Venture Capital and Private Equity Opportunities in China

by: Shaun Rein

As part of JPMorgan’s (NYSE:JPM) China Conference in Beijing, a panel of private equity specialists discussed life in the fast lane of the mainland’s rapidly evolving venture capital scene.

China Market Research Group founder Shaun Rein, who chaired the session, asked a string of tough questions: Will China ultimately block deals for nationalistic reasons? Is there too much money chasing too few opportunities? Can foreign-invested firms expect to make an exit on the domestic A-share market?

The participants strongly disagreed with the assertion that China is blocking deals. Edan Lee of Olympus Capital said the media had overplayed some apparent failures, while other successful buy-outs got “no ripples whatsoever in the press”. Jing Huang of Bain Capital China argued that some deals were contested for normal anti-trust purposes, adding that in other cases the Chinese government was actively chasing venture capital. “There are counter examples in which the government wants private equity firms to consider investment or buy-outs of state-owned companies.” Davin Mackenzie of Peak Capital acknowledged that his firm only pursued private-company deals, and avoided sectors which are dominated by state-owned competition. But overall, he said, “nationalism is not an issue for the vast majority of industries in China.”

Nevertheless, the China venture capital market remains challenging. Panelists agreed that high valuations in the A-share market are making it hard to transact deals, with entrepreneurs asking for multiples of more than 30x earnings for direct investments. While the bankers are optimistic they can eventually exit investments through the A-share market, the process is murky. Further complicating matters, recent regulations have made it more difficult for Chinese companies to obtain off-shore equity listings. Is there too much money chasing too few opportunities? In the short term, perhaps. But in the long run, a few billion venture-capital dollars is drop in the bucket for an economy worth more than US$2 trillion, and growing fast.

About Shaun Rein

Mr Shaun Rein, before founding CMR, was the Chief of Research for the venture capital firm Inter-Asia Venture Management. He was the Managing Director, Country Head China for e-learning software company WebCT where he also ran the company's Taiwan and South Korean operations. He also served as the Assistant Director of the Centre for East Asian Research at McGill University. He has been widely published, written about and quoted in newspapers worldwide including Business Week, The Harvard Business Review, Forbes, Dow Jones' MarketWatch, Knowledge Wharton China, Yahoo Finance,, Investor's Business Daily, The Wall Street Journal and Barron's. Mr Rein won an award from Harvard University for "Excellence in Teaching". During his decade in China, he has assisted hundreds of Fortune 500 and SMEs determine how best to take advantage of the growing opportunities in China. He is on the board of advisors for Ad: Tech and is Senior Advisor to the venture capital firm China Metropolitan Ventures. He is on the Board of Advisors of Pacem Production's Building China Modern series of PBS documentaries. He previously served as the Secretary General of the Asia Society's China Board, Form Director for St. Paul's School, and sat on the Advisory Committee for Shareholder Responsibility to the Harvard Corporation. He received his graduate degree from Harvard University focused on China's Economy and a BA Honours degree from McGill University.

About Edan Lee

Mr Edan Lee is a Hong Kong-based Managing Director of Olympus Capital Holdings Asia, a leading Asian direct investment firm managing US$800 million of committed capital. He leads private equity transactions for Olympus Capital in China. He holds a number of directorships in the firm’s portfolio companies, including China Minzhong Organic Food Corporation. He is also a Director of Peking University’s Research Center for Venture Capital. Prior to joining Olympus Capital, Mr Lee was Project Director for AES China Generating Company. At AES, he developed and financed some of the largest direct investment projects in mainland China at the time for the US-listed company. Previously, he was a management consultant with McKinsey & Co. in the U.S. and Australia. Mr. Lee holds an MBA from the Stanford Graduate School of Business and a BS and BA degree from Rice University.

