China: Full of eastern promise

One of the richest men in China, in monetary terms, is a Chinese-born naturalised Australian called Shi Zhenrong, who is valued at US$2.2bn following the IPO of his solar power company Suntech Power Co Ltd, which became the first-ever Chinese private company to list on the New York Stock Exchange (NYSE) last December and in the process raised US$400m.

Wuxi-based Suntech Power, now valued at around US$5.5bn, is a venture-backed company boosted with funds from Actis China Limited, DragonTech Ventures Management Limited and Goldman Sachs, which helped the green energy company complete offshore restructurings last year by co-investing US$80m., backed by DFJ ePlanet Ventures, also ranks as one of China’s venture-backed champions following its listing on the NYSE’s NASDAQ list last August with its offer price of US$27, an opening price of US$66 and closing price of US$122.54 per share, respectively. Its market valuation reached about US$3.958bn when calculated at the closing price on the first trading day.

With high profile international successes like these, it’s no wonder VC funds from the Silicon Valley and other international funds have set up shop in China’s main cities or will be doing so soon, on the look-out for China’s next star turn. “Overall the VC and PE markets in China have come of age after 10 years of people moaning that there were no exits,” says SC Mak, managing director of Walden International in Hong Kong. “People are looking out for the next Baidu or the next Google equivalent in China.”

Research conducted by Chinese venture capital research company Zero2ipo shows mainland-based domestic and foreign venture firms raised record new funds totalling US$4bn in 2005. Perhaps dispelling the myth that Chinese companies have had limited exit options, additional research published by Zero2ipo announced that 37 China Concept Stocks listed overseas in Q4 2005, including 10 VC-backed companies, debuting on HKMB, HKGEM, NASDAQ, NYSE and SGX. Collectively, they raised a total of US$12.483bn, accounting for 54.72% of the total fund raising of new stocks in those six markets.

“There’s a lot more money around this year than there was last year. Some funds that had representative offices in Beijing and Shanghai now have a full presence,” says Constant Tang, executive director of Latitude Capital Group in Hong Kong. There’s certainly no shortage of domestic capital available in China, much of which is sourced from the thousands of Chinese governmental agencies and departments (Chinese institutional investors cannot invest in private equity), but domestic currency investment remains landlocked because of offshore access issues and foreign exchange restrictions.

International capital that operates freely through the offshore investment vehicles typical on China’s venture capital scene is more preferable for high growth Chinese companies that have international aspirations. “Having an international VC back your company gives you a boost whether it’s for raising the next round of funding or for a trade sale or an IPO,” says Tang. “There is a perceived comfort level if you have a well-known international VC as one of your investors.”

The idea is that those VCs will have noticed and ironed out any potential pitfalls in a company’s business plan, giving later round investors the confidence to invest. But in such a busy market, a degree of caution is advised. “People have to be cautious who they talk to and do business with. Just because a VC has been in China for a few years does not mean that they know what they’re doing. Some venture professionals lack proficient deal execution skills,” says Rocky Lee, head of the venture capital & private equity practice, China at DLA Piper in Beijing.

Overall, China has espoused the concept of innovation and government officials regularly talk about innovation and venture capital in the same breath. The reason for this, many investors say, is that the country needs international commercial expertise to help develop and grow new businesses, restructure stagnant state-owned enterprises (SOEs) and nurture a service culture to cater for segments of society eager to spend their money on new lifestyle trends. “The Government sees the development of the VC market as a catalyst for the development and innovation of the economy. There’s a very high focus on innovation in China,” says Mak.

There has to be because China’s economy is totally reliant on maintaining a certain level of economic growth most nations in the western world can only dream of. But China needs to maintain a GDP annual growth rate of around 8% just to make sure there are sufficient jobs available for the next generation of workers, especially in a country of around 1.25 billion people (1999) or about one-fifth of the planet’s population. “We’re all nationalistic to some extent and so are the Chinese. The Chinese Government has a desire to seek western expertise to some degree but does not want to be dominated by foreign capital,” says Bruno Raschle, managing director of Adveq in Zurich.

