Book proposal and book review

99 The China Business Model. Copyright © J. G. Hussain, J. Li and J. M. Scott. Published by Elsevier Ltd. All rights reserved.2017

http://dx.doi.org/10.1016/B978-0-08-100750-1.00005-XDOI:

CHAPTER 5

The Equity Gap Amongst Technology-Based Small Firms: Practices and Challenges for Government-Backed Venture Capital in China Javed G. Hussain1, Jun Li2 and Jonathan M. Scott3 1University of Birmingham, Birmingham, United Kingdom 2University of Essex, Colchester, United Kingdom 3Teesside University, Middlesbrough, United Kingdom

5.1 INTRODUCTION

China has formulated and charted its long-term economic reforms to lib- eralize and move its economy toward the market-oriented system. Its pol- icy to increase the efficiency and market responsiveness of state-owned enterprises and to develop private enterprises has helped to intensify com- petition and has motivated all sectors to respond to internal and external demand. The government has considered competition and moderniza- tion of working practices a prerequisite to break out from the status quo to become a more progressive economy. Therefore government reforms and liberalization since 1978 has led to “miracle growth” (Li & Wang, 2014) in the Dragon over the past several decades. The unstable financial environment, demand-deficient world markets, and reductions in the stock market have, however, all contributed to a halting of growth and affecting all sectors of the Chinese economy over the last few years. Ever since then, the Chinese government has realized the importance of SMEs (Hussain, Millman, & Matlay, 2006) and particularly the external and internal chal- lenges for SMEs and technology-based small firms (TBSFs). Whilst China remains competitive in low-skill based production, there is now a recogni- tion that research, innovation, and technology development are all essen- tial to compete within a global market. To be sustainable and to ensure that China’s bandwagon continues to roll, Li (2015) suggests that the momentum

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for growth needs to be driven by entrepreneurship, investment in research, and knowledge-driven innovation. China’s surge in growth has been attrib- uted to the low-technology manufacturing model that has enabled impres- sive export growth. Yet, it is a system that is not sustainable in forthcoming decades. Wen Jiabao, the former Chinese Premier, in his speech to the 18th National Congress in 2012, suggested that low-technology enterprises give rise to “unstable, unbalanced, and unsustainable development.”

There appears to be a strong realization amongst policymakers since 2006 that China needs to move forward from the labor intensive manu- facturing stage to one that supports the infrastructure of enterprises with innovation and technology. The Chinese government initiated a “Medium and Long-Term National Plan for Science and Technology Development (2006–20)” (MLNP) to empower entrepreneurs in adapting innovation at all stages of production. The government’s policy was to inspire entre- preneurs to develop an indigenous or home-grown capacity for original technology, knowledge, to assimilate knowledge and technology acquired from abroad within its manufacturing and service sector. Facilitating infra- structure and an environment that are both conducive to innovation, how- ever, requires new types of financing that support innovative TBSFs in the early stage that the underdeveloped seed and early-stage market fails to offer. Thus the equity gap for TBSFs has been identified as a crucial factor in precommercial and emerging industries.

A prerequisite for the growth and enhancement of any entrepreneurial ecosystem is to have a well-developed, vibrant financial ecosystem that pro- vides risk capital for viable enterprises. Cassar (2004) suggests that adequate finance has implications for the start-up, success and failure of enterprises. China’s capital markets are underdeveloped, so the TBSFs are particularly constrained—a phenomenon often associated with developing economies where private enterprises encounter barriers to accessing external debt and equity finance. Chinese entrepreneurs, specifically those that are technology- based, have faced institutional challenges in their access to equity finance. To deal with market imperfections and the conservatism of banks, the Chinese government and policymakers initiated a number of policies to mitigate the finance gap and to encourage high-technology firms to take on high risk and reward initiatives. One notable challenge identified was access to equity finance and consequently the government launched the venture cap- ital guiding funds (VCGFs) in 2008 to meet the financial needs of high- technology firm entrepreneurs. Li (2015) suggests that the government’s rationale for providing risk capital was the belief that there is a positive

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relationship between access to risk capital, innovation, and the growth of TBSFs.

