Strategic imperative: Chinese corporates embrace PE

Corporate venture capital is the latest buzzword among Chinese conglomerates, with those interested covering the full gamut of industries from microchips to meat processing. One China-focused fund manager recalls being invited to a meeting at which an unnamed pork producer probed him on how it might develop its full potential as a corporate VC.

"The corporate firm has hired a reputable investment banker as chief investment officer to lead the team. He can choose which GPs to invest in without any intervention from the parent company," the manager adds. "In this case, the group is trying to give more flexibility to the private equity subsidiary."

Corporate venture capital is part of a broader movement whereby large Chinese companies are expressing their appetite for M&A. These investments might bring financial or strategic value to the parent companies, and they are no longer limited to technology - sectors such as financial services, healthcare and agriculture also feature.

The question for independent private equity firms is how they address these new industry participants, if and when their paths cross - as a permanent piece of the jigsaw or a temporary phenomenon?

"Major Chinese corporates are keen to establish their private equity platforms, it is a trend that has become more significant in the last year," says Lorna Chen, a partner at Shearman & Sterling. "Start-up companies, which are usually targeted by leading technology firms' corporate venture capital units, as not the priority when setting up these platforms. They are targeting growth capital type of deals instead."

As such, "corporate venture capital" is not a wholly appropriate moniker. A typical approach might see the corporate first set up a fund structure that allows it to invest domestically in sectors that are complementary to its core business, then create an offshore entity through which overseas investments can be channeled. Natural resources are a frequent target.

Investment strategies can vary enormously. The aforementioned pork processor appears to be happy operating as a hands-on LP. Others choose the conventional route of setting up a captive private equity unit - much like any number of technology companies in the US - by hiring investment professionals or they form partnership funds with independent GPs.

Chen adds that it is too early to tell how the regulators will respond to these new entrants and what this means for their role in the market. However, she is generally positive about Chinese companies wanting to strengthen their core business through investments.

Tough timing

The rise of corporate funds is in part a function of challenges facing China's PE industry. As IPO exit multiples dropped, and new listings slowed to a crawl before the regulator imposed a one-year suspension in order to clean up the market, investor faith in private equity began to falter. China fundraising shrank to $19 billion last year, from $32 billion in 2012 and $55 billion a year before, according to AVCJ Research.

It is therefore difficult for Chinese managers to survive, particularly those operating in the renminbi-denominated fund space. Aware that corpus sizes and management fees are likely to be smaller investment professionals are willing to consider a move to the corporate side.

For example, Yu Bo, a healthcare-focused partner at Jiuding Capital, left the firm in the middle of last year to set up ZRT Healthcare Capital, which is backed by Zhongrong International Trust.

"It is usually difficult for corporates to hire direct investment professionals with industry experience. They may have tried to make investments using in-house staff, but it didn't work out the same way as for independent GPs. Partnering with them seems a visible option," says Dayi Sun, managing director at fund-of-funds Jade Invest.

An M&A fund run in partnership with an independent GP appeals to corporates as a means of accelerating consolidation within fragmented industries. The GP offers expertise in deal sourcing and execution that can ultimately help a corporate maintain its status as a market leader.

Furthermore, it doesn't incur the same risk and cost of setting up a dedicated PE platform, but it allows exposure to the asset class if a corporate did want take such a step in the future.

Once again, Jiuding is a good example. At the end of last year the GP launched a $33 million M&A fund with Shenzhen-listed Gifore Agricultural Machinery China, seeking acquisition opportunities in the agricultural machinery sector. The Sichuan province-based enterprise is also one of Jiuding's most successful previous investments: the private equity firm delivered an IRR of 12.78x on exiting Gifore via IPO in 2009, when the market was at its peak.

In November, Haitong Capital teamed up with logistics firm Orient International Enterprise to establish a renminbi buyout fund with a target of $493 million, while Shanghai Yimin Commercial Group partnered DT Capital on a RMB750 million ($124 million) M&A fund that will primarily focus on acquiring retail chain stores and emerging e-commerce platforms. Shanghai Yimin committed RMB236 million to the fund.

In the Haitong Capital and DT Capital cases, the corporates are serving as anchor LPs. They receive favorable terms and in return the GPs can go and raise capital from third-party investors, using the partnership as a marketing tool.

LPs are drawn to sponsored funds in part because the sponsor can offer detailed knowledge and execution ability in a particular industry. These corporates know all their peers and competitors and through these networks they learn about potential acquisition targets that might be beyond the reach of independent GPs. It also opens up new exit opportunities as the corporate may seek to buy portfolio companies.

However, sponsored funds can represent a risk in terms of investment consistency and corporate influence. One well-known case is China F&B Venture Investments, which received a RMB245 investment from Uni-President China Holdings - the mainland subsidiary of Taiwan-based foodstuffs conglomerate Uni-President Enterprises - in 2008. Uni-President soon bought a controlling stake in the VC firm and raised capital from other investors.

"Some LPs were inspired to invest in Uni-President's corporate investment arm at that time as there were more trade sale opportunities from parent company. However, a number of prospective investors were concerned about the parent having conflicts of interest with financial investors in the fund," Jade Invest's Sun says.

