The China Business Review, November-December 1999

 

The Rise of Venture Capital in China

Context and cases for newcomers and skeptics

 

Paul H. Folta

Contents:

Part I: Venture Capital in China and Asia

Part II: Venture Capital Cases

 

Summary:

 

Venture capital has reached a new level of prominence in China since the mid-1990s, and its influence and impact on traditional participants in foreign direct investment (FDI) is only likely to grow. Venture capital groups working in China have, in recent years, enhanced the ability of traditional participants in the establishment and expansion of industrial, service, infrastructure, and new technology projects to achieve their objectives.

Experienced China project-development specialists and strategists in Western corporations might occasionally have dealt with venture capital groups working in China. More often they have dealt with the usual players, including state-owned enterprises (SOEs); Chinese entrepreneurs; overseas Chinese companies; and intermediaries associated with trading companies, vendors, government offices, investment bankers, and consultants. In China's increasingly competitive environment for sound projects and attractive local partners, a broader awareness of venture capital's role in China could prove useful to investors. Even more valuable may be the examination of several cases that illustrate a venture capitalist's typical interactions with the major participants in various hypothetical investment projects. The cases, drawn from actual situations, illustrate the process by which the venture capitalist can exert influence both cooperatively and competitively.

Part I: Venture Capital in China and Asia

The Context

Venture capital groups have participated meaningfully in project development worldwide. Recent Chinese projects have ranged from toll roads to consumer goods to Internet start-ups and have been described in specialized sources such as The Asian Venture Capital Journal, business journals such as The China Business Review, and public and online news services.

Venture capital is often called private equity investment since the recipients of most venture capital investments are companies not listed on stock exchanges. Most investments take the form of shares or loans convertible into shares at a certain price in the future. Investee companies might be at early stages of development, but in China and Asia they more often are companies that have already established a market and are in various stages of expansion. Usually, these investments introduce technologies or services that might be advanced by international standards, but that have already been developed and demonstrated to be effective in economically advanced countries.

In 1995, only 1-2 percent of venture capital fund investment in China went to "seed stage" projects–research and development, or product-development investments made before a product even exists or a company is even organized. In contrast, about 30 percent went into start-ups, about 65 percent into expansion projects, and the balance into buy-outs, according to Anthony Alyward, in "Trends in Venture Capital Finance in Developing Countries" (International Finance Corp. [IFC] Discussion Paper No. 36).

Venture capital investments typically range from a few million to the low tens of millions of dollars for industrial and service-oriented investments. Investments in infrastructure projects range from the low tens to the low hundreds of millions of dollars. Usually venture capitalists take passive equity stakes of 10-49 percent of effective voting control and require at least one out of five seats on the board of the investee company. In Asia, investors hold such stakes for an average of 4-5 years.

Fund managers are typically professional fund-management companies associated with international financial institutions or independently established companies with track records of managing investments in China. Funding commitments come from groups such as insurance companies, pension funds, corporations, and high-net-worth individuals, and are pooled in closed-end funds. Financial institutions also make private equity investments on a project-by-project basis, either paid for from the institution's funds or syndicated to other institutions.

Although industrial and service corporations technically also engage in private equity transactions when they invest in joint ventures, such investments are not considered "private equity investments," which solely emphasize financial returns. Instead, they are called "direct investing" or "corporate venturing" since they are made for strategic considerations and involve a significant degree of board and day-to-day management control. Foreign venture capital investment in Asia is best considered a component of foreign direct investment, given the usual size, degree of control, and duration of venture capital (VC) investments.  

China Funds

There are different types of venture capital funds oriented to investing in China, as examples from press and industry sources indicate. Most are based in Hong Kong, but some have head offices in Beijing. Other funds invest in China from elsewhere in Asia or from the United States or Europe.

The Walden Group, managing over $850 million in Asia, focuses its $100 million China Walden Fund on early stage, high-tech private enterprises launched by local entrepreneurs.

Since its inception in 1985, ChinaVest has invested over $200 million in Greater China–China, Taiwan, and Hong Kong–primarily in expansion projects. One recent investor in a ChinaVest fund, John Hancock Mutual Life Insurance Co., has reportedly invested $60 million in Chinese infrastructure projects since 1996.

Chase Capital Partners, an affiliate of Chase Manhattan Corp., had $100 million under management in Asia with about 50 percent in China. This year it raised a new Asia Opportunities Fund of $521 million, with $250 million from Chase and $100 million from the World Bank's IFC, according to press reports. The fund limits its allocation of total investments to no more than 40 percent for any country, including China (see also Ting Yu Seng and Abhay Agarwal, "A Bigger Role for Private Equity," Business Times [Singapore], July 27, 1999).