About Davin Mackenzie

Mr Davin Mackenzie is a managing director and the Beijing representative of Peak Capital, a private equity firm focused on the Chinese mid-market. Earlier, he was with the World Bank Group's International Finance Corporation [IFC] from 1993 to 2000. During the last four years at IFC, Mr Mackenzie was its Country Manager for China based in Beijing. He spearheaded IFC’s activities in indigenous private sector financing, SOE restructuring, western province investment and financial sector development. He also oversaw the growth of IFC's PRC portfolio of more than 40 investments worth around US$1.2bn in commitments. He led a number of advisory initiatives with the PRC Government, including projects related to FDI, private infrastructure and domestic private sector development. Prior to IFC, Mr Mackenzie worked for Mercer Management Consulting in Washington D.C., and for the Bank of Boston in Taipei. He was formerly the Chair of the Board of Governors of the Western Academy of Beijing and is on the management committee and the former Chairman of Sports Beijing. He is also an independent Non-Executive Director of AsiaInfo Holdings Inc., Chia Hsin Cement Greater China, Enerchina Holdings, Sinolink Worldwide Holdings, and The9. Mr Mackenzie has a Bachelor’s degree from Dartmouth College, an MBA from The Wharton School, and a Masters in International Studies from the University of Pennsylvania. He also attended the World Bank Executive Development Program at Harvard Business School in 1999.

About Jing Huang

Mr Jing Huang is Managing Director at Bain Capital, based in Shanghai. Prior to Bain Capital, he was Managing Director China at SOFTBANK Asia Infrastructure Fund [SAIF]. Earlier, he was a Partner at SUNeVision Ventures and Senior Manager of Strategic Investment at Intel Capital. Before embarking upon his investment career, Mr Huang worked as Director of Research Operations at GartnerGroup. He was also Co-founder and Vice President of Marketing at Mtone Wireless and a Lecturer at China Media University. He currently serves as Independent Board Director at Shanda Interactive (NASDAQ: SNDA) and at Gemdale Corporation (Shanghai: 600383). Mr Huang received an MBA from Harvard Business School, an MA from Stanford University and a BA from Beijing Foreign Studies University.

About JPMorgan’s Hands-On China Series

JPMorgan has assembled a roster of specialists on China, veterans with years of experience and independent opinions on all aspects of the country’s development. As practitioners, these China hands will guide investors with knowledge gained from direct involvement in issues facing China’s future.


SHAUN REIN, FOUNDER, CMR: The Carlyle Group has had successive problems securing permission to close some of their deals in China. They were trying to invest and take an 85 per cent stake in Xugong [Group Construction Machinery] and it is now down to perhaps 45 per cent now, and that negotiation has been going on for years. Bearing in mind current examples including WaHaHa and Danone and that you are the representative of foreign private equity firms, how does a foreign firm navigate through some of the difficulties in China, especially in the face of rising nationalism?

JING HUANG, MANAGING DIRECTOR, BAIN CAPITAL CHINA: If an industry in any country is dominated by a company that owns 65 per cent market share — and a foreign investor wants to buy that company, without doubt, the government will take a close look at the deal, if for no other reason than antitrust purposes. In the case of the Xugong deal, a then sizeable amount of money, over US$300 million, is at stake, somewhat related to a public-listed state-owned company. So the central government will play some role in the approval process by Chinese regulations. However, currently, there are much larger deals being considered in other industries, making the Xugong investment seem relatively small now. Frankly, the press is paying too much attention to the Xugong deal, describing the incident as an example of Chinese government disapproving of foreign private equity investments in China. In fact, there are counter examples in which the government wants private equity firms to consider investment or buy-outs of state-owned companies.

SHAUN REIN, CMR: Could this situation be sector specific? For instance, Xugong works in an arena that is akin to “defense”, so naturally the government would prohibit foreign investment in that sector.

JING HUANG, BAIN: If a state-owned company dominates a sector, the investor will always have a hard time buying control. But typically the Chinese government would like foreign investors to buy under-performing companies that operate in a competitive market; those with a declining market share. Many times, the government wants the foreign investors to provide not only capital, but also management know-how to save these companies.

