It has been a banner year for China's private equity and venture capital markets, but the excitement has been tempered somewhat by the emergence of unprecedented challenges.

The success several sizable China-focused funds have had in raising large amounts of capital was offset by a number of changes to government regulations, which have also coincidentally had a negative impact on investment sentiment and deal structuring.

The old rules were replaced by new ones following discussions between China's venture capital community and government officials.

In January this year, the State Administration of Foreign Exchange (SAFE) announced that all asset transfers to overseas holding companies of Chinese businesses required its approval. This also applied to taxation of stock options, but SAFE failed to issue detailed application procedures.

The rules aimed to block illegal asset flight and tax evasion, but were believed by the market to have created administrative obstacles for the use of venture capital by many Chinese private companies, particularly small and mid-sized enterprises (SMEs).

Most of China's SMEs prefer to list overseas as an indirect means of receiving tax breaks and other favourable policies available only to foreign investors. They first establish a company overseas, or what are known as special purpose vehicles (SPVs). SMEs then transfer their assets into them and reinvest back in China through these SPVs.

An increasing number of private Chinese enterprises in recent years have also used overseas SPVs to raise funds aimed at circumventing high listing standards and strict forex regulatory requirements. This method also encouraged the participation of venture capital (VC), which relies heavily on easy exit channels. This resulted in a significant decrease in Chinese private overseas listings and VC investment.

The rule has had a significant impact on market sentiment.

"We will progress very slowly and painfully if there are no improvements in the future, and it will turn off VC investors throughout the world," Robert C Partridge Jr, the managing director of transaction advisory services at Ernst & Young said in September.

Members of the China Venture Capital Association (CVCA) have responded by organizing themselves for better communication with the government.

The situation eventually changed. SAFE promulgated a new rule to replace the controversial regulation late last month. The new rule, which became effective earlier this month, allows domestic citizens to use mainland assets to set up overseas SPVs for fundraising purposes. This paves the way for return investments in China. The regulation also specifies procedures and requirements.

"This is the first time I've seen a policy replaced so quickly," says Yan Yan, a managing partner at SAIF Venture Capital. Although still unsatisfied with several inefficiencies, he appreciates the regulator's open-minded approach.

Many still do not think the new rule is clear enough, however, because it failed to precisely define what is meant by the term "domestic citizen", for example.

"I think we'll have to wait until next summer to see a significant number of SMEs list overseas according to these procedures," says Ronald Wan, head of SBI (Softbank Investment) E2-Capital.

China's VC industry has finally matured after more than a decade of development. Foreign and domestic venture capital firms have invested in about 3,000 companies in China so far.

Attracted by high economic growth and encouraged by a number of successful investments, an increasing number of venture investors in recent years, particularly foreign venture investors, have launched plans or have been contemplating China investment strategies.

There have already been more than 100 venture-backed initial public offerings (IPOs) and mergers and acquisitions (M&As) in China. Most of these have been overseas IPOs and cross-border M&As. These transactions primarily took place in the telecoms and Internet industries. Internet-related companies offered the best returns to their VC investors, says a report by Zero2IPO, a market research company.

Outdoor advertising company Focus Media is a successful example of VC investments. It evolved out of foreign financing by VCs. Focus Media is only about two years old, but it went public on the NASDAQ this past July. It raised US$170 million.

The Internet industry is not enough to satisfy the appetite of aggressive VC investors, however.

"We value China's Internet-related companies, but I'm also optimistic about the consumer market," says Yan Yan.

Shanda Interactive Entertainment, the biggest Chinese online game operator and one of the most successful VC cases in China this year, will not be the most successful investment for SAIF, Yan says.

"It will be bigger next year," he says, but does not reveal details.

The report also says that overall VC performance in China has been improving.

"The substantial growth of the Chinese economy and several industries, a critical mass of entrepreneurs, and the improving regulatory environment, should direct more VC into China," the report says.

This recipe for successful VC investment is widely shared throughout the industry.

"Successful investments need the right business model, and China has great ones. They should also be financed properly," Partridge says.

The exit strategy is also important. "The problem with China is that it does not have a very good exit framework for VCs, particularly for foreign VC," he says.

VCs are still finding great business models in China. They are still finding ways to properly finance deals, but they can't get their money out easily because of the regulatory environment and currency controls.

"One of the fundamental challenges China faces in the VC industry is that the government needs to create a solid VC system," Partridge says.

(China Daily 11/14/2005 page4)