Notes

Venture Capital, Private Equity, and Hong Kong's Entrepreneurial Businesses by Forbes Private Capital Group Hong Kong News Reviews Alert

Acknowledgements

We are very grateful to all our interviewees featured in this paper. We would also like to thank K.O. Chia and Marvin Lai of HKVCA for their comments. Thanks particularly go to Joanne T. W. Yu, a second-year student at the University of Hong Kong, for editing this paper. This paper would not have been done without their generous assistance.

Disclaimer HKVCA endeavors to ensure that information provided in this paper is correct. However all persons accessing the paper undertake responsibility for assessing the relevance and accuracy of its content. HKVCA cannot guarantee its accuracy, suitability, fitness for purpose or completeness. The information is provided to you on an "as is basis" and, to the extent permitted by law, is without warranties of any kind, either express or implied. Copyright in all information and material resides with HKVCA. Apart from fair dealing for the purposes of private study and research, no part may be reproduced or reused for any commercial purposes whatsoever. To copy otherwise, or republish, requires prior specific permission.

Introduction

As an industry group, we find 2012 an opportune time to bring venture capital and private equity into the discussion of entrepreneurial businesses in Hong Kong. There is increased consensus among the community and the new government leadership that small and medium businesses are in need of greater vitality for the good of Hong Kong. It has also been a decade after the watershed year of 2001 that saw our city's entrepreneurial fervor reaching its peak, the launch of GEM Board and government-backed on-site incubation programs, and then the burst of the tech bubble. In the 10 years that followed, we witnessed, admiringly, the venture capital- and private equity-backed entrepreneurial boom in Mainland China, heralded by the IPO of Tencent and Ctrip in 2004. Thus it would be instructive to (i) look back holistically how entrepreneurial businesses have actually fared in Hong Kong in the past decade, (ii) identify the nuances and viable models how entrepreneurial businesses at different stages may work with angel investment, venture capital and private equity, and, through this paper, (iii) make the lessons known to you, our audience, namely: entrepreneurs and aspiring entrepreneurs; industry veterans, who may consider joining the management of an entrepreneurial business or even setting up one; investors; government and policymakers; and the general public. It is so that we have a clearer perspective how value can be created with Hong Kong's entrepreneurial businesses as we proceed into the next 10 years.

Setting the stage: the state of venture capital and private equity

Hong Kong has been the hub of Asian private equity and venture capital ever since its advent in the pre-Asian financial crisis days in the 1980s and 1990s. The two biggest industry events for Asia private equity are held here every year. We have a number of independently-owned home-grown private equity firms that have become industry leaders in China, regionally, or even internationally, including prominent names such as SAIF Advisors, Baring Asia Private Equity, and Pacific Alliance Group; Mount Kellett Capital Partners is even named after a mountain in Hong Kong.

The Asia private equity and venture capital industry has grown tremendously in size in the past 10 years. According to Emerging Market Private Equity Association, annual private equity and venture capital fundraising in Asia has increased from HK$55 billion in 2001 to HK$224 billion in 20111, While Hong Kong's venture capital private equity industry is easily overshadowed by the city's business volume in the secondary and derivatives markets, it is important to draw the distinction in terms of their impact on the real economy. Venture capital/private equity makes direct investment into businesses, whereas in the case of secondary market activities, securities simply change hands in an open exchange. This paper contains real-case interviews on how angel investing, venture capital and private equity have contributed to Hong Kong businesses over the last 10 years.

Until recently with the investment in TVB and City Telecom, Hong Kong's venture capital and private equity industry has largely evaded the attention of the local press. This is very different from Mainland China, where private equity and venture capital is one of the most talked-about phenomena in the media. According to Fortune Magazine2, private equity is considered to be one of the "15 most important things that shaped the lives of Chinese people in the past 15 years", along with residential properties, high-speed trains and mobile phones.

There is indeed no need to overhype venture capital and private equity. Yet it is helpful if through this paper policymakers and the local business community can better understand how venture capital and private equity works as an industry, in order to form the right expectations of engagement, as we all should do when conducting business.

How venture capital and private equity functions

Venture capital and private equity is a fund management business. As such, venture capital and private equity fund managers raise funds from investors who subscribe to the specific strategy of the fund products they market. Investors typically will go into the fund as "limited partners", meaning that they cannot interfere in the day-to-day operation of the fund, including the fund managers' investment decisions, except on a few pre-specified occasions. The fund typically has a finite life, and that means normally the investors cannot withdraw at will. In exchange, other than fund management fees, the fund managers do not get paid economics before investors receive their profits. These universal features have a number of important implications:

First, a venture capital or private equity fund manager can only invest according to what is prescribed as the fund's strategy, and should serve the best interests of its investors within the premise of the fund. Looked in another way, a venture capital/private equity firm may organize a fund product that is tailored to a specific strategy, should there be sufficient demand from investors.

