The Challenges Face by the Venture Capital in China

China becomes one of the fastest growing markets for venture capital investing in the world, however, there are significant challenges to such venture investing in a transition economy. Ahlstorm et al. (2007) point to the problems arising from the lack of institutional stability, poor property rights and weak rule of law in China.

3.2.1 Legalization and Institutionalization

VC investors in China face the unusual challenges arising from China’s institutional environment. One of the major issues is that in an emerging economy such as China, private capital and enterprises have little history or legitimacy (Ahlstrom and Bruton, 2001).

The rule of law in Western economies is well established and venture capitalists are able to carry out these activities to reduce nonsystematic risk relatively easily (Ahlstrom et al., 2007), however, in a developing economy like that of China, institutional stability is still not achieved, such factors are not present. Developing economies are often characterized by institutions and that are underdeveloped, property rights that are ill-defined, enforcement that is nonexistent and little legitimacy for private firms.

The study further concluded that successful private firms in China will be present which comes from two primary sources. First, there is opposition from many government officials who worry that the socialist system is being undermined and so argue against the introduction of so-called capitalist ideas such as venture capital. “Labor exploitation” by investor control over the means of production violates basic Marxist principles, which still form the basis of official policy in China. This mentality insists that the smaller funded and private enterprises of today could become the monopoly capitalists of tomorrow and could negatively impact the socialist system in China.

Second, many officials and policymakers in China have practical concerns about tolerating increased competition for state enterprises that the new enterprises could bring.

The largest employer in China continues to be the state: in 2003 state-owned enterprises (SOEs) employed a majority of industrial/service workers in the country and controlled over 50% of all industrial assets there. SOEs still dominate vital industries such as financial services, power, and telecommunications. Although their social services burden is being reduced, SOEs must provide numerous employee benefits that are not required of private firms and as such receive most government financing and access to equity markets.

Many officials in SOEs oppose private firms as potential competitors (Steinfeld, 1998).

As a result, the enforcement of government policies towards firms with private backing is often much tougher than on government related businesses (Tan, 1999). Similarly, taxes, fees,

and penalties levied at private firms can be at punitive levels for their political and economic interests (Gold et al., 2002). This lack of formalization in the institutional environment leads firms to depend on strong ties to government officials and other key sponsors to safeguard them from excessive interference (Peng and Zhou, 2005). This environment differs considerably from what most venture capitalists are used to working in as they strive to formalize informal arrangements both within firms and across to institutions.

3.2.2 Information Transparency

Started from late 2010, the investors’ trust has been seriously shaken as dozens of Chinese companies listing in the U. S. have withdrawn financial statements, faced auditor resignations, failed to timely produce current financial statements, and/or announced special financial investigations. It is a serious challenge that businesses in China have failed to establish a corporate governance system that prevents fraud from occurring and fully discloses it when it does occur.

Despite the growth of venture funding in China, there is still unknown about the venture capital industry. Kambil et al. (2006) summarized practical advice for venture capitalists of all type operating in China. They argued that venture capitalists operating in China face unique challenges.¹³

In contrast, venture capitalists in developed economies, such as the U. S. and Western Europe, have found ways to reduce the risk associated with new venture investment by reducing the nonsystematic risk involved in investing. For instance, they conduct a serious of careful due diligence, provide management and personnel assistance, careful monitoring of the investment, and well-planned exit strategies.

13 In particular they found that there is a lack of information available, both to the venture capitalist in terms of who is reliable and can be funded, and to entrepreneurs in terms of how to maintain proper financials. This requires a great deal of effort on the part of the venture capital firm to gather information for investment needs.

The results cause the venture capitalists to find the “domestic solution” for making up the weakness which is quiet popular in the developing economies. It is popular that VCs may use of contingent contracts which may include convertible and redeemable financial instruments whereby equity stakes are adjusted depending on whether performance targets are met. In a weak institutional environment such as China’s enforcing contingent contracts may be problematical (Wright, 2007).

3.2.3 The Social Network

A well-functioned environment for VC includes market-friendly, laws and regulations, and minimal enforcement of those laws. Thus, venture capital in this setting relies heavily on social network ties, including those of the venture capitalist, to help to substitute for the formal institutions present in the North American system (Bruton and Ahlstrom, 2003).

In China, social capital in the form of “guanxi” is vital as a source of information and as a basis for influencing business behavior in every part of the deal: from sourcing and developing the deal, to its management and exit (Kambil et al., 2006). Guanxi or social capital from“guanxi” networks bridge the trust and information gaps enabling business transactions among individuals or firms.

Guanxi is a highly personalized Chinese system of social capital enabling mutual, preferential favors based upon trust or mutual benefit. It can substitute for and even override institutional or legal guarantees, helping those with high levels of social capital to jump ahead of queues and snip through layers of bureaucratic delays. Guanxi is practically universal – influencing the most mundane to the most critical Chinese relationships. It is highly personal, specific, local and contextual and therefore one person’s guanxi, no matter how high, will never trump all.¹⁴

14 Guanxi lasts as long as the personal relationships of the parties involved and hence is subject to the whims and vicissitudes that affect the lifespan of any personal relationships. In short, the cultivation and use of guanxi

For the “guanxi” consideration, Fuller (2010) identifies three distinct pattern of investment behavior by VC firms investing in technology sector start-ups in China. The first pattern is the service-oriented, technology-light investment behavior exhibited by the foreign venture capitalist firms not founded by ethnic Chinese. The second pattern is the technology creation investment pattern exhibited by foreign firms founded by ethnic Chinese and embedded in ethnic Chinese communities. The third pattern consists of local state-funded Chinese venture capital firms that choose either to invest in state-directed projects or opt out of investing in technology start-ups entirely.

3.2.4 The Control on Foreign Exchange

Today, China’s tight management of exchange rates is still a main obstacle for foreigner to invest. Even the Chinese government has gradually loosened the control on exchange rate,¹⁵ however, the control on capital account is still under the strictly management of the People's Bank of China and the State Administration of Foreign Exchange.

China has long maintained a fully convertible current account and a selectively convertible capital account that favors liberalizing long-term capital flows while restricting short-term capital flows. In reference with the QFII (qualified foreign institutional investor) regime for the stock market, the QFLP (Qualified Foreign Limited Partners) with respect to RMB-denominated funds (RMB Funds) that contain foreign-sourced RMB as investment capital, ¹⁶ as well as the QDLP (Qualified Domestic Limited Partnership) are therefore considered major policy breakthrough because of China’s longstanding capital control as discussed later in Section 3.3.2.

success of investors. It is a discipline that takes time to develop and provides a foundation for the successful execution of disciplines outlined below.

15 China has gradually reformed the foreign exchange system regarding the official foreign exchange rate with RMB in 1994, 2005 and 2010, respectively.

16 In China, there is a difference between RMB-denominated funds and US dollar-denominated funds due to foreign exchange considerations. RMB-denominated funds invest from within China while US dollar-denominated funds invest from outside China via special purpose vehicles. Foreign-sourced RMB is RMB that is the result of a foreign exchange conversion from a foreign currency such as US dollars.

Domestically-sourced RMB is RMB that is not the product of a foreign exchange conversion. Any RMB from a foreign-invested enterprise is deemed to be foreign-sourced RMB.