Venture Capital in China Part I

Venture Capital Potential in the Middle Kingdom

While the economic possibilities and promises of China often seem limitless according to the media many serious Western investors also share this unbridled optimism. One area in particular, venture capital, has demonstrated a commitment to bringing the potential of China based investments to fruition. This attempt to tap the benefits of bridging the East and West via a digital silk road is more complex than is generally portrayed by the eager media. China still remains a unique and sometimes implacable culture that offers many obstacles to the over-eager Western investor seeking to extract her resources. To understand the reality of the situation an assessment of current VC trends along with the investment trends and opportunities in China must be performed. Then an understanding of the dynamics of foreign investment in China along with the issues of intellectual property must be gained. Finally, there is the exit strategy dilemma from China which poses yet another unique obstacle to the foreign investor. Overall, this will provide a high level understanding of the subject of foreign venture capital in China and the realities involved in this type of investments.
It is generally accepted that 2004 marked the beginning of a new cycle in venture capital investment as investment vehicles from the late 90s wound down and new opportunities surfaced. The primary areas that define this new cycle are summarized as follows:

1. Restructuring of existing portfolio investments in boom-economy allowed firms to redefine fund focus
2. Economic recovery allowed for new wave of VC capital calls and fund raising – 2004-2005 yielded over $17B
3. New opportunities appear in the life science and technology sectors in both emerging and mature markets
4. Globalization of investment strategies for VC firms and their portfolio companies. In regards to China this meant that there was large funding available focusing on areas that China had demonstrated resources and proficiency in. Also, given the size and classic view as an untapped market, China is an ideal focal point for VC fund managers.

Given the relevance of globalization as a business catalyst, a report from Ernest & Young’s Venture Capital Advisory Group had the following insight:

“As competition grows, regions such as China, India and Eastern Europe are impossible to ignore. The growing consumer markets of the Far East—especially China—present increased opportunities. Indeed, a China strategy has become the top issue for every venture capital firm and corporate investor as the business case for investing in China continues to grow,”

Undoubtedly reports such as this, as well as media-hype, have led to the designation of China as the undiscovered country for new investments.
China truly is a fantastic resource in terms of invention and innovation especially in the area of technology. China is expected to graduate over 250,000 engineering and technology related job candidates in the next year. This greatly justifies China as a source for new investments in 2005 which were largely in the areas of Internet and wireless applications and services which garnered over $205M and IC design with $180M. The high-tech areas are closely followed by Telecommunications which was allocated approximately $190M in invested funds. Traditional services and firms collectively also received almost $200M in investment. In total, foreign capital made up 75% of total venture investing in China in 2005. The majority of these investments occurred in Beijing and Shanghai with additional deals taking place in Shandong, Shenzhen, and Jiangsu.
While the amounts allocated are impressive as are the returns from the more high profile ventures/IPOs such as Baidu and SMIC, the obstacles that are encountered must be recognized. The most basic of the issues encountered are simply a lack of current business law parameters that allow effectively established a venture capital firm type structure. Without the modern VC partnership structure it is difficult and risky to operate an effective venture firm. However, a new regulation was established on March 1, 2003 that replaced preexisting guidelines for establishing foreign-based venture capital funds that eased monetary requirements and allowed for more flexibility in management structure.

(To Be Continued in the Next Posting)