Some venture capital funds are joint-venture management groups. For example, a $50 million Beijing Technology Development Fund was set up in 1999 by the US arm of WI Harper Group; Beijing Enterprises Holdings Ltd. (which reportedly provided $10 million); and Qinghua University Enterprise Group. This followed the 1994 establishment of a successful $85 million China Dynamic Growth Fund partnership among Hambrecht & Quist Asia Pacific; the Bank of China (which committed $10 million); and the China International Trust and Development Corp.

Another recent joint fund, valued at $100 million, is between International Data Group (IDG) and the Ministry of Information Industry (MII), the government body supervising China's telecommunications, postal, and media sectors. IDG, a Boston-based information-technology publishing and research company operating several joint-venture computer magazines in China, has managed another $100 million venture capital fund since 1993 through which it invested in 55 high-tech companies in China. Nearly half of the IDG fund investments are in Internet companies, with the rest in software, hardware, and biotechnology firms.

Other funds include the First Eastern Investment Group, started by lawyer Victor Chu in 1988. First Eastern manages over $500 million under six joint-venture funds with Chinese state enterprises such as an Irish Stock Exchange-listed fund with GE Capital Services and a trading company, CMEC, which is under China's State Bureau of Machine-Building Industry. The company has invested in expansion and pre-IPO (initial public offering) bridge-financing projects in 10 provinces. First Eastern typically seeks to appoint key staff such as the deputy general manager and chief finance manager.

Asian Strategic Investments Corp. (ASIMCO), based in Beijing, was started in early 1994 by US investment banker Jack Perkowski. It manages $400 million and is known for its investments in automotive components and brewing facilities throughout China's inland provinces. It has emphasized management control, distribution, co-investments with companies such as Caterpillar Inc., and technology-licensing arrangements with groups like Nippon Piston Ring. Not one of its general and limited fund partners has invested over $25 million. ASIMCO eventually aims to convert from a fund to a corporate structure and to list itself.

The Range of Deals

China deals vary in size, shares, stage, and duration of investment. Most funds consider an investment of less than $2 million not worth their while, given the cost of due diligence and risk of failure to complete the investment. Sometimes they will invest less if due diligence is managed cooperatively with other investors.

For instance, the Beijing Technology Development Fund recently invested in two start-ups–about $3 million in an Internet-development company and $3 million in a wireless-local-loop equipment manufacturer. US-educated Chinese entrepreneurs started both companies.

IDG invested $2.4 million in Huicong, a Chinese market-research and information joint venture with $6 million in revenue, giving IDG 20 percent ownership, rights to appoint a vice chairman, and one board seat.

Suez Asia manages $400 million in funds, half from French financial groups, and has made 30 percent of its investments in China. Known for providing financial engineering and strategic advice, it invested in 25 percent of a private Chinese food-flavorings company (which now has $40 million in sales, and a 15 percent net profit margin).

The American International Group Asian Infrastructure Fund II (AIG-AIF II) and Sithe Energies (New York) invested $200 million in Sithe Asia Holdings, an independent power producer. AIG-AIF II contributed 40 percent, according to press reports. The proceeds will be used to fund other Sithe Asia projects and add another power project to the two it currently operates in China and three more it is building there.

In some cases, foreign-controlled funds have forced the clarification or modification of Chinese regulations in sensitive areas such as aviation and telecommunications operations. For example, in 1996, George Soros reportedly acquired 25 percent of the then-unlisted Hainan Airlines Co. Ltd. by purchasing Chinese government-held shares, despite the fact that PRC regulations prohibited foreign purchase of government shares. Subsequently, the ratio of foreign investment allowed in domestic airlines was raised to 35 percent, and might be increased to 40 percent in the future to facilitate further funding. Following its listing, Hainan Airlines sought a 25 percent-stake in Hainan's new Haikou Meilan International Airport for about $23.9 million to promote a critical expansion program.

Previously, Chinese airlines were banned from investments in airports to prevent monopolistic practices. Also, foreign ownership of airports was limited to 49 percent; foreign involvement in critical airport operations is also highly restricted. Thus, the indirect investment structure offered by Hainan Airlines and the local government's flexibility likely provided foreign investors with important operational transparency while maintaining the Chinese government's objectives of control.

Because foreign investors have experienced difficulty in resolving control and transparency issues with local partners, Wuhan, Hubei Province, has the only airport that has received direct foreign investment, according to press reports.

In telecommunications, the first of the "Chinese-Chinese-foreign" (CCF) equipment lease and operating services structures for telecommunications projects was developed by venture capital group SC&M International, Ltd. (US), Brooks Telecommunications (US), the Guangzhou City Government, and other Chinese groups licensed by the central telecommunications authority in 1994. This project built the first broadband integrated services digital network (BISDN) backbone around Guangzhou. Although this project broke new ground in foreign participation in telecommunications operating services, the PRC government has recently sought to dissolve subsequent CCF ventures (see The China Business Review, May-June 1999, p.16).