So, the issue does not rest with whether the deal involves a state-owned enterprise versus a privately owned company but with the specific nature of the transaction. The concern is more about a market-dominant company, such as Xugong in the earth-moving equipment market, being bought by a foreign investor and subsequently being sold to a strategic foreign player such as Caterpillar. We could discuss, whether, even in the USA, the government would take a close look at this deal and ask whether a foreign investor should be permitted to control a sector that is dominated by this company.

SHAUN REIN, CMR: In your experience, has the rise of nationalism in China had any bearing on investment choices in specific sectors?

EDAN LEE, MANAGING DIRECTOR, OLYMPUS CAPITAL: In 2006, Olympus Capital completed a buy out transaction in China that required a change of control. This deal involving US$75 million in the food and agricultural sector fell below the radar screen. There were no ripples whatsoever in the press. It wasn’t controversial. The relationships built at various levels of government allowed the deal to go through. By and large, local governments are supportive of foreign investment that adds value to the enterprise and takes these companies to the next level. That said, the Chinese government makes it clear that there are certain sectors that are off limits to foreign investment. In reference to the Xugong case, a smaller domestic competitor pointed out openly to the press several issues in this transaction, and in doing so complicated that deal in major ways. So it appears that the Xugong deal is an isolated incident and is, in no way, reflective of a negative trend. On the other hand, Asia-wide operations indicate that negativism towards foreign investors is a lot stronger in countries like Korea and Japan.

SHAUN REIN, CMR: Is being “low profile” or “under the radar” part of the strategy when Olympus Capital makes investments in China?

EDAN LEE, OLYMPUS: “Low profile” is one strategy and yes, it is our approach. The other option is to be “high profile” and conduct large, visible transactions. But this approach does not suit our business temperament, nor business practice in China.

DAVIN MACKENZIE, MANAGING DIRECTOR, PEAK CAPITAL: Certainly, Peak Capital uses this strategy. Generally, Peak Capital is interested mostly in manufacturing or consumerretail situations where there is less “ensconced” state-owned competition and less regulatory issues. We only pursue deals that are privately-owned and exclude all stateowned enterprises and in doing so, avoid the issues that have been brought up by the Xugong case. Given this approach to investment, most investors find that nationalism is not an issue for the vast majority of industries in China. In fact, by any standard, China is one of the most open economies in the world. Just about any manufacturing industry is completely wide open. SHAUN REIN, CMR: Which sectors are Peak Capital looking at right now?

DAVIN MACKENZIE, PEAK: Our key areas are manufacturing, consumer retail; manufacturing not in the sense of the suppliers who look after the Wal-Marts of the world on an OEM basis, but Chinese companies that can leverage the strong manufacturing base that China has, and also to add to that, branding, design capability, sales and marketing ability in target markets, like North America, Europe etc. And in many cases that company will work in tandem with companies in the USA or other markets. For example, a portfolio company manufacturing in China moved its headquarters (and the CEO) from Hong Kong to New York, hired an American and started acquiring American brands in the US. Right now, this company is eating the lunch of competitors, that is, global companies who have never manufactured in China. Using that approach—to create mini multinationals—may in some cases allow indigenous companies to grow to a higher level. Originally, the company may have been established maybe two or three generations ago in Hong Kong or Taiwan, or in some cases, be a 100 per cent foreign-owned company. There are strong indications that in the future China will move from being just passive “order takers” of the world to entrepreneurs with unique designs, branding, sales and marketing etc. The other investment strategy developing in China is used by consumer retail players who adopt retail business practices from other parts of the world in China where historically, such models were not used. The service sector in general remains at a low level of development and as such is massively under invested. For example, the mail-order industry in China did not exist 10 years ago, and one of our investments has successfully adapted this service to the Chinese environment. The business potential is huge.

