When talking about the current state of Taiwan’s venture capital market, Taiwanese venture capitalists like to use the popular Chinese game of Mahjong to illustrate their point. “In Mahjong, you need four people to play,” says Ben Yang, managing director of Pacific Venture Group. “If you don’t have all four players, then you have no game to play. [Similarly] a thriving VC industry needs at least four basic elements: people – both entrepreneurs and VCs – technology, a good market and capital.”
The consensus among Taiwan’s VCs is that these elements have fallen in place and the Taiwan VC industry has entered a period of maturity. “It [the Taiwan venture capital industry] is at a mature stage considering the number of funds and size of the Taiwan market,” says Yang. Chin Lin, president of China Venture concurs, “in Taiwan, we are gradually starting to shift from an immature to a more mature venture community.”
Ever since the Taiwanese government first began to promote venture capital in 1983, the VC industry, spurred by its emphasis on developing the high-tech sector, has emerged into one of the most developed in the world.
According to statistics compiled in the Taiwan Venture Capital Association (TVCA) 2000 Yearbook, which was jointly produced by Venture Economics, 153 funds managed a cumulative $3.4 billion in capital by the end of 1999. VCs made more than 4,490 investments representing $3.1 billion in cumulative total disbursements as of year-end 1999.
Taiwan’s VC industry has witnessed unprecedented growth since 1996. The number of funds raised has more than tripled in the past three years to 153 in 1999 from 47 in 1996, and the amount of capital raised has more than quadrupled to nearly $1 billion raised in 1999 from $221 million raised in 1996. Levels of disbursements have also reached record highs. Taiwanese VCs made 1,499 investments representing $970 million in 1999, up from 471 investments representing $88.1 million in 1996.
Furthermore, venture capitalists in Taiwan have begun to focus more and more on riskier early-stage investments. “[During the 1980’s], VC’s started to go after later-stage investments to achieve returns,” says Lin. “Most new fund managers start off that way. In the past few years, we’re seeing more and more investments in early-stage and seed-stage companies just like in the U.S.”
According to TVCA, overall disbursements in early stage companies – including seed and start-up stages – as a percentage of all disbursements increased to 31% in 1999 from 14% in 1994. “Taiwan VC’s are becoming very mature,” says James Chew, chairman and chief executive officer of Fortune Venture Investment Group, “and most VC firms are making money.”
Government Initiatives Spawn VC industry
In an effort to spur the development of high-tech industries, the Taiwan government issued the “Regulations Governing Venture Capital Investment Enterprises” in 1983, which was one of the world’s first venture capital government regulations. This government-led initiative to develop a domestic venture capital industry had both positive and negative effects.
“The negative effect is the control issue – the government wants to lead,” says Dr. Ta-Lin Hsu, chairman of H&Q Asia Pacific Ltd. “On the positive side, there are two effects. First, the Taiwan government set aside a 20% tax credit on investments made in strategic industries – high-tech industries. But you could not claim this deduction all at once – only gradually over the lifetime of the investment. Second, was the creation of a fund-of-funds by the Executive Yuan Development Fund and Chiao Tung Bank.”
The Development Fund of Executive Yuan and Chiao Tung Bank was initially a NT$800 million ($25 million) seed fund formed in 1985 that expanded to NT$2.4 billion ($75 million) in 1991. This fund provided capital to 16 VC funds, including H&Q’s first fund formed in Taiwan. As a result of these government-led initiatives, Taiwan was the first destination of choice for U.S.-style VCs such as H&Q Asia Pacific that wanted to establish a presence in Asia.
Another sign of Taiwan’s maturing VC industry is the recent repeal of the 20% tax credit at the end of 1999. While the 20% tax credit has been a very good vehicle to incubate the VC industry in Taiwan, according to Yang, Taiwan VCs seem to have outgrown the need for government hand holding. Most VCs have, in fact, responded to this annulment with aplomb.
“This will not have that much of an effect in the VC landscape,” says Hsu. “This is a game of survival of the fittest and if you are good, you can always raise money.”
“I think it’s fair to lift the tax credit. If you perform well, investors will follow you as well,” says Lin.
U.S.-Style VC Without An LP Structure
An important key to success for Taiwan’s VCs has been their ability to make investment decisions despite the limitations of having a shareholder structure. In the U.S., the limited partnership structure has afforded VCs not only tax benefits but more importantly a division of liabilities and decision making. Hsu says the LP structure in the U.S. has limited liabilities but also has little say in the investment decisions, giving the general partners’ wide discretion. Hsu says the LP structure has been “the secret of success for American VC’s.”
