US-China Venture Capital Partnerships

US and Chinese venture capital firms can help each other access broader markets and realize higher returns on their investments.by Tharon SmithChinese and US enterprises are searching for ways to collaborate and build high-performing global companies, and partnerships are the next step for realizing growth and capital returns. Silicon Valley, New York, and Shanghai have served as cross-border incubators for early stage companies focused on bringing US technology to Chinese markets and vice versa. These projects are an early indication that venture capital partnerships between the United States and China will be the future driver for increased capital gains and significant investment returns.

Venture capital encourages private investment, stimulates private consumption, and supplies global public markets with viable, high-growth enterprises. Institutional limited partners and US venture capital industry investors are starting to look for new models, managers, and emerging economies for growth. At the same time, PRC government limits on investments in real estate and stock markets and a lack of alternative assets have increased investors’ appetites for cross-border venture partnerships. Chinese investors are seeking growth outside their home market, and trying to make efficiency improvements domestically that would equate to higher financial and non-financial returns, such as job creation, infrastructure construction, community building opportunities, and educational and professional training improvements.

US-China cross-border venture partnerships provide a framework to bring both industries together to participate in the future economic and market growth of both countries. Although building partnerships takes time, attention to detail, openness, communication, cultural sharing, and well-defined expectations, new venture capital firms are demonstrating that these partnerships can be successful.

CHINA’S VENTURE CAPITAL INDUSTRY

Since PRC government agencies first started targeting infrastructure, technology, and science research and development (R&D) for domestic investment in the 1980s, the venture capital industry has evolved to become more popular with private and foreign investors that hope to capitalize on the growth of the Chinese market. Government-backed venture capital funds followed government agendas and invested in major infrastructure projects that allowed venture to thrive, such as technology parks, innovation centers, and laboratories. In 2011, global enterprises raised $5.9 billion in venture capital. Ernst & Young estimates that China will likely pass Europe to become the second largest venture capital hub by the end of 2012.

According to the Renaissance Capital Global IPO Review, Asia-Pacific remained the most active region for investment in the second quarter of 2012, accounting for 47 percent of deals globally. Venture capital activities in mainland China have shifted from purely infrastructure development to innovation in science, technology, and consumer products and services, and foreign firms have been increasingly involved in this new wave of investment. For example, venture capital firm IDG-Accel has invested in technology to expand the Internet and e-commerce in China. Chrysalix Energy Venture Capital, which invests in green technology, alternative energy, and environmental waste recycling, expanded its focus to China in 2011 with a $300 million fund.

The venture capital industry in China is still in the early-stages of development, and the domestic stock market remains inefficient. Participants buy and sell stocks with little knowledge or guiding practices, companies lack global standards, and governance is an ongoing concern. But the domestic Chinese venture capital industry has made improvements in areas such as legal, accounting, syndication, enforcement, sourcing, overseas public offerings, and screening of deals. Domestic Chinese venture capital firms are beginning to accommodate the government’s desire for private investment in an effort to develop an entrepreneurial environment on the mainland. In addition, venture-backed company exits—by listing on China’s stock markets or through domestic mergers and acquisitions (M&A)—have also been on the rise this year. M&A activity amounted to more than $6 billion as of early August, according to Thomson Reuters data, marking the highest levels of Chinese deal-making in five years. Chinese domestic stock markets have been showing signs of improvement and global stock markets have been more receptive to China-based enterprises. This means Chinese companies now have more opportunities to go public both globally and domestically.

CROSS-BORDER VENTURE PARTNERSHIPS

US venture capital investors are particularly eager to identify high-growth enterprises and emerging technologies with broad applications across markets. China’s venture capital goals include turning domestic companies into global competitors, acquiring new technology, and expanding into new markets. Venture investors in both countries have overlapping goals and important lessons to share with each other. In cooperation with design centers, innovation parks, and research organizations, cross-border venture partnerships can leverage resources, networks, and knowledge between various institutions.

