Venture capital (VC) is widely recognized as a powerful engine that can drive a nation’s innovation, job creation, knowledge economy, and macroeconomic growth. As such, governments from various jurisdictions around the world have tried to promote the development of VC markets. Generally, government programs have not been especially successful.
China offers a fascinating case study of how a VC market can be engineered — its VC market is one of the fastest developing and largest engineered markets in the world. Before 1985, VC did not exist in China. But after three decades of development, China is now the world’s second largest recipient of annual VC investments, behind only the US. In 2016, 636 new VC funds were set up in China, collectively raising more than USD 50 billion of fresh capital for investment. This represented a 79.46 percent increase over the previous year. Additionally, there were 3,683 VC investment deals closed in 2016, an increase of 6.91 percent from 2015, and 91.2 percent from 2014. The total amount of VC investments in China was USD 48.9 billion, surpassing the entirety of Europe combined.
The growth of the VC market in China over the past decade is without historical precedent. In the UK, VC investments peaked in 2007 and have remained relatively stagnant, totaling USD 4.8 billion in 2015 (0.168 percent of UK’s 2015 GDP). In Germany and France, the value of VC investments in 2015 amounted to USD 2.9 billion (0.086 percent GDP) and USD 1.9 billion (0.078 percent GDP) respectively. In stark contrast, China’s VC market has maintained its rapid growth since 2002, with fund raising, investments and exits reaching a record high in 2015 (0.450 percent GDP).
In contrast to the US, China’s VC market did not emerge as a result of market forces alone, but was instead consciously and strategically designed by the state from the outset. Specifically, governmental policies and actions facilitated the development of the VC market in order to encourage innovation and technological development, and to stimulate structural reforms of the economy. China’s fascinating experience seems to challenge the orthodox view that top-down governmental efforts to promote VC are likely to be unsuccessful. Moreover, China succeeded in building a VC market despite what commentators have considered weak investor protection and a lack of judicial independence, all of which have led to doubt regarding the effectiveness of private ordering in China. The pivotal question is: How has China managed to create the second largest VC market in the world despite its immature legal infrastructure?
My article titled “Engineering A Venture Capital Market: Lessons from China”, which will be published by the Columbia Journal of Asian Law, analyzes Professor Ronald Gilson’s theory of “simultaneity” in engineering a VC market in the context of China. Based on both quantitative and qualitative data, the article explores the elements of China’s experience in engineering a VC market, as well as concerns about its continued growth. It concludes that the rise of VC in China is attributable to (1) increasing capital supply through various governmental programs, easing regulatory barriers towards institutional and foreign investors, providing tax incentives and improving the exit environment; (2) enhancing the availability of financial intermediaries by introducing the limited partnership, which creates an efficient relationship between venture capitalists and investors; and (3) encouraging entrepreneurship by improving the regulatory environment for small businesses.
Through these measures, China has facilitated the simultaneous availability of capital with the appetite for high-risk and long-term investments, and the emergence of a class of entrepreneurs with the skills and incentives to put that capital to work. A key factor for the rapid development of the Chinese VC market has been its increased reliance on market forces in allocating capital.
On the other hand, the Chinese government’s role in allocating capital is not without flaws. In particular, local government intervention is prevalent within local government guidance funds (GGFs). Local governments often mandate the sectors, companies, or locations to be funded. It is common for a local government to require that a VC firm inject GGF funding in certain companies within the region. This could lead to conflicts between the GGF and the VC firm, resulting in disincentives to the latter in finding promising projects and causing it to be less willing to receive funding from GGFs in future projects. There are also problematic local regulations that unduly restrict the duration of investments and size of the portfolio companies. Moreover, the selection of managers in some local GGFs is flawed. The managers of certain local GGFs are usually not selected from the private sector, but are statutorily appointed.
Further, local governments or GGFs often guarantee investment losses suffered by VC firms, resulting in a lack of incentives on the part of the VC firm and the entrepreneurs. Such subsidized VC firms are less incentivized to perform effectively and to work for the best interests of the funds. Guarantee schemes that are funded by taxpayers’ money also create public grievance towards the GGFs as the very nature of VC investments is high-risk. Guarantee schemes are also problematic because they are usually implemented by officials who may not possess sufficient expertise in calculating the losses suffered, and who may prefer to compensate VC firms that are government-backed.
In addition, there are institutional obstacles, including the flawed cadre appointment system, and the flawed incentive mechanisms of government officials that prevent local governments from achieving the delicate balance of allowing local government funding to operate based on market forces while concurrently pursuing the governments’ policy goals. This residual degree of bureaucratic allocation prevents the Chinese regime from being fully efficient. China serves as an (imperfect) model for other governments seeking to engineer a VC market where enfettered market forces have failed to do so.
Cognizant of the problems within the local GGFs as discussed above, the Chinese central government and many local governments have begun to move towards a market-oriented approach in the provision of funding for VC. This involves attracting more private investors and reducing government intervention in the operation of the GGFs. Since 2015, government agencies including the National Development and Reform Commission (NDRC) and the Ministry of Finance, as well as many local governments, have issued measures to reduce government intervention in the fundraising and operations of local GGFs, and mandate the market-oriented approach among GGFs. For example, the Interim Measures of the Government Investment Fund 2015 governing GGFs specify that GGFs should operate based on market forces and the funds should be managed by professional managers instead of the government. The NDRC Interim Measures for Management of Government Funded Industrial Investment Fund 2016 also specify that government investment funds shall operate based on market forces and the government who provides capital “shall not participate in the daily operation of the funds.” This would allow venture capitalists and entrepreneurs to work more effectively and achieve positive results in a venture capital cycle driven primarily by market forces.
The lesson to be learned from the Chinese experience is that the optimal role of a government in engineering a VC market should be to provide the necessary enablers, while playing only a limited role in the capital allocation process, by simply providing seed funding, while leaving specific capital allocation decisions such as the selection of portfolio companies and designing of investment strategies to private VC firms with the right incentives. This is a lesson that could be valuable to other countries, such as Japan and Germany, that have attempted to promote the development of a VC market without significant success so far, and to other countries that are attempting to promote the formation and growth of a VC sector.