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VCs Fuel A New Gold Rush In China By Mark Boslet Dow Jones Newswires October 27, 2004

Joseph Tzeng and his partners think there are three types of U.S. venture investors looking for deals in China. First, the doubters who decide after visiting China that Silicon Valley is big enough and they don't want the greater risks of investing overseas. Second, the zealots convinced that everything in China is made of gold. Finally, the pragmatists who recognize the enormity of the Chinese market as well as the grave uncertainties of its unsettled business climate, but who invest anyway. Tzeng, managing director of Crystal Ventures, ranks himself among the third group. "This could be the third-biggest event in our lifetime," he says during a phone interview from his Taipei office. But "this is super dangerous." Over the past year, venture investors from the U.S. have descended on China like locusts hungry for the buying power of its 1.3 billion citizens. They are willing to brave the difficulties for potential returns they believe could be better than in the U.S. Some say the pivotal event occurred last September when Silicon Valley watched New Enterprise Associates and Oak Investment Corp. put money in Chinese chip maker, Semiconductor Manufacturing International Corp. (SMI). SMIC collected $630 million from a group of investor before going public in March. The fever shows no signs of abating. According to the Asian Venture Capital Journal, venture and private-equity investors placed $1.19 billion with Chinese companies in the first half of 2004, quickly closing in on the $1.67 billion spent in all of 2003. In 2002, investments came to just $350 million. The flow of capital is pushing up company valuations, luring inexperienced firms and raising comparisons with the dot-com gold rush at the end of the last century. Some participants fear the money is inflating a bubble that could eventually pop. "Whenever I see hot money coming in, it gets me nervous," says Tae Hea Nahm, a general partner at Storm Ventures. "It reminds me very much of investing in Silicon Valley in the late 1990s." But most of those who endure the long transpacific flights to and from Beijing and Shanghai are convinced the long-term opportunities are good. They say that because of the mainland's fast growing markets and factories, successful technology investors can no longer ignore this rapidly developing corner of the world. The VCs are swarming into China with different strategies. Most still see it as an outsourcing opportunity for their existing portfolio companies, and as untapped markets for young companies' products. But increasingly, many are putting money to work in Chinese companies, despite a certain caution and despite the still evolving nature of Chinese business law. According to the Asian Venture Capital Journal, 49 companies were funded during the first half of the year, compared with 64 in 2003. The numbers are small, but growing. Some experts predict as much as $15 billion of venture capital will pour into China over the next 5 years. "You can't ignore China," says Patrick Ennis, managing director at Arch Venture Partners. "You can't stay away." Arch is looking for technology there to feed to startups in the U.S., but hasn't yet made a deal. Still, he acknowledges that "intellectual property concerns are key," Ennis says. Laws are not well established in China, and the business environment isn't decades old like it is in the U.S. Helping to fuel the increase in Chinese companies is a reverse migration of U.S.-trained Chinese natives. They graduated from Stanford University or M.I.T., and VCs are following the brains. Yet, despite the presence of these foreign-trained entrepreneurs, investors say they fear the lack of adequate local knowledge. Nahm says Storm's strategy is to invest in Chinese companies alongside experienced Chinese venture capitalists, such as Legend Capital or Authosis Limited. Storm has put about $3 million in three early-stage Chinese companies since late 2000. The local partner can work with the company in China while Storm can try to open doors in the U.S., he says. Tzeng says Crystal goes to even greater lengths to safeguard its deals. Since 1997, the firm has invested more than $30 million into six early-stage companies and maintains one full-time partner in China. Two additional partners spend part of their time there. Because of the lack of Chinese business law, Crystal will insert legal protections and conduct codes into the contracts it signs with startups. The rules require entrepreneurs to separate personal expenses from company expenses, and bar hiring discrimination, sexual harassment and bribery. The protections require a company to return an investment or potentially surrender control of the board if a conduct code is broken. "We are very serious," says Tzeng. Making money is an open question. "I know people are worried about that," says Nahm, who believes IPOs and acquisitions will provide paybacks to VCs. "I don't see why it would be different than another investment" in another part of the world. But the path to profits isn't always clear. SMIC is trading well below its opening price on the New York Stock Exchange, suggesting later-stage investors may not have achieved the returns they hoped. On the other hand, some Chinese VCs have probably made good returns. After talking with limited partners that have invested in Chinese funds, "I don't think the returns for U.S. investors in China have been higher than historically in the U.S.," says Winston Fu, a general partner at U.S. Venture Partners. However, longtime venture investor Intel Corp. (INTC) has received a good return on its investments, says Cadol Cheung, director of Asian investments. The company has completed four dozen deals in China since 1998. In some instances, companies have gone public on financial exchanges where Intel can realize a cash profit, Cheung says. UTStarcom Inc. (UTSI) trades on the Nasdaq Stock Marker, for instance, and ChinaCast Communications Holdings Ltd. is listed in Singapore. In deals where Intel has not been able to transfer money out of China, the company has put funds into its own Chinese operations. Nevertheless, some venture capitalists say the time isn't right for them to invest in China. Keith Benjamin, a managing director at Levensohn Venture Partners, says the distance makes it difficult. Levensohn invests only in companies that are within driving distance of its San Francisco offices. "You need to be on the board and on call," he explains. "You can't do that remotely." Yet there is the lure of adventure. "If I was 20 years old and getting out of college, I would think of doing a stint" in China, says Benjamin.

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