Behind the Great Wall: China opens its doors to domestic and foreign venture capital funds –

The guest list reads like a ” Who’s Who” of the venture capital and high-tech world: Microsoft Corp., Yahoo! Inc., America Online Inc., Sun Microsystems Inc., Kleiner Perkins Caufield & Byers and Institutional Venture Partners, as well as representatives from Nasdaq, Morgan Stanley Dean Witter and Goldman, Sachs & Co.

And while it is still unclear whether Bill Gates, John Doerr or Geoff Yang will attend this conference on high technology in Beijing, what’s more significant is that the Chinese government is hosting this first-ever event – and similar gatherings are scheduled for later this year.

In an attempt to spur economic growth in a nation slowly shifting to a free market from a regulated economy, China is beginning to see the “dawning of a venture capital trend,” says Ta-Lin Hsu, chairman of Hambrecht & Quist Asia Pacific.

“Right now, venture capital is the hottest thing in China,” says Mr. Hsu, who might attend the July conference hosted by the Ministry of Science and Technology. “Government officials at various levels, the sons and daughters of various officials, are all chasing it now because they see it as hot and sexy.”

Many in China, from the children of President Jiang Zemin and Prime Minister Zhu Rongji to university students and fledging entrepreneurs, have been clamoring in recent months to join the country’s venture capital frenzy.

In response, mainland China has grown eager to create government-backed venture funds or to collaborate with firms based in the United States, Hong Kong, Taiwan, Singapore and elsewhere. Simultaneously,VC firms with a history of investing in China, such as H&Q, the Walden International Investment Group, Doll Capital Management Inc., ChinaVest and Advent International Corp., are positioning themselves to take advantage of the country’s blossoming opportunities.

The most recent example of Beijing’s immersion in VC is the formation in May of the Beijing Technology Development Fund, the first government-backed vehicle to aid fledging high-tech companies. Jointly sponsored by Beijing Enterprises Holdings Ltd., an arm of the Beijing municipal government, and San Francisco-based venture firm WI Harper Group, the vehicle already has signed two letters of intent to back an e-commerce technology company and a wireless communications company, according to WI Harper.

The $50 million Beijing fund – with $10 million from Beijing Enterprises and $40 million from WI Harper’s U.S. institutional investors – will focus on technology, including software, multimedia, Internet, telecommunications, biotech and health-care companies, tapping the country’s universities, research institutes and science and engineering communities for deal flow. Tsinghua University Enterprise Group, another major sponsor of the fund, will market technology developed by the university.

At the same time, foreign private equity investors such as the $155 billion California Public Employees’ Retirement System (CalPERS) have shown renewed interest in China and the Asia Pacific region as a whole. The pension in May approved a $75 million investment in Carlyle Asia Partners L.P., a vehicle that will make individual investments ranging from $25 million to $150 million in a range of industries throughout Asia, particularly in telecommunications, aerospace and defense, information management and consumer products, says Brad Pacheco, the pension’s spokesperson.

Lessons Learned

China’s most prominent foray into VC happened in the mid-1980s, with the launch of the now-defunct China Venture Investment Corp., a state-owned enterprise designed to invest in early-stage, high-tech companies. In reality, the Beijing-based group did not operate as a venture fund, but mainly made real estate investments, says Wen Yong Wang, an attache in the Science Affairs office of the Chinese Embassy in Washington, D.C. Backed with tens of millions of dollars, the group began collecting a lot of bad debt and was declared bankrupt last year by the Central Bank.

The fund’s failure was blamed on the lack of several important domestic factors, including an environment to foster entrepreneurial growth, laws to protect such activities and venture capital and management expertise, he says.

“In view of the failure of the China Venture Investment Corp., people are a little more cautious in the actual practice [of venture capital],” Mr. Wang says. “But venture capital is a very hot topic … the public and the decision makers in the government are very enthusiastic about this idea.”

Investing in China clearly is not for the weak of heart, and there are many examples of foreign investments and joint ventures that have gone belly-up. The most visible flop was a $200 million investment three years ago in Sui-Fung Ceramics Holding Ltd., a maker of porcelain bathroom fixtures, which was backed by HSBC International Corp., Mr. Hsu says.

The Chinese government, notorious for its massive bureaucracy, has no accurate figures on the number of home-grown or foreign venture capital funds and their dollars invested, Mr. Wang says. Because China lacks private institutions, its indigenous funds are raised with capital from local banks or government-owned enterprises, which means most Chinese still have only a vague idea of how the industry operates. And unlike U.S. funds, whose mission is to seek high returns, domestic vehicles in China make socially responsible investments to promote employment or certain industries, says Lip-Bu Tan, chairman of the Walden International Investment Group.

Apart from the China Venture fiasco, the country has raised other domestic venture funds in major cities including Beijing, Shanghai and Shenzhen, but nothing that resembles venture capital as the United States knows it. The Chinese government, however, is drafting regulations for venture capital financing and plans to hold a national conference in August to rewrite its science and technology policy to better reflect market changes.

Why Now?

Despite many inherent pitfalls, there is no business-related subject that stirs more excitement in China these days than venture capital, say industry watchers such as H&Q’s Mr. Hsu, whose firm introduced Starbucks Corp. to Beijing at the beginning of this year.

There are many reasons China has taken an interest in venture capital at this time. Most significantly is the desire to emulate successful Internet companies such as Inc. and America Online, leading to waning interest in state-owned consumer industries like textiles and machinery, Mr. Hsu says. Meanwhile, Microsoft, Cisco Systems Inc. and Intel Corp. all operate huge research and development facilities in China, which house the country’s leading high-tech minds.