SHAUN REIN, CMR: Recently, PBoC Governor Zhou Xiaochuan talked about China’s efforts to build up the capital markets by encouraging domestic Chinese companies to raise money in China instead of listing in the NASDAQ or Hong Kong. How are these new efforts by the Government to bolster Chinese capital markets combined with the booming A-Shares market changing your investing and exit strategies?

JING HUANG, BAIN: This is a timely question because entrepreneurs of some of the portfolio companies of foreign VCs and foreign PE firms are debating whether the A-share market is an IPO venue. It is unlikely that this question would have been raised two years ago. In fact, at that time most forecasters would have estimated that a further five to 10 years was required before the China market could provide the exit platform for private equity and venture capital. Now the reality is that the China stock market is expanding fast and people are searching for opportunities to invest directly into Chinese companies for A-share listings as an IPO venue. Another consequence of this bubble of the A-share valuations is that entrepreneurs have much higher valuation expectations for pre-IPO private placement deals. If comparables on A-share markets are trading at 50x PE, the founders feel that pre-IPO deals should be done at 30x PE. Their logic is that a trader could flip and still make a good money at 30x PE. However, private equity firms do not pay that valuation. We look at the overall, global markets, we find the long term PE may be at 17x or 18x PE. Our offer would have been around 9x PE. When they ask for 30x PE, there was no deal for us. Currently, we walk away from good companies with good management, because the valuation was too high. All this was a consequence of accelerating A-share market. It is ramping up so fast.

SHAUN REIN, CMR: Some of the bigger PE firms announced that they would put a billion dollars in China in the first year or two of being here, but still they have not made any investments. Is this climate going to make it difficult for new private equity firms to begin to invest in China? Given the current flood of money, will entrepreneurs have unrealistic expectations for valuations such that somebody might invest money even at a 30 PE level?

JING HUANG, BAIN: The problem of pouring capital into China is not only from new private equity money; it is also from hedge funds. Hedge funds could pay a higher valuation betting to double their money in 24 months. But we require even higher return multiples because we devote a long term investment of capital, time and energy over five years. So, in effect PE firms are competing with hedge funds, and are competing with the A-share valuation. It just means that the growth capital and flow of the deals might slow down.

EDAN LEE, OLYMPUS: There is also another important driver to consider: the A-share market as a potential exit alternative. On 8 September 2006, a new set of regulations promulgated by the central government came into effect which made it almost impossible to re-domicile companies offshore or at least, created a much more tightly controlled process relative to the previous regime. As a consequence, there are about 600 cases pending at MOFCOM in which companies have applied to shift their assets offshore so that they can IPO in Hong Kong or in New York. With those barriers, where an offshore IPO becomes restricted, people can either invest directly onshore into a Chinese company or they can invest into a company that has already re-domiciled themselves. By definition the supply of companies in the second category would be reduced over time, so as a consequence if the current regulatory posture stays in place PE firms need to consider the A-share alternative. Olympus Capital is working on a couple of transactions now where the A-share would be the primary exit route.

SHAUN REIN, CMR: A lot of the investment banks are very nervous because they only had the licenses to IPO companies in Hong Kong or New York and now the Chinese government is saying “no”. If they want approval to IPO, the company must first do it in A-shares, before it can go abroad. Are you worried that you may not be able to exit some of your investments from an IPO standpoint, because you might not get permission?

JING HUANG, BAIN: In the case of Bain Capital, the holding period is longer than usual because efforts are made to improve operations after the initial investment. So, in the longer term, although an immediate IPO option might be relevant, we place higher priority on corporate governance issues. In Chinese corporate law, there are no preferred shares and no employee stock options. So we really devote our analysis on running this private company for several years. We feel it is difficult to predict the best timing for an IPO in China because the timing could be dictated by the ever-unpredictable, call it dynamic, Chinese regulatory environment. We certainly believe that five years from today, the regulatory environment will be more open and more transparent than it is now.

