Too much cash chasing too few deals is resulting in spiralling asset valuations and a tendency to overlook smaller start-ups
Record fund-raising combined with a dearth of deal-making has caused a venture capital (VC) overhang in China, leading to higher valuations and some observers to warn of a boom and bust in the most competitive sectors.
According to China-based venture capital research company Zero2IPO, mainland and foreign venture firms raised a record US$4 billion last year while investments fell 16.7 per cent over the previous year to US$1.057 billion.
A venture capital overhang results from too much cash chasing too few deals, and while the situation seems like a boon for China's entrepreneurs it is widely regarded as a negative for the industry due to spiralling deal valuations and a tendency to concentrate on blockbuster expansion investments over traditional start-up venture funding.
The relative nascent history of VC funding in China is characterised by multimillion-dollar deals with companies already boasting proven records in revenue and earnings. Online gaming company Shanda Interactive received funding from Japan's Softbank on this basis in 2003. Softbank also invested in Focus Media's first round in the same year when the display advertising company was already making profits.
Last week, the mainland's Oak Pacific Interactive secured US$48 million in late stage financing - the largest ever VC deal in China.
'The tendency to go with proven track records and proven revenue models was the right one in the past. There were many companies that had already developed through several rounds of self- or local government-raised capital, so when it came to securing institutional financing they already had proven track records,' said Duane Kuang of Qiming Venture Partners.
'In addition, the multiples from investing in start-ups did not make them worth the risk [at around five times revenue compared with two or three times for established firms].'
Mr Kuang said multiples were now right for more traditional 'Silicon Valley-style early stage investments' at about 20 times. But he warned the most popular sectors, internet and wireless services, were already showing signs of overheating.
Vincent Chan, chairman of the Hong Kong Venture Capital and Private Equity Association and vice-president of Jafco Investment, said an influx of US venture capital firms was pushing up valuations.
'The pot is getting bigger. [Valuations have] gone up even higher. United States VCs are setting up new offices in Beijing and Shanghai every month,' he said.
But much of the focus was concentrated on mid- to late-stage investments. 'There are still some VCs willing to invest in the early stage or pre-revenue stage,' he said. 'However, many former small fund managers have been able to raise much larger funds [this year and last].
'There is a general tendency for them to work on bigger deals. Some have changed focus from venture into growth capital and compete with the traditional expansion capital investors.
'I believe there is a funding gap between early stage and late stage.'
That may be putting it mildly. Shanghai-based venture capitalist Adam Bornstein warned of 'a massive glut' in mid-stage funding.
'In the US there are well-organised angel investor communities and a number of early stage VCs nurturing young entrepreneurs that ensure a fertile middle ground,' he said.
'However, in China there really isn't anything like this. The reality of the situation is that this overhang ... is polarising the market, whereby funding is flowing to ventures with higher valuations while starving promising early-stage opportunities.'
This trend is not surprising. With so many VCs raising substantial funds in the past 12 months, including Qiming, SAIF Partners, Sequoia Capital China, Intel Capital and IDG Technology Venture Investments, the onus is now on them to deploy the capital.
Time frames might differ but large funds usually chased larger deals of at least US$4 million, Mr Bornstein said.
If the process of due diligence was the same for small deals as well as large ones, it made sense to concentrate on the latter.
'These VCs [also] can't justify dipping into ventures priced below US$4 million [pre-money] because if they did the VC would end up owning a majority of the company, and there would be little upside for the entrepreneur.'
But few venture capitalists interviewed by the South China Morning Post seemed unduly put off by the higher valuations in the most sought-after sectors. Jafco this month has poured an undisclosed amount into a mainland mobile advertising firm that had been incorporated only in January.
But Mr Chan said not every deal could be early stage because of the time and resources involved in guiding their development.
Cadol Cheung, Asia managing director for Intel Capital, acknowledged expectations of higher valuations among China's entrepreneurs was increasing but argued that whether they had become unrealistic ultimately depended on the value gained at the exit.
'If the exit market is good then the valuations will rise accordingly,' he said. 'Wireless is hot right now in VC interest, but it is also a strategic interest for Intel.'
Others saw opportunities away from the buzz, such as Mr Kuang, who predicted better value and good growth prospects in semiconductors and software.
Meanwhile Mr Bornstein, a smaller player in comparison with the large international funds, appears to enjoy looking at opportunities others overlook.
'We get to pick the ripest ideas and most talented management teams,' he said.