China venture market frothy but still attractive

By Tiffany Wu

SAN FRANCISCO (Reuters) - Western venture capitalists say the flood of money to China is forcing financiers to overpay for investments, but most think they can find the rare bargain in the fast-growing Asian market.

Venture funding in China, estimated to have doubled in the second quarter to a 2-1/2-year high of $480 million, shows no signs of slowing despite growing wariness about a bubble, said financiers at the Reuters Venture Capital Summit in San Francisco this week.

Doll Capital Management co-founder David Chao said funds were pouring money into bad deals through "shotgun investing."

"I had one of our companies check into how many YouTube-like companies are there in China," he said, referring to the popular U.S. online video-sharing site. "There are 150 of them -- 150 -- and many of them, most of them, are being venture-backed today."

"If you ask me, 'are there bad deals done?' Most likely 148 of them are bad deals," he predicted.

Faced with moderate local returns, Silicon Valley financiers are flocking to China in search of higher yields, hoping to discover gems like Semiconductor Manufacturing International Corp. (SMI.N: Quote, Profile, Research, Stock Buzz) (0981.HK: Quote, Profile, Research, Stock Buzz) or advertising firm Focus Media Holding Ltd. (FMCN.O: Quote, Profile, Research, Stock Buzz).

Rising living standards in the world's most populous nation present tremendous opportunities, said Bob Grady, who runs the VC arm of Carlyle Group, the largest private equity firm.

"I don't see, frankly, a real dampening in enthusiasm on the part of investors," said Grady, who also serves as chairman of the U.S. National Venture Capital Association.

RISK PREMIUM FOR CHINA

Financiers at the Reuters summit said hot sectors include value-added mobile phone services, clean technology and Web 2.0 companies, the new class of interactive online services that encourage users to share text, pictures and video.

But with too much capital chasing too few deals, valuations are frothy and some financiers who travel regularly to China are warning of a recklessness similar to the dot-com boom.

The difficulties of doing business in China are well documented: the yuan currency is not freely convertible; financial exit strategies are limited with China having halted domestic IPOs last year; intellectual property protection is weak, making it hard to make money on innovation; and there is a shortage of management talent in a country dominated by state enterprises.

Claude Leglise, managing director of WI Harper, said yields in China should be 5 to 10 percentage points higher than in the United States after factoring in country risks. But returns are actually just a few percentage points higher.

"When there is more money made in conferences to talk about investing than money made in deals, then that's probably a bubble," said Leglise, whose company invests two-thirds of its money in China and the rest in the U.S. West Coast.

"The world is absolutely awash in liquidity and it's super hard to find a place where the market is inefficient enough to give you 1,000 basis points," he said.  Continued...