China Venture Capital Report
1st May 2010
High risk, high impact
From humble beginnings, China’s venture capital market has seen a meteoric jump in size and importance. It’s not a market for the faint-hearted though, finds Tom Spender.
China attracts superlatives for many things and its venture capital industry is fast becoming one of them.
“I’m extremely excited by China – there are an extraordinary array of things going on there that are much more dynamic than I’m seeing anywhere else in the world,” says Andrew Rickman, chairman of the UK-based angel investor Rockley Group, which launched a $100 million joint venture fund with Shandong High- Tech Investment Corporation last May.
The big opportunity in China lies in its internal growth, says Rickman. “China needs projects and technology that help it continue its domestic growth in a stable way. That’s what it has to do in order not to fry the planet with global warming and not continue to pollute its rivers, while at the same time keeping its population happy with progressive improvements in living standards,” says Rickman.
For the venture capitalists, that translates to opportunities in sectors such as healthcare, energy efficiency, health and safety, consumer companies, financial services and clean technology, including solar and wind energy and water treatment.
China in the global context
“There are greenfield opportunities across all sectors,” says Xiaodong Jiang, who launched Silicon Valley-based New Enterprise Associates’ Beijing and Shanghai offices in 2005. “In terms of returns I would think that China is ahead of the US and if you find the right strategy, the failure rate on average ought to be lower, although there are fewer absolute breakthrough innovation companies so the absolute upsides may be lower compared to, say, a Google.”
While their populations together account for 37 per cent of the world’s total, China is about five years ahead of India in terms of development and ten years ahead in terms of the size of the market, according to William Bao Bean, partner at Softbank China & India Holdings, a fund with 14 investments, including six in China and three in India.
Yet while there is a huge buzz about China, the actual amount of venture capital investment there is still a fraction of the level seen in the US, although it’s rising fast. In 2000, only about $5 billion in VC money was invested in China, according to Jiang. By contrast, the small European country of Austria, with a population of just eight million, saw $10 billion in VC investment. A decade later and China’s VC market is worth between 30 and 50 percent of the US market by value, Jiang estimates.
While still growing in terms of its global share, the growth of the venture capital industry took a hit last year under the impact of the global financial crisis, even though China recorded 8.9 per cent overall growth. In fact, according to statistics from the Zero2IPO Research Centre, the number and amount of funds raised, and value and number of investment and exit deals all dropped compared to the 2008 figures.
Within China itself, venture capital is a rapidly evolving market. The more developed eastern seaboard attracts the bulk of VC money, says NEA’s Jiang. More than half of NEA’s investments are in companies located in the Yangtze River Delta region, which has a population of about 100 million but contributes about 25 per cent of China’s GDP.
Jiang sees particular opportunity in healthcare services and $100 million of the $350 million he has invested is in this sector. He says the Chinese government is now considering greater market participation in what is one of the last remaining state-owned sectors. “I don’t think there’s a bigger services sector of comparable opportunity, given the number of people and the ageing society,” he says. Rockley is using the relationships it has developed through its partnership in Shandong, which lies to the southeast of Beijing, to set up similar arrangements with six other local authorities in industrial areas all over the country, Rickman said.
“These partners are typically investing about 30 to 40 per cent of the money going into investment and they are also out there searching out deals,” he says.
Rockley is concentrating on later-stage companies, typically valued between $50 and $100 million, that need technology from elsewhere to become more efficient, stay profitable even in lean times and impact the environmental less.
“Our experience is it’s much better to go for businesses that are post-revenue. They may not be using absolutely leading edge technology. Instead they need technology that is well focused on market demands as they are today. There are massive needs in energy efficiency and health and safety which are unique to China.”
By contrast, pre-revenue investing in China is “truly terrifying”, Rickman says.
“It’s just more difficult to create that stability and longevity within the tech field in China at the moment,” he says. “Part of it is people tend to clear off with intellectual property which is a bit of a problem.
Loyalty isn’t as good as it needs to be in China to support an early stage model.” In any case, argues Bao Bean, low set-up costs for businesses and the widespread use of capital from family and friends in the absence of a developed VC industry means there’s less demand for early-stage money.
“You can get to a point where the company has a product and even revenue on family money so the requirement to seed isn’t there,” he says. Spring Capital Asia invests for a “very long” period of 10 years and sees “significant growth” in clean tech, healthcare and professional business service companies located in second and third tier cities such as Tianjin near Beijing, Nanjing in the south and Xi’an and Chengdu in the centre and west of the country. There, says Felix Wong, CFO of Hong Kong-based VC firm Spring Capital Asia, the growth potential for companies is “much bigger” than in first tier cities such as Shanghai.
The risk factor
Wong says agility and experience are key to managing the political risk inherent in investing in a rapidly-evolving yet also centrallyplanned economy.
“There’s a lot of political risk. You don’t know what China will be facing in the future – there could be a revaluation of the currency for example. VC in China will go its own way. It’s a country with a planned economy and following policy is very important. All you can do is react very quickly because the market changes very fast – but this also affords opportunity,” he says. But politics are not the only risk, Wong adds. “A lot of young graduates who want to earn a lot joined the industry in 2005. How can these people know what will happen in the future? When things go sour, how do you divest? The trickiest part is how you turn around a deal in the middle. It’s about making sure shareholders don’t use it to build their own personal empire. They may be cowboys. How to change this? How to make sure the new generation behaves differently? It takes time. We ourselves are learning and have to upgrade ourselves constantly.”
Both Wong and Rickman are skeptical of current conditions on China’s newest stock exchange, the ChiNext index, which launched last October in Shenzhen following 10 years of preparation. Aimed at smaller companies, it has been seen as an equivalent to London’s AIM market and New York’s Nasdaq. However, companies listed on ChiNext are trading at P/E ratios of up to 80 times, perhaps tempting companies that may not yet be ready to list, Wong says.
“It’s not something we are looking for with our investments. You can get an exit but these companies will not sustain these valuations unless they have a key product,” says Wong. Yet companies face a wait of about two years to be able to list on ChiNext and China’s other stock markets, a backlog that suggests China’s regulatory authorities are having difficulty dealing with demand.
“It may be the regulatory authority and its ability to progress the IPOs. In China it takes longer at the moment than anywhere else in the world and at the same time stock market valuations there are about twice anywhere else in the world with the exception of Nasdaq,” says Rickman. Investing in venture capital in China, therefore, is not for the fainthearted. However, it is a market that is becoming harder to ignore for venture capitalists, especially those looking in particular at technology.
“Whereas 10 years ago any tech developer needed to know what was going on in the US, now they need to know what’s happening in both the US and China,” says Rickman. However, he adds that China still has some way to go before it becomes the single most important market.
“There is still plenty of scope in the rest of world to develop very advanced tech companies. It will take a long time before those are dominated by China,” he says.
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