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by Corporate VC SIG Chair
David Ai, Vice President, Hitachi Corp.

David Ai: You have been doing VC investments in China for several years now. Could you tell us who the main VC investors in China are and what are the differences among them?

Jing Huang: In terms of the categories, there are the Foreign Venture Capitalists and Domestic Chinese Venture Capitalists. I would say that the foreign VC’s are absolutely the driving force nowadays in China. The domestic Chinese VC’s were numerous in numbers. In 1999 and 2000, there were several hundred VC firms. During this time, government agencies, local municipal government agencies and economic development zones had some money. Let’s say $5 million or maybe $20 million. They set up little incubators and early stage funds. However they did not really hire the professionals to manage the funds. The government officials turned into VC’s. So obviously, after some years, their track record was really bad and many of them died out. Now, there are some domestic VC’s. I would respect:

• Legend Capital Limited (The VC arm of Legend Computers.) They operate like Intel Capital and do serious work.
• Shenzhen Venture Capital Co. Ltd (40 portfolio companies and they are doing great)
• Big Provincial VC's – such as Guangzhou VC and Chengdu VC's.

• SoftBank ASIA Infrastructure Fund
• Walden International
• Acer Technology Ventures ASIA Pacific Ltd
• E. M. Warburg Pincus & Co. Asia. Ltd
• ING Baring
• IDGVC (Most respectable early stage VC’s in China)

David Ai: Is the China VC market hot? If so, why do you think it is?

Jing Huang: I would agree with this statement particularly after 2003.

When I first arrived in China in 2002, people did not talk about China as a hot VC area. All of a sudden in 2003 the foreign VC’s invested a lot in big and high profile deals. The two normal explanations are:

1. Growing Chinese economy
2. Regulatory environment is more favorable for foreign investors to do deals in China

David Ai: What are some of the issues and challenges in this hot market?

Jing Huang: For any market which is highly pursued, you should raise the question – “Are you paying too much?” I think it is particularly good for Chinese entrepreneurs who can speak English. They can talk to foreign VC’s or VC’s in Silicon Valley. Entrepreneurs who speak English have a lot of interested VC to present to. Valuation of deals since the beginning of the year is steadily rising from the VC point of view. It has reached a point where I would ask whether I should regularly walk away from the deals because they are too expensive.

David Ai: Do you think part of the high valuation is also driven by the several successful IPO’s from China concept companies in Nasdaq? What is your view on the long term exit scenario for China based startups?

Jing Huang: Part of the reason is that starting from late 2003, we have seen a lot of IPO’s on NASDAQ of China concept companies, providing good exits for some of the VC firms who were early backers of these companies. However, what I have observed is an interesting phenomenon where these IPO’s have not held up to their IPO price. Public investors like the hedge funds, mutual funds, or the retail individual investors give heavy discounts to China concept companies in comparison to the US comparables. For example, you see heavy discounts of up to 50% and more when you check the PE multiples of Chinese portals and compare them with companies like Yahoo.

This suggests that mutual funds and hedge funds feel uneasy about China concepts and they give the “China discounts” as they feel there are certain country risks that they are unable to quantify and so pay lower valuation and leave buffer room for errors.

I have the view that the VC’s should also give country discounts. What you find interesting nowadays is that a lot of foreign VC’s do not give discounts and instead probably pay premiums. This puzzles me as I feel there are still a lot of business risks, regulatory risks and market risks in China.

Foreign VC’s who have stayed in China for more than two years shy away from paying too much (because they) have had their share of failures in China. They are more careful than the new foreign VC’s that pay up the valuation.

David Ai: What kind of companies does your firm invest in?

Jing Huang: Different firms have different strategies. The US VC’s might be more willing to take the product risk, technology risks and they are more used to home runs like 100x to 1000x that they can earn. They may not be too concerned if many of their portfolios are failures

We target 5 to 10x for a particular deal. We care about downside protection. We try to raise the success rate from 10 – 20% to 50%. We probably will shy away from risks that we are not comfortable taking. We do not take technology risks. We might take a later stage product risk. Our fund feels comfortable taking market risk particularly in terms of applying proven technology to the Chinese market. We also feel comfortable taking some regulatory risks. From this point of view, we have a different profile from the typical technology VC’s.

David Ai: We have heard from traveling foreign VC’s that there seems to be a shortage of management talent in China? Do you agree to this and what’s your outlook to this perspective?

Jing Huang: There is certainly a shortage of management talent who can speak English. I would say that there is not a shortage of entrepreneurs in China. There is a shortage of entrepreneurs who speak good English or write good business plans.

My team focuses its efforts on local Chinese entrepreneurs. We feel our pipeline and deal flow is very strong. Local Chinese entrepreneurs have good experience in developing the market and are shrewd business people and know how to deal with the local governments and local market segments and are very good in terms of their channel capabilities. They are not so sophisticated in terms of their financing activities. A value addition after our investment is that we try to help them develop a more systematic financial control and induce international management practices within their companies. We help them change into those companies that foreign capital would feel comfortable with.

There is value in taking a local successful Chinese company and help internationalize their management practice, After doing this, you can achieve 2 -3x of your investment return.

However the challenge is how to introduce the international talents into these companies. The founder/CEO’s may not feel comfortable in paying market salaries to a CFO who can talk to Wall Street. There is a constant kind of conflict in terms of the compensation concepts and corporate culture concepts between the new internationalized management talent and the local business CEO/founders.

These are the challenges we feel comfortable in taking and solving. We are doing some sort of arbitrage of the local value and foreign capital valuation of these companies.

David Ai: What about the challenges we have heard such as accounting and legal issues in China?

Jing Huang: From the accounting point of view, what we find is that the China GAAP is increasing becoming similar to the US GAAP except for a couple of areas. In particular - revenue recognition and depreciation of capital expense. Chinese companies recognize their revenues too early (compared with US GAAP guidelines).

From our side, we require our prospects to do auditing by the big 4 companies. We also hire a big 4 company to do a financial review as our investment comes at a later stage. We are very careful in terms of using US GAAP in our evaluation.

Another issue is China is - Related party transactions. Typically in China, the successful business people rely on the companies that are controlled by their family members. Business is done with relatives. This area is very sensitive especially in terms of pricing. Is there a transfer of value? Or value leakage? These are constant challenges that we deal with.

Legally, the challenges are that the foreign VC’s do not still feel comfortable investing directly in Chinese domestic companies. The typical structure is that, an offshore holding company is set up and the foreign VC invests in the holding company. The holding company then sets up subsidiaries in China to do business. The subsidiary then acquires assets or equity of the Chinese company. This structure is very complicated. Legal fees are higher due to this structure and differ from case to case.

The intellectual property laws including patent laws, trademark laws have been around for years. The difficultly is implementation. Generally, business people do not have high regards for other people’s intellectual property. I would say that it is increasingly becoming aware that you could use Chinese IP laws to pursue legal cases in China and even win. Microsoft for example is very aggressive in terms of hiring lawyers to identify cases and pursue them.

It is definitely changing for the better.

David Ai:What is your view on the Chinese domestic stock market? What are some of the problems with domestically registered companies going public domestically?

Jing Huang: The major issue is that the Chinese stock markets do not allow liquidity of the original founding shares (including institutional shares held by VC’s). Only public floated shares are tradable in the market.

Though the Chinese domestic second board in Shenzhen opens up the channel for small to medium companies to go public but they still have not solved the problem of the liquidity of original shares.