Is Chinese venture in a bubble?

Chinese venture capital is booming. In the first nine months of this year, venture capitalists active in the Peiple's Republic invested almost as much money as they did in all of 2005 – which in itself was a record year for the rapidly growing industry.

In the first three quarters of 2006, $1.18 billion of equity capital was injected into 145 deals, according to the China Quarterly Venture Capital report, published by Ernst & Young and Dow Jones VentureOne. By contrast, $1.2 billion was invested in 151 deals during the whole of 2005 – a strong indication that the 2006 total will set a new record in terms of venture capital put to work.

To surge in activity should come as no surprise considering that a whopping 31 new funds with a combined capitalisation of nearly $4 billion was raised for the China venture market in 2005, according to Zero2IPO, a China-based industry data researcher and publisher. For the first three quarters of this year, 28 new funds totalling $2.97 billion have been raised.

The numbers underscore a general industry consensus: large amounts of capital are being set aside for China, and more Chinese companies are getting funded. Most professionals canvassed for this article also pointed to sharply rising valuations in the past 12 to 18 months. But few predict that the market is facing any serious threat of a bust similar to what the industry witnessed in early 2000.

RISING VALUATIONS
Nevertheless, there are signs that the temperature is on the rise. Ludving Nilsson, managing partner of Jade Alternative Investment Advisors, managing partner of a new China-focused fund of funds, says: “Some investments, where valuations have jumped as much as 50 percent in the past 12 months, are irrational.”

However, Nilsson also says the recent increase in valuations of early-stage companies in China is comparable to the US, argues that some sectors, especially internet and wireless, appear to be more overheated than others.

Daniel Yang, a partner at SAIF China in Beijing, also cautions against painting an overly dramatic picture and insists current valuation trends need to be put into perspective.

He says: “If it is a good investment. I don't mind paying $10 million or so. A 20 percent increase in valuation, from $5 million to $6 million, is not a big deal for a successful investment which has the potential to make a ten times cash return.”

Any analysis brought to bear on the current state of Chinese venture capital also needs to take into consideration that differente dynamics prevail in different segments of the market. Seed and first-round financing is particularly buoyant and continues to make up the majority of the deal flow. In the quarter to 30 September, 70 percent of all transactions were in this segment with 38 deals completed, up from 25 over the same period in 2005, according to the China Quarterly Venture Capital report. In terms of volume, seed and early stage saw a 65 percent jump in capital deployed from the same quarter a year ago.

Some argue that investors backing early-stage companies in China are buying relatively mature assets, which justifies somewhat fuller pricing. “While early-stage investing dominates the venture capital landscape in China, many of these companies have already achieved a level of business maturity that surpasses their US venture-backed counterparts. For example, 69 percent of the companies funded in the third quarter in mainland China are already shipping product compared to 56 percent in the US, and percent of the Chinese companies are already profitable compared to 7 percent in the US,” says Bob Partridge, China leader of Ernst & Young Venture Capital Advisory Group.

Entrepreneurs in China are also getting smarter when it comes to negotiating valuations. Gone are the days when a venture capitalist can get a good deal on the cheap, market practitioners argue.

OVERHEATED WEB 2.0
But once again, any view on whether Chinese venture is currently moving forward at a reasonable pace needs to distinguish between different sectors. For example, too many funds chasing after internet and wireless start-ups are believed to have inflated valuations in these sectors.

Next-generation internet funding is particularly popular with US investors that are trawling China for deals – and hence a strategy that Roman shaw from DT Capital Partners is looking to avoid. Says the managing partner of the Shanghai-based venture firm: “The venture market in China is too diversified to speak of a hubble. I am here in Chongqing [in central China, the country's third-largest city] conducting due diligence on an autoparts company. How many US investors would come all this way?”

Shaw likens the Chinese VC market to that of the US venture market in the 1960s and 1970s when investments were made across a wide range of stages and industry sectors, as opposed to today's primary focus on technology opportunities.

This view is shared by many of Shaw's peers who say that in the context of China, a broad definition of venture capitalism should be applied, as more traditional sectors such as industrial and consumer businesses are often on the radars of China-focused venture funds. At a conference organised by China Venture Capital Association (CVCA) in Baijing in November, a panel of local professionals concluded that the term “venture capital” as understood in the US context should not be applied to China, because it does not capture the wide range of sectors that China funds operate in.

