Over $500 million in venture capital was earmarked for China in the first half of 2005 alone. With a shortage of deals and management talent, opportunities abound for both investors and investee companies from abroad. In the third instalment of this four-part series, Paul Waide pulls back the curtain to reveal the complex machinations of China’s vibrant private equity market.
IT’S GUANXI BUT NOT AS YOU WOULD EXPECT IT
Connections are as important to raising capital in China as in any market. You might expect China-focused venture funds to be seeded with sons and daughters of State Council members, regional governors and other political power brokers. Surprisingly, they are not. Unfortunately for Australian entrepreneurs, they are not seeded with alumni from our leading universities either.
China’s VC boom offers several lessons: operating experience in difficult environments is valued at a premium, and longevity often counts for something. And no matter where you are in the world, everybody understands “Stanford,” “Harvard,” and “MIT.”
Chinese venture capital had a glorious year in 2005, and 2006 promises to be even better. Venture backed upstarts Alibaba, Baidu, and Focus Media were all valued at over US$1 billion by the end of 2005 courtesy of high profile IPO’s or trade sales, and the $100 million to $500 million neighbourhood was littered with venture backed companies. Australia’s venture capital industry by comparison would be lucky to claim those sort of statistics over the past 10 years. If you were an entrepreneur looking for backing in 1999, there was no better place to be than Silicon Valley. Today, an entrepreneur can attract just as much investor interest in Shanghai or Beijing as in Palo Alto.
It is not just the number of new funds and the amount of capital committed to them that should attract attention, but the limited partners that have invested. Gobi Partners managed to convince Sierra Ventures’ Ben Yu that Gobi was one of the best vehicles for Sierra to get exposure to the Chinese market. Yu, a Hangzhou native and University of Western Australia graduate, now works out of an office in Sand Hill Road and normally invests directly in technology companies. Gobi gives Sierra exposure to China’s boom without having to expend day-to-day resources on overseeing investments.
“I won’t be surprised to see a couple more relationships similar to Gobi/Sierra get announced this year but I don’t see a lot more in the future,” says Sierra’s Yu. “I believe that, at some point in the next couple of years, most US firms will either decide to do nothing in China or set up their own presence.”
Gobi is not alone in its ability to attract venture capital firms to invest in first time China venture capital funds. Mustang Ventures launched in 2005 with $10 million investment from Trident Capital. Mustang’s Rob McCormack and Leonard Liu also landed some Google founders among their first fund’s limited partners.
Telecom equipment vendors Alcatel and Motorola also decided it would be easier to let investment professionals manage venture investments in China. Both vendors engaged Shanghai New Margin, one of the first Western style Chinese VC firms to be founded in China, to manage venture funds on the Mainland. Shanghai New Margin’s patron is Jiang Mianheng – son of former Chinese President Jiang Zemin (a reality that dispels the myth that government connections do not play a part in China’s venture industry). Despite New Margin’s ability to raise funds and attract partners, its exits have been low profile and sparse over the past two years.
“If you were an entrepreneur looking for backing in 1999, there was no better place to be than Silicon Valley. Today, an entrepreneur can attract just as much investor interest in Shanghai or Beijing as in Palo Alto.”
Venture capital funds invested approximately $US1.1 billion in early stage and high growth Chinese companies in 2005, according to Beijing-based Zero2IPO Venture Capital Research Centre. In 2006 the industry is entering a new phase, with successful operating executives from the first wave of China’s technology boom now moving into investment roles. Neil Shen, founder of travel site Ctrip.com, is now a general partner at Sequoia. Former Sina.com COO Hurst Lin has joined Doll Capital Management. And former Sohu.com COO (and honorary Australian) Victor Koo has formed 1Verge – a fund focused on internet search technologies.
Anyone with a keen eye will note in table 1. that some of the big exits (Alibaba, Focus Media, Baidu, 3721) were common to several of the funds listed. Between 2001 and 2004, venture firms in China often opted to defray risk by bringing competitors in on deals, much as investors do all over the world. However, with new $200 million China venture funds being announced on an almost monthly basis, the kind of pre-exit investor roster we saw for FocusMedia and Alibaba is unlikely to be seen again, as VCs shoulder higher risks to deploy capital.