 

Scale of Funds

The pools of venture capital funds under management and funds available for investment in China and Asia have been growing rapidly since 1990. Although these funds remain small relative to GDP and as a contribution to FDI, they are an indication of investor interest regardless of whether deals reach completion. Moreover, the portfolio of actual investments in China and Asia has grown continuously since 1990.

According to data collected by the Asian Venture Capital Journal (AVCJ Holdings Ltd.) for venture capital fund management companies investing in Asia's 10 largest developing economies (Asian VC funds), about 10 percent of investments go to Chinese projects (see Table 1). This category excludes both funds set up for Asian infrastructure, which target about 30-40 percent of their investments for China projects, and China-specific VC funds (China VC funds). In 1990, the China VC funds pool was only $113 million or about 0.03 percent of China's GDP, versus $4.3 billion for Asian VC funds. Asian VC funds had grown by 1998 to $29.6 billion. Asian infrastructure funds were at least $4.0 billion in 1998, mostly with the raising of AIG-AIF II in late 1997 and two new funds in 1998. By 1998, the China VC funds had declined from their peak of $3.6 billion in 1996 to $3.1 billion.

For all Asian venture capital funds, including Japan, Australia, New Zealand and other smaller Asian countries, the Asian Venture Capital Journal reports that 63 percent of the commitments came from Asian sources in 1998. Sixty-five percent of commitments to China VC funds came from Asian sources in 1998.

Combining the Asian VC and Asian infrastructure funds' China-related allocations with the China-specific VC funds yields a total China VC fund pool of roughly $7.2 billion, or 0.75 percent of China's GDP in 1998. In comparison, the Asian VC fund pool plus Asian infrastructure funds made up 1.31 percent of Asian GDP in 1998. 

These figures pale in comparison to the US fund pool from 1990 to 1998, which was made up of about $275.6 billion in private equity. These funds went mostly into US mergers and acquisitions, and $59.1 billion of this went to venture capital funds, or 0.69 percent of GDP, according to the Private Equity Analyst Newsletter database (www.assetnews.com).

Venture Capital vs. Foreign Direct Investment

Total newly raised China VC funds in 1995 made up 4.7 percent of China's FDI that year, and 2.4 percent and 2.0 percent of China's FDI in 1997 and 1998 (see Table 2). New Asian VC funds plus Asian infrastructure funds in 1995 made up 8.5 percent of FDI invested in Asia that year, and 7.5 percent and 8.5 percent of Asian inward FDI in 1997 and 1998, respectively. This poor fundraising for China and Asia in 1997 as the Asian crisis hit indicates that venture capital funds and their investors are more risk averse and less "vulture-like" than sometimes thought.

Given the relatively small rise in China's FDI in 1998 (2 percent) and drop in Asian FDI in 1998 (-7 percent), and the supposed dire need for foreign investment in the region, VC funds raised for Asia appear more opportunistic than those raised for China. Of course, these figures may reflect other issues among investors and local companies seeking capital–such as perception of risk, value, and willingness to share management control. It possibly also reflects the speed at which funds can be raised.

Comparing the 1997-98 growth in VC funds actually invested with the expansion of the VC fund pools fills out the picture. In Asia, VC investments increased even as GDP and FDI growth slowed. China-oriented funds mimicked this trend in 1997, but not in 1998 (see Table 3). Again, "vulture-like" investors would not have been expected to slow their investments in China in 1998.

It is entirely possible that additional funds were available for investments in China in 1997 while investors waited to see what would be the extent and duration of the Asian economic crisis. Then in 1998, investments to China slowed as attention shifted back to the rest of Asia and as fears about China's moderated growth took hold. It may be too soon to place too much weight on this limited data. But it is clear that foreign private equity is a force that is neither easy nor wise to ignore.

Domestic PRC Funds

Within China, 80 entirely domestic, technology-oriented funding groups (trust, venture capital, and credit funds) managed $480 million in 1999. The Ministry of Science and Technology added $360 million to this in the form of an innovation fund for small high-tech firms. The small size of these funds is not surprising, given the absence of a regulatory framework in China for venture capital firms and the slow pace of the development of such guidelines. (China's December 1998 securities law does not address venture capital in depth.) In addition, local funds domiciled in China would not have the same foreign investor status and tax advantages as those based offshore.

The Importance of Chinese Entrepreneurs

More significant than local investment funds are Chinese entrepreneurial enterprises. Entrepreneurial enterprises have been formed by individuals; groups of businesspeople and technical experts formerly under a collective enterprise structure and supported by local government bureaus; SOEs' trusted managers, bureaucrats (or sometimes relatives) empowered to spin off independent companies; or other groups such as university or government research units that obtained private-enterprise status.

