The World Economic Forum held the capstone event of its “Nurturing the Early Stage Investment Climate in China” program in Beijing, wrapping up the two-year initiative in a venture landscape markedly improved, participants and organizers said, from how it was when the project kicked off.

“China’s early stage is in really good shape, with lots of entrepreneurs, lots of services, a whole ecosystem,” said Max Burger-Calderon, Hong Kong-based Asia chairman for Apax Partners Worldwide, at the event Saturday evening.

“The environment now faces the same issues as anywhere in the world,” he added. “You don’t have to apply different criteria here than you would anywhere else.”

The World Economic Forum (WEF) initiative winds to a close at a time when Beijing has made innovation its watchword, and a key pillar of China’s developmental strategy as outlined in the current (eleventh) Five Year Plan—a document that also enshrines venture capital as a critical factor in China’s goal of moving up the value chain.

At the opening keynote at the WEF’s China Business Summit on Sunday, Chinese Vice Premier Zeng Peiyan sang paeans to innovation, calling it “the soul of a nation’s advancement and the everlasting driving power of national prosperity.”

Venture Hotbed

While real innovation may still be forthcoming, there’s little doubt that the money to fund it will be in place.

At the WEF initiative’s capstone meeting, Gil Forer, the London-based global director of the venture capital advisory group for Ernst & Young, previewed second-quarter 2006 data compiled by his firm and Dow Jones VentureOne benchmarking four VC hotbeds—the United States, Europe, Israel, and mainland China.

The report, due to be released this week, highlights China’s rapid ascent as a focus of venture activity, with $3.1 billion in venture capital raised in 2005 and $1.5 billion already in the first half of this year. Thirteen funds have been raised so far in 2006—already surpassing the 12 raised last year.

“China is up there,” said Mr. Forer. “It’s vibrant, things are happening, and it’s a real hotbed. Five years ago, there was nothing in terms of venture here.”

To Anand Sunderji, now vice president at Zurich-based Adveq Management but until recently the coordinator for WEF’s Early Stage China initiative, it’s not just a hotbed—it’s a jungle. And that, by Mr. Sunderji’s lights, is a sign of maturity.

“We now hear VC firms [in China] talking about their competitors in ways you just didn’t hear 18 months ago,” he said. “You have some gorilla VCs in the market, and when they see a good idea they pay up to take it off the market. To be a good venture firm in China today, you’ve got to be very nimble—quick on your feet, like a gazelle.”

Duane Kuang, former director of the IntelCapital China Technology Fund and now managing director of the Shanghai-based venture fund Qiming, said the problems that plagued China’s early-stage environment five years ago have mostly gone away.

In 2001, Mr. Kuang said, he would have listed several major problems: a dearth of exit possibilities, a lack of limited partner interest in China-focused venture funds, insufficient autonomy on the part of China-based investment professionals, a shortage of experienced practitioners on the ground in China, a lack of qualified entrepreneurs, and a lack of seasoned managers.

“These are all problems that I would have rated a five on a scale of one to five,” he said.

Nowadays those same problems have either been totally resolved or have fallen off his list of top concerns.

Regulatory Déjà Vu

However, said Mr. Kuang, one issue that rated a five back then remains just as problematic today: regulatory uncertainty.

“I would rate that one a six [now],” he said. “Beijing is tightening controls in certain areas. There’s no shortage of capital, and they’re starting to ask themselves, ‘What do we need this foreign money for?’”

New regulations on mergers and acquisitions issued by China’s Ministry of Commerce (MOFCOM), and which were in force as of Friday, threaten to complicate life for venture investors.

The regulations would require MOFCOM approval any time a Chinese national seeks to establish an offshore company, according to the interpretation of many lawyers, standard procedure for any mainland entrepreneur who wants to list a company abroad.

“These regulations impact 99.9 percent of the deals that I look at,” said Mr. Kuang.

Regulatory issues spooked venture investors in mid-2005, too, when China’s State Administration of Foreign Exchange (SAFE) issued two directives, known as SAFE Circulars 11 and 29, intended to close loopholes that allowed Chinese nationals to exploit tax incentives given to foreign investments (see Investors Rethink China Exit).

The circulars effectively prevented Chinese entrepreneurs from setting up offshore holding companies that could eventually exit through either a U.S. IPO or a trade sale. Venture investment quickly evaporated—until, that is, SAFE reversed itself, issuing a third circular negating the previous regulations (see China Repealing VC Regulations).

Lobbying to change SAFE’s mind on the two circulars was a focus of the Early Stage Climate initiative in 2005.

“There was a good dialogue on the SAFE [State Administration of Foreign Exchange] circulars,” said Kevin Steinberg, chief operating officer of the World Economic Forum’s U.S. operations and director of the Nurturing the Early Stage Investment Climate in China project.

Mr. Steinberg was quick to note that the change in SAFE’s attitude was not necessarily the result of WEF’s efforts. But he added that without the WEF program, on the regulatory as well as on other fronts, “progress may not have been achieved as quickly,” he said.

Network Effect

The success of the project, said many participants, came chiefly from bringing the group together and forging connections.

“It was a way of gaining a common level of knowledge,” said Thomas Smith, managing director of Silicon Valley Bank, who was a partner at IBM Ventures when the initiative was launched.

“I came in knowing nothing about China, and walked away much more highly educated,” he said. “The value was in bringing this group together. Were we able to influence policy? I don’t know.

“But we were able to sensitize the collective group as to how to work in China, and the group was a catalyst to move things forward—not from a government policy and regulation perspective, but in practice and involvement,” added Mr. Smith.

“We initially thought this platform would be about making policy and regulatory change,” said Mr. Sunderji. “But we found that the sessions without that focus have actually been more fruitful.”

He recalled one session held at StanfordUniversity focused on university research spin-offs, which brought leaders from China’s foremost engineering university to the intellectual seedbed of Silicon Valley.

“We had Mary Watanabe of the Stanford Office of Licensing, which works on patents with companies, talking with [Tsinghua Science Park incubation program director] Jeromy Xue, and had a great discussion on how things work at Tsinghua and how they work at Stanford,” said Mr. Sunderji.

Other segments of the project included a VC boot camp, held in collaboration with the China Venture Capital Research Institute in April of this year, in which aspiring venture investors were selected to participate in a week of intensive training by leading VCs, LPs, and legal professionals.

“I like to describe the whole project as being about ‘accelerated collaborative learning,’” said Mr. Sunderji.

Remaining Challenges

As accelerated as the process may have been in China over the last few years, neither Beijing nor Shanghai, the twin epicenters of China’s tech boom, have really recreated the full ecosystem of Silicon Valley.

A surfeit of low-hanging fruit—relatively low-risk, high-upside investments with short time horizons, with only business-model innovations at best and no bona fide technological innovations—has meant little VC money has flowed into more potentially disruptive technologies.

Related to this problem has been a lack of differentiation among VC funds—a similar investment focus especially among non-Chinese funds—which could, said Qiming’s Mr. Kuang, prove problematic for VCs when fund-raising.

Mr. Sunderji doesn’t believe that so-called “business model innovation” is something unique to China.

“I once mistakenly believed that in the U.S., VCs invest in tech innovation, and China, just in business model innovation,” he said. “But in the last 18 months, especially with the Web 2.0 phenomenon, we’ve seen VCs have been making money in low- or no-tech plays—pure business model innovation.

“The era of business-model innovation won’t go on forever,” he added. “And there will be opportunities in real technology innovation.”

Contact the writer:KKuo@RedHerring.com

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