Internationally, it has been reported that the absence of risk capital neg- atively impacts on survival, longevity, and growth of SMEs (Aldrich, 1999; Christensen, Raynor, & Anthony, 2003; Marlow & Patton, 2005). The same results are supported by Newman, Gunessee, and Hilton (2011). Though sup- port for technology-orientated entrepreneurs has grown globally, it is still contested whether public risk capital provision has enhanced or inhibited the creation and growth of TBSFs (Rigby & Ramlogan, 2013). Of the two schools of thought, one supports government intervention to address issues of market imperfections to overcome the equity gap, whilst the other suggests that government intervention leads to geographical distortions. It has been suggested that programmes supported by governments have the potential to distort the function of the market (Lerner, 2009). On the supply side, State intervention through providing finance can stimulate original innovation or can encourage the adaption of available technology but can also cause a number of challenges. This chapter examines the financing of innovation and technology-based entrepreneurs in China by first exploring the context of State intervention in China and considering structural economic issues. Next, through a literature review, it captures the issues related to entrepreneurs’ equity gap (specifically within China), and considers mitigating initiatives, responses, and supply-side State intervention strategies. It examines the neces- sity for State intervention and its implications for creating market imperfec- tions and the efficiency of the State in narrowing the finance gap for TBSFs.

The chapter then provides an overview of the literature and govern- ment strategies to support TBSFs through government-backed venture capital funds (GVCFs), followed by an evaluation of these funds and their impact upon China’s objectives to meet the demands of emerging high tech enterprises. Section 5.4 considers some guiding principles for venture capital funds in adapting to the demand of entrepreneurs, and Section 5.6 of the chapter presents the overarching conclusions.

5.2 LITERATURE REVIEW

Venture capitalists enable budding entrepreneurs and established compa- nies to realize their full potential which they might not otherwise be able to achieve due to internal and external financial constraints. Empirical studies have established that technology firms with high growth poten- tial face an equity gap due to market failure, which has spurred debate

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about the value, impact, and case for state intervention (Alperovych, Groh, & Quas, 2016). The aim of State venture capital funds is to mitigate the impact of market failure for start-ups, given that commercial banks are reluctant to support enterprises with a high level of uncertainty and risk. Private venture capital funds concentrate on providing high risk equity capital but they tend to favor promising high risk, while reward invest- ments usually offer returns in the short-to-medium term.

Hellmann and Puri (2000) and Kortum and Lerner (2000) sug- gest that private venture capital funds are more suited to the seed- and growth-financing stage and would not necessarily fill the equity gap for the medium to longer term. High-growth technology firms often have high risks and have longer time horizons to develop, so they encounter finance constraints. Therefore state intervention becomes important to address market failure (Brander, Du, & Hellmann, 2015), to safeguard economic prosperity and jobs. Governments are not purely motivated to correct market failures by injecting entrepreneurial capital. The State intervenes— promoting economic growth, create employment, and encourage adapta- tion of technology to improve productivity, reduce pollution, and above all to generate greater tax revenues to promote economic and social cohe- sion. The State-backed funds do bridge the equity gap but they also could potentially crowd out private venture capital providers. State-backed funds could also encourage economically nonviable projects that are not sustain- able over the long term leading to welfare losses for the country. Critics argue that government funded only ventures do not “add value” (Grilli & Murtinu, 2014, 2015) and such ventures tend to be inefficient (Alperovych, Hübner & Lobet, 2015). Furthermore, state intervention gives rise to “col- lusion and regulatory capture” (Lerner, 1999). State funded ventures are often accused of lacking transparency and conducting political malpractice for personal gain (Becker, 1983; Peltzman, 1976) negatively impacting on economic activity. Earlier studies (Kortum & Lerner, 2000) reported that venture capital finance facilitates firms to innovate. Subsequent studies, however, (Caselli, Gatti, & Perrini, 2009; Engel & Keilbach, 2007; Lahr & Mina, 2012; Popov & Roosenboom, 2012; Ueda & Hirukawa, 2008) reject Kortum and Lerner’s (2000) findings and suggest that VCGFs do not fos- ter new innovations, instead investing in the existing firms with innovative projects. There is limited research from a number of countries testing the performance of public venture capital funds and even these studies offer mixed results. Studies carried out in the United States, Europe, and Israel suggested that some state-supported venture capital funds have generated

