Beyond the China buzz

Over the span of just a few years, so-called emerging markets have gone from being “a long way from Silicon Valley” to being the must-have component of any sensible limited partners diversified portfolio. In particular, the growth of China-focused funds has been particularly noteworthy, with surveys of US venture capitalists ranking China as the most compelling overseas market.
In addition to headline-grabbing transactions being closed by leading VC houses, the number of dedicated China funds is steadily growing. These funds are being launched by the “usual suspects”—established VC firms with demonstrated track records, leading international technology firms, investment banks and other global financial players, as well as local principals with unique (and scarce) experience buying, building and realising companies in China. Such funds focus on sectors familiar to the least-travelled domestic VCs—digital media, software for corporations, mobile telephony, semi-conductor, outsourcing and consumer internet services.
Although the “China buzz” has been increasing substantially of late, venture funds have been active in China for over fifteen years, driven by the best of Western experience and Eastern opportunities. Known and trusted structures are paired with local market insights.
A particular concern for LPs and GPs alike is the appropriate structure for a dedicated China fund to take. The drivers here are not dissimilar to the factors underlying VC fund structuring generally:
1. the type and location of underlying investments
2. the type and location of the investors
3. the manner in which the investors will realise the return on their investments
4. the manner in which the principals of the GP/fund manager will be compensated
Unfortunately, these decisions must be made in the context of a country whose markets are evolving at a much faster rate than its legal and regulatory systems.
As part of the 2003 Regulation of the Administration of Foreign Invested Venture Capital Enterprises, the possibility of a domestic VC fund took a small step forward. Ultimately, for the VC market in China to reach its full maturity, a robust domestic VC fund structure will be essential.
Only then can local LPs and local GPs efficiently and effectively partner to develop local companies. However, the burdensome requirements for such vehicles—including limiting investee companies to PRC entities, when many companies have offshore holding structures—have limited their appeal.
In the absence of a viable onshore Chinese fund vehicle, venture capital funds focused on the market have been established recently using both Delaware or customary offshore (e.g. Cayman Islands, British Virgin Islands) jurisdictions. Where double tax treaty availability and other related concerns arise (e.g., stock exchange listings), jurisdictions such as Mauritius and Hong Kong may be considered.
In addition to the limited partnership structure favoured by most GPs and LPs active in VC, which allows for tax transparency and tremendous flexibility in drafting, offshore companies are also used as fund vehicles, providing investors with the familiarity of a share-capital based structure as well as the possibility for obtaining a listing on a leading stock exchange (e.g., Stock Exchange of Hong Kong). Choice of vehicle is partly driven by whether established VC investors are being sought, who bring with them the expectation for market standard documents. For other investors, especially in the case of first funds raising limited amounts of money, the simplicity of a company structure can be compelling.
In addition to the traditional US-based investors, China- focused funds include LPs from across Europe and Asia, thereby requiring GPs to be familiar with the marketing restrictions in numerous counties—a potentially costly and time-consuming task. Such investors may include large multinational financial institutions (e.g., International Finance Corporation) and investment authorities of neighbouring states. These non-traditional investors frequently bring with them distinct commercial and legal concerns (as well as political or non-commercial agendas) that must be addressed within the fund structure. If the VC fund is to be managed from the United States, the fund will typically be structured as a US-domiciled limited partnership, as this provides the most favorable tax treatment of performance fees both from the manager and the investor perspective. If some or all of the management will be outside the US (i.e., China), the fund may be domiciled outside the US but nonetheless elect partnership classification for US income tax purposes.
Success in the Chinese market is based in part on having the right people on the ground in key cities and regions. The fund management firms involved with Chinese VC funds, therefore, often operate on a cross-border basis, raising complicated questions with regards to their tax-efficient operation. In order to ensure that the carried interest in the venture capital fund is received by the key principals in the GP in as tax efficient manner as possible, various structures such as offshore unit trusts and exempt limited partnerships can be used to obtain optimal results.
China is an exciting opportunity for VC funds, but an imperfect environment in which to operate. As a result more time on both the front-end and the back-end of each investment. VC fund vehicles, therefore, must accommodate these structuring demands.
Almost without exception, Chinese companies require more due diligence efforts than their comparables in other developed markets. In addition to cultural barriers, the role of governmental policy on numerous industry sectors is a variable that must be understood. Risks associated with “political volatility”—both in China and the US (in the form of anti-Chinese backlash in the US Congress or the media) —must be identified and quantified.
For many VC investments, government approvals are crucial for successful investments and ultimate realizations.
The range of potential approvals is quite broad, and can be required for such varied actions as joint venture contracts, foreign exchange approval, feasibility study reports or environmental discharge permits. Although most of the approvals are vested with the local government authorities, if a project’s overall size exceeds certain thresholds, then central government approval is required.
If necessary approvals are not attained at the beginning, problems may arise if the portfolio company requires further financing or eventually hopes to be taken public.
Startups are challenging in any environment. In China, those challenges are present and often multiplied. In particular, the question of whether the management of a possible portfolio company is as good as it can be is paramount.
The GPs assessment of the quality and commitment of a proposed management team can change quite dramatically quite late in the process.
As a result, VC fund document must make adequate provision for the increased time necessary to cope with the lack of transparency and identify viable opportunities, as well as the costs of needing to walk away from a deal when it becomes evidence that something is not right. On the exit side, China can be particularly challenging given the tightness of the initial public offering market and difficulties in obtaining domestic listing listings on the A or B share market or accessing the H market. As a result of the primary focus on trade sales, VC funds need to take a longer perspective on realisation, and LPs need to accept that the ability to hold assets significantly longer is ultimate necessary to generate the target returns. Although China has put tremendous work in to adopting a modern legal system consistent with Western business practices, there remains much to be done to improve the Chinese court system. At a very basic level, the rights of a VC fund in legal agreements are only as good as their prospects for effective enforcement when a breach occurs or is imminent. Enforcement of claims and execution of court judgment are not always to the satisfaction of foreign investors. VC funds must take the necessary steps to ensure that their legal rights—and ultimately the rights of their LPS—are sufficiently protected.
Finally, one must not forget that China is a vast country where regional differences can be quite significant. Just as China was thought of not too long ago as a component of many funds “Asia ex-Japan” focus, increasingly GPs and LPs understand that China itself is comprised of regional zones with different opportunities. A recent notable trend is the rise of regional focuses within China. Due to the importance of local knowledge and experience, more VC funds may find success by demonstrating their ability to maximize their deal sourcing in a single region rather than attempting to position themselves as “pan-China”. In sum, VC funds focused on China that are targeting US investors will typically have largely the same fundamental legal structure as traditional VC funds, although certain terms will need to be adapted to meet the particular challenges faced in the current Chinese market.
Using the appropriate fund structure – from both the LP’s and GP’s perspectives—is essential to achieve the commercial objectives on the ground.

Timothy Spangler is a partner in the London and New York offices of Kaye Scholer. He is head of the firm’s Investment Funds Group.