GOLDEN OPPORTUNITIES, HIDDEN DIFFICULTIES

Venture capitalists are looking for inroads into China. But many U.S. telecom firms have been turned off by the possibility of not cashing in on their investments because of China's complicated foreign ownership policies. The secret to cracking open one of the world's most lucrative markets may lie not only in the right corporate structure, but in diversification.

China is the second largest market for every good and service worldwide, but for foreign venture capital firms and other equity investors, its morass of regulations make it a mystery. Although the country is the second largest recipient of direct foreign investment in the world — about $40 billion annually — private equity investment in China either has failed miserably or produced spotty returns.

Telecom companies in particular were scorched a few years ago because they structured investments based on the advice of Hong Kong consultants that either ignored or misunderstood mainland China policy, said Jack C. Fensterstock, president of China Capital. The result: Large U.S. carriers and other companies lost a ton of money.

Hopes spring anew, however, as experts predict China will open up once it enters the World Trade Organization sometime next year; then it will be forced to abide by international business practices. A proposed quartering of China's telecom market among four carriers also will entice equity investors. The government, for example, wants to break up the fixed line monopoly, China Telecom, and give 10 of its provincial networks in the north to China Netcom, a wholesale carrier that counts Goldman Sachs and News Corp. among its investors. Whether this will be enough to whet VCs' appetites and stimulate an influx of private equity is another question.

The Chinese government already has proposed new regulations on foreign venture capital. It allows VCs to be involved in a portfolio company's management and for the first time grants legal status to limited partnerships. “It's a step in the right direction, but the China market is not comparable to what we're used to in the U.S.,” said George Koo, deputy director of the Pacific Rim services group for Deloitte & Touche.

For now, the structural restrictions on VCs coming from outside China have put a chokehold on Western technology investment. For example, in telecom services, which are mostly run by the state, foreign investors can own only a minority interest. If a wireless company wants to build a next-generation cellular network, the government stipulates that it must have some Chinese ownership. And VCs can only invest in a company that is at least 25% owned by foreign shareholders. “They don't want foreign capital to come in and dabble,” Koo said.

Perhaps the biggest obstacle to investing in Chinese ventures is the expatriation of capital, or lack thereof. If you pour capital into a Chinese company, it's hard to cash out because of the country's currency controls. “When China becomes a free-flow trading partner, they're going to have to make the flow of currency a lot more open,” said Peter Chu, managing partner for AsiaTech Ventures. “That's a lot of the hope behind WTO.”

There are also very few exit paths for start-ups because the established Chinese stock markets in Shanghai and Shenzhen have strict listing requirements. A Nasdaq listing brings its own problems — culturally, Chinese management find operating with transparency for investors difficult, Fensterstock said.

There has been much talk of a Nasdaq-type board for Chinese growth companies. But the new board won't likely happen anytime soon. “The bloom is off the rose for an Asian, Nasdaq-like board,” said Michael Brownrigg, vice president and partner for ChinaVest. “There are many reasons for having a second board but few reasons to do it in a hurry.”

Cognizant of the lack of exit strategies, ChinaVest, a firm that claims to be the oldest U.S. venture capital company in greater China, looks for merger and acquisition opportunities from the beginning, hoping to eventually sell out to a multinational. “You have to be smart about designing liquidity,” Brownrigg said.

Not too long ago, joint ventures were the structure of choice for companies entering China. But experience proved joint ventures to be thorny propositions that lead to culture clashes. For example, China's social welfare requirements make it extremely difficult to lay off staff. “From our experience, the joint venture with [locals] has been very difficult,” said Lip-Bu Tan, chairman of Walden International and a member of its international investment committee. “We don't recommend [it].”

Walden, which has invested $150 million in 23 different companies since 1994, had a tortuous time exiting its early investments. When it invested in China's largest washing machine manufacturer, it had to hold its stake for eight years because its class of shares weren't convertible. China's strict rules on the ownership of Internet content companies also meant it took Walden a year and a half of regulatory wrangling and restructuring to get its portal investment Sina.com listed on the Nasdaq.

But Walden is wiser now. One way it diversifies its China play while reducing risk is by investing in U.S.-based companies that sell into China. One is Centillium Communications, which owns nearly 100% of the asymmetrical DSL market in Japan. Walden held a 7.4% stake in Centillium at the company's IPO.

Another Walden investment is UTStarcom. The telecom equipment vendor, founded in 1991 and based in Silicon Valley, does about 90% of its sales in China, according to Hong Liang Lu, UTStarcom's founder, president and CEO. Two wholly owned subsidiaries manufacture UTStarcom's products in mainland China, keeping shipping costs low. Lu believes the willingness to bring technology back to China is key if U.S-based ventures are to be successful. “There's a lot of hesitancy from large corporations to transfer technology to local factories,” Lu said.

Another investment mistake is force-fitting products and technologies suited to other countries into the China market, Lu said. It's like trying to sell a Cadillac into a country with a bicycle culture. UTStarcom sells a wireless personal access system that gives cordless phone users short-distance mobile capabilities at the cost of wireline, a product that is well-suited for China's insular provinces, Lu said.

Foreign-based companies still come under the thumb of Chinese regulators, however. For example, the state still owns a large chunk of telecom service providers and thus can choose which equipment companies fail and which win.

Investing in parent companies that own Chinese interests is another way to go. AsiaTech Ventures structures an overseas entity of which the China company is a wholly owned subsidiary. “Our money stays outside of China,” Chu said. “The structuring has to be done carefully. Hopefully there's enough value at the top… because that's your exit. But you have to transfer hard assets into the subsidiary to build it up.”

There is a danger, however. “If you set up elaborate holding companies, it's not clear to anybody which element of the company owns what — as soon as you have uncertainty, you depress the value of the assets,” Brownrigg said.

But investing in China has its attractions. While a VC might invest in a U.S. technology company in $10 million to $15 million chunks, a VC firm in China gets the same size stake for one-third that amount. AsiaTech Ventures typically invests anywhere from $250,000 to $42 million in its China start-ups, Chu said. “It's partly risk mitigation,” Chu said. “To commit large sums of money and not know how the exits are working out is a high-risk, high-dollar proposition we're not ready for yet.”

Will there be China-based entrepreneurs worthy of VC financing? Most experts think so, but the lack of management skills, the difficulty of getting an independent board of directors and business plans that lack an understanding of market economics pose obstacles, Fensterstock said. Although many entrepreneurs have great technology ideas, their business plans “don't get into who the customers are and what strategies they're going to deploy to get them.”

Other investors disagree. U.S. entrepreneurs can't write an effective business plan, either, Brownrigg said. “That's the role of the VC,” he said. Although there's a “huge reservoir” of talented workers, there aren't a lot of seasoned, midlevel executives, Brownrigg said. “One has to be careful where one prospects,” he said. “Younger companies with Western-oriented managers understand gross margins and understand it takes capital to grow a business plan.”

Mainland China produces about 1 million engineers per year. “We see a lot of well-trained local Chinese,” Lu said. Like many U.S. companies that want to do business in China, UTStarcom also prospects for Chinese nationals who were educated in the U.S. Besides forming the right corporate structure, the key to investing in China currently appears to be diversification. AsiaTech invests in 47 companies outside China to balance its portfolio. ChinaVest invests in Chinese industries outside technology. “Many [Chinese] companies outside technology have a high-growth profile,” Brownrigg said. “If you only invest in technology in China, you're too concentrated.”

Limited partnership funds dedicated to China appear to be a long way off. “It wouldn't make sense right now,” Chu said. “I don't know how to make the money out of China for somebody who invests in me.”