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positive results (Li, 2015). For example, the Small Business Investment Research (SBIR) programme established in the United States in 1982 proved to be successful in creating awareness and success of TBSFs. Lerner (1999), comparing firms which received SBIR support with those who did not, reported that though some firms were not successful in securing finance at first they learned from experience and subsequently they were successful in securing funds from venture capital funds the following year. The process of preparing information to apply for funds from venture cap- italists during the first time enabled firms to carry out self-appraisal. The appraisal served as a catalyst for TBSFs to secure external funds. The success in securing external equity was, however, more skewed toward the TBSFs which already had accessed external equity previously from venture capi- talists, possibly due to greater familiarity with the requirements of venture capitalist firms and the investment-ready nature of equity seekers. Analysis of other publicly supported venture capitalist schemes in the United States, such as the Small Business Investment Companies (SBICs) that aimed to increase the supply of equity funds, had mixed conclusions (Clarysse, Knocjaert, & Wright, 2009; Li, 2015). Baygan’s (2003) analysis of SBICs found that publicly funded equity funds failed to meet the requirement of sectors most in need. Li (2015) draws upon their conclusions (Baygan, 2003; Clarysse et al., 2009) to suggests that publicly supported venture capitalists are competing in sectors which are already well funded and hence do not necessarily increase the overall supply of funds, suggesting that the equity- deficient sectors’ or enterprises’ demand remains unmet.

The UK equity gap is most severe for firms engaged in cutting-edge technology (Pierrakis & Mason, 2008; Storey & Westhead, 1997), thus hin- dering innovation, growth, and job creation. It is suggested that technology firms have the capacity to create employment but they are restricted due to lack of access to finance (Cowling, Liu, & Ledger, 2012; North, Baldock, & Ullah, 2013). European-wide initiatives have attempted to overcome the finance gap by establishing government-backed venture capital (GVC) schemes. To examine the impact of GVC schemes, the National Endowment for Science, Technology and the Arts (NESTA) conducted a study in 2009 that examined 782 enterprises backed by 6 government- supported venture capital funds for the period 1995–2008. Its evaluation reported that there was some positive impact on the recipients of pub- licly backed equity on the performance of firms in comparison with the control sample. However, the effect of GVC is transient. At an early stage of the enterprise, there is a positive impact on job creation and growth;

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however, the effect declines after 3 years but has a marked improvement after 6 years. The study suggests that GVC-supported firms’ performance exhibits a cyclical pattern. These enterprises, when invested in, go through investment capacity building, develop infrastructure, deplete funds, seek additional investment, and then they take off. The pattern is consistent with the central tenet of the financial growth cycle of firms with high growth potential that, at the same time, exhibit high risk (North et  al., 2013). Therefore the review of enterprises’ performance suggests that justification exists for government-supported technology firms as they make a posi- tive contribution toward the economy. On the other hand, critics of GVC schemes argue that they tend to have high costs, crowd out the private sector and to be an expensive method of creating jobs. This view is coun- tered by the National Audit Office (NAO) (2009) which found that 84% of respondents in their survey reported that, once they received funds from GVCs, they also were able to secure additional funds, so GVCs could be considered as an enabling fund. These findings suggest that GVC finan- cial support serves as a signal of confidence to finance providers and vali- dates the status of the enterprise that, in turn, enables it to attract external finance. The other criticism reported by NAO (2009) was that the gov- ernment-supported funds tended to have a bias toward the South East of England and had high administrative costs (Mason, Lynton, & Stephen, 2016). The House of Commons Accounts Committee (2010) similarly suggested that GVC-supported TBSFs lacked efficiency, their structure is skewed against the taxpayers’ interest and gives rise to geographical and regional inequalities. Mason and Pierrakis (2013) describes financing of TBSFs by GVC as a “drip feed” that stifles innovation and growth. The experience of the United Kingdom compared to Canada is not dissimilar. Analysis of a Labour Government fund initiative carried out by Cumming and MacIntosh (2006) reported there was no evidence that the fund leads to a significant increase in the supply of venture capital. These results are consistent with Da Rin, Nicodano, and Sembenelli (2006), whose survey amongst 14 European countries reported that GVC spending propor- tionately displaced private venture capital. Harrison and Mason (2000) suggested that GVC could cause significant and notable regional disparities by enabling concentration in certain geographical localities. In addition, instead of increasing the supply of funds the GVCs may crowd out private funds. Cumming (2014) challenges these findings by examining the data for the period 1989–2011 for GVC in 13 European countries and thus

