China Hype Creates Confusion for VCs

BEIJING-As Western venture capitalists fly in almost daily to see what all the buzz is about, the hype about China just gets louder. And that’s making it harder for VCs to get a clear understanding of how the market has changed and whether the changes truly amount to improvements.

Case in point: Top Chinese officials have been chatting up their government’s efforts to attract foreign VC. But, when pressed, they admit that regulatory reform has been slow. Also, a number of changes that that are being passed off as new have actually been in place for more than a year and have had little impact.

Zhongqi Shen, deputy director general of the Department of Finance & Facilities, told a rapt audience of venture capitalists at the recent 2004 Asian Venture Forum in Beijing about two “big breakthroughs” in venture capital regulation that the Ministry of Commerce hopes will encourage the development of Western style VC in this country.

Among those in the audience for Shen’s presentation were top VCs John Doerr, Dixon Doll and Don Valentine.

Shen, who’s department is part of the Ministry of Science & Technology, explained that the first regulatory change allowed venture firms to operate either as Chinese companies or as ” non-legal person entities,” and that the latter is similar to the Limited Liability Partnership structure that VCs are accustomed to. The Ministry was encouraged to make this significant change, Shen said, because, “China wants to see more management teams from U.S. venture firms in China” and to learn about the LP/GP structure used in the United States and Israel.

The second big change was made in the foreign exchange regulations under which venture firms may “reduce” the shares they hold in portfolio company after an exit, and under which the firms may transfer capital resulting from the sale of those shares after one year of ownership. That change appears to conform to the standard practice of lock-up periods in the United States.

In separate discussions with PE Week, Vincent Tso and Keith Lee, partners in the Hong Kong office of law firm Preston, Gates & Ellis, made it clear that all of the changes discussed at the Venture Forum had been introduced in March of 2003, and that there was nothing substantially new in the Chinese government’s presentation. Lee told PE Week that the important insight he gained from the Minister’s presentation was that the Chinese government intended to revisit the laws regulating limited partnerships very soon, although no timetable was given for reforms.

Lee pointed to several limitations still in place under the 2003 regulations, such as the fact that capital resulting from a share reduction would be in Chinese currency (yuan or renimbi) that isn’t convertible to a foreign currency. Lee also reported hearing that as few as 10 “foreign invested venture capital investment enterprises” have been started in China since the government’s first attempted to promote the industry through regulatory reform beginning in 2001.

For now, the safe bet for firms investing in China is not to do it directly. Instead, they should invest indirectly via a Wholly Owned Foreign Entity (WOFE). For example, VC-backed Semiconductor Manufacturing International Corp. , which launched an IPO amid much fanfare in March, was set up as a WOFE.

Indeed, Shen himself was careful not to set expectations too high for the world of private equity. He noted that things change slowly in China and that while “non-legal person entities” were now free from regulation by the Ministry of Commerce, there were gray areas left undefined in Chinese civil law, under which the individuals involved in the quasi-LLP structure would still have joint liability to third parties.

The minister referred to many other areas of liability and regulation that would require “much study, cautiously and practically pursued to advance” further improvements for venture capital investors. Shen assured attendees that his department, which has been tasked by the Chinese government with developing such recommendations, would meet its responsibilities to further develop venture investing in China. He made it clear that the government will, when it believes appropriate, take further steps that VCs would love, such as improving intellectual property protection and making China’s currency free-floating and freely convertible.

IP protection-or lack thereof-is a major source of fear for VCs considering investing in China. Just last week the Chinese government overturned Pfizer’s patent for Viagra in a major blow to the IP rights of foreign companies doing business here.

Shen’s presentation was made with a summary geopolitical comment about how important the “Province of Taiwan” and its technology is to China. It appeared to be intended to let the sharks in the audience smell financial blood in the waters. The subtle hint was that China’s government would like powerful VC firms, their limited partners and their political friends in Washington to help influence Washington’s “Two Chinas” policy. There was also the implication that if U.S. VC-backed companies were not allowed to develop and sell sensitive technologies to the Chinese, then the Chinese may purchase such technologies from Israel.

In a separate presentation at the Asian Venture Forum, Shihui Hu, deputy director general of the Torch High-Tech Industry Development Center, explained the Torch program, which administers 53 different regional science parks established throughout China. The program has relationship with more than 50 different venture firms that help to fund some of the 20,000 startups in the program, he said.

Hu referred to one such agreement, signed in the previous week by Israel-based Infinity Venture Capital Fund. It is a $75 million dollar joint venture formed between Infinity, Suzhou Industrial Park, CSVC Capital and IDB, one of Israel’s leading financial holding companies and an LP of Infinity. (It was not the first such joint venture, as some publications reported.) The joint venture will invest in software, telecommunications, semiconductors and medical devices. As part of the joint venture, Infinity will open offices in Shangai and Suzhou, said Amir Gal-Or, a managing director of Infinity.

By the end of this week in Beijing, it was clear that the Chinese government is serious about increasing foreign private investment in China. Given the intensifying pace of VC investment and the number of China-based companies that are scheduled to go public on the NASDAQ, it was no surprise that attendees at the event spent time arranging to meet again.