JAFCO, one of Japan's biggest private equity firms, poured roughly US$50 million into a dozen early or middle-stage Mainland technology investments a few years ago, according to its Hong Kong-based director, Vincent Chan. Just one of them, an early 2002 investment in search engine developer Beijing 3721 Technology, validated the firm's entire China strategy. In March, JAFCO sold its stake in 3721 to Yahoo for US$120 million.
Such deals have only become feasible in recent times. Five years ago, China was coming out of a venture capital slump. Funds stayed away, many of them wise to the dismal examples of early venture investors pioneering a market without rules. Investments had gone up in smoke; due diligence was difficult and expensive; accounting practices were woeful. But by 2000, China's accession to the WTO was on the horizon, China began aligning itself with the conventions of capitalism, and venture capital investors took another look.
From 1999 to 2000, new China venture capital investments jumped from US$421 million to US$858 million, according to industry monitor AVCJ Group. Total portfolio investments by 2000 had reached US$4.2 billion – a high figure blamed on the difficulty of exiting investments. The numbers have risen and fallen and risen again since. Venture capital investments in China, usually made with three – to five-year horizons, can run from US$0.5 million to US$10 million, but on occasion do run to many times that. Funds operate in any or all niches: from seed capital, to start-up, to expansion, all the way to mezzanine, or pre-IPO, capital. The market sectors of interest of the VCs range from infrastructure, manufacturing and consumer ventures to telecom, IT and web-based services, from social to financial.
VC fund outlays are still minuscule compared to investments made by industrial giants building aircraft or automotive plants, but aggregate venture investment is playing an increasingly prominent role as SMEs take a bigger stake in the economy. The fact that some brokers have launched private equity funds (which typically look for 25-40% annual returns), after a lifetime spent in the public markets, underscores their rising importance. Like other investors already in the field, they recognize the emergence of genuine Chinese entrepreneurs, savvy to global business imperatives, determined to create successful companies at home.
JAFCO's exit from 3721 was what is known as a 'trade sale.' In China, trade sale opportunities are suddenly mushrooming. "That's driven by the imperative for people to have a China strategy," said Jean Eric Salata, managing partner of Baring Private Equity Partners. "And acquisition is the quickest way in."
Baring had two trade sales in the last year, Internet portal Netease and network infrastructure builder Vanda Systems, both earning "10 times money," Salata said. In aggregate, Baring's Mainland investments have netted an average annual internal rate of return (IRR) of 70%, he said. China was Baring's best performing arena in the region, with seven exits on 12 investments.
There are exceptions to these happy stories. Jonny Marwell, CEO of Edinburgh-based Standard Life Investments, told a conference in Sydney in March of how he saw unspecified millions disappear in a Mainland mining venture that unraveled in the early 1990s. Maxwell, who was with another firm at the time, said three executives involved in the scam were arrested and are still in a Shanghai prison for their trouble.
Maxwell conceded there was money to be made in China, but to meet his firm's risk-reward requirements, there had to be Western-style governance and disclosure – and legal infrastructure, all of which China still lacked. Explaining why he liked Australia as an investment destination, Maxwell said: "For one thing, I can sue people."
Australia is an instructive reference point. Its economy, a fraction of China's size, drew US$2.8 billion in private equity investment in 2003, placing it third and ahead of China, in fourth place with US$1.27 billion, according to regional league tables compiled by AVCJ Group. If that doesn't suggest the mainland has some growing to do as an investment destination, last year's figures for South Korea (US$3.3 billion) and Japan (US$7.3 billion) should.
What's more, China's 2003 numbers were dramatically skewed upward: US$630 million – nearly twice the US$350 million private equity investment China drew in all of 2002 – involved just one company, NASDAQ-listed contract chipmaker Semiconductor Manufacturing International Corp. But also, China's 2002 numbers were skewed dramatically downward in the wake of the tech stock collapse: in 2001, China's total private equity investment was US$1.57 billion.
The bottom line is that put against China's overall inward FDI, which the Ministry of Commerce put at US$53.3 billion for 2003, "private equity is still not even a drop in the bucket," as one fund manager put it. But the pace is picking up. Newbridge Capital, after losing its bid to be the first foreign owner of a Chinese bank when its Shenzhen Development Bank management buyout unraveled, returned to take a 5% stake in China Minsheng Banking Corp this year. Carlyle Group, which successfully exited Shanghai travel portal Ctrip on its spectacular NASDAQ debut, is setting up shop in Shanghai – a sign that trips from Hong Kong are insufficient.