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refuting the assertion that GVCFs crowd out the private sector. In fact, the Canadian government supports its TBSFs through its venture finance ini- tiatives and it has been argued that their competitiveness does not diminish.

In this regard, according to Wonglimpiyarat (2015), the competitiveness of Canada is innovation-driven and is supported by government venture finance. Furthermore, the Canadian government’s commitment is evi- denced by its launch of its Venture Capital Action Plan (VCAP) in 2013. The Canadian government anticipates that the fund will motivate private sector venture capital, leading to an increase in the supply of funds that will promote technology-based projects in TBSFs. GVC initiatives have often been criticized for their lack of entrepreneurial attributes, undercapitaliza- tion, and short-term objectives (Lerner, 2009; Li, 2015; Murray, 2007). The suggestion is that at this stage of setting up GVCs, there is a notable lack of clarity in the rationale, size, and intentions of the funds. Government initia- tives are not dictated by local, regional, and political interests rather than the economic rationale that results in GVCs’ underperformance. European studies have suggested a marked underperformance of enterprises funded by GVCs (Baldock, 2016) but such studies used “outmoded funding mod- els” to evaluate the benefits of such schemes over the medium- to long- term. Evidence from Belgium (Manigart, Baeyens, & Van Hyfte, 2002) suggested that the right type of fund is more important, rather than the distinction between private versus public providers. Proponents of GVCs (e.g.,  Rigby & Ramlogan, 2013) argue, however, that information asym- metry and external market failures necessitate the need for government intervention in the form of GVC subsidies. The venture capital providers— whether private or public—are a blend of markets or ecosystems for finance which serve a range of clients at different stages of their operations. Thus a “one-size-fits-all” policy would be misguided. Nevertheless, despite their fragmented nature, Li (2015) draws upon Hood’s (2000) Scottish experiences and suggests that GVC initiatives need to have a rationale, clarity of objectives, and accountability, and should attract and retain high caliber experienced management teams who understand the commercial realities and functioning of public sector ethos. To date, the literature on venture capital has focused mainly on United States and Europe (Bruton & Ahlstrom, 2003) predominantly provided by private investors. Literature specifically evaluating government-backed initiatives within China are notable by their absence, creating a major gap in the extant literature. The aim of this chapter is to contribute toward addressing this relevant topic.

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5.3 EVALUATION OF VENTURE CAPITAL FUNDS IN CHINA

Since China’s institutional environment differs from the West, it war- rants a closer examination of the growth of private and public venture capital funds to support high-growth technology enterprises. Bruton and Ahlstrom (2003) suggested that China was, and remains, a complex econ- omy for venture capital (VC) operations, despite the reforms which took place in the 1980s. Due to their different cultural, legal, and enterprise models, there are marked differences in the type of VCs in China and the West. China’s economy emerged from the command economy and has transitioned for several decades, leading to a rapid change in its financial and enterprise environment. At an early stage, China lacked private ven- ture capital funds as we know them in the West but informal providers of finance existed for the high-technology sector, to a limited extent. To overcome this deficit, State-supported venture capital institutions emerged after the 1980s (Xiao, 2002) but, although these were not initially a pol- icy to reform and promote technology-orientated industry, since 1985 the growth of VCs has mirrored the economic upsurge of China (Ahlstrom, Bruton, & Yeh, 2007).

