Zero2ipo: researching China's VC industry

Wearing a battered suit, testimony to his recent hectic flight schedule to Hong Kong, Shenzhen and back to Beijing, Gavin Ni is young and quietly spoken. Unlike many Chinese active in venture capital funding, Ni is not a US returnee. He chose to stay in China after finishing his studies at Tsinghua University and had a brief stint in journalism before switching into the venture capital field. Unlike many returnees, who sometimes latch on to American habits of conviviality to an almost alarming degree, Ni speaks with the reserve typical of a Chinese businessman confronted by an unfamiliar journalist.

Ni got involved in entrepreneurship early, as president of the Entrepreneurs Club during his college days in the early 1990s. He briefly became a national figure thanks to the success of his 'business plan' competition. Hundreds of universities across China got involved and the contest obtained nationwide publicity.

That is where Ni met Netease's William Ding for the first time. He remains his hero. "He so young, and the richest man in China," says Ni almost reverentially.

As he chats about those times, Ni makes a serious observation in an offhand way.

"Entrepreneurs are often translated as 'qiyejai' in Chinese, but that's quite wrong. It's odd that it's used so much as the equivalent of the English term because a 'qiyejia' is simply the head of a big firm, it could even be an SOE," he points out.

It's a very interesting remark because the term is used very broadly in China as a translation for the English word 'entrepreneur'. But if it's also used in the sense Ni uses it, it seems to imply that this uniquely evocative term, at least in Western eyes, has been lost something in translation. An 'entrepreneurial spirit has far more to do with qualities such as toughness, self-reliance, imagination and endurance than with status, let alone the status of working at the top of a stodgy SOE.

In view of this linguistic mix-up, it is not surprising that the Chinese venture capital market is an ambiguous one. Ni, founder & CEO of Zero2IPO.com, perhaps personifies the ambiguity. Despite the name of his firm, he carries out very little venture capital investments.

Since the founding of the firm four years ago, he has preferred to focus on providing research for Western VCs and training for Chinese VCs - what few of them there are. The company is still small scale, with revenues last year of around Rmb 10 million ($1.2 million), but its growth rate has been in the order of 80% per annum for the past five years.

Ni's role as advisor and middleman is a familiar one. The western investors take on the risk and provide the capital, while the Chinese side provides the know-how and the contacts.

It is a division of labour that can easily be abused, but the consequences are not usually so stark to discourage people for long. Much of the wealth flooding into China is petty by global standards.

Investors of all stripes are ready to throw a few million dollars into China as seed capital. If things go wrong, the reaction is a shrug of a shoulders and a tax write off, with perhaps some reference to the price of the 'entry ticket' of doing deals in China.

That attitude is perhaps born from recent history. There was a flood of venture capital into China during the tech boom, followed by a crash. In the second half of 2002, total venture capital invested amounted to just $163 million, estimates Ni, down almost 40%% on the previous half.

But at a recent Beijing VC summit, luminaries such as Bo Feng, made famous in a book by a US journalist for his role during the Chinese dotcom boom, mingled with more recent arrivals such as Ni - who had in fact organized the conference.

It was difficult not to hark back to the glory days of the founding of portals Netease, Sina.com and Sohu.com. Although these companies suffered a share price collapse after the tech boom deflated, they have since recovered strongly.

It is noticeable that these US-listed success stories were invariably financed by foreign venture capitalists. Ni estimates that where 50% of VC funds came from locals in 2001, it has now dropped to 17%. In the first half of 2004, foreign VCs outperformed their domestic counterparts not only in terms of total investments and average deal size, but also in terms of number of deals for the first time.

Zero2ipo's survey shows that foreign VCs' investments accounted for 85% of the total in the first half of 2004, with average deal size above US$10 million, which was about seven times that of domestic VCs. Their number of deals, which was 37, slightly exceeded that of domestic VCs.

