Venture Capital as a Mechanism to Promote the Outsourcing Industry in China

by Feifei Wu

The author is a master student majoring in civil and commercial law at the Shanghai University of Finance and Economics and focuses on economic and law. She participated in the Georgetown Public Policy Institute’s summer program at Fudan University in Shanghai in 2009. Email Feifei Wu at phoebe.wff@gmail.com Since the financial crisis erupted, many small and medium-sized enterprises (SMEs) in China went bankrupt. This article analyzes the capital composition of small and medium-sized outsourcing (service) providers (SMOPs) and summarizes the challenge of fundraising. It proposes venture capital as a new channel for financing SMEs. Venture capitalists (VCs) can boost the development of enterprises, consummate management systems, and improve production efficiency. This article concludes that VC investment and the valued-added effect of a VC-SMOP partnership can promote the outsourcing industry. China’s new Growth Enterprise Market (GEM) provides an opportunity for VCs to exit SMOPs, once they have reached a sufficient size. The Current Situation of China’s Outsourcing Industry The Situation of China’s Outsourcing Industry Outsourcing plays an important role in China’s economic development and is becoming the core of many firms’ competitive strategy. Outsourcing could change China’s position in the global industrial value chain. In 2009, outsourced production contributed $26.2 billion or 0.8% to China’s GDP . China’s outsourcing industry has grown significantly and is forecasted to increase its market size and industry revenue at an annual rate of 19%, 22% respectively (Jiang, 2008). However, compared with global outsourcing destination countries like India, Ireland, and Australia, China’s outsourcing industry is in its infancy, considering its comparatively small market size and industry revenue. The SMEs-dominated outsourcing industry has a short establishment term and consists mainly of regional outsourcing providers. These SMOPs lack the ability to construct their own delivery centers. SMOPs’ insufficient scale is still the key factor which restrains the outsourcing industry’s development. The Capital Structure of the Outsourcing Industry and Difficulties to Get Financing Ideally, the financing of outsourcing SMEs uses a hierarchical capital structure, because different types of capital demands require unique investment approaches. However, the narrow set of financing options in China restricts SMEs development. SMEs in China usually have access to only three financing sources. First, the largest funding source is self-financing and retained earnings. Self-financing consists of SMEs’ own assets, partners’ or shareholders’ capital, loans from relatives, operation financing, credit loans, SMEs’ inside borrowing, and some social insurance funds. Second, bank loans are provided primarily through mortgages, guaranteed loans and credit loans. Still, bank loans are the most important external financing for SMEs, a typical characteristic of China’s financial system. Third, government support could be funded through tax breaks, grants-in-aid and loan assistance, and subsidies. Self-financing is low-cost, simple and convenient, but often too small and thus it can hardly meet the needs of SMOPs. Such SMEs can get few bank loans because of the high risks involved and because they often lack meaningful collateral required for the loans. China’s underdeveloped credit management and guarantee system adds to the constraints that SMEs face. Considering the high lending costs, banks regard outsourcing SMEs or SMOPs as retail business which cannot achieve sufficient economies of scale. Finally, the government puts heavy requirements on smaller firms for obtaining subsidies (which disproportionally favor large corporations and state-owned enterprises (SOEs), which discriminates against small firms like SMOPs. The root of the difficulties is the underdeveloped financial system in which bank loans are still China’s most important means of corporate finance. There are additional challenges for SMOPs’ financing. First, SMOPs are mainly low-skilled machining companies that lack deep competitiveness as they have been unable, so far, to create core technologies or establish brand names. Thus, they cannot withstand large economic shocks. Second, SMOPs can easily be impacted by adverse outside environments and attract few investors due to great risks. Third, the available facilities as guarantees to get approvals for loans are few and outdated; the ability of SMEs to repay money is limited. Fourth, there are many types of outsourcing SMEs in need of frequent, but small amounts of financing, which heightens the complexity and financing costs. The current global financial crisis poses significant risks to China’s rapid economic development. The majority of SMOPs are facing unprecedented financial difficulties, which are exacerbated by the government’s reduction of export rebates (which are provided on imported intermediary goods that are used for the production of exported goods), a potential RMB