SHAUN REIN, CMR: Aside from the capital, what can a foreign VC firm offer Chinese entrepreneurs? Do they value the professional expertise and experience in restructuring as a “value add”? Or are Chinese entrepreneurs more interested in working with a domestic VC firm because of so-called connections?

DAVIN MACKENZIE, PEAK: The short answer is that the domestic venture capital industry within China is small. So, there is not a choice between a foreign or domestic private equity firm but instead, the basic decision is whether to work with a private equity firm or not. Generally, Peak Capital acts as a bridge to a greater purpose such as identifying entrepreneurial goals like being a world-class company, achieving greater wealth. Importantly, they need to realize they can’t reach the goals from their current position without private equity. The vast majority of Chinese enterprises, while they may have very successful businesses, still don’t know much about international practices of governance within accounting or legal compliance. Nor do they know how to present themselves to investors. That is where we can help them. If they’re not interested in that offer, then there’s not much for us to agree on for business.

SHAUN REIN, CMR: Do you foresee a situation where the Chinese government puts more of the foreign reserves into venture capital and private equity? What do you think the role of the domestic VC industry could become?

DAVIN MACKENZIE, PEAK: In theory, the role could be very large because this is one of the largest economies in the world with one of the largest pools of savings. Combine these two aspects with one of the largest pools of entrepreneurial talent in the world and there is no question that in the long term, China will have a domestic venture capital industry. Institutional investors are very new and they are actually not allowed to invest in private equity as an asset class. This morning here at this forum, Mr Gao Xiqing, from China’s National Social Security Fund [NSSF], confirmed that fact; his government allocation for private equity is zero. At present, the main constraint is that a legal and regulatory infrastructure needs to be put in place; at the moment it is either non-existent or insufficient. So one of the reasons why the foreign venture capital firms are not rushing into making domestically domiciled private equity investments is that there are many basic aspects of company law that are not yet in place in domestically-domiciled enterprises. Furthermore, investors cannot get preferred shares in China, a basic requirement before anyone starts investing in domestic companies in a big way. While the A-share market is ‘hot’ now, it is still a mystery as to how a firm gets listing approval; the process is not transparent, and historically, has not shown itself as being open to foreign firms even though there are no legal restrictions on foreign investing firms listing in the domestic market. In reality, only a few foreign firms have experimented in this regard, albeit in small ways only. Add all these factors together and there are few incentives for the domestic venture capital industry to emerge. Notwithstanding the small regulatory improvements and new directions that are emerging, change will happen, but it is going to take time.

SHAUN REIN, CMR: Are VC firms worried that China will only approve domestic VC backed companies to enter the A-share market? Is the Chinese government reluctant to let foreign investors take companies public on the A-shares, because they don’t want non-domestic VC backed companies to make too much money, in the way that Lone Star did in Korea?

EDAN LEE, OLYMPUS: This situation is not worrying because in the instances in which we’re contemplating an A-share listing, the private entrepreneur—our partner—has a greater stake in the company and therefore, it is their interest to try to maximize their value. In that sense, we certainly try to seek an alignment of interest between the parties.

SHAUN REIN, CMR: What do you feel about all of the Silicon Valley firms, such as Kleiner Perkins that has just announced that the opening of offices, one in Beijing, one in Shanghai, that are dropping into the China market and starting to invest? Do you think that these types of firms will make money or are they going to get hurt like a lot of the firms did in the late 1990s? Is there too much money chasing too few deals?