Other factors include the need to find an alternative capital flow in the wake of the Asian economic crisis and China’s long-term objective to improve its “rickety and inefficient” banking system, which has poured huge sums of personal savings into companies with a zero or negative rate of return, says Nicholas Lardy, a senior fellow at the Brookings Institution who specializes in the Chinese economy.

“There are a lot of things that need to be done to improve the efficiency of resource allocation, and private equity funds could be one mechanism at the moment for trying to do that,” he adds.

As the world’s seventh largest economy, and with only 2% of its 1.2 billion people attaining higher education, it would be a clear exaggeration to declare a high-tech revolution in China, but there certainly is a “minor wave” washing ashore, Mr. Tan says.

“Lately the Chinese government is pushing a lot of initiatives for technological development and encouraging venture capital funds,” he says. “So there is some kind of renewed interest of organizing China funds.”

For the past decade, private equity in China mainly consisted of overseas Chinese, mostly in Hong Kong, Taiwan and Singapore, making hundreds of billions of dollars in direct equity investments in infrastructure and manufacturing businesses, Mr. Lardy says. On a smaller scale, foreign venture capital firms began raising institutional money for investment in China in the early 1990s as part of a trend referred to as “China fever,” Mr. Hsu says.

As a participant in that wave, H&Q in 1994 raised the China Dynamic Growth Fund, in partnership with the Bank of China and the China International Trust and Investment Co., a quasi-government investment house. The $85 million vehicle, which includes $10 million from the Bank of China, has invested more than $65 million in Chinese companies in the last five years, including Sinogen International Ltd. and its subsidiary Shandong EPOgen, biotech companies that focus on the treatment of hepatitis and kidney disease, Mr. Hsu adds.

Most agree that venture investing in China is no simple task – the country has no legal system to protect foreign investors, business transactions operate through an “old boys'” network and exits are very difficult to come by because the government, with only a few minor exceptions, lists only state-owned companies on its stock exchange. Indeed, a majority of foreign funds either fail or produce very low returns, say industry watchers.

Moreover, China-U.S. relations remain tense as the two countries wrangle over issues such as the handling of Kosovo, human rights, alleged nuclear espionage, illegal donations to the Democratic presidential campaign and Beijing’s desire to join the World Trade Organization.

On the brighter side, however, economic reforms introduced by former Chinese leader Deng Xiaoping in the late 1970s slowly have taken shape, and Prime Minister Zhu has made steps to make China more inviting to outside investors. Following the 1989 crackdown on the student democracy movement in Tiananmen Square, the government made an informal pact with its people: Don’t interfere with our politics, and we won’t interfere with your entrepreneurial needs.

“There is a more friendly environment for venture capital to survive,” Mr. Wang says, conceding that a majority of businesses are still state-owned. “Now we are in a very critical moment of transition, and a very large part of our economy has been very solidly based on a market economy, but it still needs maturing.”

A Toehold in the East

Peter Brooke, chairman of Advent International and a 40-year veteran of the venture industry, says having a toehold in China makes for a very wise investment strategy. He admits, however, that Advent devotes a very small portion of its global fund to China and that returns have been in the lower single digits. The firm mainly invests in China because it has the world’s largest population, Mr. Brooke says. “We want to be in a position to take advantage of it when it really does develop [into a market economy].”

As part of a two-prong investment strategy, the firm backs Chinese companies that export manufacturing products and have earnings in American dollars or euros. Secondly, Advent only invests along with family groups and industrial companies that can act quickly in a time of need.

“It does take a very thoughtful strategy to be able to make money in China, and no one should underestimate that,” Mr. Brooke admits. “If the company in which we invest gets in trouble, our partners have always been able to supply the managerial talent that can turn the business around.”

Advent’s 1997 Global Private Equity Limited partnership III invests 7% of its more than $1 billion in Asia, and half of that goes to China. The firm has avoided any involvement with government-backed venture funds because it does not want to relinquish any control over its investments.

Mr. Brooke’s advice to those who want to invest in China is to develop a strategy, build relationships with well-connected partners and be prepared for a long wait.

Mr. Tan’s Walden Group has spent the last four years perfecting a different strategy for investing its more than $100 million China Walden Fund, and the most successful approach has been something akin to American-style VC, he says.

For the last two years, the fund has directly backed early-stage, high-tech private enterprises launched by local entrepreneurs, including an $11 million investment in the Beijing-based, the largest Chinese Internet portal company; a $4 million investment in Shenzhen-based Liming Network, the country’s largest systems integration company; and $5 million in Shanghai-based New Wave Semiconductors, a fabless design company. Walden decided in the mid-1990s to give up joint ventures and expansion financing to state-owned companies because it provided uneven results, Mr. Tan says.

Although Walden has had ups and downs in its China investments, overall returns stand at about 8% to 9%, and the group hopes to reach somewhere in the low 20s by the time the vehicle is fully invested in the next few years, Mr. Tan says.

Mr. Tan offers similar caveats regarding investments in China, and many overseas China funds, particularly those focused on traditional industries, have overall done very poorly, he says.

So, is China ready for venture capital? Yes and no.

“It’s tricky – you need to know the local way of doing business, and there are still a lot of barriers and difficulties,” Mr. Tan says.”But there is kind of a minor wave coming up, and there are a few venture capital funds being formed recently. I hope they will be successful because I think it would be good to have some success stories to help build up the industry there.”