These entrepreneurial enterprises all face the same obstacles: marketing and distributing products, competing and protecting their brands and technology, obtaining new technology, working with foreign partners, finding funds, obtaining suitable labor, and managing local- and sometimes central-government interests. Their success is best reflected in the growth of the private sector, which new estimates for 1997 put at 53 percent of GDP for all sectors, including services and agriculture, and 51 percent of industrial production.

These firms have invested increasingly significant sums of local and foreign currency in private transactions in China. They often act more as mergers-and-acquisition players than passive venture capitalists, usually investing through structures that give them and their partners or affiliates effective control. In other cases, however, they invest passively both for profit and to obtain access to other business opportunities.

In addition to Chinese entrepreneurs, overseas Chinese play an important role, as do Chinese investors, whose funds often "round trip" through Hong Kong. Based on various sources, an estimated 69 percent of China's FDI comes from Chinese or overseas Chinese.

Influence–Value Added

"In a business situation, try to understand the context of the word friend or pengyou to learn what level of influence or actual guanxi really exists and whether your friend has the interest to use his or her friendship for you or for others to your benefit," a Chinese colleague once advised. Too often, when Western corporations strategize and develop projects in China, they fail to recognize sufficiently the influence and interests of the various parties involved. This lack of understanding often has delayed and undermined the desired outcome–an acceptable, risk-adjusted profitability for a project in a given time frame. For this reason, it is useful to review the roles of the groups which, to some degree, almost always are or may threaten to be involved in the development of many China projects.

°  Chinese entrepreneurs: The availability of and leverage offered by private equity is no longer new to leaders of Chinese entrepreneurial enterprises. These firms often perceive venture capitalists, whether fund managers, institutional investors, or private individuals, as offering financial and strategic managerial advice that will ultimately lead toward a mutually acceptable outcome.

Such an outcome might be significant growth in the venture's value, with shares sold to a strategic industrial investor at a higher price–along with more favorable terms and commitments for technical improvements, and possibly also offers of access to new markets. Alternatively, it might be an IPO on one of China's stock exchanges, on Hong Kong's new Growth Enterprise Market secondary stock market, on another main Asian stock exchange, or on the US NASDAQ. Chinese entrepreneurs see an IPO as not only a route to profits but also as a symbol of corporate success and independence.    

°  Brokers or intermediaries: Quite often, Chinese entrepreneurs work with a diverse set of local and foreign trading companies, government officials and contacts, overseas Chinese companies, and a wide variety of technology vendors, consultants, and investment advisers. These intermediaries help entrepreneurs structure protective holding companies in China or offshore, manage suppliers and technical partners, introduce potential Western industrial investment partners, borrow money, and raise private equity funding. Often, such groups not only act as deal brokers, but also promote their own strategic interests, which a skillful entrepreneur attempts to balance against the interests of other parties.    

°  Private equity specialists: Entrepreneurs and their intermediaries have more and more frequently sought out private equity specialists as venture capital has grown and as venture capital representatives have promoted their funding and relevant expertise. Perhaps more important, venture capitalists increasingly get the initial call because they often appear more closely aligned with the local Chinese entrepreneur's immediate interests, and less interested in controlling the company, than Western industrial groups. Thus, Western industrial corporations–which hold key technology, markets, management skills, and funds–might no longer be at the top of the list for partnerships.

Furthermore, it has been increasingly common for deal brokers and vendors to act as principals as well, exchanging equity for their payment. Once such value-adding groups–intermediaries, venture capitalists, and vendors–have met with the entrepreneurs, and plans have been outlined with the help of eager investment bankers, the confidence of many Chinese entrepreneurs grows further, even during the current period of economic retrenchment. 

°  Western industrial firms: In many recent cases, Western companies have opted to set up wholly foreign-owned enterprises in China, thus bypassing all partnering options. These decisions may have been due not only to an unwillingness to accept many SOEs' inefficient assets, but also because they have found themselves unprepared for the–as they see it–unfounded confidence of Chinese entrepreneurial groups. In some of these cases, Western companies might have missed opportunities to leverage off of the influence and interest of venture capitalists in order to partner with profitable Chinese entrepreneurs.

According to a recent survey, private Chinese companies have produced an average return on equity of 19.5 percent, whereas foreign-funded companies averaged 3.1 percent. A survey earlier this year, reported in the Economist, found that 60 percent of multinational corporations in China since 1993 had achieved positive cash flow. Of those in China since 1985 only 50 percent had positive cash flow. Previous studies found that only 40 percent of 70 major MNCs in China and fewer than half of the foreign-invested enterprises in Shanghai were making profits.

