Beijing blundered in January and again in April with investment-limiting regulations that dramatically cut foreign venture capital activity. But then the State Administration of Foreign Exchange reversed itself in October with the liberating Circular 75 – putting venture capital on the road again, having deflated its tires for most of 2005.
But only a few weeks later, with hardly time to uncork the champagne, foreign venture capitalists were again rattled. This time not by SAFE, but by the National Development and Reform Commission’s Measure 39, which authorized special support for domestic venture capitalists "at the expense of foreign rivals" or so the news reports claimed.
A closer look at this string of regulations, though, suggests that Beijing is seeking only to free China from an uncomfortable reliance on foreign venture capital while consolidating the homegrown variety. The main aim of the January and April directives was to keep domestic operators honest by stopping them from selling state assets to their own shell companies registered overseas.
But in doing so, it also contrived to shut off one of the main avenues by which foreign venture capitalists buy stakes in Chinese firms. Investors were spooked across the board, resulting in an estimated drop in overall investment of 25% to 30% in 2005.
The SAFE blunder was as much a discovery as an error, showing how important foreign venture capital had become. In the first half of 2005, foreign venture funds provided 86.4% of the capital for the 22 Chinese companies listing on NASDAQ. Seventy-five percent of Chinese companies listing on NASDAQ or Hong Kong’s GEM board used offshore companies to do it.
But there seems little to fear in Measure 39, which outlines a general direction of Chinese venture fund development. It permits, but does not compel local governments to invest in, extend loans to, and offer loan guarantees to local venture funds under a still un-established administrative framework.
Some already see the measure as doomed. "Venture capital and private equity are not about money, but about know-how, people, and knowledge," said one venture capitalist, who did not wish to be identified. "Governments think throwing money at young companies creates sustainable organisms. To help grow young companies, you have to inundate them with intelligent support."
While conceding that Measure 39 "could make the life of legitimate VCs more challenging, but not much more," he was confident that companies seeking venture funds would soon find "cheap money" brings little help "and no foreign connections."
Maurice Hoo, VC partner at Paul, Hastings Janofsky & Walker, also agreed that foreign venture funds face little threat from the NDRC initiative.
The movement from SAFE’s earlier, investment-killing decrees to the liberating Circular 75 amounted to the transformation of an approval system into a registration system. Through the initial measures, Beijing seemed to be telling venture capitalists: we are sick of seeing China’s assets migrate to Bermuda and the Cayman Islands, and by plugging the offshore WFOE (wholly foreign-owned enterprise) option, we will force you onshore.
One could still apply for permission to establish a WFOE, as many did, but no permissions came, and investment was cut off. SAFE had wrecked venture’s modus operandi. Suspicions of an anti-venture conspiracy persist, but bungling more than ill will seemed to be the likely cause. SAFE had simply failed to devise any approval system. So when officials received applications, they did not know what to do with them.
Under the registration process outlined in Circular 75, it is a matter of allowing activity until fault is found rather than forbidding it unless it is proven faultless.
Many venture capitalists are in-and-out operators. They buy a start-up company, sort it out, then sell it, either by direct sale or through a stock exchange listing. The WFOE is the offshore company in which Chinese shareholders of a Chinese company exchange their onshore shares for shares in the offshore firm, transforming the Wuhan Widget Works into Widget International (Cayman Islands) Ltd. Now a foreign company, venture capitalists list or sell it and the Chinese shareholders get their cut.
Circular 75 restored the key elements of this system. "The Chinese venture market is on the move again," enthused Gongmeng Chen, director of China Venture Capital Research Institute in Hong Kong. Chen claims some credit for the shift, having had SAFE officials sit in on his June and September round-tables in Shenzhen and Beijing.
Cheering as the news is, the good old days are not back. While the WFOE, now a "special purpose company", has returned, there is more policing in Circular 75. Chinese shareholders must first register corporate details before transferring offshore, and keep SAFE informed of every step along the way to listing or sale. More critically, profits, dividends and return on capital must be repatriated within 180 days of receipt.
Circular 75 also presents serious tax problems. For those who have made offshore profits, they have until March 31, 2006 to retroactively register previous dealings. "When things were offshore, it was difficult to figure out how much people had. Now it has become very clear," said Paul Hastings partner Maurice Hoo.
He is particularly pleased with Beijing’s ability to admit a mistake and make such a drastic change. "It is very positive that the government is willing to reconsider its approach after hearing the views of the industry," Hoo said. "I don’t see why people shouldn’t look at it as a positive move that makes the industry more robust."
Despite these hopes, some skeptics remain. "There is really no advantage here. They are legitimizing activities we were doing before," said Hong Kong M&A lawyer Keith Lee, a partner in Preston Gates Ellis.
While opposed to state intrusion, the publicity-shy venture capitalist predicts China will have its own working capital market soon enough, and that most Chinese companies will list in Shanghai and Shenzhen rather than in Hong Kong, New York or London.
This view is supported by Andrew Ostrognai, a Hong Kong lawyer specializing in venture fund formation at Debevoise & Plimpton LLP. "Over the next five to ten years that will be the direction," he said.
Caveats aside, hopes are now high that as the Annus Horribilis of 2005 for venture capitalists becomes vapor trail, the open road lies ahead – with homegrown venture capitalists becoming players along the way.