JING HUANG, BAIN: If a venture capital firm does not have an operation in China, but sends professionals to China once a month, can they perform at high levels consistently in the long-term? That is the test. By now most of the name brand Silicon Valley VC firms already have operations in China in one form or another. Kleiner Perkins selected a local partnership -- TDF. Some firms create a new partnership, a new GP, to act as a supplier in China or send their general partners to China to raise money to form a new GP. Some limited partners may also get together and create a new firm. A local presence is not only for doing the investment, but also for managing portfolio companies. When people look at China, even though it is a hot concept, they may forget that it is very, very difficult to make money in China. There are specific China risks which are systematic that investors need to be primed for. In fact, wise investors will shy away from any valuation that does not give the China risk the necessary discount. Although some VC firms fly their partners into China and scoop a handsome return on their investment, as a strategy for portfolio management, such a flying approach does not work in any parts of the world.

DAVIN MACKENZIE, PEAK: The basic business model of having a local presence is very important. One of the characteristics of developing Chinese companies, particularly in the high tech centers that the VC firms are investing in, is that the management teams are quite young by North American standards. Therefore the staff needs more supervision, which is impractical if the senior management is not based in China. Taking a short term view of the market situation, it is undeniable that there is a large amount of money pursuing a very relatively limited supply of deals in the venture capital sector. This situation has led to valuations that are not heavily discounted to what you might require in North America, but in fact, are offered at a premium. And the current research shows that series A and B rounds in China at present are being done at premiums at 20 per cent or more to what they’re being done at in Silicon Valley, Israel or in other developed venture capital markets. But, in the long run, the amount of money that’s actually being invested in China is still relatively small; perhaps it is just the beginning. Take PE money for instance, if analysts deduct a couple of the large bank mega deals that were done over the last few years, from the amount of private equity venture capital money coming into China on a yearly basis, the final estimate is around a billion US dollars plus or minus a few hundred million. This is not a huge sum for an economy that’s now worth US$2 trillion; looking at the number of companies that are being financed by venture capital, the dollar figure is still quite small. Indisputably, there is a beneficial value to the inflow of new money, which is to make more entrepreneurs consider using private equity and venture capital. Historically it was not an option for them. Five years ago, the number of people who understood venturecapital and private equity in China was very limited; now the number is huge. There have been a lot of successful models and they make our job much easier. So, in fact, I think there’s going to be more and more opportunities over time.

EDAN LEE, OLYMPUS: Olympus Capital is biased towards a more active investing approach with significant ownership stakes. We try to seek control where possible, although in China, that situation is more the exception rather than the norm. We don’t typically invest in passive transactions where we would have a minimal role. My personal bias is towards more of a local presence in business. China is a volatile place; in the long-term, markets move up and down in cycles so it would be rather difficult to be based off-site especially if the company is struggling with operating issues. Our job as investors is to work with them and guide them; tasks that are hard to do from a distance. On the venture capital side, the intensity of competition has definitely increased so much to the point that, allegedly, two companies at around the same stage of business development, using similar business models, could only be distinguished from each other by the simple fact of whether the founder had gone to school in the USA and could communicate with Silicon Valley firms. The firm with the English-speaking capability received a higher valuation than the otherwise comparable firm. All things being equal that should not be the case, but perhaps because people are flying in, flying out; they derive greater comfort from communicating with someone that they think they can relate to. And if that’s a reflection of things to come, then let’s watch the venture capital end of the market closely.

SHAUN REIN, CMR: When you’re choosing to back entrepreneurs, how important is it for them to be fluent English speakers—ideally to a standard in keeping with the old boy network—when you’re trying to present the investment to a US-based committee? Is it more beneficial for them to be a mainlander or a foreigner, resident in China for five years? Do you find g trust issues because of the lack of the same native language?

JING HUANG, BAIN: My preference is for local talent because they can override psychological barriers more easily than foreigners in China. Local entrepreneurs still regard even people from Taiwan, Hong Kong or Singapore as outsiders because they speak Mandarin with an accent. All people in our Shanghai office are 100 per cent mainland Chinese nationals or people who grew up in China. It may be of interest that for one of our portfolio companies, before closing the deal, all transactions were conducted in Mandarin: most materials provided by the company were in Chinese though Bain Capital internal communications leading to our approval process were in English. As we entered the post-deal, “blue printing process”, the team realized that one of the founders spoke very good English. If we knew that, we would have asked him to present to our partners in English! This came as a positive surprise.