In many cases, Chinese entrepreneurs have been at the forefront of reforms through fait accompli agreements with foreign groups, particularly involving private equity deal structures as in the Hainan Airlines case. This may imply that Chinese entrepreneurs and venture capitalists could be a strong combination for Western industrial groups to tap. Perhaps this is one reason why 45-55 percent of China VC funds came from non-financial corporations between 1995 and 1998. In contrast, 39-47 percent of Asian VC funds came from non-financial corporations during this period. Recently, among venture capital funds in the United States, such corporations contributed 30 percent of those reporting on contributor types.  

VC is Here to Stay

Considering the venture capital funds available and invested in China and the interests and needs of the various actors in China investment projects, the role of venture capital is potentially significant. Understanding the role that venture capitalists might play in the investment process, MNC strategists and managers would be wise to consider how they might more effectively cooperate or compete with this rising group of investors.

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Part II: Venture Capital Cases

To illustrate the recent expansion of the influence of venture capital in China, suppose that you are a private equity specialist.

The investment fund you represent wishes to be a relatively passive investor, but generally requires at least one board seat on the ventures in which it invests. According to your fund's strategy, start-ups are to be avoided. Yet your fund accepts that many expansion projects have start-up type risks even if one of the parties is a foreign technical or industrial partner. You must conduct due diligence to identify and reduce such potential problems, but you will have to accept some risk or else there will be a high premium on a more mature deal. You must put in some "sweat," or add value, to create goodwill in order to justify locking in your rights, otherwise you will face serious competition as the deal progresses. 

In many cases, a good deal can take from one to two years to complete from your first introduction, particularly if government and multiple parties' board approvals are required. You must seal the deal sooner, but without funding it until all the preconditions are met.

The key to your job is to understand your various counterparts: what problems they face, what actions they need you to help them carry out, and the results that they and you can reasonably expect. The following scenarios are drawn from a variety of possible situations, based on the author's personal and observed experience, and are not necessarily intended to represent a single hypothetical deal.

The Chinese Entrepreneur

Situation: As noted, the Chinese entrepreneur often has a growing local market, but lacks capital and skills to expand, diversify, or achieve quality levels necessary to increase market share significantly and/or export to developed economies. He might have local political support, but government involvement also can be a liability. The entrepreneur will be very cautious about whether, how, and when to obtain central-government approvals, which are required for deals over $30 million. 

Action: After the initial introduction, identify the local and international market potential by researching news, journal, and trade articles. Consider the evolution of that market in more developed Asian countries and in the West to identify likely future patterns in that sector in China. Understand the keys to success and barriers to entry. Talk to Western corporations, local competitors, suppliers, buyers, trade associations, government bureaus, and international bankers. Ask about the sector, successful companies, competitors, and relevant trends in the general region. For reasons of confidentiality and to evade your competition, you might not wish to reveal the entrepreneur's company name or project details. 

Get to know the entrepreneur personally and understand, as soon as possible, his and his enterprise's broader interests, opportunities, and problems. Visit the head office, plant, and subsidiary organizations and talk with executives and the key staff, individually if possible. Discuss and define your and the entrepreneur's exit strategies. Note the business problems he or she faces and determine whether they can be solved with your fund's money within an acceptable time frame.

If, after analysis, it is clear that the project requires a foreign technical or industrial partner, quickly break the news to the entrepreneur and offer a solution that both parties can accept. For example, tell the entrepreneur that you cannot invest at all until you complete financial, technical, and legal due diligence; structures and agreements are in place to solve identified problems; and your own committee approves the proposal. Explain your investment process and how you will keep the entrepreneur informed of your progress. If a foreign technical or industrial partner is required, outline a mutually acceptable plan to identify, evaluate, and negotiate with such a partner.  

Include these points in a detailed letter of intent (LOI), designing it to protect your company and outlining all of the key likely terms, requirements, intentions, protection rights, confidentiality issues, future steps, and time frame. Consider establishing onshore and/or offshore investment holding structures, and the conditions under which the Chinese entrepreneur might participate in such a structure. If he or she participates offshore, such participation should be conditioned on the Chinese authorities' approval.  

Results: Signed LOI leading to a 40/15/45-30/10/60 cooperative joint venture (CJV) (meaning the Chinese entrepreneur would have 40-30 percent voting shares, you would have 15-10 percent and the foreign technical or industrial partner would have 45-60 percent equity-equivalent control depending on other terms and super-majority rights). The LOI includes the possible addition of an investment holding company above the CJV.

Under the terms of the LOI, the CJV would try to raise 20-40 percent of the total investment; all other parties would guarantee or contribute their pro rata portion of this debt in a shareholders' loan. Certain required assets could be contributed or leased to the CJV as part of this debt, but at fair market value–determined by a neutral body if necessary.

The partners agreed on and outlined the process of arranging approval to convert profits to foreign currency.

