VC exploded following the successful IPO of Shanda (盛大互动娱乐有限公),which yielded a 1,300% return for the Softbank Asia Infrastructure Fund. Other subsequent successful IPOs included those of Kongzhong (空中) in July2004, Focus Media (分众传媒) in July 2005, Baidu (百度) in August 2005, and Tencent QQ (腾讯QQ)and Home Inns (如家酒店集团)in October 2006.
As a result of this surge, the Chinese VC market experienced a huge influx of capital from the U.S. and Europe. According to Zero2IPO Research, total capital raised increased more than 30% between2004 and 2005. In 2008, $23.4 billion of capital was raised, representing an increase of more than 100%.
The number of VC firms operating in China also grew rapidly. But as one industry expert notes, “There was a lot of money chasing a limited number of good deals.” It was an unsustainable market. During the height of the investment craze, certain VC funds altered their investment strategies to focus on growth-stage or pre-IPO investments because they were perceived as a “free ride.” These companies had proven business models and significant cash flows and were much closer to going public than startups. They also required significantly less due diligence, direct management, and understanding of the underlying technology or business model. Increasingly, larger funds also contributed to this trend, with later-stage investments requiring more upfront capital. VC firms had less incentive to earn high returns because they could make money from management fees.
Another challenge during this time was the nature of entrepreneurs in China. Many worked on multiple deals concurrently, resulting in less focus on sustainable business models. One example that highlights the issues was ITAT. Among the many banks involved in the deal were Goldman Sachs, Merrill Lynch, Morgan Stanley and Deutsche Bank. But allegations of accounting fraud and questions concerning ITAT’s business model forced the cancellation of its $1 billion IPO. Most entrepreneurs and investors were simply seeking a quick return on investment and did not consider long-term growth.
This situation mirrored the previous dotcom boom in the U.S. The frenzied pace of investment and unrealistic valuations created conditions for a Chinese VC “bubble.” Around the end of 2007 and beginning of 2008, China’s VC industry experienced a rapid slowdown in the quantity of new investments. According to industry data, the increase in the total amount invested slowed from an average of 67% in 2007 to 29% in 2008. One venture capitalist comments, “The euphoria of the previous years had clearly disappeared.”
What You Know, Who You Know
Initially, large foreign firms dominated Chinese VC, but recently domestic firms have become significant players. Although foreign and domestic VC firms operate under different constraints and cultures, both acknowledge that having access to the right people and local resources is critical.
The major advantage foreign firms have over their local counterparts is easier access to capital thanks to better connections with foreign pension funds, insurance companies and other investors. This is crucial because of the limited number of exit options for renminbi-denominated VC funds in China. Another advantage that foreign firms have is greater investment and business-building experience, which they have gained in home markets. Finally, foreign firms bring established investment processes and greater professionalism.
At the same time, domestic VC firms have major advantages over foreign companies. Most important is a deeper knowledge of local markets, which is vital for sourcing deals and adding value to portfolio companies. Their local relationships and contacts with governments, universities and state-owned enterprises are also critical in a market in which most deals are sourced through personal and professional networks. Meanwhile, in terms of the regulatory environment, a foreign firm with foreign-denominated funds investing in a domestic company must form a complicated offshore limited partnership, which adds an additional level of complexity.
In the long run, domestic firms will increase their advantage over foreign firms as the domestic market becomes a more important source of capital. A number of executives believe that as the Chinese stock market develops healthier exit options for RMB investments, most capital will be sourced domestically. Local RMB-denominated funds are already showing signs of gaining popularity.
Foreign firms realize that they must become more localized to survive in China. Although firms previously imported experienced staff from abroad, they are increasingly able to find highly qualified candidates locally. Many foreign VC firms now manage only the fundraising through their home offices and grant full autonomy to their Chinese teams to execute and manage deals.
Of Culture and Collaboration
The first step in the VC investment process is identifying opportunities. In China, deals are typically sourced in three ways. The most common and effective method is through personal and professional networks. As found in many other sectors in China, success in venture capital relies heavily on relationships and extensive networks. The second method is through financial advisory firms, which provide banking services to new companies. One drawback to this method is that these firms have incentives to generate inflated valuations. The third method looks within a sector to identify potential market leaders. While this can be time-consuming, it is feasible because a number of sectors are still underdeveloped in China.
In the U.S. deals are also sourced mainly through personal and professional networks. However, the second and third methods are rarely used. The managing director of a prominent Shanghai-based VC firm says this is because, “in the U.S., the VC industry is already highly efficient.”
Once an opportunity has been identified, a VC team must conduct due diligence. This is an essential step in the process globally, but in a market with so much uncertainty, it takes on added importance. Due diligence in China typically requires more effort than in Western markets because of crude financial information and opaque disclosure. Some VC firms even comment that readily available information signals an “over-shopped” deal and might be cause for concern. Due diligence can last from three months to more than a year, and the process varies widely, sometimes as a result of legal issues.
Because of these difficulties, due diligence is heavily dependent on trust and local networks. It is important for VC firms to spend time with entrepreneurs to get to know them, and it is equally important to know whom to call for references. Against this backdrop, due diligence in China typically involves more senior decision makers than in the West.
The last step is deciding whether to commit capital and invest. Among the numerous criteria for selecting a deal, the most important factor cited is people. There has to be mutual trust between the VC firm and the entrepreneur. There is always the risk of an entrepreneur taking the investment money but not delivering on pre-agreed commitments. Just as importantly, many Chinese entrepreneurs are unfamiliar with the concept of venture capital, and its legal frameworks are still unstable, so trust is necessary to form a workable relationship. A number of established VC firms in China have incorporated the concept of “cultural fit” and “willingness to collaborate” in their identification and due diligence processes.
Once deals are secured, venture investors actively will want to participate in the company’s development to generate a healthy return from the exit. The amount and level of involvement vary depending on the venture capitalists’ preferences and experience, as well as the invested firm’s stage of development.
Implementing a corporate governance structure is widely acknowledged to be the most significant value-adding service. The primary objective is to instill a high level of transparency and accountability in management and operations, which is particularly important in China. This structure not only ensures successful management of the investment during the holding period, but also maximizes valuation by gaining market confidence. Typical corporate governance activities include setting up an independent board of directors, improving accounting and reporting standards, and working with independent auditors.
Venture capitalists also add value by providing access to resources and relationships. Business in China is highly dependent on the ability to access the right people, information and government offices. Many venture capitalists in China are extremely experienced and have extended networks both in China and overseas. Thus, early-stage companies often benefit tremendously from being part of venture capitalists’ networks and having access to those resources.
Results in attempts by VC firms to implement “value-added” initiatives in Chinese companies have been mixed. Entrepreneurs are fearful of venture capitalists taking control of a business and do not welcome outside interference. It is particularly important in China to invest additional time to develop trust and build a long-term partnership to minimize difficulties down the road. The managing director of one of the first foreign firms to enter China identifies this as being among the most difficult and important tasks. A number of executives like him acknowledge that the ability to “read” the local market and people, acquired through years of experience, gives a VC firm a strong competitive advantage. The ability to generate real returns on these investments requires patience, trust, persistence and mutual understanding.
Dispelling Common Myths
The challenges facing China’s VC industry has become a popular topic in global media. Yet some industry experts say the challenges – such as the movement of capital, the talent pool and regulatory environment – are overblown and contend that for every risk, there’s an opportunity. For example:
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