Cross-border venture partnerships bring together US and Chinese enterprises at a relatively early stage of development to engage in activities for growth and innovation. Unlike the more common joint ventures where an investor is a passive partner in the company, venture partnerships encourage groups, companies, or corporations to jointly participate in business operations. Venture partnerships use strategic alliances and equity partnership models to facilitate cross-border deals, develop the investment relationship early, and commit to profitable, long-term goals.

Venture capital partnerships have taken several different investment forms, such as special purpose vehicles, equity joint ventures, and investment funds structured with both US and other foreign investment as limited partners such as “parallel funds.” Venture capital partnerships aim to innovate by bringing together both foreign and domestic investment partners as well as forming and cultivating foreign and domestic enterprise teams to build global companies.

Challenges of partnerships

Despite the rapid growth and success of China’s emerging venture economy and the experience of US-based venture investors, cross-border venture partnerships remain challenging. Political, ideological, cultural, and regulatory uncertainties in the United States and China present difficulties in cooperation and understanding. In addition, partners must consider obstacles in media misrepresentation, due diligence, accounting, rule of law, intellectual property rights, and gaps in management talent and leadership.

US venture firms that have attempted to enter the China market have not been entirely successful. Some of the top venture funds that have good reputations and track records in the United States have opened representative offices in China for the purpose of venture capital investment, but failed to cultivate long-term relationships with local officials and businesses. The most successful US funds operating in China have well-developed local partners and established track records of high performance in domestic investments and exits, demonstrating their ability to leverage local talent, make connections and invest with longer time horizons.

Building and sustaining an entrepreneurial culture in China is a difficult task. In general, China’s system lacks the opportunity for first time entrepreneurs to fail and regain social acceptance to try again. This leads to hesitation and overwhelming pressure to succeed. In the United States, high-performing individuals and teams are encouraged to learn from their mistakes. Creativity, collaborative problem solving, and the process of art and design are also highly valued in the US venture capital industry. These traits and values have yet to be fully embraced in China, where issues such as fear of failure have stifled innovation in most high-tech areas.

OPPORTUNITIES

Led by the PRC government’s desire to boost domestic consumption and increase investment in innovation, China has a growing need to transform domestic companies, upgrade consumption-led industries, and improve public shareholder markets. The United States has a successful history of building great companies, leading global industries, and cultivating one of the most desired stock markets in the world. Venture capitalists from the United States and China can benefit from working together to share knowledge and build companies to take advantage of economic growth and increases in domestic consumption.

US venture firms that want to develop closer ties with China can start by investing in and building high-growth and impactful enterprises with their Chinese counterparts. Several pioneers in this area include venture capital firms such as GSR Ventures, Granite Global Capital, and Qiming Ventures. These venture funds have led the way for venture partnerships, building great companies such as Alibaba.com (private), China’s travel website Qunar (initial public offering scheduled for 2012), and childhood online entertainment company Taomee (listed on the New York Stock Exchange).

US venture investors interested in China should examine the needs of the domestic venture capital industry and Chinese entrepreneurs. In China, there are currently gaps in the areas of early-stage company investment, operational know-how, and creative engineering and problem solving. In the domestic venture capital industry, Chinese investors are looking for partners to create global distribution channels, marketing and branding expertise, and design and creative capabilities. Chinese venture institutions want to professionalize and equip managers for future increased expansion and growth. Foreign partners can assist Chinese domestic investment professionals grow the venture capital exit market internally and globally.

US investors can play a role in shaping China’s venture industry, while also expanding their own brands and making connections to Chinese R&D institutions. US investors that want to access growing commercial technology, health-care services, and Internet-based markets in China can provide procedural and systematic improvements and efficiency gains through advanced US technology and products. For example, US healthcare service providers and leadership development organizations are increasingly interested in providing services and evaluation practices to Chinese healthcare and financial services companies. US organizations, such as Silicon Valley Bank, are investing in the future of early stage technology and commerce companies in China that focus on the commercialization of products and services, such as online commercial sales, high-tech solutions, and mobile education to solve the current challenges of these rapidly changing Chinese industries.