“China is not just a country; it’s an economy with almost infinite opportunities. We’ve been investing there since 1998 so Adveq has experienced the old China and the new China,” says Raschle. “We’ll continuously see hypes in certain sectors,” he says. “People need to have a deep insight into the local economy, which has to be benchmarked with experience and understanding of the rest of the world.”

China boasts a middle class of around 100 million people who have disposable incomes, own cars and houses and have careers in the main cities dotted around the vast country. “Around 10 years ago people went to China to lower their manufacturing costs on exported products but now the focus is on the domestic market for Internet and wireless,” says Mak.

The telecoms and Internet sectors are generally accepted to account for around 60% of all new IT investments. IT, as a total grouping, has accounted for around 80% of the US$935m of fresh venture investments in China in 2005, according to Zero2ipo.

There are an estimated 400 million mobile phone users in China and around 100 million net users, or Netizens as they have become known. “Especially in the wireless and Internet sectors, Japan and Korea are leading the way with product development and they are finding their market in China,” says Mak.

Disposable incomes in the cities are generally rising. In many cases, incomes are increasing at a faster rate than the opportunities people have to spend them. This may account for why so many Chinese people have adopted the mobile phone and Internet crazes because other leisure activities are relatively limited. Just 10 years ago, it was not an uncommon site to drive through Beijing at night and see crowds of young people engrossed in ballroom dancing in open-air dance halls under motorway flyovers. Although the dancing continues today, China’s switched-on generation wants to surf, blog, SMS and chill just as much as they do anywhere else in the world.

With the Beijing Olympic Games just two years away, a massive push on sports is only to be expected. Orchid Asia has tapped into the hype by investing in Sport100, one the leading sporting goods retail chains in China. Promoting leisure time has taken on more emphasis in China in recent years. The country enjoys three national holidays, Chinese New Year, the May holiday and the National Holiday (in October), which have all been extended to 10 day periods in an attempt not only to allow the workforce some free time but also to stimulate the various leisure and service industries China, through increased consumer spending.

The contrast between the cities and countryside in China could not be starker. Away from the polluted city streets clad with more and

more concrete and glass buildings, some of the country’s 800 million rural population are gearing up to join the urban centres. It is estimated that some 200 million Chinese citizens live on US$1 or

less a day.

“The biggest barrier in my opinion is making a quick profit from the Chinese culture at the cost of longevity, and we as westerners should keep that in mind,” says Raschle. “Like the Gold Rush in the US in the nineteenth century, this is what is happening in China now.” Like the Gold Rush, some people will no doubt end up with fool’s gold in their quest to strike it rich, but that’s not a condition peculiar to China.

VCs active in China say newcomers need to develop good local contacts, local industry knowledge as well as a clear understanding of what impact local, regional and perhaps even national government objectives may have on potential investments.

The fact that some government officials and private company executives are driving cars and watching TVs they would be hard pressed to afford on their salaries does not mean all deals will be based on just developing the right kind of contacts. Increasingly, a more savvy understanding of venture capital means the market is moving in a different direction, and with it, that means valuations are generally on the increase.

“The fact that there is more money now in China than ever has resulted in higher valuations as competition for deals has increased, especially in the wireless, media, Internet and high technology business areas,” says Lee. “I think new media will be the next big trend.”

“Valuation levels are higher than before. More and more it’s about valuations, money talks,” he says. “Companies perceive that there is a lot of money and they will shop. They know where to go to meet VCs. I suspect that when these companies look to raise capital they talk to just about everyone.” However, the nuances and market hype have to be weighed up carefully. “It’s not just about valuations, it’s also about the value added, what you can offer to improve the company,” says Mak. “I would be very careful about valuations. There are lots of business models with many of them suffering from copycat producers.”