You and the entrepreneur worked together to identify and select a "friendly" foreign technical or industrial partner. Such a partner could obtain more control in the CJV by, for example, stepping up technology transfer, increasing export targets, or sharing in the sale in China of its products manufactured overseas through approved arrangements with licensed affiliates.

All three parties agreed to form a unified business plan to submit to the authorities for approval. Since the project was expected to be over $30 million, you showed the draft LOI to the relevant industrial department in charge at the local level for their informal approval (and your added protection) before the LOI signing.

The partners outlined terms in the LOI related to the entrepreneur's possible participation in an offshore holding company, possible IPO of either the onshore or offshore companies, and exit options (priced at market rates).  

In this case, the foreign technical or industrial partner pulled out of the deal because of a shift in strategic priorities. But, since your fund committee had become sufficiently comfortable with the deal, you decided to proceed. The local partner would maintain provisional control during the search for another foreign technical or industrial partner. Any future partner, however, would not necessarily be given control. 

Southeast Asian "Overseas Chinese" Company  

Situation: Many overseas Chinese (huaqiao) companies have diversified products, international markets, and opportunities to obtain controlling shares in their various JVs in China, but the recent economic downturn has robbed them of capital. They know the local language and have developed expertise in many aspects of conducting business in China, but appear to lack the sophistication of their Western competitors.  

You are not fooled, however. Even the most traditional of these companies understand modern business practices and technologies quite well. They have executives who have graduated from the best Western schools and have worked in leading international companies. Their "problem" seems to be getting the same respect that their still-wealthy Asian financiers and wiser Western industrial executives give them.  

Action: Ensure that you understand the huaqiao group's capabilities, local-partner relationships, and government connections. Explain that to meet the time frame they desire (possibly immediately) your due diligence process requires their assistance. If you have noted deficiencies in the project, you might point out that this exercise can be constructive for them as well. You might insist on receiving a business plan with a financial model, but you would not need to sign a confidentiality agreement until they have actually agreed to provide you with hard documents. Although they will realize that the price you are willing to pay will decline as you identify problems and risks, remind them that you are asking the same questions they will have to answer should they seek additional financing or an IPO in the future.  

Openly address the risks you identify, but describe them in terms of how your funds can add more value to the enterprise by helping solve these problems. Clarify both parties' exit strategies. Sign an LOI after receiving the business plan. If you need to build a business plan together, then this indicates their limitations or their lack of transparency, and you might need to insist on including a Western technical or industrial partner. Without their cooperation, you are probably wasting time if they intend to stay involved in the target company.  

Results: An LOI was signed. But since much better information had been provided than in the other deal with the local entrepreneur, the parties were able to commit to more specific and wider-ranging items. The parties agreed to rewrite the business plan, but to complete it only after extensive joint discussions with alternative vendors for the required new equipment and possibly also an additional study. You would be allowed to contact the buyers of the venture's products in China and overseas, but would not disclose your intentions. Depending on the results, this could lead to a preliminary term sheet to be borne out by further due diligence.  

Local or Offshore Intermediary (Deal Broker, Trader, or Government Officer)  

Situation: Some professional brokers specialize in seeking opportunities to introduce projects to financial or strategic investors. Chinese and foreign business executives involved in trade or selling equipment are also often in a position to introduce a project to foreign investors.  

In some cases, traders may try to initially build, or later inject, themselves into a deal with a company with which they have business. Their motivation may be to avoid the squeeze on profit margins in their trading business, or simply to get the "upside" or profit potential of being a principal. Chinese government officials also sometimes broker deals on behalf of their bureaus, or act for themselves in order to shift out of government work. Their guanxi and inside knowledge has a limited lifespan, so they need to make the most of it before their value and leverage decline.  

The target company that such intermediaries represent often needs someone trustworthy who understands how to protect the company's basic interests. But the company owners will not need an intermediary who tries to position himself out of proportion to the value he can bring to the deal.  

Action: Ask the intermediary for details. Analyze the capabilities and strengths of the broker's relationship with the local enterprise owners and position in the deal; his intentions, transparency, and honesty; and the ongoing value of his role. Ask to see evidence of the broker's relationship with the principals of the company. How the broker gets paid (often in shares) depends on an agreement with the principals. Sometimes the broker already has created and holds shares in a JV with the company. In other cases, the broker's role is undefined, and he will try to establish his position in the project as you show interest.  

In general, do not sign a confidentiality agreement or LOI with the broker, who might present this to the owner as a validation of his role and as justification for participating in the project. A precondition to your signing an LOI might well be the clarification of the role or exclusion of the broker. If the broker's role is clearly defined and authorized with written evidence, explain your company's strategy and process, and insist on seeing project documentation and meeting the principals of the deal. If the investment amount sought is greater than the amount your fund can invest, then set out what the process and criteria will be in seeking other investors. If your management committee agrees, then you might consider helping to organize the brokering and due diligence process if certain rights of first refusal are provided in return. This might threaten the role of the broker, but the broker role faces much uncertainty anyway, and such a cooperative step might be in everyone's interest. If you like the deal enough, you might strike an agreement with the principals to be a cornerstone investor and take an earlier position upon resolution of certain issues and possibly at a lower share price.  

