Promoting Innovation through a Chinese Government Venture Capital Fund

China’s new government fund for venture capital has real potential to significantly promote China’s domestic entrepreneurship and innovation. But if access to the new funding is too easy, the projects main objective will be jeopardised.

China’s new government fund for venture capital has real potential to significantly promote China’s domestic entrepreneurship and innovation. But if access to the new funding is too easy, the projects main objective will be jeopardised.

On 14 January 2015, the State Council — China’s chief policy body — announced it will allocate 40 billion yuan (US$6.5 billion) to a new venture capital fund to support new startups and foster emerging industries. The announcement read that the fund ‘comes at the right time’, but that ‘follow-up efforts are still required to ensure the fund works’. The government said the fund would come from the government’s existing budget designated for the expansion of emerging industries. There has been no announcement on details on its management. The Government referenced including ‘social capital’ and invited tenders from fund managers.

The goal is to promote innovation. But the success of the fund will not simply depend on how widely new funding is spread. Instead, it depends on the ability to pick winners from among China’s fledgling startups, foster profitable businesses, and secure market returns to investors.

China’s economic strategy has recently faced challenges. Abundant labour from China’s rural hinterland has tapered off, entitling workers to demand better wages and conditions. The global financial crisis demonstrated that demand for China’s labour-intensive exports is not indefinitely reliable.  China is working hard for a ‘soft landing’ from its growth slowdown by improving its economic structure. The startup venture fund is the latest concrete step toward climbing the value chain. The new fund will ‘help breed and foster sunrise industries for the future and promote [China’s] economy to evolve towards the medium and high ends’. Recent success stories such as Alibaba Group, Huawei and Lenovo signal bright possibilities for Chinese industry’s capacity for world-class innovation in competitive global markets.

China’s private small and medium enterprises (SMEs) are driving its economic growth, but they still struggle to access finance and investment. Yiping Huang wrote that asymmetric liberalisation of China’s factor markets distorts China’s capital market against SMEs. Product markets have been completely liberalised, but the state deflates prices for factors of production such as capital, labour and land. The state-owned banks lend at below-market rates; as a result, they do not lend enough to meet demand. Asset-rich SOEs have lending priority.

The government statement said SMEs — especially startups — have few or no mortgage-worthy assets by banks, and must turn to other financial organisations, especially venture capital funds.

China’s venture capital market is small and has been constrained by a variety of restrictions in the past. According to research by Z-Ben capital consultancy, China has around 3100 hedge funds with RMB388 billion (US$62 billion) under management, and another 2500 private equity managers who oversee RMB1.2 trillion (US$192 billion).

Government restrictions on the venture capital market are loosening. In late 2014, regulators allowed insurance companies to invest their huge pools of premiums into venture capital. Caixin recently reported that Anbang, a relatively small Chinese insurer, is making big forays into private equity, raising questions about whether regulators are keeping up. China’s ‘princelings’ are reportedly flocking into the nascent venture capital industry.

The danger is that such a significant increase in the supply of venture capital will ‘water down’ the performance expectations of investment recipients. Recipient firms might develop the same ailment as their larger state-owned cousins: inefficiency caused by easy access to government capital.

The solution to this risk is ‘mixed capital’. The government recognised this, and referred to the possibility of raising ‘social capital’ (or really private capital) for the fund. ‘Mixed capital’ has already been discussed in relation to improving the performance of SOEs. Zhao Changwen, from the Development Research Center of the State Council, wrote that ‘mixed ownership’ would raise the performance of public capital. The idea is that public capital invested in conjunction with social capital and private investors have a say in the management of assets. CASS economist He Fan noted that if private investors are sceptical over whether they have management control of their investment in ‘mixed capital’ assets, they are unlikely to invest in these ventures.

The same goes for venture capital. If the state is to have any hope in successfully achieving a ‘mixed capital’ fund with rates of return that attract private investors, investors will need to be confident that they will have a say in investment decisions. Investors will want fund managers who can create winning formulas for picking startups and innovative SMEs. They will need to support them to become profitable businesses in order to make a return on their investment.

If the government cannot attract ‘social capital’, the failed fund may well become yet another inefficient government subsidy program, rather than a real investor in the future of innovation in Chinese industry.

Can a Chinese state venture capital fund drive innovation? is republished with permission from East Asia Forum