"There are more people on the ground in China now," said Simon Littlewood, CEO of London Asia Capital. Though hardly operating on Carlyle's scale – where ideal investments according to one source run from US$50 million to US$100 million – London Asia has been moving at speed, buying up stakes in growing and profitable companies at the rate of one a month.
London Asia started in Chinese media, branched out into financial services and now finds itself on the edge of optics – having just struck an alliance with East Lake New Technology Development Zone in Wuhan, Hubei province. According to Littlewood, the zone agreed to give London Asia details of tenant companies seeking strategic investors or looking to list in an offshore market.
Much like an earlier agreement with Wolong Economic Zone in Yantai, Shandong province, the Wuhan deal doesn't lock out other venture firms, Littlewood said. But it puts London Asia on the ground in a park that claims 1,400 technology players, many focused on high-end optics like lasers and related communications technologies. "Half the due diligence is done by partners we trust before we even look at [prospects]." That compresses deal process time from 12 months to six, he said.
Littlewood welcomed moves to revive China's second board in Shenzhen, which will provide a domestic exit opportunity for VC funds when it launches, possibly by the end of this year. Dai Biao, a spokesman at the China Securities Regulatory Commission (CSRC), declined to reveal when or even if foreign investors would be allowed to participate. "At this stage in the cycle, we're not concerned," Littlewood said, confident restrictions will be lifted by 2006, when London Asia will look at floating companies. "We're sitting on profitable companies."
JAFCO's Chan applauded the plans for a second board, but added: "as long as founder or 'legal' shares are not tradable, it provides limited help to international VCs. Exits for offshore venture capitalists investing in US dollars are still limited to overseas listing and trade sales to strategic players."
Chang Sun said he welcomes a second board, both as president of the Chinese Venture Capital Association and as managing director of Warburg Pincus Asia. "If it is set up, it will spur private equity and VC activity," he said. Warburg has invested around US$400 million in "greater China" – over a dozen companies in all, including AsiaInfo, Harbour Networks, Kasen and MediaNation. "We will try to invest more in the coming years, perhaps US$100-150 million per year," Sun said.
The Mainland's quickening pace has come with easier access, at least for offshore holding vehicles of Chinese companies, to capital markets in Hong Kong and the US for IPOs. Although they have yet to produce much in the way of tangible results, Beijing has made efforts to replace administrative arbitrariness with more clear-cut rules in areas such as M&A and fund formation.
Robert Woll, managing partner at Morrison and Forester in Hong Kong, credits the market's ingenuity at devising workarounds – like creating offshore listing vehicles, and backdoor listings via acquisition of Hong Kong public companies. But reforms intended to get a domestic VC industry off the ground – including regulatory changes that allow Chinese subsidiaries of foreign private equity firms in theory to participate and raise RMB investment funds – have so far produced no visible results, Woll said.
There's a reason. "A domestic fund cannot, because of currency convertibility restrictions, invest in an offshore holding company," he said, adding that China still has severely underdeveloped capital markets and no currency convertibility. "That overrides everything, so it doesn't really matter what [reformers] do, even if they copied limited partnership statutes from the United States." "Liquidity events drive the whole venture process, but they just don't exist," Woll said. Foreign investors could even live with convertibility restrictions, if their portfolio companies could at least list in China. "But you can't. A venture-backed company cannot go public in China or anywhere else without the CSRC's approval." And that doesn't come easily for non-SOEs; over 1,000 companies are said to be stalled in the applications queue.
Woll doesn't think Beijing is being willfully slow. "China is still a socialist country structurally," he said. "There is only so much reform it can handle – keep in mind, company law was passed only 10 years ago." He doesn't rule out the reform pace picking up, and even foreign venture-backed companies being allowed to list in China, but such possibilities remain long-term.
In the meantime, investors will resort to workarounds, including trade sales to investors who just have to get a piece of China. Salata cited Baring's recent exit from Yong He – selling China's home-grown fast food chain to Philippine restaurant giant Jollibee Foods Corp, instantly graduating Jollibee from non-player to the mainland's third largest chain after McDonald's and KFC.
Rising interest in China is natural, Salata said, with 50,000 private companies springing up in the last 10 or 15 years, including Yong He. "There aren't too many economies with that pace of company formation going on," he said. None with China's pace of economic growth, anyway.