Results: The LOI signed with the target company owners includes an agreement for your company to lead the due diligence and fundraising effort. You will fund the due diligence effort depending on certain specified milestones. You clarified that these costs will be shared by you and future investors.  

American or European Industrialist  

Situation: MNCs share many common problems in China. The MNCs with existing investments will likely not want to give up equity for your money. They believe that they have already removed most of the risk and will not need your expertise. "At how many basis points above LIBOR would you be willing to help finance our new equipment?" might be their tongue-in-cheek reply to your inquiry. But some are also seeking a new partner or market and, if you have access to either, then they will almost certainly deal with you.  

Action: If you have established a firm and mutually beneficial relationship with a local enterprise with which the MNC hopes to partner, the MNC usually has no choice but to work with you. You can make it easy for both the local enterprise and the MNC and ensure that they get closer to what they want more quickly. Both know that you will work to help consummate the deal–otherwise why would you bother in the first place? You empower the local partner with your potential capital, knowledge of finance, and understanding of the MNC's culture. You enable the MNC to see that it can get what it wants–usually control. If it does not respect your agreements with the local partner, the deal might go to the MNC's competitor.  

For a weaker and privately held MNC with a listing potential in its home country, you might consider investing in the company rather than in the deal, with the money used for the deal. However, recognize that this might threaten your relationship with the Chinese entrepreneur if it is not justified and explained clearly.  

Results: The MNC, which already had a few projects in Asia, including one in China, agreed to work with you and your local partner and to negotiate for increased control. Since its board might not support the JV's IPO, you (and possibly the entrepreneur) received a put option to sell out to the MNC after a defined time and at the greater of an independent valuation or a set price-earnings multiple. Since the JV's value would not be realized without cooperation, the MNC judged that the entrepreneur–particularly with your support–would be fully committed to the venture's success.  

During negotiations, you tried to argue for better clarification on use of the MNC's international sales channels, a stepped-up schedule for technology improvements, and higher commissions to the venture for the MNC's use of the venture's domestic sales channels.  

The MNC initiated last-minute efforts to obtain a call option on your shares, which would have capped your upside by enabling the MNC to buy you out at a given price or multiple of earnings. With the support of the entrepreneur, you were able to prevent a call option and received clarification on international sales and technology improvements. The MNC ended up with the management and key voting control it wanted, including control over the venture's name and its brand names.  

Chinese State-Owned Enterprise  

Situation: "Yes, we would like to see your corporate brochure. How can you help us IPO our company?" was the reply to your initial inquiry to the SOE. Since then, however, you have shown proper earnestness, respect, knowledge of China, and proof of direct access to funds. While relaxing after a nice dinner you were told, "By the way, we do have a subsidiary enterprise that is looking for a foreign industrial partner, and perhaps you could locate such a partner company with whom we could spin-off this enterprise."  

Action: Do your homework before making commitments. The SOE management must report to various government bureaus, including its "industrial ministry in charge," and it will try to hold you to your commitments, even if they are only verbal. Listen for nuances such as, "We are interested (xingqu) in..." rather than "We have approval (pijun) to..." and find out what is already written in stone and what is flexible.  

Identify contingent liabilities such as environmental problems or assets–like the SOE's hospital–that you do not want. Emphasize the need to shed such unwanted assets to end up with ones you can put to effective use. Ensure that you understand–and try to protect yourself from–possible future competition from the other SOE subsidiaries that you wish to exclude from the venture.  

Check that valuable existing licenses such as distribution, service, and import/export rights stay with or are given to the venture. See whether your sales or supply arrangements might be affected by inter-provincial or inter-ministerial rivalries.  

Try to learn in advance who will be representing the Chinese side of the venture's management team, and whether he or she is qualified, or got the position through political connections. If this person was brought on for political reasons, then consider assigning him or her to a government relations office under the business management's control, where government skills and contacts can be best utilized.  

Results: The SOE prematurely introduced an established MNC to the subsidiary and you decided not to pursue the deal. Two years later they finally received approval to form the JV, but the market opportunity had already moved and competitors had expanded their presence.  

European or American Investment Banker or Consultant

Situation: Investment bankers and consultants often prefer assignments from Western corporations to help them raise finance, structure projects, and identify local Chinese partners. However, they also seek or are sought out by Chinese companies needing similar assistance. In either case, such advisers need to get mandated for fees, usually including an up-front retainer. Western corporations serious about China are able and prepared to pay for such services, but usually do not seek venture capital funding.   

