By: Steve Dickinson
This post is part I of a two part series on why investing in Chinese companies can be so different than investing in Western companies. In this first part, I address how the way Chinese companies typically view investment is so different from that in the West. In Part two, I will talk about how this differing view so often impacts Chinese joint venture deals.
I often write and talk about how China’s lack of intellectual property protections stems in part for its contempt for the intangible. As an extension of this attitude, China also has what I would call a contempt for investment. For the Chinese, work is generally all that counts. Investment has no permanent value and it tends to be treated like a loan. Once the investment is repaid, the investor is expected to depart and allow the executives who run the company to receive all future rewards. Investors that insist on sticking around to earn a return on their investment are considered to be fundamentally dishonest. Since the investor is operating in bad faith, it is perfectly acceptable for the Chinese company owner to use extra-legal methods to get rid of the investor that overstays its welcome.
This attitude explains one reason why investment in Chinese companies is so difficult. Take the typical venture capital portfolio. The typical venture capital investor is not expecting that every investment will result in a substantial return. Instead, it hopes that one investment of many will score big, resulting in a pay-off that compensates for the relative failure of other investments in the portfolio.
It is difficult to make this approach work in China. The Chinese side is quite happy to accept venture investment in a project that fails. When the project fails, the investment is lost, but the effort of the founders is also lost. As far as the Chinese side is concerned, both sides lost the same amount and they feel no need to compensate the investor for its losses. In fact, the entrepreneur usually believes the loss of its time and effort is a much greater loss than the loss of the investor. After all, the investor only lost money, which can be replaced. The time and effort of a young entrepreneur cannot be replaced. This loss is therefore much more tragic that the mere loss of money.
On rare occasions, however, the project will work and the venture will succeed. In that setting, the entrepreneur founders will expect that the investor will be happy with receiving a return equal to its investment plus a small amount of profit roughly equivalent to the interest it would have earned on its money. When the founders learn that the investors intend to ride the project to the very end, reaping the majority of the financial benefit, the founders believe that they have been tricked. Their work is the entire value of the company. How can it be justified for the investor to stick around and reap the rewards when the investor has done no work? No one expects their banker to continue to demand payments after the loan has been repaid. In fact, such a demand from a lender would be seen as fundamentally wrong. The same is often seen to apply to an investor. Since the investor’s continuing demand for payment seems fundamentally wrong, the founders will work to eject the investor in some way, even if this is actually damaging to the company. The fact that this attitude is completely contrary to current Chinese law is irrelevant. The attitude is deep-seated and seems to pre-empt any consideration of what is provided for in China’s legal system.
This attitude makes private equity difficult to do in China. I am often challenged when I say there really is no domestic private equity in China. Critics point out the large number of funds that are called “private equity funds” that operate all over China. However, when examined, these funds seldom resemble what we call private equity in the United States. The Chinese funds are more like what we would call “short money lenders.” They lend to a project at high rates of interest. They take their capital and interest and then leave. They usually do not attempt to enter into any kind of a long-term arrangement with their investment targets. This is because they fully understand the basic principal: loans are acceptable, even at high rates of interest. Equity investment is not. Work counts, but investment does not. Think communism.
What are you seeing out there?