By Tim Burroughs

China’s VC market is evolving as funds started by or raised from founders of first-generation internet firms. Concerns about conflicts of interest must be addressed, but the influence of their ecosystems will grow.

Just over two years ago, Andrew Teoh passed up a role on Chinese e-commerce giant Alibaba Group's mega IPO for a career helping companies get started on the journey that might end in a public listing. The world will soon find out whether Alibaba Group can live up to the hype. Teoh, meanwhile, is preoccupied with Ameba Capital, the VC firm he founded with the former CFO of Kingsoft Holdings.
“A lot of people asked me why I was leaving a potentially $200 billion company, but I went to Alibaba to really learn how companies work, having previously been only on the advisory side,” Teoh explains. “I always wanted to start my own business and every step in my career has been geared towards that goal.”
Previously a banker in the tech, media and telecom (TMT) space, Teoh joined Alibaba in 2005 to focus on corporate development. This included participating in Yahoo's investment in 2005 and the IPO of B2B division He moved on to corporate finance where his last major project was the $1.6 billion deal that likes of Silver Lake and Temasek Holdings get equity in the company.
Teoh's present existence is far removed in pure dollar terms. Ameba raised $25 million for its debut fund, principally from successful entrepreneurs and tech sector investors. It has backed 22 start-ups, has three exits in the pipeline, and is now preparing to launch a successor fund with a bigger target.
A rising tide
Ameba is just one member of a new vanguard of Chinese PE and VC firms that is able to raise money by dipping into the growing ecosystem of domestic entrepreneurs. Either started by or raised from founders of successful first-generation internet businesses, these funds have a pedigree that is rooted extensive deal-sourcing networks and proven operational ability.
“A lot of people have made money in the tech sector and some of them are coming into the buy side, self-funding or raising capital from within their circle,” Teoh adds. “You are going to see more and more of that. Not only people like myself, but also guys leaving the big VC firms to form their own funds and raise money from people they know.”
Venture capital fundraising in China for the first five months of 2014 reached $5.2 billion, beating the totals for the previous two years in full.
There is a cyclical element at work here. Nearly half the capital raised went to Legend Capital, GGV Capital, Matrix Partners, Qiming Venture Partners and DCM. They all raised their previous vehicles between 2010 and 2012 so were expected to return to market in 2013-2014. This almost synchronized activity is in part responsible for the China VC fundraising spikes in 2011 and 2008.
But the old guard is increasingly complemented by the new. Yunfeng Capital, a tech-focused private equity firm, recently closed its second fund at $1.1 billion. The firm was set up by David Yu and Jack Ma, founders of Target Media and Alibaba, respectively.
Vision Knight Capital, founded by CEO David Wei raised $550 million for its second fund. Vision Knight targets the consumer-technology space and, given the partners' operating backgrounds, classifies itself as a PE firm. Shunwei Capital Partners, founded by super angel, Kingsoft veteran and Xiaomi CEO Lei Jun, closed its second fund at $525 million.
Other angel investors have also launched vehicles, notably ZhenFund, created by Bob Xue and Victor Wang, founders of US-listed New Oriental Education, in conjunction with Sequoia Capital, and C.C. Zhuang, co-founder of travel site Qunar, who started Crystal Stream Capital.
There is one fully-fledged VC spin-out. The TMT investment team from IDG Capital Partners departed last year to form Banyan Capital and they closed their debut vehicle at $206 million in January. The LPs are predominantly CEOs of companies they backed while at IDG. This compares to Yunfeng raising its first fund almost exclusively from a set of leading founding partner entrepreneurs. However, the firm managed to diversify its LP base for Fund II, picking up allocations from several institutional players.
Vision Knight's Wei reports a similar experience between his two funds. Institutional players account for 70% of the Fund II corpus but it was a very different story the first time around.
“With Fund I it is very difficult to win the trust from institutions because you have no track record and your strategy needs time to be proved,” Wei says. “We went for high net worth entrepreneurs. We wanted them not just to put in money but also be part of our network. In Fund I we had four institutional investors and they were all introduced by entrepreneurs' family offices.”
Even though space in Vision Knight Capital Fund II was limited, the number of entrepreneurs participating has actually doubled to 36. Wei likens them to buying an insurance premium: “You don't need them immediately but maybe you will need them in the future.” Half the deals in Fund I came through entrepreneur introductions, but there is no guarantee of the same happening in Fund II. Value-add could come through day-to-day consulting on portfolio companies.
