First time challenge

Joe Zhou, founder and managing partner of Beijing-based Keytone Ventures, talks to PEI Asia about the close of the firm’s first fund and the specifics of early growth investment in China.

In July Beijing-based Keytone Ventures closed its first fund on $200 million. Fund 1 will focus on early growth investments in the technology, clean-tech, media and consumer sectors in China.

Founded in 2008, Keytone has a team of seven including managing partner Joe Zhou and partners Stella Jin and Peng Jin. Zhou was previously the managing partner of a team hired by Kleiner Perkins Caufield & Byers in 2007 to launch KPCB China and its $360 million China-focused fund. He remains an affiliated partner at the venture firm. Stella Jin and Peng Jin both formerly worked at IDG-Accel China Growth Fund.

Last month Keytone Ventures was featured in our article on Asia’s Rising Stars, in which some of the region’s most prominent LPs named their pick of the region’s first time funds.

You closed your first fund on target at a time when many experienced managers are struggling to reach theirs. How did you find the fund raising environment?

When the fund came out in April 2008, the fundraising environment was not too bad. The initial reaction to the fund was very good: in June we held a first close with close to half the size of the fund raised and we expected to have a final close in November. At that time we were looking at least 2x to 4x over-subscription, but then the environment changed very quickly. In November, we still managed to close at about two thirds of our target. At the beginning of this year things became worse. Last year, at least people had unused allocation reserved for China – this year, very few people opened up their allocation. To finally close on target this June as a first time fund without affiliation to any major US VC brand was extremely challenging. I think part of the reason we were able to get it done is that over the year we have developed and kept our strategy and style.

What is this differentiation?

Our clear differentiation is our approach and the stage of focus. We are one of the few teams that have gone through downturn before and have a strong track record. We focus on early growth stage which means it is not too early and it is not too late either, and we take a vision-driven approach that rarely leads to a random deal – ie, someone knocking on your door. In many cases, we will develop themes and approach our target instead of being approached and we typically do deals in sectors that we understand. We are trying to build strong vertical expertise: looking at industries we are familiar with, watching out for certain opportunities in the value chain and placing our bets. The typical approaches in China by many funds are either: pick a sector and do a lot of deals which are not necessarily very differentiated, the failure rate of this approach is very high; or doing random late stage deals, the price paid in this approach is typically high.

One of the fund’s focuses is in technology. How does early growth stage technology differ in China to other key technology markets, for example the US?

In the US, the venture capital industry has been doing this kind of investing for over 40 years. They mostly cover early-stage technology – breakthrough technologies, game-rule changing technologies. In China we focus on how to make business out of a ready technology.

In the US, if you have a unique idea, it is relatively easy to build your business. The challenge is to come up with an unique idea – the whole US society is so mature that there are very few new ideas.

In China it is the opposite. The idea is easy to find; there are many greenfield opportunities that have never been done by anyone. But from idea to a business is much more difficult, in many cases, there’s no business infrastructure to leverage and you do not have a ready talent pool. And there is almost no M&A market. Because of this the failure rate in the Chinese venture capital industry has been very high.

LPs have been giving US-based venture capitalists seven to 12 years to make it work. In China, they have much less patience, giving you only three to five years, because the fund cycle is faster in China and there are examples in the good market environment where money has been made in two or three years. Although the life span of a fund is 10 years. If it takes me 10 years to make my first exit, I may not be able to raise a second fund, and I definitely won’t be able to raise a third fund.

Will you look to launch an RMB fund in the future?

It is something we are looking at and trying to form our opinion on. Clearly the domestic IPO market has become more visible and there are certain advantages to having an RMB fund. In the relatively long run you are going to have to include RMB-based LPs in your LP base, but currently there are certain challenges to mixing the two, the primary limitation is RMB restrictions on flow and targeted exit markets. Hopefully by the time you have domestic-based LPs, the RMB will have become an international currency that will not be as restricted as it is today. We are still looking at our options. For example, should we look at RMB funds as a purely commercial opportunity or do we look at it as a strategic opportunity?