China’s challenge to overcome the equity gap for high-tech firms must be examined within the context of its cultural, political, and institutional contexts. Cultural norms and practices are embedded within institu- tions that inform the actions of firms, the Government, and individuals. The equity gap amongst high-growth firms has been considered to have a nega tive impact on innovation, growth, and private investment: a particular challenge for economies such as China transitioning from a command economy to a mixed economy. To overcome finance gaps within Chinese technology firms, venture capital has been considered as an essential tool to stimulate growth, a policy that is consistent with the 18th National Congress of the Communist Party, which aspired to promote “technol- ogy and innovation” as core policy to generate economic prosperity. China remains committed to innovate in order to “promote social productive forces” to compete internationally (Hao, Sun, Tian, & Pan, 2015). The ven- ture capital industry is informed by history, the financial environment, and institutional structures (Cetindamar, 2003). China’s underdeveloped capi- tal markets necessitated its Government to intervene by establishing public venture capital funds to promote the supply of equity for high-technology firms—at least over the short-to-medium term (Hood, 2000). Public ven- ture capital institutions serve as stimuli to promote confidence and a signal

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that the Government is supportive and committed to overcome the equity gap not currently being filled by the private sector (Li, 2015).

The policy objective of public venture capital in China was to acceler- ate the flow of capital in overcoming the equity gap that may accelerate the adoption of high-technology methods through innovation. The Communist Party formally supported science and technology (S&T) through venture cap- ital funds in 1985 that led to the formation of the China New Technology Venture Capital Corporation (CNTVC), endowed with US$10 million of funds (40% from the State Science and Technology Commission and 23% from the Ministry of Finance). The objective of the fund was to support high- technology firms in dedicated industrial zones, but failed due to a lack of skills and experience of fund providers that was eventually closed in 1997. Learning from this experience, and improved economic conditions, both within China and internationally, boosted China’s VCs by 2000. China still has relatively lim- ited domestic sources of venture finance for high-technology firms that con- tinue to rely on the Government and wealthy citizens to support high risk, high-technology firms. To overcome the historical underdevelopment of its financial environment, the Chinese government established the Innovation Fund for Small Technology firms (InnoFund) in 1999 to promote and fos- ter innovation, and the adaptation of technology, to enhance knowhow, and enhance international competitiveness. Establishing the fund signaled the Government’s intention to support innovative TBSFs by providing grants, loans, and equity finance, thus resulting in large private venture capital inflows that has helped TBSFs accelerate their research and innovation activities. By 2005, China noted almost US$1.17 billion inflow of foreign venture capi- tal investment, a figure that compares favorably with that of nearly US$325 million in 2002 (Pukthuanthong & Walker, 2007). Despite the development of the VC market in China, new TBSFs still struggled with accessing exter- nal finance and the equity gap facing new TBSFs remained. For example, VC firms invested an average of RMB 32 billion annually between 2004 and 2006, but 44% of VC was invested in firms in the stage of expansion and 26% in firms in the stage of maturity.1 The lack of external equity invest- ment means that high-tech SMEs were over-dependent on informal financial sources from individuals and firms’ employees (Xiao, 2011). To help technol- ogy firms overcome the constraint of the equity gap, the Ministry of Finance and Ministry of Science and Technology jointly issued the Interim Regulation on the Management of the Venture Guiding Fund (VCGF) in 2007. This was

1 See China Statistical Yearbook on Science and Technology 2013, p. 176.

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followed by the launch of US$6.5 billion Venture Capital Fund, specifically designed to assist start-ups in “sunrise” industries to enhance China’s competi- tiveness and productivity.

The other impediment to promoting public sector initiatives was the outdated tax and regulatory system that was not robust enough to provide protection or legal recourse for investors from fraud (Bruton, Ahlstrom, & Singh, 2002). Furthermore, venture capitalist groups encountered informa- tion asymmetry, hence the need to monitor and steer the sector and pro- vide a framework for the industry. By 2007, to respond to law and tax concerns, the Chinese government initiated changes to tax policies to overcome venture capitalist providers’ concerns. The Government facili- tated second board markets to provide venture capitalist exit routes; as part of the same strategy the government launched the Small and Medium Enterprise Board of the Shenzhen Stock Exchange (SSE) in 2004 followed by the establishment of a Growth Enterprise market within SSE in 2009.