Raising capital from capital from third-party investors has always been hard for corporate VC or PE units. The exceptions to the rule are Fosun Capital and Legend Holdings' private equity and venture capital subsidiaries, Hony Capital and Legend Capital. They are well established, experienced in dealing with institutional investors and employ market-oriented strategies far removed from corporate VC.

Getting crowded

If Chinese corporates in most industries are just getting their first taste of corporate venture capital, the technology specialists are already familiar with the menu. The territory is still dominated by the Chinese internet giants, Baidu, Alibaba Group and Tencent Holdings, but others are now following suit as they seek monetize their user bases across several verticals.

Qihoo360, a Chinese anti-virus software provider that listed in the US in 2011, is aggressively pursuing acquisition opportunities to broaden its product portfolio. The company started its corporate VC unit two years ago with a few professionals but now headcount in the M&A and investment teams is more than a dozen.

Private companies with ample cash flows are also following this strategy. The country's largest B2C retailer JD.com - formerly known as Jingdong.com or 360Buy - is building up its corporate VC team to make select investments that might increase its market share.

"The mentality of Chinese technology firms is changing. Their main businesses are already very competitive and it is difficult for them to develop new products independently in a timely manner. They are now looking to invest or acquire new start-ups that are doing well," says James Mi, co-founder and managing director at Lightspeed China Partners.

David Wei, founder and CEO of Vision Knight Capital Partners, notes that technology companies' corporate VC units tend to perform three functions: strategic M&A, venture capital investment and making LP commitments to other funds. The impact of the first is immediate, with new businesses often plugged into existing platforms. The latter two represent a longer-term, information-driven play, offering companies visibility on technological developments and deal flow domestically and globally.

Alibaba broke new ground by investing in Silicon Valley-based apps search engine Quixey last year and more cross-border deals have reportedly followed. Tencent, meanwhile, became an LP in Eastern Bell Venture Capital's logistic-focused renminbi fund, offering logistics sector insights. It has since made at least one direct investment into the sector.

The primary motivation remains strategic and industry participants do not expect financial imperatives to top the agenda any time soon. After all, compared with the mature model of global corporate VCs - the likes of Google Venture, Intel Capital and Cisco Investments - Chinese's corporate VC is still at a nascent stage.

"In house teams will ultimately start to raise capital from external sources and have more of a financial return incentive. But it's unlikely to happen in the next three years," Wei says.

Strategic angle

Over-emphasizing the stratgic angle can sometimes scare-off independent GPs looking for co-investors. Of particular concern is that when these big players enter a new business they often have no clear idea about maximizing the value of the start-up's products. Influence, when exerted, may therefore be malign.

A few weeks ago Wandoujia, a Chinese Android app search engine, is secured a $120 million round of investment led by Japanese corporation VC Softbank Corp. In this instance, the sum was so large by typical Series B standards that the mid-size growth capital GPs didn't have the capacity to handle it. DCM, which invested in Wandoujia's previous round alongside the Innovation Works incubation fund, specifically sought out Softbank as an investor.

"Wandoujia has the potential to be a listed company because it is search engine platform, which potentially puts it in Google territory," says Hurst Lin, managing director of DCM. "The company needs a huge amount of money to maintain its business value and compete effectively with the big domestic internet companies."

He adds that Softbank has a less proactive investment approach and fewer operations in China, so it is rarely overbearing with portfolio companies. The group's previous investments include Alibaba and online video site PPTV, neither of which were swayed in their respective business strategies.

Such investors are also more flexible when it comes to exits. Had Wandoujia received investment from Baidu rather than Softbank, this would limit its trade sale options further down the road - Baidu might not look favorably on a sale to Tencent, for example, preferring to buy the business itself.

That being said, entrepreneurs aren't living in fear of receiving capital from a strategic investor. A start-up with ties to a large internet company will have access to capital, resources and skill sets. Influence, when exerted properly, can encourage innovation.

"Even if they don't invest huge amounts in some fundraising round, their impact on business development is long-lasting," says Ray Yang, managing director at Northern Light Venture Capital.

However, a distinction can be drawn between technology VC units and investment arms of Chinese companies from traditional industries. The ties between technology and venture capital are well established and the strategic rationale is usually quite clear. These are not one-off, random investments.

"There are always new innovative businesses to provide deal flows, so they are different from traditional industries where growth is organic rather than through acquisitions," Yang adds. "I don't think there is much deal flow coming from pork sellers. They may do 1-2 acquisitions and they won't invest a lot."

If there is no strategic imperative then there is no incentive to persevere with investments. Suning Commerce, an offline electronics retailer that is aggressively developing an online business, can absorb the costs of a VC program because it has the potential to make a long-term contribution to the firm's core business. A corporate that invests haphazardly is unlikely to treat its investments in the same way.

Ningbo Shanshan Corporation, a Shanghai-listed shirt manufacturer, is a classic example. The company launched Shanshan Venture Capital in 2007 with a view to diversifying its business away from garments. Within a few years the parent had run into financial difficulty and the VC unit was soon abandoned.

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• Topics
• Greater China
• Venture
• Expansion
• China
• Venture
• M&A
• Growth capital
• Northern Light Venture Capital
• Lightspeed Venture Partners
• Vision Knight Capital