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Government Ownership and Venture Performance: Evidence from China* Government ownership and venture performance: Evidence from China* Jerry Cao† Singapore Management University & Asia Private Equity Institute Mark Humphery-Jenner‡ UNSW Australia Jo-Ann Suchard§ UNSW Australia * This paper benefited from comments received at the Australasian Finance and Banking Conference (2013), and from seminar presentations at Singapore Management University and UNSW Australia. We also thank Vish Ramaswami, Hyacinthe Some and Melvyn Teo. † Singapore Management University. Email: [email protected] ‡ UNSW Business School, UNSW Australia. Email: [email protected] § UNSW Business School, UNSW Australia. Email: [email protected] Government ownership and venture performance: Evidence from China Abstract We study the government's role in VC market in China. The impact of government depends on whether the fund is wholly or partially government-owned at central or provincial level. Partially government-owned VCs improve venture success, e.g., the likelihood of exit via an IPO and the likelihood of exit in mainland China. Investment from provincial government-owned VCs is associated greater exit-success, with such advantage diminishing with more funds. Government- owned funds exhibit worse performance at the fund-level. Our findings suggest that government VCs may benefit through political connections may help VCs, but that excessive government control leads to inefficiencies. Keywords: Government Ownership, Venture Capital, Private Equity, China, IPO JEL Classification: G24, G34, G38 1 1 Introduction In emerging economies, the government has significant influence over markets owing to political control and discretionary regulations. Government has widespread presence in the economic entities through direct ownership or via indirect vehicles. For example, Shleifer (1998) shows that government direct ownership is associated with inefficiency and value destruction in state owned enterprises (SOEs). On the other hand, research shows that government ownership conveys political connection, which can facilitate access to bank loans, government concessions or regulatory favors (Faccio, Masulis and McConnell, 2006; Claessens, Feijen and Laeven, 2008; Li, Meng, Wang and Zhou, 2008). Most of these studies focus on SOEs in which government has direct ownership. A relatively less explored area is the role of government indirect ownership through investment vehicles, such as venture capital (VC) funds. Dewenter, Han and Malatesta (2010) examine the value impact of sovereign wealth funds when they invest in listed firms. Unlike sovereign wealth funds, VC funds are an important financing source for entrepreneurial activity and innovation in both developed markets (Gompers and Lerner, 1999) and emerging economies (Sapienza et al., 1996). The existent literature on the government’s role in VC has mostly focused on government support of VCs (e.g., via grants and subsidies) in developed markets (Lerner, 1999; Leleux and Surlemont, 2003; Brander et al, 2014). The role of government ownership of VC funds remains relatively under-explored, especially in the context of emerging markets. The distinction between emerging markets and developed markets is especially important given the increased political and economic risks that are evident in those economies and the potential relevance of political connections in resolving them. 2 China is the largest emerging market in which the venture capital sector has become an important force in the country’s industrial transformation. China’s VC industry has grown rapidly during the past two decades, from virtually non-existent in 1991 to a peak of US$92.59bn in 2011, becoming the second largest global VC market next to the US. Unlike the US VC market, China’s market features significant government involvement. For example, the first VC fund was established in 1985 by the central government when the State Science and Technology Commission and the Ministry of Finance joined together to create the China New Technology Venture Investment Corporation. This was followed by many provincial governments establishing their own VC funds. Unlike in the VC industry in the U.S. and most developed markets, the Chinese government often has direct control of VC funds through whole or partial ownership. For example, Shenzhen Venture Capital Groups has the Shenzhen municipal government as its controlling shareholder; Yunnan Huili Equity Investment Fund Management Company is partially owned by Yunnan Industrial Investment Holding Group, which is wholly owned by the Yunnan government. Government owned venture capital, as a percentage of domestic venture capital invested, varied between 25 to 34% in 2005-2008 (China Venture Capital Research Institute, 2009). The purpose of this study is to analyze the impact of Chinese government ownership on the success of portfolio companies and the performance of the funds themselves. Government owned VC funds have several advantages over other funds. They have preferential access to information and to companies because of government’s linkages with high- technology development zones and incubators. For firms, government connections can help obtain access to capital (Chen et al., 2013a), which is especially relevant if they have a high level of intangible assets (Zheng and Zhu, 2013). For entrepreneurial firms in emerging markets, one 3 advantage of having sponsorship from government VC funds is their ability to help establish connections with government agencies. This is especially important in China, where IPOs require prolonged government approval.1 We therefore hypothesize and test whether companies backed by a government owned VC fund are more likely to achieve a successful exit, especially through an IPO on domestic exchanges. Despite the potential positives of government owned VCs, government ownership could lead to inefficiencies and misallocation of resources (both within the portfolio company and within the VC fund itself). We therefore distinguish between types of VC funds according to the amount of government ownership (wholly vs. partially owned) and its source (central government level vs. provincial government level). Due to the trade-offs between the advantages of government ownership (i.e., political connections) and the disadvantages (i.e., inefficiency, exposure to politically motivated decisions and misallocation of resources), we would expect that the benefits would mainly accrue in those situations where government does not have complete control over the fund. In this case, the fund could still obtain the benefits of political connections while attenuating the inefficiencies that would otherwise be overwhelming. Further, VC funds with provincial government stakes will behave differently when investing in local (that is, firms located within the same province as the government agency) vs. non-local entrepreneurial firms. For example, the provincial government can provide their VC funds with better private information and access to regulators when investing locally. However, we expect that the benefits of provincial government owned VCs will decrease with the number of such VCs, as a 1 In China, companies that want to raise funds through domestic IPOs not only need government support but also approval from China Securities Regulatory Commission (CSRC). Chen et al., (2011) show that a government background can help firms to navigate the increasingly discretionary aspects of regulations. 4 preponderance of provincial government owned VCs would expose the company to an increased risk of politically motivated decision-making. The impact of government ownership is also likely to vary with political and economic uncertainty. Specifically, if government ownership conveys benefits of political connections, government backed VC funds should be more able to achieve a successful exit during times of political uncertainty. We also expect that government VCs will be less sensitive to market conditions when deciding whether to exit a company. We therefore hypothesize that government owned VC funds, especially ones owned by the provincial government, should be more likely than other funds to exit investments in China at times of political uncertainty2or poor market conditions in China. Although government ownership in VC funds is associated with benefits in accessing capital markets such as IPOs, government ownership in private companies could result in inefficiency. Thus, even if government-backed VC funds can provide some benefits to their portfolio companies, the government funds themselves could perform worse. Subsequently, we compare the performance of government-owned funds and other funds by examining the performance of all exited transactions. In particular, we examine the performance of government owned VC funds, as proxied by the fund’s average exit multiple and its success rate. We hypothesize government-owned VC funds achieve lower returns despite of preferential access to IPO market. We collect a comprehensive sample of 4700 Chinese venture-backed companies from ChinaVenture, and supplement the data with hand-collected information on ownership of VC funds. We identify if the fund is wholly or partially government owned and if the government- 2 In this context, political uncertainty involves the risk of unexpected and significant changes in government regulation and the legal environment. 5 ownership is by the central government or by a provincial government. Our sample includes entrepreneurial companies based in mainland China, Hong Kong, and Taiwan (though
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