Hence, if a Hong Kong-focused fund can be raised successfully, the venture capital/private equity investor mandated to manage the fund will have to invest in Hong Kong companies. Likewise, if there is not a dedicated Hong Kong fund in the market, a Hong Kong investment opportunity must be compelling enough to attract investors not tied to a Hong Kong investment mandate.

Secondly, while venture capital and private equity can be patient capital, the fund manager's principal fiduciary duty is to exit the investment within the finite fund term and realize gains for its investors. Its objective is fundamentally commercially motivated. In fact the greatest social responsibility for a commercial fund manager is to manage competently the money entrusted upon by its investors, which may include non-profit organizations, pensions, education endowments and government reserve funds. To think of supporting Hong Kong entrepreneurial businesses as an act of charity does not help in adding vitality to the economy sustainably. Rather this paper aims to make the point with real-case examples that, at different risk-levels, investors can find “investable” entrepreneurial enterprises and managers in Hong Kong that are committed to high-quality business judgment and execution, and that Hong Kong can be a place to build great entrepreneurial businesses.

Finally, as practitioners investing in the real economy, we are in a credible position to echo the voice of the Hong Kong enterprises covered in this paper: acknowledge the pace of change that has been taking place around us. Acknowledge how fast China’s industries can learn, especially in the past few years, and that they will continue to do so in the years to come. Acknowledge that the Asia private equity industry has come a long way over the past 10 years, not only in scale, but also in sophistication and institutionalization. Most interestingly, at this juncture of a Facebook IPO and a China slowdown, acknowledge the need to calibrate the right dosage of opportunism as we orient our next steps forward.

We hope this paper will provide you with illuminating insights as you plan your new venture, your new career, your new investment theses, and the policies for this wonderful city.

How did we fare? Successful entrepreneurial businesses in the past 10 years

Setting out parameters to measure how Hong Kong has been in creating successful entrepreneurial businesses in the past 10 years is easily a controversial exercise. What constitutes a Hong Kong company? What defines success?

This study looks at the number of Hong Kong businesses—defined as Hong Kong-headquartered or Hongkonger-founded businesses—that achieved a proper IPO on the Hong Kong Stock Exchanges (Main Board and GEM Board included) between 2001 and April 2012 and remain listed as of 2 May 2012. This rules out Hongkonger-founded businesses that had an IPO elsewhere (e.g. Rainbow Department Store in the Shenzhen Stock Exchange) or achieved listing through reverse takeover (e.g. Hong Kong Resources and Brightoil). Further, we define success as companies with a market capitalization of HK$750 million (just roughly US$100 million) as at 2 May 2012, which is a very low hurdle to be considered a small-cap company by international standards.

The following companies are also eliminated from the study:

• Spin-outs or affiliate of another listed or family group, except for companies that were acquired as private equity-style investments;
• Companies that have significantly deviated from their original business, or have been taken over through reverse merger;
• Companies whose stocks are suspended or being investigated for accounting scandal, or show very poor financial prospects (defined as those that are trading significantly below book value and generating negative return on assets);
• Real estate companies; and
• Companies that operate their headquarters outside of the Guangdong/Shenzhen region and have very little business presence in Hong Kong, even though they are founded by entrepreneurs who are Hong Kong citizens (e.g. shipbuilder Rongsheng in Shanghai, or auto dealership Zhongsheng in Beijing).

The results are shown in the following page. 51 companies meet the criteria, representing just 3% of the stocks listed in Hong Kong. A number of household names that are seen as the beacons of Hong Kong’s entrepreneurial success stories in the recent years, including Milan Station, Moiselle, Convoy Financial and Solomon Systech, unfortunately do not make the cut. Further, if the list excludes “grey hair” companies, meaning those founded during the 1980s (such as I.T. and Hong Kong Economic Times) or earlier (such as Belle, Embry, Lee & Man, and Dah Chong Hong), only 37 companies would meet the criteria, meaning on average only 3 to 4 such companies a year have managed to achieve an IPO since 2001 and still remain healthily around. This is quite a dismal number.

While the methodology of this study may have room for refinement, the message is clear: there is in the past 10 years a dearth of entrepreneurs in Hong Kong who have the ambition to build new big businesses—after all, US$100 million is small market capitalization—and managed to pull it off. Hong Kong is not short of small and medium enterprises, but if the IPO scene is any indication, for a long time we really lack entrepreneurial companies that break out to become larger players. Read More