appreciation, financial institutions’ lending policies biased against SME and rising labor costs. Many SMOPs in China had to stop operating or go bankrupt. The Perfect Match of VCs and SMOPs to Promote China’s Outsourcing Industry Characteristics of VCs and Promoting SMOPs Development As discussed, the three traditional financial tools (self-finance, bank loans, and government support) do not meet SMOPs’ specific needs sufficiently. A solution to SMOPs funding difficulties could be the cooperation with VCs. VCs and SMOPS are a perfect match, because the former prefer high risks and returns, and can provide quicker financing at lower costs compared to banks lending, while SMOPs need uncomplicated and fast funding sources. Additionally, VCs do not require collateral or investment guarantees and thus are much more ready to invest in outsourcing providers, compared to banks which demand collaterals before granting loans. VCs can alleviate the bottle-neck of SMOPs’ financing and can exit immediately. Financing problems are the primary obstacle to a fledgling company’s growth, and financing is particularly important to address talent and capital issues, the bottle-necks of SMOPs development. Talent can be absorbed by capital. It is difficult for start-up companies to finance themselves because of high uncertainty and a lack of guaranteed assets. VCs could contribute significantly to overcome this handicap. In the United States about 80% of new technology companies are supported by VCs (Jiang, Wang, Pan & Wu, 2009). For promising but immature SMOPs, sufficient provision of venture capital can increase the production scale fast and can support a sustainable development. VCs can bring in needed capital and can also meet the refinancing needs at lower costs than traditional financing channels. Besides capital, VCs’ added value is embodied in a broad set of business services. To be successful, VCs must have a broad general knowledge of business and all its disciplines: Marketing, management, finance, operations, and accounting. In addition, most VCs must acquire specialized knowledge in one or more high-technology industries, and play different roles, such as: (1.) Being a watch dog. Watch dogs are to some extent related to a company’s performance. Once an investment is made, the VCs begin working with the company through board meetings, recruiting, and offering advice. Together, these activities comprise the monitoring group. To be successful, many VCs believe that these activities provide the best opportunity for VCs to add value and are the main source of competitive advantages. (2.) Supporting the management. The beneficiary company of VCs investments is usually too immature to attract talent. While VCs can play the role of a headhunter, due to their reputation and board connections, they are usually experts providing strategic consulting, such as senior manager selection and considering refinancing options, leading to a better performance of the invested company. (3.) Providing networking resources. VCs own enormous networking resources, which provide business relationsh
ips that facilitate the communication with other institutions. These resources include financing channels, experienced managers, business networks, professional service institutions and valuable strategic information. (4.) Boosting the company’s image. When companies receive venture capital, it is a good sign of their excellent quality because of the strict criteria of program selection by VCs. VCs can improve a company’s image in the eyes of new talent. It also helps to cooperate with other companies to build complementary resources. A Perfect Match: VCs and SMOPs In September 2009, the People’s Bank of China (the central bank) released Suggestions on Financing Support for the Outsourcing Industry that detailed and opened up the direct financing approach, encouraging VCs to invest in outsourcing (Xu, 2009). Outsourcing can provide higher value added, strong labor absorption, and fast development, and is supported by all levels of the Chinese government as well as by VCs. Between 2005 and 2008 Chinese VCs provided $784 million in outsourcing investments in 78 business projects (Zhang, 2008). A successful example of VCs cooperating with outsourcing-providers is IDG’s RMB 20 million investment in Sandia Medical Technology, which provides contract-based outsourcing services. The investments brought in new funds and new clients so successfully that Sandia received again funding in 2008 due to high net assets gains. Insufficient management experience of SMOPs can lead to problems with legal, financial and managerial issues. As a financial investment instrument, VCs play a positive role in polishing up management operation systems and improving production efficiency: First, they mitigate risks and reduce asymmetric information problems; second, they support the development of SMEs so that they can thrive without the need for outside consultants and prevent them from becoming targets for takeovers; and third, VCs improve outsourcing SMEs’ technical expertise through technological innovations. VCs are