GGV Capital is one of a number of established players that carves out an entrepreneur sidecar vehicle alongside its main fund in order to create an alignment of interest with potentially useful players in the technology space. Hans Tung, managing partner at GGV, explains that while the firm's ties to the likes of Baidu, Alibaba and Tencent Holdings (the BATs) are well established, it wants to maintain relationships with executives from businesses in the tiers below.
“You have first-generation entrepreneurs and VCs. They know each other, they started businesses together. Now they are putting money into businesses started by second-generation entrepreneurs,” says Lye Thiam Koh, principal at Northgate Capital. “Experience and capital is being recycled into the system and making it more robust. That is extremely important.”
This phenomenon is by no means unprecedented. The virtuous circle is well-established in Silicon Valley and perhaps best exemplified by the “PayPal mafia,” named for the start-up money-transfer service sold to eBay in 2002. PayPal alumni have since set up, joined, merged or invested in a vast array of VC firms and start-ups, including the likes of YouTube, Yelp, LinkedIn and Tesla Motors. The mafia epithet has since been attached to networks emanating from Facebook and Twitter.
Then and now
That China is now following suit is a sign of the deepening investor and entrepreneur pool. The contrast with the environment less than 10 years ago couldn't be starker. In 2005, having co-founded online travel agency Ctrip and taken it public, Neil Shen formerly entered the VC space as managing partner of Sequoia Capital's China franchise. While he may well have been able to raise a fund independently, Shen opted to align with the brand, knowledge base and fundraising expertise of a US firm.
Sally Shan, head of China at HarbourVest Partners, describes then and now as China PE 1.0 versus China PE 2.0. In 1.0, GPs would leverage whatever affiliations they could to get started, whether it was a US VC firm or a Chinese corporation like Legend Holdings or CITIC Group.
“The supply of capital was limited and trust and credibility were hard to gain among the LPs without a track record,” she says. “Under China PE 2.0, there are Chinese individuals and organizations participating as LPs. The deal sourcing opportunities and ways to create value and secure exits are deeper.”
Derek Sulger, now a partner at consumer-focused buyout firm Lunar Capital, was in a similar position to Shen nearly a decade ago. He had founded wireless value-added services provider Linktone and taken it to NASDAQ the year after Ctrip. Sulger was approached by several US VC firms looking to set up China-based affiliates but ultimately chose to go it alone in PE.
Sulger identifies two qualities that made Shen stand out. First, he was an entrepreneur with experience of running a business and this had inculcated a belief in the value proposition of making investments in platform-like companies and using them to find other synergistic opportunities. Second, he previously worked as a banker and then as a CFO.
“The guys who have raised funds have something they deeply believed in and the stubbornness of an entrepreneur,” Sulger says. “But there is also a big difference between talking about investing money and being a custodian of money. If you have a background in finance the compliance side becomes instinctive. Some entrepreneurs will struggle if they don't have the patience to deal with the administrative side, and that's not only being a fiduciary but also managing a team.”
The implication is that not everyone is cut out to manage money once their LP base stretches beyond friends and family and into institutional territory. It is worth noting that Vision Knight's Wei and Ameba's Teoh both forged careers in finance before moving into operations. At Shunwei, Lei Jun teamed up with Tuck Lye Koh, previously of GIC Private and C.V. Starr.
As such, Teoh considers himself to be part of the Alibaba ecosystem but not typical of it. He expects more spin-outs but with a view to starting pure operating businesses, not funds.
The other obstacle is simply time. Many entrepreneurs remain fully occupied by the businesses through which they made their fortunes and not in a position to make angel investments, let alone set up institutional funds. “It takes a lot of work to raise a professional fund and I don't think many entrepreneurs will do it,” says GGV's Tung. “They would put money into sidecar vehicles instead.”
Risk factors
While the Alibaba ecosystem may have made the most visible contribution to Chinese private equity – with Vision Knight, Ameba and Yunfeng – the full scale of funds, start-ups, M&A events and LP commitments that can in some way be traced back to alumni of the BATs is virtually impossible to fathom. And it doesn't stop there.
Another ecosystem has arguably sprung up around the Lei Jun-Kingsoft-Xiaomi axis; Qihoo 360, a US-listed antivirus software developer has become an aggressive M&A player and is said to have backed several VC funds. Now online retailer have gone public it is expected to embark on a series of acquisitions and online video provider Youku Tudou may do the same.
It begs the question when ecosystems become a vice rather than a virtue. There are certainly risk factors involved, not least that a fund is perceived to be aligned with a particular company could essentially become an extension of its M&A efforts.