Xiao (2002) suggests that China needs to overcome issues such as transparency, information asymmetry, and the financial information deficit required by fund providers to make lending decisions. To regulate VCGFs and maintain their relevance, the National Development and Reform Commission, the Ministry of Finance, and the Ministry of Commerce issued a joint directive in 2008 that regulates the establishment and man- agement of VCGFs. The directive states that the role of Government is not to be the lead investors but to use public finance as leverage to attract and direct private sector funds in the high-tech industries of the future which are designated as the priority areas. It is anticipated that this model has the capacity to foster greater willingness to take on high-risk, high- reward enterprises that could speed up industrialization and innovation to compete internationally in highly competitive industries, offering a range and quality of products. Secondly, there is a realization within the Government that the expertise expected of VC fund managers is often lacking within its employees to manage the activities of VCGF. To over- come this constraint, VCFGs invest in private VCs and act as private inves- tors. This model of participation brings together private sector expertise and knowhow (nationally and internationally) and, instead of competing with private sectors, VCFGs complement them and act as private investors. Such cooperation enables private venture capital professionals to carry out the identification, screening, and due diligence for their investment decisions.

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5.4 PUBLIC VENTURE CAPITAL—VENTURE CAPITAL GUIDING FUND

The Chinese government uses four VCGF models to achieve its set objec- tives: (1) The funds-of-funds model is designed to mimic private investor behavior and limits government exposure to risk, liability, and interfer- ence with fund decision-making. The funds-of-funds invest in a portfolio of VCs and diversify their exposure to certain sectors or industries, and the surplus generated from some VCs is used to cushion losses incurred in others. (2) The Coinvestment model aims to invest in Government priority areas and share risk through joint investment in high-tech small firms not otherwise supported by private VCs. It is often complemented by the VC investment subsidy model to encourage VCs to invest in early-stage small high-tech firms, normally about 5% of the investment, which carry high risks. (3) The Investment Guarantee encourages VC funds to identify early- stage high-tech firms, mentor and support them free of charge, and then apply for a development grant of RMB 1 million to recover its research and development costs subject to investing in the company when the 2-year mentoring period ends. At this stage, the VCFG provides a financ- ing guarantee to VCs that it will provide another grant of up to RMB 2 million in order to subsidize production and marketing costs. (4) The Financing Guarantee enables VC funds to borrow debt finance from banks and small investors as their risk is minimized, enabling high-tech small firms to achieve optimal capital structure and incur low cost, as the cost of debt is lower than cost of equity.

5.5 GOVERNMENT-BACKED VENTURE CAPITAL—IMPACT

Governments play a dominant role in the promotion of the venture capital industry. GVC schemes are widely used in the United States, Canada, and Europe and globally to encourage access to finance for TBSFs. As with European and other developed economies, the Chinese government has recognized the potential of venture capital to steer its economy from labor intensive to a knowledge economy. In 2008 the emerging industries were identified to be supported through the GVCFs) and increase the supply of finance through venture capital for start-up high-technology firms. The results reported suggest that VCGFs gained greater penetration amongst high-technology businesses and have further increased the supply of funds. By 2009, 43 venture capital funds used funds-of-funds methods to support

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projects worth RMB 309 million. Ding and Li (2015) reported that these funds were increased to RMB 2.382 billion by 2011, and there is now over RMB 6 billion available to support high-technology firms. Fig.  5.1 illustrates the trend over the period 2001–12. The upward trajectory of funds under venture capital management demonstrates the success of VCGFs which is in line with the economic trends of Chinese economy.

Although the data demonstrate impressive VC growth and the impor- tance, the Chinese government attaches to VCs as a tool mitigating the finance gap for TBSFs, the measure of VCs’ impact remains elusive. It has been argued that the increase in the availability of VC funds provide us with no evidence whether government-supported sources, VCGFs, com- plement or crowd out private venture capital providers (see Harrison & Mason, 2000; Li, 2015). However, the review of financing model schemes above indicates that VCGFs work with private venture capital providers and not necessarily in competition with them.

Measuring the performance of VCGFs remains a challenge as govern- ments tend not have explicitly stated objectives. Within regions, indus- tries, and entire countries, VCGFs serve multiple aims and objectives at regional and local levels, thus complicating evaluation tools for the impact. These challenges are universal. To evaluate the impact VCGFs in Europe and Canada, empirical studies reported mixed results about the efficiency and the effectiveness of the government-backed venture capital schemes (Li, 2015). In China, evaluation of the VCGFs commenced in 2008, but findings remain incomplete at this stage and Li (2015) reported that none of the funds have reached the end of their life. Therefore the impact of Government-supported VCs is unclear.