In contrast, Chinese parties often do not want to make commitments to pay, even if they can. The Chinese enterprise knows that it can benefit from the investment banker's or consultant's expertise and introductions to various alternative foreign technical, industrial, and venture capital partners. The enterprise–and foreign technical partners–may know that often the most critical assistance will come from the foreign technical partner. So, without an acceptable mandate, the advisers delay, and the enterprise might seek out new competing advisers. The adviser might then start giving advice and introductions under an agreement that provides for payment upon success. However, the quality of advice and understanding is often unsatisfactory, since the enterprise does not fully trust the adviser, who is less sure of success.

Action: Most advisers will not want to see you at the table prior to their mandate, because you have many of the same skills, but you directly represent funds. Yet, you can help advisers learn to appreciate you. In fact, they might bring you another deal later or significantly enhance this deal for you. If they already have a mandate, are reputable, you get along well, and you like the deal, but they are having a hard time raising interest, then consider being a cornerstone or lead investor.  

If you sourced the deal, but it is premature–requiring a lot of work that you have no time to conduct–then consider passing the deal on to a reputable investment adviser who can enhance it and bring it back to you later. Personally handle such a turnover of your relationship to the Chinese entrepreneur or SOE, and put the necessary arrangements in writing. Explain to the Chinese entrepreneur or SOE that such advisory work will be required for an IPO anyway.

Results: You decided to pass the deal to an experienced investment adviser. He brought it back to you just as you had hoped, with a preliminary financial model, and with much of the initial validation of the business concept accomplished. The IPO should occur about three years from the funding date, plus or minus one, depending on how quickly you and the investment adviser can help the local company determine which foreign vendors to select and how soon you can finalize a strategic marketing relationship with an MNC. The vendor might even offer financing, and you have learned that one MNC also might want to invest (maybe a mixed blessing).  

Either or both the vendor and MNC have expressed willingness to participate in an extended market study if invited. Part of your investment would be used to pay the investment adviser's fees, but that was a transparent up-front agreement. You expect to pay a higher premium over net asset value (NAV) for the investment, but this is justified by the adviser's contribution, which raised the probability of the deal's completion and the expected earnings growth over the original plan.  

Venture Capitalist Competitor

Situation: You have made progress on a new project and have signed an LOI with the Chinese enterprise and/or your foreign technical or industrial partner, but issues of material importance remain outstanding. The enterprise and the foreign technical or industrial partner believe that they can work out these issues later. You stall. The investment adviser (or broker) informs you that another private equity group has expressed interest in the deal and that the new investor does not seem to have a problem with these issues.  

Action: You decide it would be useless to issue threats based on the violation of agreed principles. Instead, you politely remind the Chinese entrepreneur or SOE and MNC that the outstanding issues you seek to resolve are legitimate, that such issues were anticipated in the LOI, and that you clarified earlier that it is only responsible of you to require further progress on or to have sufficient understanding about how these issues will be resolved. Privately remind the local partner that since the new investor does not know the local partner, the new investor likely will rely on the MNC and this will swing the balance of power by building a "foreign consortium." Explain that if they force you out they will likely strike less favorable terms later and that the MNC and new investor might already have confidential side agreements between themselves.

If there is no MNC or the local partner otherwise brought in your competition, then remind them that everyone's goal is to build trust, create value, and reduce risk. Also, remind the local partner of your LOI and understandings concurred by the local political authorities. Consider suggesting that you meet with the new investor and evaluate the option of sharing the investment and risk with them. This also will help you gauge the local partner's character and commitment to you.

 

Quickly discuss the situation with your management to understand your maneuvering room and devise alternative means to stay in the deal.

 

Results: Although the MNC had introduced the competing investor group, the local entrepreneur supported your meeting with the new investors. The new investors shared your concerns, but explained their confidence in the existing plans to resolve these issues. However, they also shared your interest in getting a good price for the deal and promoting the IPO. Also, they were glad to see the depth of your relationship with the local entrepreneur. In the end, the new investors supported your deal structure, but gave the MNC more confidence in your intentions. You, the local entrepreneur, and the MNC all gave up enough shares to give the new investor one board seat. You only wanted one board seat anyway, so the results were quite acceptable.

 

Paul H. Folta has a Ph.D. from Johns Hopkins University, Paul H. Nitze School of Advanced International Studies and is the author of From Swords to Plowshares: Defense Industry Reform in the PRC (Westview Press, 1992). In addition to having a consulting practice, he has worked for various Asian venture capital funds in Hong Kong.

Originally published in the November/December 1999 issue of The China Business Review. 

www.chinabusinessreview.com 

Reprinted with the permission of The US-China Business Council, Washington, DC.

 www.uschina.org   

Copyright 1999 by the US-China Business Council
All rights reserved.

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