also beneficial toward investing SMOPs by exiting investments to maximize the financial return. Historically, IPOs are the most lucrative exits for VCs (Metrick, 2007). The main alternative for IPOs is a sale to a strategic buyer, which is usually a large company. Sometimes these sales are very profitable for VCs, but only if there is significant competition for the acquiring the company, and often this includes the possibility of an IPO. SMOPs conform to the listing requirements of the China Growth Enterprise Market, which was launched officially in October 2009. The GEM is a stock market for SMEs with lower entry barriers compared to the regular stock market. It is run by the Chinese Securities Regulatory Commission (comparable to the SEC in the US) and is designed to support the development of enterprises in high-growth industries, such as the high-technology sector, and SMEs supporting the development of rural areas and the Northwest of China. GEM creates an exit opportunity for VCs and provides a financing channel for SMOPs. Financing SMOPs’ rapid development brings high returns to VCs and favors sound development. Investing in SMOPs also provides a shortcut for VCs exiting. One example of a successfully launched IPO at GEM is Li Si Chen Technology, which is China’s premier domestic service outsourcing provider for office information systems. It was listed on the GEM with 2650 shares issued. Conclusion and Policy Options The structure of China’s financial markets impairs the operational efficiency of SMOPs. Sufficient supply of venture capital can help to expand SMOPs’ production size quickly and can support a sustainable development. VCs can bring in needed capital and meet the refinancing needs while lowering financing costs. Moreover, VCs provide added value through business services that help SMOPs address legal and managerial challenges. Further, the launch of GEM in 2009 has opened up an exit mechanism for VCs as well as an attractive and uncomplicated financing platform for SMOPs. Corporate success requires steady improvement of goods and services to meet rising consumer demands. The strategy of next-round development could be based on cost minimization. Here, VCs can make a crucial contribution by investing in Chinese SMOPs. The domestic outsourcing market should be given investment priority, although offshore outsourcing is an option too. In 2007, the total market revenue in Chinas outsourcing industry reached $15.2 billion, of which domestic outsourcing projects accounted for 85% (Zhang, 2008). Future growth potential for SMOPs and cooperation potential with VCs lie in the rising market (i.e., high-tech market) as well as business or knowledge process outsourcing in the high-end of the industry supply chain. References Belcourt, M. (2006). OutsourcingThe Benefits and the Risks, Human Resource Management Review, 16(2006), pp. 269-279. Caniels, M., Roeleveld, A. & Semeijn, J. (2007). Power and Dependence Perspectives on Outsourcing Decisions, Working paper, Management Sciences, 07(02), pp. 1-21. China Stock Review (2009, January 12). China’s GEM is Expected to Launch in 2009. Retrieved January 28, 2010 from: http://www.chinastockunion.com/Chinese-GEM-is-expected-to-launch-in-2009 Doh, J. P. (2005). Offshore Outsourcing: Implications for International Business and Strategic Management Theory and Practice, Journal of Management Studies, 42(3), pp. 696-702. Fu, Y.-y. (2009, September 15). Li Si-chen outsourcing service providers listed on the GEM 2650 shares to be issued. Retrieved February 2, 2010 from: http://www.cio360.net/Page/1797/InfoID/309672/SourceId/11227/PubDate/2009-09-15/Default.aspx Grover, A. (2007). International Outsourcing and the Supply Side Productivity Determinants, CESifo Working Paper, No.2088, pp. 1-13. Huang, W. & Ma, D.-d. (2009). The Best Financing Channel for Outsourcing Small and Medium-sized Enterprises after the Financing Crisis, Modern Finance and Economics, 29(02), pp. 22-26. Jiang, S.-h.,Wang, M., Pan, Y.-q. & Wu, A.-q. (2009). Venture Capital Promote the Development of a Company, Jiangxi Social Sciences, 2009(06), pp. 92-96. Metrick, A. (2007). Venture Capital and the Finance of Innovation. Hoboken: John Wiley & Sons. Ren, L.c. & Wang, K.-l. (2009). Based on the Social Capital of China Undertake Service Outsourcing Research, East China Economic in Management. 2009(08), pp. 49-52. Schramm, C. J. (2005). Building Entrepreneurial Economies, Transition Studies Review, 12 (1), pp. 163-171. Xu, P. (2009, September 9). China Will Strengthen Financial Supports on Outsourcing Industry. Retrieved January 30, 2010 from: http://news.xinhuanet.com/fortune/2009-09/09/content_12023471.htm Yin, F. & Chen, X. (2009). An Empirical Analysis of Foreign Direct Investment in China Mainland’s Service Industry, Computer System & Applications, 2009(06), pp. 17-20. Zhang, J.-y. (2008). Investment Opportunities for the Outsourcing Industry. Retrieved February 4, 2010 from: http://news.zero2ipo.com.cn/n/2008-10-7/2008919163655.shtml?highlight=

Email Feifei Wu at phoebe.wff@gmail.com

 

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