Alibaba has invested alongside Yunfeng on several occasions and then Yunfeng participated in the 2011 investment in Alibaba that featured Silver Lake and Temasek.
Alibaba committed $100 million to Yunfeng's second fund and the company said in its IPO filing that the alliance is beneficial to its business. The LP tie-up “formalized an institutional relationship” with the GP. “We expect that, through its expertise, knowledge base and extensive network of contacts in private equity in China, Yunfeng Capital will assist us in developing a range of relevant strategic investment opportunities,” it said.
Teoh is upfront about the perceived conflicts that might arise if Tencent were to emerge as a strong partner for a portfolio company in an Ameba fund with LPs including current and former members of Alibaba and Kingsoft. “We have also invested alongside Baidu, non-BAT strategic corporates and typical VC funds, so it's pretty neutral across the fund,” he says. “At the end of the day the portfolio company is number one and we want to be objective.”
He stresses that marketing efforts for Fund II will be based on exits – as evidence of a systematic business model – not Alibaba connections. Vision Knight's portfolio also has minimal Alibaba crossover and Wei expresses a similar view on fundraising. “It helps to open the door, but it doesn't mean too much when you raise money. It doesn't prove you are a good fund manager.”
The general consensus is it best to remain independent as long as possible and only bring in a strategic partner if there is a particular need – and then make a selection based on what best serves the portfolio company. As one industry participant observes, Alibaba brings money and credibility but is hands-off in its approach, leaving the entrepreneur to address issues. Baidu and Tencent, meanwhile, are known for using their clout to bring user traffic to start-ups.
The relatively small size of China's start-up community and classic complaints about a lack of transparency doesn't help the perception issue. GGV's Tung admits that China is more incestuous than the US because there are fewer professional managers, although he adds that they are less inclined to flip start-ups.
Northgate's Koh adds that LPs look closely at the ability of individuals within a VC firm to remain impartial and independent. “It is good to have certain affiliations when you are just starting and the industry is young and less mature,” he says. “But if you look at the US today you don't see VCs that are affiliated to Cisco, Microsoft or Google because they are independent.”
Governance is another concern. LPs are wary of being denied access to timely information that allows them to track fund performance because the manager hasn't put in place strong reporting infrastructure. It comes down to whether they see the value in creating a long-term institutional franchise or, as one industry participant puts it, “taking the low-hanging fruit because there is a relationship.” The latter approach doesn't bode well for the performance of subsequent funds once the fruit runs out.
“They don't have the urgency to work really hard as some of the more professional firms on developing a strategy and building a team because they don't need to,” an LP adds. “People don't know how many funds there will be. They don't have to form the LP-GP relationship. A lot of institutional investors are not familiar with this from the first generation of GPs.”
These fears have yet to be fully realized and the transition from entrepreneur-dominated Fund I to institution-dominated Fund II experienced by several players suggests LPs are comfortable with what they are seeing. For some institutions, there might be an acceptable trade-off between a slightly lower level of transparency and the bumper returns that come through exposure to strong start-ups that emerge from a particular ecosystem.
HarbourVest's Shan adds that the new managers offer strategies that are tailored to the needs of the market, taking a deeper dive into specific sub-segments and thereby allowing LPs to be more selective and refine their strategies.
Still singing
The important caveat is that all this is taking place at a time when the market is going up. Fundraising has spiked thanks to established players coming back to market and new entrants breaking through, but performance is also a factor.
PE-backed IPOs on US exchanges by companies in the TMT, healthcare and education spaces have raised nearly $2.5 billion from five offerings so far in 2014, more than any full-year total on record. Six companies generated proceeds of $657.3 million last year, a marked improvement on 2012 when confidence in Chinese stocks collapsed for a while.Trade sales have been similarly robust, reaching a record high of $4.5 billion from 27 deals in 2013 and the nearly $1 billion for the first five months of this year.
As the fervor over Alibaba suggests, valuations are heady and the venture capital industry itself is cyclical. The virtuous circle represents a fundamental shift and it is here to stay, but it remains to be seen how LPs behave when the market turns. Do they become less accommodating towards newer GPs or will these managers outride the storm, supported by their industry knowledge and operational capabilities?
“I wouldn't be surprised if there are more groups raising their first funds in the next couple of years, provided the market is doing well and there is enough liquidity in the system, ” says J.P. Gan, managing partner at Qiming Venture Partners. “As long as music keeps on playing everybody will be happy, but the question remains when the music will stop.”