For the first time, the Chinese government has exempted a U.S. venture firm from having to pay a hefty 10 percent withholding tax for repatriating profits, in a major move that could spur another major wave of U.S. investment in China.
Patrick McGovern (pictured here), head of IDG Ventures, the venture arm of major publishing group International Data Group (IDG), disclosed the Chinese move in a recent interview with VentureBeat. He said the Chinese government made the exemption for his firm last month. It’s too early to tell whether the favor will be extended to other U.S. venture firms soon, he said. McGovern was favored, he said, because of his early commitment to China beginning more than a decade ago.
McGovern said the move is a big deal, because it makes his Chinese investments — already profitable — even more lucrative. He said the exemption by Beijing is why he recently pledged to increase his investments in China to a whopping $60 billion by 2020.
That goal, which McGovern first stated several weeks ago, was so ambitious I had a difficult time believing him when he first mentioned it. After I inquired about it at the time, McGovern agreed to drop by my office here in Silicon Valley to explain why he was doing it. That’s when he dropped word about the exemption. Turns, out, he’d been pushing for the exemption for some time. Now that it’s in place, the advantages of investing in China are manifold.
Here are more details about the accord, based on my interview with McGovern: IDG Ventures in China becomes the first foreign investor with permission to invest from a renminbi (Chinese currency)-denominated fund. It means IDG can take their Chinese companies public on local Chinese stock markets without paying a tax. That means IDG Venture no longer needs to set up a shell company in the Cayman Islands, convert dollars into renminbi and then invest it into a mirror IDG start-up company in China — the standard procedure that it and most other venture capital firms have had to use. Until now, IDG and other firms did all this in order to take Chinese companies public on foreign exchanges, such as in Hong Kong or the Nasdaq. If VCs wanted to take a company public on a local market, they were forced to pay a 10 percent withholding tax for taking money out of China. All this is no longer needed for IDG.
McGovern’s IDG Ventures was the first VC firm to begin investing in China back in 1993. Since then, it has plowed $450 million into 180 companies. The value of that investment is now $1.6 billion (counting exits, sales, and value of other holdings), with the average investment being about four years old, McGovern said. Based on this, the firm has seen an internal rate of return of 41 percent (for the uninitiated, this means a net return each year of 41 percent).
Going forward, the opportunity in China is huge, McGovern says. The Chinese have $2.4 trillion stuck away in savings accounts, with only 15 percent of that in the stock market. The small amount in stocks is because of China’s traditionally weak stock market. However, that’s changing as the Chinese warm to investing and tire of the 3 percent or so they’re used to getting from banks. Increasingly, as domestic money cascades into stocks, companies are going public on China’s domestic stock market in Shanghai and elsewhere, instead of waiting to become big enough to go public in Hong Kong or in New York on the Nasdaq. Between $400 billion and $800 billion more may cascade into Chinese stocks over the next two to three years, McGovern said.
While IDG and other investors previously avoided the local stock market, preferring instead to simply sell their investments, that is now changing. With money sloshing around, it’s far better to go public locally in China, because you can get a better valuation, specifically up to a “20 percent premium,” McGovern says, compared to a sale.
In that light, it’s easy to understand why IDG decided to not reinvest in Boston’s Flybridge Capital Partners, the firm previously known as IDG Boston. With China returning a 41 percent IRR, it didn’t make sense to invest in New England, where IDG was generating only 10 to 12 percent IRR, he said. (Flybridge declined comment.)
In recent years, IDG has boosted its investments in China, forming funds to back more mature companies to complement its existing funds to back early-stage companies — by teaming up with Silicon Valley’s Accel Partners. By 2020, IDG’s money for early-stage investments will grow to $3 billion, up from around $950 million now, he says. And for more mature companies, or so-called “growth”-stage companies, IDG Ventures is earmarking $12 billion, up from $1.4 billion now. It’ll be creating $20 billion for mezzanine fundings (those that come right before an IPO), up from $600 million now. And finally, it’s committing to $25 billion for buyouts by 2020. All told, that’s $60 billion by 2020.
McGovern says he thinks foreigners are raising too much money, which is causing valuations of Chinese start-ups to rise — as too much money chases too few companies. Although, of course, it is in McGovern’s interest to say that. Normally, funds that took four years to be invested are now being dispensed hastily between 1.5 and 2.5 years, he says. (One firm we’ve heard about is Andy Yang’s SAIF, which has raised $1.2 billion recently, with only three partners.) McGovern says the excess capital will lead to lower returns over time.
So far, McGovern’s IDG has had a field day. It paid $2 million for a 20 percent stake in Tencent, which is now worth $1.2 billion. It invested in search engine Baidu at $2 a share, and it is now $350 a share. It invested in Sohu at 22 cents; it’s now $45. He invested $6 million into Ctrip, and got a $800 million profit.
He says 117 of his firm’s 180 investments are still alive.
IDG Ventures has 50 employees in China, with eight general partners.
McGovern predicts between 9 and 12 percent annual GDP growth over the next 10 years. This is all something to think about as we sit here stagnant in the U.S over the next year or so, and I’m sure we’ll see another push to China by U.S venture firms.