The Great Wall

This time, it is different. In this second ?China fever? within a decade, foreign private equity investors' interest appears to be conspicuously subdued. Back in 1992, a visit to South China by the late patriarch Mr Deng Xiaoping sparked off a flood of interest from foreign investors. In the 12 months ending 1994 alone, some 16 funds amounting to $3bn were launched by organisations outside of China. The year also saw the establishment of Asian Strategic Investments Corp. (ASMICO), China's largest foreign private equity investment house. ASIMCO attracted an initial commitment of $160m from global investors, and its fund pool was subsequently increased to $500m.

But this time, even though China regained its status as a member of the World Trade Organisation late last year and investment opportunities for foreign investors are assured, the response is far from enthusiastic. In 2001, there was no significant initiative by foreign organisations to launch a China fund. In 2000, Liberty New World China Enterprise, which secured US$150m from its sponsors, was by far the most ambitious undertaking.

In the second half of the past decade, China's venture investment industry went through extensive changes. The agenda for its burgeoning venture industry, to fund technological advance in the country, is clear. But for foreign private equity investors, the long shadow of regulatory hurdles has never left China's budding investment scene.

Growing wealth
As China returns to the WTO fraternity, it is not only enjoying robust economic growth but has also demonstrated its capability to weather the financial havoc during the 1997-98 Asian financial crisis by implementing extensive reforms.

As part of China's sweeping efforts to overhaul its entangled financial infrastructure in 1998, its venture capital industry was also purged. The sprawling business interests of the 3.2m strong People's Liberation Army were curtailed, including the then listed venture capital fund China North Industries Investment Ltd., and 999 Pharmaceutical, which at the time was one of the most prized investments involving a consortium of foreign investors. But the closure of China Venturetech Investment Corp., China's first venture capital firm, was by far the most pragmatic move. It marked the beginning of a new era in the history of China's private equity market in which state government's influence no longer dominated.

The China venture market, at the dawn of this new millennium, is imbued with capital and bustling activity. It is home to an estimated 258 venture capital firms, commanding a staggering fund pool of no less than Rmb30bn ($3.63bn). But, unlike in the past, domestic corporations and private enterprises account for over 75 per cent of these firms' fund sources, while foreign investors take up a mere 17.5 per cent. The locals also dominate in terms of new investments made: of the Rmb4bn ($483m) that were invested in 2001, the amount deployed by local venture capital firms exceeded that by their foreign counterparts by 50 per cent. In terms of number of investments, four deals out of five were funded by Chinese houses.

The road to technology superpower
In China's grand scheme to become a paramount player on the global scene, venture capital is crucial as it is seen as the road to technology supremacy. The mandate for its venture capital industry is clear. While various local city governments all recently revised their respective regulatory parameters to attract foreign capital and technology transfers, Beijing was ready to brush aside geopolitical differences in order to achieve its goals. 1999 saw Beijing take the pragmatic move to approve the appointments of both Taiwan nationals and overseas compatriots to manage its venture funds.

So far, China's technology drive has won enthusiastic support from its compatriots across the Strait and a warm response from other economies. It used to be politically impossible for Taiwan venture capital firms to set up branches in mainland China, but today, Acer Technology Ventures Asia Pacific and Pacific Venture Group are already there, and they will soon be joined by TCW/YFY Investment Partners (Taiwan) Ltd. In the first quarter of last year, KTB Network became the first South Korean venture capital firm to open a China office in Beijing.

Regulatory and exit concerns
However, if China wishes to attract a substantial pool of foreign private equity investment, there are major regulatory hurdles it must remove. Goldman Sachs' recent plight in China Netcom is one of many stories that illustrate the problem.

In February last year, Goldman Sachs teamed up with News Corp and committed $325m to take up a 12 per cent shareholding in China Netcom, at that time the largest direct equity investment by a financial and corporate investor group. But the Ministry of Information and Industry's recent decision to merge China Netcom with operations in ten Northeastern provinces was a major setback for the investors. The edict not only diluted their equity position, but also made the assets as a whole less lucrative, making future fundraising for China Netcom a formidable task.

Another difficulty facing the deal is exit: if Goldman Sachs and News Corp were planning an offshore listing for China Netcom, their divestment program will certainly have to be revised. With China Telecom (Group) Co., the subsidiary of China Telecom, scheduled for an offshore listing this year, China Netcom is unlikely to receive similar approval from the China Securities Regulatory Commission for some time.

There are other regulatory constraints creating a burdensome exit path for financial investors. In the past, access to listing opportunities in other jurisdictions has been crucial therefore, and investing in companies with a legal base outside of China to avoid exit problems has been a common feature of foreign investment in the country. In the two years ending December 2001, a total of 26 such investments amounting to $814m were made in China by international firms. 81 per cent of these deals have mechanisms that allow private equity investors to divest their interest offshore.

It would be too prohibitive for foreign investors to be limited to only those companies that have the capability to seek listings outside of China. ?China is no longer a sleepy child,? remarks Mr Harjit Bhatia, managing director of GE Equity. Given China's excellent record in advancing its economy, Mr Bhatia feels that the time has come for the country to address the exit issue facing foreign investors.

After all, there are encouraging signs of strong private equity investment performance. However, Southeast Asia is yet to fully recover in order to re-establish investors' confidence, and given the uncertainty of Japan's ailing economy, China is in a unique position to secure an inflow of a colossal pool of foreign private equity capital. But unless foreign financial investors reach a level of comfort with China's regulatory requirements in the foreseeable future, this golden opportunity will disappear with the wind.

Kathleen Ng is editor and publisher of the Asia Private Equity Review in Hong Kong.