SHAUN REIN, CMR: Davin, although you have lived in China for many years, have you found being non-Chinese to be an issue or does has there been direct benefit because mainland Chinese do not have international expertise?

DAVIN MACKENZIE, PEAK: The vast majority of people working on private equity in China are local Chinese and that’s the way it should be, I am one of less than a handful of senior people in private equity in the industry who are not local Chinese. I have lived here for a long time and can speak the language, and that helps, but the initial point was about the English-speaking ability of entrepreneurs and the managers that we back, and how important is it that they speak English. It helps, but it’s not important. I think entrepreneurs who know how to make money are visibly equipped with what the job needs. That skill comes through, even if they don’t speak a word of English; their mastery of the company, the enthusiasm, the passion they have, the clarity of their vision about their company, that comes through no matter how poor the translation. Chinese who have lived overseas and might have worked in the USA or Europe have learned, besides English, international business practices, whether in accounting or legal compliance. That experience is important, but it’s certainly not only those who’ve come back from overseas that are able to understand that, and we’ve invested in plenty of companies where the entrepreneurs have never lived overseas, do not speak English, but have a full understanding of what it takes, and what we require as international investors. That pool of people is getting larger.

SHAUN REIN, CMR: What sector do you think is the best place for investment over next six months? Can you tell us about a recent, specific deal?

JING HUANG, BAIN: Manufacturing is a sector that a lot of VCs are now looking at. This sector requires management know-how and, due to our efforts to improve company operations, a direct benefit flows to portfolio companies as well. Our second preference is for the consumer goods and retail sector.

EDAN LEE, OLYMPUS: I would add environmental services and agriculture to the pot. Across Asia, we have invested over $300 million in the agriculture sector. And as a followup to previous comments on use of a local management team versus a foreign management team, investors are dealing with farmers in this sector, so it cannot be more localized than that! DAVIN

MACKENZIE, PEAK:Our industry focus is manufacturing and consumer/retail. We’ve just doubled down with one of our consumer/retail groups—the mail order catalog company. Due to the increase in consumer spending, the ever-growing disposable income, if you get the formula right, the growth is explosive.

Q & A Session

QUESTION: Are you setting up any Renminbi denominated funds or are you still keeping everything in US dollars?

EDAN LEE, OLYMPUS: We don’t have any plans to set up such funds. My understanding is that the regulatory regime has many conflicting rules. The central government is trying to clarify that situation; clearly the industry is still in the early stage of evolution.

JING HUANG, BAIN: Bain Capital is not setting up a renminbi fund now though we could be studying that alternative for the future. Recently, we raised an Asia fund and were several times oversubscribed. So it is unlikely that we will raise another fund soon.

QUESTION: In the US, between 1999 and 2001, there was a lot of hype about untested technologies. At that time, pretty much anyone with a business plan was getting funding until the bubble burst. This triggered close reassessment of the criteria by which a venture capitalist chose to invest in early-stage companies. Media reports suggest that the Chinese government has set biotechnology as a priority area for development; references to nano-technology also abound. Do you feel like there are any sectors emerging in the China investment environment that are, in your opinion, “untouchable” because of the bubble potential?

DAVIN MACKENZIE, PEAK: I am not aware that biotechnology or health related sectors are a priority arena even for VC, especially in China. As much as China would like to have a biotechnology industry, I have not seen a lot of money going into that area.