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One of the stated objectives of GVCFs was to provide access to seed capital for new start-ups. Li (2015) suggests that there is inconclusive evidence to confirm the achievement of this objective. Reporting for the period 2003–12, seed capital averaged 10.8% of the funds allocated for new start-ups or seed capital. During the overall 10-year period, for 7 years investment in the seed stage was below this average. These find- ings suggest that the objective of the fund was not achieved, highlighting the risky nature of new start-ups and problems encountered in targeting and supporting new start-ups. These results neither confirm nor refute the assertion that Government-backed VC crowded out private VCs.

The performance of VCGFs is determined and influenced by a number of factors. The experience of fund managers, the mission of the sponsor, the cost structure of projects, and the exit routes and strategy adopted by VCGFs impacts upon performance (Carter & Van Auken, 2015). Indeed, a bespoke strategy to fund specific sectors, a certain deal size, over a specific time frame, and the ability to make follow-on investments within a geographical region all could improve the effectiveness of CVGFs to mitigate the finance gap for TBSFs (Lerner, 2009; Li, 2015). In the United Kingdom, Government has initiated support for high-tech firms to serve local needs or follow the trend in the sector. Similar evidence is reported in China, where the Government has established VCGFs to support start-ups in the high-technology indus- tries in creating jobs and economic activity leading to the creation of high- tech clusters. A precursor to this strategy is the education and experience of scientific personnel to work within the cluster. In the case of China, not all the regions have conducive environments to promote high-technology firms due to underdeveloped infrastructure that fails to retain or attract skilled labor (Zhang, Peng, & Li, 2008). Local social capital, traditions, edu- cational and training provisions, and infrastructure serves as a gravitational force for the concentration of a sector that leads to formation of a clus- ter. An attempt through the use of VCGFs to attract firms to form a clus- ter, without the accompanying supporting infrastructure, often fails (Li & Geng, 2012) suggesting that not all the regions have economies of scale or the business ecosystems to establish VCGFs. For instance, Ding and Li (2015) find that key innovation-oriented intermediaries, consisting of productiv- ity promotion centers, S&T business incubators, university-based science parks, and technology transfer centers, were mainly concentrated in three regions of Beijing-Tianjin, Shanghai-Jiangsu-Zhejiang, and Guangzhou- Shenzhen. As compared with these three regions, many other regions lacked an innovation ecosystem that helps innovation to flourish.

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Once China’s central government approved the policy of supporting new start-ups and high-technology firms through VC, local governments enthusiastically promoted VCGFs. Their focus, however, has been regional and local and they tended to support certain industries through the use of “funds- of-funds” methods. Local initiatives supported by VCFGs, according to The Ministry of Science and Technology (MOST) survey, reported that 87% of VCGFs required VC fund partners to invest in specific industries locally; 61% set a minimum threshold above which applications would be supported. The survey also reported that local governments supporting VCGFs were more restricted in terms of local conditions placed on VCs to access grants from local governments. These results were validated by the Zero2IP survey of 2011 that reported that over 60% of support through the use of funds-of-funds accompanied the condition to invest locally,2 countering the spirit and ratio- nale for establishing VCGFs. Conditions imposed by the local government adversely affect support for regions or industries where they have competitive advantage.

Competition between local government and the region to attract pri- vate VC using the VCGF as a vehicle was tense, despite not all the regions having a sufficiently large concentration of firms in the high-technology sector to warrant sufficient opportunities for investment. The problem could be traced to the initial economic reforms in China that were aimed at decentralizing decision-making. Through decentralization, the authority was devolved in a number of areas, such as public finance for local eco- nomic and social development, from the central government to provincial and local governments. The mushrooming of VCGFs across the country, particularly in the less developed regions, may divert funds toward com- mercially less viable firms, leading to economic losses for the country. Li (2015) suggested that VCGFs and the local government policy of incen- tives and conditions offered to support local industry distort market oper- ations, leading to the creation of a mismatch between supply and demand; possibly compromising the funds’ independence and performance without aiding the creation of a cluster. The creation and promotion of a cluster, according to Porter (1998), depends on the depth, complexity and busi- ness environment. Ready factors of production supported by financial services and the businesses in the accompanying sectors support one

2 See a report in China Jingji Daobao on January 7, 2012, “the butterfly effect of govern- ment guiding funds to reshape the driver of regional development,” at http://www.ceh. com.cn/ceh/cjxx/2012/1/7/97382.shtml Accessed 15.12.14.