While Taiwan does not have limited partnerships, its “two company” shareholder structure allows venture capitalists to function like GPs in the U.S. Essentially, this two company structure consists of a fund company that provides capital and a VC management company that manages the funds. Since members of the VC management company are not considered employees of the fund company, Hsu says venture capitalists can function as GPs as long as they earn the trust of the fund company.
“The fund company still has the ultimate authority on the deployment of the fund, but if you gain their trust, the fund company will allow you to make investment decisions,” he adds.
This contrasts Japan where Hsu says a corporate shareholder structure has severely limited the VC industry capacity to grow in the past (although the Japanese government did pass the Limited Partnership Act for Venture Capital Investments in 1998 allowing limited liability partnerships for the first time.) Hsu lists several negative consequences to having this type of corporate structure: investment decisions are made by consensus; the largest shareholders influence investment decisions; a risk-averse, conservative approach to investing where equity stakes in a portfolio company are very small (0.5-2%); VCs do not sit on the boards of portfolio companies they invest in; and you get blamed for making mistakes.
Future Concerns: Becoming The Chicken Head Rather Than The Oxtail
In the end, Taiwan’s VCs seem to see more similarities than differences with U.S.-style venture capital. With so many U.S.-educated Taiwanese, the prevalence of good small and medium-sized companies, and access to liquid capital markets, VCs feel that they possess the experience and the expertise to expand beyond their borders. “The challenge is how far can Taiwan’s VCs develop outside of Taiwan,” says Yang.
According to the TVCA, a little more than 20% of all disbursements made by Taiwan venture capitalists in 1999 went overseas to the U.S. even though less than 4% of capital came from foreign sources. VCs have started to look for strategic partners overseas to diversify risk, to stay abreast of innovation, and to track deal flow. “If a fund has more than $100 million, you are dealing with lots of different types of investors,” says Yang. “You need to consider risk management, so we need to have regional involvement.”
“Most VCs put money in Silicon Valley, Canada and Israel,” says Phina Lee, assistant vice president of Hotung Group. “Now we are looking to invest in Europe…liquidity is the most important thing for us.”
Sources of funding represent one major difference with the U.S. however. While pension funds have contributed about 40% of the capital raised in the U.S. since 1979, corporations have been the major source of funding for Taiwanese funds. More than 49% of the total capital raised came from domestic corporations, more than any other source of funding. There are several reasons for this. Although the Ministry of Finance removed the ban on investment in venture capital funds by domestic insurance companies and private banks in 1994, restrictions still remain. For example, the amount of investment in VC funds by insurance companies cannot exceed 25% of capital stock of the invested venture capital fund, and contributions by private banks cannot exceed 5% of capital stock of invested venture capital funds.
This has raised some criticism from VCs that see inconsistencies in government policies to develop the appropriate financial and legal infrastructure. “The problem in Taiwan is that the government has never been efficient in providing infrastructure,” Yang says. “Take out the tax incentives, but you have to release the handcuffs in banking, insurance, securities, private sector.” Yang believes that it is time for the government to let banks as a private company decide what they want to do with their funds. To this effect, he hopes that the government will consider further measures to increase sources of funding such as raising the 5% threshold on investments by banks to 10% or 25%.
So where do Taiwan’s VCs see the money flowing to down the road? Semiconductors, information technology, telecommunications and opto-electronics have received the most attention. According to the TVCA, VCs made 318 information/ Internet investments representing $216 million in 1999. The semiconductor sector received 234 investments representing $199 million in 1999. Yet VC’s remain cautious about the Internet space.
“The problem with dotcoms,” says Yang, “is that it’s a very technological and market-driven issue. In Taiwan, the market is too small.”
Hsu notes, “Taiwan is currently in a time of change right now. PCs are waning and the industry is saturated, and while semiconductors are big, they have limitations now.” Instead, Yang sees telecommunications as a good growth area. “Telecom’s growth potential is better than semiconductors . . . it tends to be more regionalized if not more internationalized.”
Taiwan VC’s find more promise in the Internet if the China market opens up. “In the Internet investment, we can compete if we leverage the market in China,” says Chew. “If we’re talking about just Taiwan, there’s no future because the market is too small.” As a gateway to the Chinese market, VCs see a huge potential role. “Although Taiwan’s population is relatively small, when you count all of the Chinese speaking population, the potential is huge. If you know Chinese characters, you are covering one quarter of the world’s population, ” says Hong.
Already a force in the Asia private equity sphere, “the future for Taiwan venture capital is very bright,” says Hong. After years of unprecedented growth, VCs feel like it’s time to stretch their wings. “We want to become leaders,” says Hong. “We want to be the chicken head rather than the oxtail.”