Global ambitions: China targets Israel VC

For the first time, a delegation of 22 Israeli VC and PE funds, led by the Ministry of Economy, embarked on a fundraising tour of Hong Kong, Shanghai and Beijing in January. Their objective: to expose the Israeli start-up ecosystem to Chinese investors and convince them to invest in funds and partner with portfolio companies.

"We want to develop long-term partnerships with Chinese enterprises and financial investors," says Kobi Rozengarten, a general partner at Jerusalem Venture Partners (JVP), one of the delegates. "We're seeing more Chinese large companies backing Israeli fund managers, making co-investments or targeting direct investments through M&A. Few Chinese players have actually acquired companies in Israel, but we will see more of this."

While in the past 20 years, US companies have been the primary investors in Israeli start-ups, followed by Europe, the growing Chinese presence cannot be ignored.

In 2014, 12 Israeli venture capital funds raised $914 million between them, representing a six-year high, according to the Israel Venture Capital (IVC) research center and KPMG. Carmel Ventures' fourth fund was the largest vehicle, attracting $194 million, with 25% of that coming from Chinese investors - namely Baidu, Qihoo360 and Ping An Insurance. JVC also reached a first close of $160 million on its seventh fund, which has an overall target of $180 million. Chinese LPs put in about 40%, with Qihoo360 participating once again alongside fund-of-funds Shengjing.

China rising

"There is no doubt that Chinese investors are becoming significant LPs in Israeli funds. That's the trend," says Yoram Oron, founder and general partner of Vertex Venture Capital in Israel. "In 2014, one third of the capital raised by Israeli fund managers came from Asia-based investors, compared with just 5% 10 years ago. That portion could be even higher in 2015."

Two months ago, Alibaba Group made its first foray into Israel, backing Tel Aviv-based Visualead, which creates Quick Response (QR) codes technology. The announcement came barely a month after Baidu said it would invest in video capture specialist Pixellot. Elsewhere, Yuanda Enterprise Group bought Auto Agronome, a maker of smart irrigation and fertilization systems, last September in order to move into high-tech agriculture, while earlier in the year Bright Food acquired a 56% stake in Israeli dairy producer Tnuva from Apax Partners.

Without a large-scale domestic market, Israeli firms are used to going global and China has been identified as the biggest market for them beyond the US. For its part, China wants to acquire technologies that will help its companies establish themselves as global leaders. What role can private equity and venture capital play in this?

Israel's ecosystem for high-tech start-ups has been 60 years in the making and it is particularly strong in communications and wireless technology. It all started with massive defense industry investments led by the government, but two decades ago the tech sector was opened up for private capital. The program, known as Yozma, prompted a handful of US VC firms, including Sequoia and Greylock Partners, to set up a local presence.

Vertex, which is owned by Temasek Holdings, was among the first Asian arrivals in the country, alongside Singapore government-backed Infocomm Investments and a clutch of local corporates.

The attraction was not only tech start-ups, but also a number of elite universities, as well as research centers run by the likes of IBM, Cisco and Intel. Plenty of entrepreneurs emerge in this ecosystem and they are well-served by leading legal and accounting service providers. Despite having a population of 8.1 million, Israel is home to about 5,000 start-ups. It claims to be second only to Silicon Valley as an innovation hub.

Encouraged by impressive exit records, global players are keen to invest. With nearly $15 billion in M&A and IPO exits, 2014 represented an all-time record year for Israeli hi-tech sector - and a marked improvement on the 2013 total of $1.2 billion, according to PwC. The standout deal was MobilEye, a road accident avoidance technology developer backed by Israeli Catalyst Investment, which raised over $1billion in its August IPO. It is Israel's largest-ever offering.

Being a catalyst

In recent years, Chinese PC maker Lenovo Group and electronics giant Huawei have also set up research centers in Israel. Around them are more than 250 multinationals of various stripes, and the technology players are increasingly acquisitive.

"When the chairman of Lenovo visited Israel recently, he said that American companies are buying advanced technologies in Israel in order to be more competitive in a global basis. Then he said Chinese firms should do the same, adding that Lenovo will do more acquisitions here than competitors such as HP," says Edouard Cukierman, founder and managing partner at Catalyst.

The local GP has actively promoted China-Israeli business. Last year, Cukierman invited 100 Chinese corporates, as well as PE fund managers, to visit Israel. In late 2013, Catalyst teamed up with China Everbright, an offshore investment arm of conglomerate China Everbright Group, to launch a $200 million cross-border fund. It reached a final close in the third quarter of last year, with most of the capital coming from Chinese corporates.

Instead of targeting early-stage start-ups, the fund backs mid- to late-stage companies across agricultural technology, energy, industrials and manufacturing, healthcare, media and telecom. It invests in Israeli-based companies as well as Israeli-owned businesses located overseas.

"We were first attracted to the market more than three years ago. We work with a lot of Chinese corporates and institutional investors to help them review overseas investments. We feel there are many potential synergies between Chinese and Israeli players," says Shengyan Fan, managing director at China Everbright. "Chinese companies are putting a lot of money into R&D and they will benefit a lot of they go for overseas acquisitions."

A number of similar cross-border funds are now emerging. Last month, state-owned CITIC Group partnered with Israeli Bank Hapoalim to set up a $150 million fund to invest in Israeli high-tech industries. Poalim Capital Markets, the investment arm of Bank Hapoalim, will establish a venture capital subsidiary in China with a view to bringing over Israeli technology.

Cross-border funds are not the only way in which Israeli VCs are engaging with China. Carmel Ventures had never tried to source LP contributions from Asia before last year, having traditionally relied on investors from the US and Europe, but Chinese enterprises and financial institutions were specifically targeted for Fund IV.