In the United States, venture firms are beginning to develop innovation centers targeted toward cooperation with Chinese entrepreneurs and global markets. In several states, incubators, creative collaborations, and R&D centers are emerging with a focus on the Chinese market. For example, InnoSpring in Santa Clara, California, which opened earlier this year, is a venture-backed incubator designed to encourage both American and Chinese start-ups to expand beyond their home markets. With Chinese outbound investment in the United States expected to reach $3.6 billion in the first half of 2012, the United States also represents a significant market opportunity for Chinese investors.

BUILDING SUCCESSFUL PARTNERSHIPS

To increase the likelihood of success for the cross-border venture capital industry, US and Chinese government leaders have encouraged entrepreneurs to develop platforms for joint investment and cooperation between domestic and foreign players in both markets. Chinese government-backed venture capital funds are currently being encouraged to acquire foreign intellectual property and cooperate to build out domestic markets for technology such as agricultural waste-to-energy, sustainable building products, and sensitive medical devices. One of the outcomes of the 2012 US-China Strategic Economic Dialogue (S&ED) was for both countries to promote more open investment and foster financial market reform and regulatory changes to qualified foreign institutional investor programs.

Venture capital is a relationship-intensive business, especially in China. The Chinese venture landscape is built not only on relationships, but also on long-term commitments. Investors should keep in mind that it takes time to build the relationships necessary to engage domestic players.

Typical Western practices that rely on legal enforcement and contractual agreements are not sufficient to succeed in China.

To build successful US-China venture partnerships, both partners should:

• Encourage entrepreneurship  Develop policies to encourage cofunding of new venture funds and emerging entrepreneurs. Implement shared value systems that support entrepreneurs and the environment in which they operate. Establish economic and financial incentives to increase cooperation at all levels of early stage company development. Encourage risk sharing and link compensation to performance.

• Balance interests  Utilize global best practices and competitive advantages to benefit the partnership, while acknowledging national frameworks, such as legal structures and policy guidelines as well as cultural and social differences. Recognize the value and importance of your partners’ vision, goals, input, and contributions. Meet as often as necessary to understand the needs of the business activities and make a commitment to overcoming differences and mutual accountability. Balancing the interests of the partners does not require that the benefits of the partnership be equal, but that each partner is able to achieve identified key goals and objectives.

• Build respect  Establish good communication channels to express issues, concerns, and challenges openly. Build trust and respect through repeated interactions over longer periods of time.

• Engage policymakers  Work with both governments to improve regulatory frameworks to guide capital flows in both directions. Work alongside organizations such as the American Chamber of Commerce in China to encourage development of venture capital partnerships.

Cross-border venture partnerships are in a position to invest and develop companies in sectors such as financial services, energy, medical technologies, clean-tech, telecom, cloud- and Internet-based businesses around the world. These venture partnerships are one of the riskiest categories of investment. When actively managed, however, they are designed to produce the largest rewards.

Development of any early stage company or new investment business model is dynamic, complicated, and full of potential pitfalls. Venture partnerships between US and Chinese enterprises need to be tailored to the needs and circumstances of each organization or early-stage team. Given the complex and rapidly changing landscape of early-stage investment between the United States and China, well-connected organizations with on-the-ground experience have an advantage as venture capitalists begin to explore potential partnerships and enterprise exchange opportunities.

[author] Tharon Smith, PhD ([email protected]) is founder and managing director of the Strontium Group, an emerging markets investment management firm that is fundraising its flagship US-China venture partnership fund. An early-stage advisor and research director, she has spent 15 years focused on Chinese economic development and has been based in Shanghai since 2007. [/author]