For some advisers and investors the dynamic nature of the Chinese economy with constantly changing markets and companies swamped by copycat producers makes it difficult to understand fully a target company. “Private companies always throw up complications,” says Matthew Phillips, a partner in transaction services at PricewaterhouseCoopers in Shanghai. “They are particularly complex in terms of the due diligence process.”

“Venture’s been a difficult sector to make money out of in China. There have been some successes but it’s generally a difficult sector,” says Phillips. “I don’t expect a significant increase in venture deals this year.”

Certain sectors in China are categorised as either restricted or prohibited industries, mainly in areas of communications such as broadcast media and telecommunications. And also areas of national security. In restricted businesses, investors are not able to take a majority stake.

“One area where we are seeing growth is in the logistics industry. It is still quite fragmented in China,” says Tang. Because there has been limited focus on this industry, it is one that still offers “reasonable” valuations, according to Tang. And it is an industry that has the backing of Chinese Government, which wants to see it modernise into a sophisticated world-standard industry.

There is the view that 2006 will be a more buoyant year than 2005, however, as some deals were delayed, investors say, by uncertainties introduced by government circulars or announcements in early 2005. In January 2005, the State Administration of Foreign Exchange (SAFE) issued two circulars, No. 11 and No. 29, which worried some investors because it introduced uncertainty for international VCs, although the point of the two circulars was to reduce potential abuses by domestic VCs.

According to a March 2006 Lovells briefing, venture capital professionals in China with their ears to the ground will be aware that prior to formal promulgation by SAFE of Circular No. 75, SAFE and MOFCOM had circulated several drafts of Circular No 75. Those who reviewed the circulation drafts were anticipating significant administrative hurdles (mandatory valuation, mandatory repatriation and a short compliance timeline), but Circular No. 75, as promulgated, is, on the face of it, a lot more business-friendly, and has done away with some of the more onerous provisions that appeared in the circulation drafts and in Circulars Nos.11 and 29. As a result, we are left with rules that are relatively practical and functional.

“It does clarify the fact that it’s

not an approval but a registration process. SAFE circulars have an impact on typical VC deals because of the offshore nature of the deals,” says Andrew McGinty, a partner at Lovells in Beijing. Circular No. 75 officially brings individual PRC residents (corporates and individuals) within the regulatory net for overseas investments, and certain offshore transactions involving PRC individual residents in particular must now be disclosed to and registered with SAFE. “We expect to see more legislation in this space. SAFE’s Circular 75 leaves a number of areas still quite vague,” says Lee.

“The issue of Employee Stock Option Plans needs to be clarified. I think the law may be changed such that there is a threshold, for example, where an employee owns less than a certain percentage of shares in the company there will be no need to report this,” says Lee. “We think we will also see further clarification on the interpretation of the PRC Company law.”

This is another legal issue that has been circling around the market for the last two years. This will focus on enabling the swapping of onshore (PRC) shares for offshore shares rather than the need to buy the shares, which is the present situation.

“We are working to improve the regulatory environment for VC and PE investors in China,” says Jasmine Lin, deputy secretary general of the China Venture Capital Association (CVCA) in Beijing. “The trend in China on the regulatory side is very positive. One issue we are working on is that there is no domestic exit available for international VCs in China. Normally, you have to exit via an offshore vehicle and the main choices are NASDAQ or Hong Kong,” says Lin.

“In a sense, we foreign VCs have an unfair advantage because we can exit our companies offshore,” says Mak. Domestic IPOs can’t be traded, the stocks are basically a long-term hold. “If you IPO in Hong Kong all of the international money managers are there and you get a lot more liquidity,” says Tang.

There is no doubting it will be some years before Shanghai, for example, achieves world class status as a stock exchange as the Chinese authorities are clearly controlling the evolution of the exchange. “The Government doesn’t want the local securities firms to be beaten by international players. They want to strengthen the local players to be champions and then they will liberalise the market,” says Tang.