"There is growing interest from Asia so it's easy for us to fundraise," says Ori Bendori, a general partner at the firm. "China has also become the biggest market for our portfolio companies. Having ties to local enterprises like Qihoo360, Ping An and Baidu could be very helpful for our portfolio."

Carmel also wants to serve as a local partner to Chinese companies, introducing them to start-ups. At present, most Chinese investors in Israeli start-ups are strategic players, but few are of institutional scale and quality. It is hoped they can get a sense of what is on offer by participating in VC funds and, once more familiar with local markets, engage in co-investments with GPs or pursue direct deals independently.

Ping An employs this dual-strategy approach of direct VC investments and LP commitments. A few weeks ago, Ping An Corporate - the company's corporate VC arm - took part in a funding round for Rainbow Medical, alongside with ZTE Corporation and Yongjin Group.

Integration angle

One of the major reasons why Israeli venture capital firms are reaching out to China is the increasingly crowded nature of the US market and the detrimental impact this has on competitive advantage. "On the US stock exchanges, a large portion of companies are from Israel. They used to be big fish in a small pond," says a Singapore-based investor. "Now, every tech firm in the world comes to the US and so Israel is starting to look elsewhere. Europe isn't a good market for them because the tech sector is very fragmented. So they look to Asia."

At the same time, industry participants attest that Israeli tech start-ups trade at competitive valuations. When a VC firm takes an Israeli portfolio company to list in the US, it is usually valued at a 20% discount to comparable domestic businesses due to the absence of a local sales network. On the M&A side, Israeli VC investors are routinely criticized for exiting portfolio companies on the cheap due to pressure to sell within a certain timeframe.

The Catalyst-China Everbright fund seeks to maximize value by targeting more mature companies that can operate in China. For every investment, China Everbright will evaluate growth potential in the context of alignment with areas in which there are favorable policy environments, such as cleantech or healthcare, or particular private sector needs.

In August last year, the fund made its first investment by committing $42 million in Lamina Technologies, a Switzerland-based cutting tools manufacturer that supplies the engineering, aerospace, automotive and transportation sectors. There is a clear fit with Chinese aspirations to climb the industrials value chain by introducing high-end technology.

"We are not only looking at companies in Israel, but also conducting a lot on-the-ground research to understand what is potentially acquirable and desirable in the Chinese marketplace, or from the perspective of Chinese corporates," says China Everbright's Fan.

Not only does the fund help portfolio companies expand their distribution networks in China, it also assists in terms of sourcing cheaper raw materials from China and even relocating manufacturing to the country to take advantage of lower production costs.

Furthermore, it is interested in working with Chinese LPs to acquire Israeli companies, consolidate industries, and enable technologies to be developed at scale. To this end, there must be a strong alignment of interest between Chinese and other investors, as well as with the management team of the target company.

"In the past, Chinese and Israeli companies have established joint ventures, which allow third-party investors to participate. But this is often very problematic because it can lead to conflicts of interests in relation to the intellectual property, the dividend distribution, and the exit," Catalyst's Cukierman says. "The model we're adopting now is quite unique in terms of solving those issues. We partner with a Chinese GP to support the development of Israeli portfolio companies."

Dr. Yesha Sivan, the executive director of the Coller Institute of Venture at Tel Aviv University, agrees that China is a relatively difficult market for Israeli companies compared to the US and Europe. This is because a local partner is almost always essential for market penetration and engagement with regulators. Identifying suitable partners can be hard, but with larger numbers of Chinese investors in these funds, it might become easier to gain traction.

Cultural divisions are another potential stumbling block, with a number of Israeli companies trying and failing to establish themselves as independent players in Shanghai and Beijing. "Israelis are very direct. When the things are not going well they say to your face. Asian people are a bit equivocal. Often Israelis don't know if a Chinese partner is saying yes or no and the find that frustrating," the Singapore-based investor says.

There is an opportunity for private equity to play an intermediary role in these situations, but concerns linger. JVP's Rozengarten admits that a few Chinese and Korean corporates were excluded from his firm's most recent fund due to suspicions about their intentions. However, as Chinese companies mature, he believes it will be possible to build long-term partnerships based on mutual respects.

Acquisition time

This greater familiarity should also facilitate M&A. The US capital markets remain the largest market for Israeli tech companies, simply because the likes of Hong Kong and Singapore don't offer deep enough coverage of the sector. Trade sales are on the rise, however, with Chinese groups completing deals worth $7 billion in Israel over the last three years, including acquisitions from private equity, according to Catalyst.

The firm expects to see more trade sales to Chinese strategic investors, typically once the target companies have established themselves in China. The implication is that exits will happen at a later stage than has been the case when dealing with US and European buyers. It is hoped this will help sustain the nascent trend of Israeli companies becoming global operators in their own right, rather than just technology feeders to large corporates.

"We see Israeli companies trying to become bigger and operate more independently. For example, Waze, which was sold to Google for about $1.5 billion, insisted on keeping their operating team in Israel. They refused to sell to Apple and Facebook because they were asked to move everything to the US," says Ori Cohen, an Israeli serial entrepreneur and a partner at Southeast Asia-focused venture capital firm Expara.

Cohen is in the process of organizing an investment forum in Israel at which Hong Kong, Chinese and Singapore VC funds will have the opportunity to network with 100 local start-ups. It represents a step away from the government-sponsored approach, with the focus wholly on entrepreneurs.

"We hope this interaction will result in us launching a fund in the future, similar to the Catalyst-China Everbright vehicle," he says. "We will remain in the private sector and I think that's what the government would like to see. They start the process but then the private sector picks it up."

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