How can foreign VCs get to China’s tech startup boom?

The slowdown in China’s industrial sector is continuing to cast a shadow over global markets and unnerve Western investors. It looks as though the behemoth’s recent period of sky-high industrial expansion – which did so much to support the global recovery through demand for imports – may be stuttering to a halt. Yet other areas of its economy may only just be starting to blossom.

One such area is technology, which is experiencing a startup boom of unparalleled proportions. If you consider the digital and mobile revolution of China’s domestic consumer base over the last decade, this is perhaps unsurprising. Of its population of 1.3 billion, more than 600 million now have smartphones, while 700 million have broadband access via a PC. From the point of view of tech companies a huge new addressable market has essentially popped into existence in a relatively short timeframe.

It’s partly thanks to this that we are seeing a wave of entrepreneurialism throughout the country, where registrations of new startups outpace GDP growth by a factor of three. 2.1 million companies were started in H1, an increase of nearly 20 per cent on the previous year’s figure, with the service sector accounting for eight in ten of these.

This is being fuelled in part by a spike in Chinese venture investing. Whereas Chinese venture capital consistently accounted for roughly 9% of the global total from 2006 to 2013, this figure rose to 18% (about $15.6bn) last year. The relationship between the two is symbiotic: the wave of innovation is attracting the money of the newly rich, which is in turn supporting riskier, early-stage businesses.

So it’s no surprise that venture capitalists from abroad are also keen to get a slice of the action. But USD managers face a major conundrum when it comes to gaining access to the sector. Here’s the rub: the type of startups they want to invest in need an Internet Content Provider (ICP) licence to operate. Yet ICP holders must be domestic companies, in which USD funds are prohibited from holding an interest.

It’s a thorny issue, and we are currently seeing a lot of discussion regarding potential workarounds. Broadly speaking, there are three possible routes in. USD funds are able to hold domestic entities in trust, via a third party, or via a China based sub-adviser. Unfortunately, none of these come close to being simple or airtight workarounds. Another route besides these is the possibility of holding an asset in a restricted industry via a Wholly Owned Foreign Enterprise (WOFE). The catch is companies in this category, should they wish to list onshore, still need the investments to be in RMB, and for the investors to be People’s Republic of China passport holders.

This last potential solution touches on another aspect of the conundrum. Finding a way in is only half the problem – there is also the perennial issue of how to repatriate profits, given the non-convertibility of RMB. Once again, there are – as of yet – no easy solutions available. The Chinese government clearly has a long term strategy to internationalise the RMB, and this journey has already started. But how quickly this will happen remains uncertain, which is a problem given that the country’s tech startup boom is happening now, not tomorrow.

One potential approach – clearly being adopted by some – is to invest now and simply gamble that the RMB will be more freely tradable by the time an exit is viable. For those not willing to take that risk, the other more substantive solutions are to enter into swap arrangements and/or finder’s fee/consulting arrangements.

The downside to these approaches is that they are tax inefficient for the purposes of USD funds. Despite this, they can still be worthwhile if the potential rewards are large enough, which, when it comes to China’s exciting new entrepreneurial wave, they might just well be.

 

Alexander Traub is managing director, Asia at Augentius

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