Unsurprisingly perhaps, the panel's discussion on whether there was a bubble in China also came to a non-conclusive end.

STAYING DISCIPLINED
Wayne Tsou, the head of Carlyle Asia Growth Capital Group, who moderated the CVCA panel, told the audience: “Whether or not there is a bubble depends entirely on one's perspective. There is data to support either case. It boils down very much to practitioners, and whether they can maintain the discipline.”

Tsou's point can be taken to imply that some investors are moving too fast. According to a source from a locally headquartered venture house, one established Silicon Valley firm, which set up a $200 million China-focused fund only a year ago, is said to have invested in 20 deals in the past 12 months. Is this firm over-investing and lapsing in discipline, or is it striking while the iron is hot?

Vincent Chan, managing director and head of North Asia at JAFCO Asia Pacific, says his investment pace has also picked up. In the past eighteen months, JAFCO Asia has concluded 14 deals in China, up sharply from an average of 5 to 6 deals per year previously.

For Chan, doing more investments does not mean discipline has been compromised. He says JAFCO's focus on technology has remained unchanged, even though the firm is now actively looking for deals in new sectors such as life sciences.

Franny Lee, a partner at Asia Vest, which has been investing in greater China and the US since 1995, says her firm is investing from a $270 million fund raised in 2004, which she expects to be fully invested only toward the end of 2007.

The issue isn't about too much money but about people. A more appropriate question is: Are there enough quality managers?

Daniel Yang

She says: “In China, so many things are emerging, and investors have different risk appetites. We are more reserved, having seen a few cycles since 1995.” Rather than being swept off their feet by the current upward momentum, Lee says Asia Vest's professionals are getting deeply involved in deals and taking their time working towards investment decisions.

Discipline is also reflected by the general partner's ability – or willingness – to stay true to their fund's original investment manadate. Unsurprisingly perhaps given the intense activity levels of recent months, there has been talk of “style drift” and claims that a few GPs may not be doing what they promised.

“I know of a couple of managers who have told investors they are raising a venture capital fund but won't think twice of competing with private equity fund managers to provide growth capital instead,” one source says of his competition.

China's robust macro-economic fundamentals have made sure that investor appetite in new venture funds has remained strong. In such an environment, it is easy to see why the idea of raising a venture capital fund could grab the opportunists.

BIGGER DEALS
Along with the dangers of style drift, the phenomenon of investee companies absorbing larger amounts of capital is the other trend that has fuelled talk of a bubble.

Steve Harmston, director of global research at VentureOne, published of VentureSource database, said: “Investors are putting larger sums into individual companies to ensure global competitiveness – with the median size reaching $5 million, the highest on record – and are directing investments to an increasing number of second and later-round financings.”

Late-stage venture financings in particular can now be very significant in size. One of the largest venture deals in recent months has been a $35 million late-stage financing for Advance Micro-Fabrication Equipment, a semiconductor company based in Shanghai. Participants in the Series B round included existing investors Walden International, Lightspeed Venture Partners, Redpoint Ventures, Interwest Partners, Bay Partners, Global Catalyst Partners and KT Venture group. Goldman Sachs joined the round as a new investor.

PEOPLE ISSUES
There will likely be even bigger rounds in the foreseeable future as more capital pushes into the market. China's double-digit economic growth and past evidence of home-runs on Nasdaq is bound to continue to attract new market participants. Whether the market can handle the growth will in no small part depend on the experience of the professionals driving it.

In other words, the most important question facing Chinese venture capital today is whether the country's talent pool is deep enough to channel capital to the right places.

Says Daniel Yang of SAIF: “In 2005, over $L5 billion was invested in Israel, home to a population of around 6 million. A similar amount of money was invested in China, which has a far larger population, if not economy, in the same year. Why speak of a bubble in China, really?”

He goes on: “The money available in China [today] isn't really that much. The issue isn't about too much money but about peiple. A more appropriate question is: Are there enough quality managers?”

There is also a shortage of chief executive officers and talents in senior management at portfolio company level, Yang Says. He is, however, optimistic that this is not going to be a problem that will take a generation to fix: “Give it another five to 10 years.”

For now, competition between VCs, for both assets and people, is set to get fiercer. So much so that it might make more sense to start a company in need of funding rhan to raise a fund if you are a first-time manager“ – sound advice for anyone contemplating a move into Chinese venture capital without a provedn track record to make the propusition work.