China PE veterans point to growth sectors

The key to investing in China is to find companies that can leverage the country’s population and relatively cheap manufacturing costs to achieve scale and branding power in new industries, according to a group of well-known private-equity and venture-capital investors from China.

Speaking at a luncheon organised by the Asia Society, the panel included a roster of seasoned China investors: Deng Feng from Northern Light Venture Capital, Wang Chaoyong from ChinaEquity International, Neil Shen of Sequoia Capital China, Andrew Yan of SAIF Partners and Hang Lung’s Ronnie Chan.

They all had different stories to tell, but generally shared a similar optimism about the size of the opportunity in China and the availability of talent to capitalise on it. As more engineers and scientists return from America, they are bringing a new wave of know-how and innovation that they can marry to China’s size to create future leaders in a variety of sectors, including technology, services and perhaps even pharmaceuticals.

As moderator, Chan, who is also co-chairman of the Asia Society, noted that all of these experienced investors have a similar background: top universities in China, followed by working experience and master’s studies at major schools in America, sometimes including entrepreneurial activities. Then back to China to pursue the opportunities there while using their US experience, both in investing and in Silicon Valley.

Deng founded Northern Light in 2006 and now manages the equivalent of $500 million in both dollar and renminbi funds, focusing on early-stage investments in technology companies.

Wang, a former Morgan Stanley banker, founded ChinaEquity in 1999 as a VC fund before expanding into PE in 2007. With $1.5 billion of assets under management, two-thirds is in US dollars and the rest in renminbi. It is known as the first market-independent fund in China – it is unaffiliated to any bank, SOE, government or foreign financial group. (Wang is also leading the drive for a Chinese entry into the America’s Cup yacht race.)

Shen founded Sequoia Capital China, a $3 billion venture with the partners of US-based Sequoia. Two-thirds is run offshore in dollars, the rest in renminbi funds. Before setting up Sequoia’s China business, Shen was president of Ctrip.com, which he co-founded in 1999 after quitting Deutsche Bank’s debt capital markets team.

Yan founded SAIF Partners in 2001 to invest both in China, which accounts for 80% of his deals, and India, which involves the rest. SAIF has $4 billion in assets under management plus an additional Rmb5 billion.

As the founder and chairman of Hong Kong property concern Hang Lung, Chan is both an investor in some of these funds and a former China PE hand. During the past 10 years, he said, the average industry return in US venture capital was negative, -5%, although the top 10 best performing US VC firms netted an average 18% annualised. Warren Buffett’s Berkshire Hathaway has returned an annualised 20%. The top 10 Chinese VC companies during the past decade returned more than 50%, and one of the panellists returned an annualised rate of 79%, though Chan declined to identify who this was.

Investment strategies are differentiating. VC is mainly geared towards tech companies, while private equity tends to focus on other sectors, where brand and scale are more important, said Wang Chaoyong.

Wang’s ChinaEquity was an early investor in Baidu, which he calls his best deal. He went in five years before the company listed and earned 120-times his money back. But he said it’s a different kind of investment, because scale is very difficult to achieve in most tech stories.

In contrast, his investment in sports shoemaker Li Ning was all about building a brand and a distribution network that could take advantage of China’s huge population. He said similar opportunities exist in services, noting an example in a hairdresser chain that has established a similar brand power across the country.

Although these PE veterans outlined a number of sectors they like (IT, cleantech such as solar equipment makers, fast-food chains, medical equipment) perhaps the most interesting view was Deng Feng’s, who said the best plays are those combining technology and services. He predicted wireless internet companies will innovate to deliver services designed for local users. “This will be huge for VC over the next five to 10 years, even bigger than the internet was for the PC,” he said.

A few of these investee companies could go on to become major global brands, as Huawei has become in supplying telecom equipment, but for the most part they are promising companies that have a billion-person market still to conquer. For example, Shen said he has an investment in Country Style Cooking, China’s first fast-food chain. But it has only 150 restaurants in the southwest of the country. Sure, maybe one day it could go global, but right now it has the potential to develop a national network of a thousand restaurants. “The domestic market is huge and we want scalability,” he said.

This is why Yan prefers China and India, versus investing in smaller countries: these bigger markets allow successful companies to achieve the size they need to then go compete on a global stage.

Shen noted it is this scale that can make comparable investments in China more compelling than in the US. Take solar power, for example. The technology might be similar, but a Chinese company can manufacture more cheaply and enjoys generous government subsidies for being in a favoured sector. The breakeven point for the Chinese company will be years ahead of its American equivalent. The US company will enjoy a more advanced technology, but Chinese counterparts are innovating and closing the gap. “Cleantech requires volume production, which China has,” Shen said.

This story doesn’t apply across all sectors. For example, pharmaceuticals remain very much a US and European field of expertise. Chinese companies are starting to compete with Indians for contract manufacturing of generic drugs, but the only field in which Chinese companies are innovative is herbal medicine — which has been banned in the EU.

One possible advantage for China is that its regulatory process for approving new drugs is far less strict than America’s, so in theory a Chinese researcher could move a new drug more quickly to market. And, as more Chinese nationals return from working in the west, they bring R&D experience. Shen said the next Baidu or Sohu.com from China might be in pharma.

Wang said his renminbi funds have invested in herbal medicine companies, but he doesn’t pursue these for his dollar funds. “These are not of interest to LPs in the US,” he said.

Yan was the most sceptical about Chinese R&D stories, in tech or other sectors. “Long-term, original research requires patience,” he said. This goes against the current grain in which everyone — entrepreneurs, SOEs, cadres — want to get rich quickly. This favours application technology (“We’re good at copying.”) but not for originating new technology. And as for herbal medicine: “It’s like feng shui, it works if you believe in it.”

Even if R&D won’t yield much, the PE/VC industry has plenty of existing targets as more trained scientists and engineers return from America to take advantage of China’s lower costs and big market. While US companies tend to own the key technologies, Chinese start-ups can provide niche applications or devices. And in China, because of its size, “niche” can mean a $1 billion local IPO.