JING HUANG, BAIN: I feel that VC firms in China tend to conduct later stage deals (by Silicon Valley standards) in which they do not create companies that create technologies, but rather back up a team that applies certain technologies. In effect, they invest in applications in the service industry that uses technology rather than the technology companies per se. In a way, one risk that VC firms take when paying a high valuation for companies that are making a small profit is scalability of that profit. In China, many start-up companies keep their operational costs low, so they can be profitable with revenue of only US$15 million. However, by US standards, if a VC firm can be evaluated on profits only, then they are in their later stage of evolution. But the question arises: can the profit grows from US$1 million to US$10 million or to US$100 million? Can the company become significant enough for IPO? This kind of evolution draws both market risks and operational risks— not trivial considerations. Also, many smaller companies are especially vulnerable to sudden, unexpected regulatory changes that might prohibit certain business expansion. In such cases, although they make $2-3 million per year, the scale of their business is unattractive to big-time investors or even the public market. In effect, they can linger in business though they do not die. The major gamble for VC firms with the appetite to invest at 20x or 30x PE is whether their investment will quadruple over the next two years. Do they want to take this risk?

QUESTION: In connection with an earlier comment about Chinese entrepreneurs who often take technology developed in the USA and then apply it in the China environment, do you think that there will be new technologies and more China-driven innovation during the next five years?

JING HUANG, BAIN: Certainly, there are new business models, new services, new applications, with unique features, emerging within China that are different from those developed in the West. Although making money from these ventures can be possible, the real issue is that of scalability, as I said before. I venture that some sub-quality companies without huge scalability are getting too high valuations.

QUESTION: If the investors have to invest in an onshore structure, how do you ensure investor rights protection?

DAVIN MACKENZIE, PEAK: Legally, it is difficult to get protection comparable to that found in established company law environments in the United States, Britain, Hong Kong, or even Bermuda. To date, most VC firms have invested in China-based companies via offshore holding companies protected by sound company law, but still this is never sufficient protection. And as we have already agreed, local presence and an ongoing relationship with Chinese entrepreneurs are essential to maintain a safe business environment. That said, ultimately it is no different for any other market in the world; a strong personal relationship with the people that you’re investing with is probably the best protection. In my experience, with both a local presence and healthy relationships, even when the plans do not work out, one’s downside will be well protected.

EDAN LEE, OLYMPUS: In cases where company investors have an exit route through Ashares, there will be differences in company structure such that we cannot go in via convertible bonds, we cannot own preferred shares. In those cases, if VC firms are buying in at seven times priced to earnings - and I do not think they are over-paying with such an entry valuation - on a risk-reward paradigm basis, seniority may not matter so much. In terms of corporate governance, the laws in China are clear on paper, but in practice whether investing through an offshore company or an onshore company, VC firms have to have a working partnership with the management team in order to be able to pull off that deal, no matter what documents may say on paper.

QUESTION: How do companies view the management improvement plan? Do they resist change?

JING HUANG, BAIN: Bain Capital’s style adopts active involvement in portfolio management, which may or may not be welcome by entrepreneurs. Earlier in this conference, our discussions about the 100-day blue-printing process and budgets for management improvement highlighted how often these requirements shock entrepreneurs. They are accustomed to having fixed asset capex, buying machines, building facilities, buying lands, and maybe paying for software, but consulting services such as those by McKinsey, Bain and BCG frighten them. From the start of negotiations, it is clear that such entrepreneurs just want your capital. You will be welcome to attend the Board meetings, but other than that, do not bother anyone! Such entrepreneurs would probably not become our partners. Bain Capital has three portfolio companies in China. In each case, we conducted or ARE conducting a 100-day blue-printing process. One company has completed the process. The entrepreneurs were skeptical first and asked, “In what way does this foreign consulting firm know more about our industry than us?” We had to explain our development strategy for a complete business survey to identify the company’s current shortcomings and to find out how to improve business practice and how to track performance. After completion, the entrepreneurs were very happy. In the final session, the founders reflected that the results exceeded their expectations and they want to repeat the process again next year. They have referred another company to us. At one of the first meetings, the firm enquired about our blue-printing process, because they understood that Bain Capital has a reputation for improving operations post-investment.