In early 2005, the Chinese government took an unusual step. It introduced regulations that had a chilling effect on new venture and private equity investments in China.
These regulations – to curtail improper currency flows by Chinese citizens – inadvertently froze new venture capital investments in China by impairing the ability of Chinese citizens and foreign residents in China to hold shares in offshore entities. As most venture investments into China are structured as offshore transactions, the regulations effectively closed the availability of venture capital funding for many early-stage and growth-stage businesses in China, especially those in the technology, media and telecoms (TMT) sector. Fortunately, in November 2005, the government made exceptions for offshore special-purpose vehicles established by People’s Republic of China residents to raise funding from offshore and subsequently invest in operating entities in China, thereby reopening the floodgates for venture financings
Venture funds skyrocket
Many investors complain that pre-money valuations are soaring as there is too much money chasing too few quality investment opportunities. This is not new; according to Beijing-based venture advisory firm Zero2IPO, 353 venture funds actively sought to invest nearly $12bn (£6.81bn) of capital in China in 2004, of which just $1.2bn (£680m) was invested. In this highly competitive funding environment, many venture investors are now considering Series A term sheets with pre-money valuations comparable to those in the US. They are also re-examining deals that did not pass muster when first presented. These investors understand the adverse impact that overpaying will have on future exit performance, but they are still moving forward on opportunities as they face mounting pressure by their limited partners to have greater exposure to China in their portfolios.
Major investment funds such as 3i, The Carlyle Group, SAIF, Warburg Pincus, Sequoia, DFJ and Baring Asia are being drawn to China’s maturing venture capital and private equity markets. This has resulted not only in more diverse investors, but also in larger deals. These funds are conducting venture deals with higher capital investment to combat competition. So while most deals are still early-stage investments ranging from less than $1m (£570,000) to $5m (£2.8m), later-stage and larger deals of $10m (£5.7m) or more are now more common. According to Asian Venture Capital Journal, the top 20 deals in 2004 raised more than $500m (£283.6m) in growth capital – more than 40 per cent of the capital raised in that year.
Investors continue to deploy capital primarily in China’s TMT sector, but there has been an increase in venture capital activity in traditional industries such as advertising, dairy products, retail, hospitality and education. Investors realise that, due to the current level of interest and capital invested in the high-tech sectors, they are at risk of being overvalued. Investing in the right company in a traditional industry with less competition from other investors can be just as profitable.
Investors are encouraging their portfolio companies to consider trade sales, especially while valuations continue to run high and a respectable exit performance is nearly certain. Even though the primary exit path for venture-backed companies continues to be offshore listing transactions, recent blockbuster M&A deals have wetted investors’ appetites for the immediate liquidity and decent exit performance offered by trade sales. Yahoo!’s $1bn (£570m) acquisition of a 40 per cent stake in Alibaba and the recently announced $325m (£184.4m) acquisition of Target Media by Focus Media are two such exits announced in recent months.
Another important trend is the increasing level of sophistication of Chinese entrepreneurs. This, especially with respect to fundraising, is helping to smooth the transaction process. Many of the entrepreneurs that have successfully attracted investor capital have experience in venture-financed businesses in the US or Europe and have had direct or indirect exposure to the funding process. They are often fluent in the language of venture economics and are able to rally the resources within their companies to facilitate the negotiation and closing of a financing without episodes of high drama or subterfuge – making the funding process more manageable for investors as well as for their legal counsel. With a deeper bench of entrepreneurs that understand the process as well as the strategic value that institutional investors bring to an organisation, less time needs to be devoted to explaining the importance of a term sheet and more time can be spent on refining the actual mechanics of the deal. This trend is likely to be boosted by the Chinese government’s recently announced goal of enhancing the competitiveness of Chinese venture capital funds. This will probably lead to a growth in China-based funds in the future.
Finally, several large buyout funds are starting to focus on China, as demonstrated by The Carlyle Group’s recent purchase of an 85 per cent equity stake in Xuzhou Construction Machinery. Buyout investment opportunities, however, remain limited in China due to the lack of privately owned, decent-sized companies and the restrictions on foreign investment in certain industries. Moreover, buyout firms have hesitated to deploy capital in state-owned companies – even if they appear to be financially attractive targets – due to the burden of complex rules regulating such assets. While China’s total buyout investment continues to grow, buyout funds are unlikely to intensify their activities in the region until the market becomes more sophisticated.
As 2006 and the Year of the Dog begin in China, with a growing number of funds and strategic investors seeking to capture the next blockbuster Chinese deal, it is likely to be an interesting year.
Steven Robinson is a partner in the Shanghai office of Hogan & Hartson. He was assisted by counsels Arthur Mok and Roger Peng