Table 1. does not show another, possibly more important connection: the powerful US university alumni networks. Doll’s Lin went to Stanford, as did 1Verge’s Koo, as did Sequoia’s Zhang and Gobi’s Tse. Orchid’s two Lis went to Harvard, as did Carlyle’s Wayne Tsou and Celsius Venture’s Carlos Bhola. The alumni networks are useful when looking for an introduction into many of the VCs, but the VCs themselves use the networks to get in on some of the best deals. Orchid’s Gabriel Li and Celsius’s Carlos Bholoa (at the time investing on his own) helped back Eachnet, the Chinese auction site eBay eventually bought, thanks to fellow Harvard grad Shao Yibo. Shao graduated in the same class as entrepreneur Huan Yiming, who boast MIT professor Nicholas Negroponte as one of her company’s early investors.
Sequoia’s new China fund would attract attention even if it attempted to keep a low profile. Sequoia, an early backer of US technology giants Google, Electronic Arts, Yahoo!, Apple, and Cisco Systems, tapped Ctrip founder Neil Shen and former Draper Fisher Jurvetson ePlanet vice-president Zhang Fan as general partners. Zhang, a graduate of China’s Tsinghua University and Stanford’s Graduate School of Business, had a banner year in 2005: he shepherded Baidu (which Draper invested in, out of its Menlo Park office) and Focus Media (Zhang’s deal) to spectacular IPO’s and was then poached by Sequoia. In 2004, Zhang took Kongzhong, then one of China’s biggest WAP service providers, to a NASDAQ IPO.
Kongzhong also illustrates the attraction of public company liquidity for investment professionals in China. In 2005, Kongzhong was able to lure JP Gan away from his job as director at Carlyle Ventures in Shanghai to join Kongzhong as senior vice-president of finance. Real estate portal Soufun pulled off a similar feat, bringing over WI Harper’s Michael Lee as president. Soufun entered a deal with the Netherlands-based Trader Classified Media that could see Soufun bought for $170 million in the next two years.
THE GOOD NEWS
Entrepreneurs considering packing their bags and moving to Shanghai, Beijing, or even Guangzhou should not be discouraged if they did not attend an Ivy League school. With so many new funds in the market there is a hunger for deals. Joe Chen and James Liu of Oak Pacific Interactive faced a feeding frenzy of venture investors when they went in search of their latest round of capital. The pair closed a $48 million pre-IPO round in early march.
VC’s not only have to compete with one another for investments but with corporate venture funds like IDG Ventures, Intel Capital and Legend Capital. Add to these aggressive hedge funds like Tiger Technology and Blue Ridge that have profited from private investments in Chinese tech start ups and the market is getting crowded. Once start-ups get big enough there are a host of funds looking to provide mezzanine financing or private capital. Telecom Venture Group, Warburg Pincus, Goldman Sachs, Morgan Stanley, Newbridge, CITIC Provident Management, Temasek Holdings and Red Gate Media have all been active on the mainland and continue to announce record size investments in Chinese companies.
For investors, the good news is that despite all their connections, the Stanford-Harvard-MIT / ex-Goldman Sachs / ex-Silicon Valley mafia have been struggling to match the performances of Scottish fund manager Martin Currie or South Africa’s MIH. Martin Currie placed big bets on China’s internet portals just as it became apparent that revenues from SMS services had grown to levels that made the portals great value, and MIH invested in Tencent, owner of Asia’s most popular instant messaging program, QQ. MIH, a subsidiary of Johannesburg Stock Exchange listed media giant Naspers, owns a stake in Hong Kong listed Tencent now worth over $1 billion after holding its stake through the technology bust.
As Andrew Qian, the investment banker who arranged Focus Media’s first big capital raising puts it, “Most important is to choose the right business partner, or the founder’s team.” Investors and entrepreneurs need to be conscious of the added layer of complexity that comes with investing in China, but the results of having a critical mass of entrepreneurs and investors speak for themselves.
Paul Waide is the founding editor and a director of Shanghai-based publication, Pacific Epoch. Waide is currently freelancing out of Melbourne while he tries to recover from imbibing four years of rampant Chinese growth.