Ni's theory concerning the scarcity of local venture capitalists is that they have no exit mechanism.

Indeed, due the to the nature of China's capital markets a venture capital investment stays locked up for three years post-IPO. When it does become sellable, it does not become a listed share but rather stays as a 'legal person' share. It is usually sold at a huge discount to the IPO price in a negotiated deal with the buyer.

"After three years, the company could be doing badly in any case. It's far less attractive than selling out at the IPO price," points out Ni.

The SME board launched in Shenzhen this summer has not broken this deadlock. It had a difficult start, attracting an enormous amount of hot money. The wild gyrations in share prices this caused, combined with a spate of corporate scandals soon after listing, meant the market was not the boon many had hoped for.

"The SME board's weakness is that it's exactly the same as the main board in Shanghai, but just for smaller companies. Exit mechanisms are still absent," reckons Ni.

One point that Ni does not raise, but other Chinese businessmen mention, is a view that VC activity is little short of insane in China, given the weak legal and regulatory environment. One businessman who had returned to China after a long stint in the US said that he when he tried to set up companies without daily supervision, money was simply stolen and the thief never seen again.

Hence, almost all Chinese VC companies are state-owned. That is surely a contradiction in terms and surely goes a long way to explain their low profile. Their inability to generate returns is evidenced by Ni's own research showing that in 2003 no foreign VC got returns of less than 10%. All the respondents in the sample who suffered the lowest returns were local, while 80% of the firms showing returns of above 100% were foreign.

Despite these obstacles, Ni is slowly moving into a more aggressive stance, planning to raise $20 million by next year, half in Rmb and half in US dollar.

"The US dollar funding will for investments in the off-shore companies that returnees from the US like to fund," he says. "The Rmb portion will go to local companies."

Ni is also hedging his bets by planning to charge a management fee of 2.5% per year for the first year and 2% thereafter.

The venture capital market is recovering from the fallout of the dotcom boom. Ni says a combination of the promise of China's private sector, the retreat of the state in certain business areas and an attractive macro picture have been drawing investors from Hong Kong, the US and Israel. His own company is largely owned by a mix of such individuals.

In that sense he is reflecting a broader trend of rising VC funds coming to China. According to Ni's estimates again, venture capital firms covered in his survey invested a total US$438 million into 80 mainland or mainland-related enterprises during the first six months of 2004, an increase of 31.86% over the same period in 2003.

Ni believes the technology and media sectors are attractive again, while the consumer sector is being targeted by investors on the back of rising Chinese prosperity. According to his research, the IC chip industry accounted for 28.34% of all dollars invested in the first half of 2004, followed by internet and telecommunications on 26.68% and 18.52% respectively.

In terms of the number of deals, telecommunications ranked top with 17 deals in total. The IC chip industry and the internet sector followed, with deals numbering 11 deals each.

But these figures are so small they often get distorted by one deal. Thus the size of investment in the IC industry only looks so large because of the investment in one deal, Datang Microelectronics. The SMIC (Semiconductor Manufacturing International Corp) and CSMC deals also caused the VC figures to spike in the second half of last year.

The internet sector has been high profile thanks to the intrusion of US giants Yahoo, snapping up 3721.com, a search portal. And Google had bought a minority stake in search technology company baidu.com. Both of these companies had foreign VC investors, and word of their success was quick to spread.

Ni believes the market is there to be taken, but he uses the kinds of easy extrapolation which were so common during an earlier dotcom age.

For example, he points out that total VC investment in the US amounts to $40 billion per year, while the figure for China is around $1 billion. But given US GDP is only eight times larger then the Chinese economy, we should be seeing much higher levels of VC investments in China, he argues.

Whether or not he that particular dream unfolds as planned, Ni seems to have hit a sweet spot with his well-respected research reports. It is not an easy topic to tackle given the innate secrecy of the market, but his long list of clients seems to show that he is generating exactly the kind of product people are looking for.