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another. Such conditions are not fulfilled when there are too few firms operating within a cluster.

Spatial distribution of venture capital is an issue for Western and Asian economies alike. It has been observed that venture capital funds’ activi- ties and presence is often parallel to the sectors’ spread and follows space, place, and capital flows (Mason et  al., 2016). Space allows interaction and flow of ideas; financial institutions tend to have their own defined geog- raphies within which they operate; and flows refer to financial intuitions’ geographical areas where their lending funds originate from. Neither in the United Kingdom, Europe, Canada, United States, or other countries the public venture capital manage to reverse the spatial concentration of venture capital. Analysis of data gathered by the MOST online database in Fig. 5.2 suggests during 2012 that there was approximately 54% of VCGFs investment activity taking place along the Yangtze River Delta, a well- developed, region that contributes 34% of China’s GDP. In comparison, the South-West and Central region attracted around 6–7% share of VCGFs. This distribution in terms of numbers also shows a skewness toward the South. During 2012, out of 299 VCGFs approved at the national level, only 9 projects approved originated from the West region and 99% of total funding approved of RMB 5 million went to the Southern region and 1% to the West region, demonstrating the geographical disparity of the dis- tribution of venture capital. China’s North and South divide mirrors the United Kingdom (Harrison, Mason, & Robson, 2010). The distinctive geography of VCGFs in China is a product of historical clustering of ven- ture capital orientated industry, and small and high-tech small businesses

0.0

10.0

20.0

30.0

40.0

50.0

60.0 GDP as % of total Guiding fund as % of total

Figure 5.2 Spatial distribution of investments by VCGFs, 2012. MOST online database.

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locating in certain regions. The clustering of venture capital funds in cer- tain cities is not unique to China, as a similar trend is also observed in Germany (see Fritsch & Schilder, 2008). Spatial concentration is due to economies of scale, local knowledge, and cost related benefit arising for venture capital funds when investing a given region.

5.6 CONCLUSION

China has aspired to improve its competitiveness through enhanced tech- nological and commercial knowledge to transform its inefficient and labor intensive industries in a short span of time to compete with Western tech- nology-orientated advanced economies. To achieve this objective, China has realized there is a need to overcome the funding gap for start-ups, high risk and high growth small technology companies, especially at the early stage of the venture development.

Given China’s evolving political history, financial institutions, labor, and the environment, lacks technological skills to engage with complex high risk business propositions. Therefore there is unmet demand for finance for TBSFs. Too often this, technology orientated, niche was served by infor- mal finance sources but that too failed to build sufficient capacity to meet the needs of the sector in an ever-shrinking global world. To promote technology-orientated industry and entrepreneurship, the Government has recognized, since the 1980s the importance of venture capital and promoted its use. The Government has supported the establishment of large VCGFs nationally and similar schemes at a local level to narrow the finance gap, especially to promote technology-orientated enterprises. The Chinese State intervenes through the use of funds-of-funds and coinvestment methods; their objective is not to displace private venture capital funds but to comple- ment them. The question of whether government-backed funds helped to reduce the equity gap for high-tech firms remains yet to be tested. However, there is some evidence that supports the creation and operation of VCGFs to overcome the equity gap for small high-technology firms in China. In particular, VCGFs have successfully supplanted informal networks to support premarket and more risky phase of firms’ journeys, thereby rapidly adapting innovation and technology to enterprises to compete in an increasingly glo- balized market. However, finance alone is not the precursor to innovation. There is now a growing realization amongst policymakers and practitio- ners within China and internationally that GVCFs are only effective if they operate within an entrepreneurial ecosystem that nurtures and sustains the

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