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Taiwan VC: global force, regional player - or pacing the sidelines?

The development of the venture capital industry over the last two decades was as apparent in some of the smaller markets as it was in those of the US and Europe. Taiwan, for instance, experienced significant growth in this time. It is now a very different landscape. Daniel M Schwartz of the Asian Venture Capital Journal discusses the rise of Taiwanese venture capital and its future outlook.

As China continues to emerge from its decades-long Maoist experiment, the world is rushing to its doorstep, eager to do business in the planet's most populous country. Situated a mere 50 km across the water is Taiwan, an island that shares the same language, history and culture with - and the Beijing authorities would insist is - China. Taiwan's venture capital community has served as a model for other developing countries seeking to incubate a venture-funded technology industry and has succeeded where economic powerhouses Japan and Korea have not.

That would seem to harbinger a ‘Golden Age' for Taiwanese private equity, but the reality is considerably less certain. Strong ties with the US venture community are well known, but Taiwanese venture capitalists are all but invisible in the PRC and rarely invest in other Asian countries. From afar, they appear uncertain of how to step into one of the great economic opportunities of the 21st century - serving as Asia's gatekeeper to China. Global economics and government policy will continue to shape their future, but the ultimate impetus for success must come from the venture capitalists themselves.

‘The giant'
The modern history of Taiwanese venture capital traces its origins to the foresight of KT Li, the Taiwanese finance minister in the early 1980s. Says Ta-lin Hsu, Chairman, H&Q Asia Pacific, ‘He was the giant.' KT first visited Hambrecht & Quist, the legendary American venture capital firm in1983. His timing coincided with the US venture boom which funded the likes of Apple Computer and Genentech at internet-like multiples.

Silicon Valley's wealth has been attributed to multiple factors: the presence of great universities; America's legal and financial infrastructure; and the open and entrepreneurial culture, which the Valley fosters.

How much of that KT understood can only be gleaned in hindsight, but he returned to Taiwan impressed by what he saw. He recruited Morris Chang from IBM and set up the Industrial TechnologyResearch Institute (ITRI), which spawned the incubator-like industrial parks. KT also set up the framework for Taiwan's venture funds by establishing a regulatory framework that included a 20 per cent tax credit for gains on venture investments.

Venture capital funds soon took off. Acer Venture was the first with $8m in 1985. H&Q Taiwan followed with a $20m US-style fund in July 1986, and Walden International arrived six months later. Says Hsu: ‘We received about 30 per cent of our funds from the Taiwanese government. It took six months to raise the fund - it was very difficult.'

The industry raised its money locally and benefited from the spectacular growth in semiconductor wafer fab plants and the PC boom. Japan and Korea were also eyeing events in Silicon Valley and initiated their own venture programs. Rather than taking equity, however, investors in these countries made loans - a decision that would soon undermine their efforts to build a venture industry.

Chang went on to found Taiwan Semiconductor Manufacturing Company (TSMC), and the rest as they say, is history. TSMC became the model for UMC and other semiconductor foundries. Along with PC manufacturers such as Acer, these enterprises became the core of the island's high tech economy. Taiwan - its economy and venture funds - prospered through most of the 1990s on a wave of internet and technology-related growth.

Fast forward to 2002
The world has changed since then. The same forces that have impacted venture capitalists worldwide have also hit Taiwan: investments have fallen precipitously, fund-raising has become difficult, and exits far and few in between. The depth of the malaise can be seen in the statistics. Taiwan raised venture capital funds worth $1.5bn in 2000, a year later it managed to raise only $1bn and this year the estimates are down to a paltry $90mn. Along with fundraising, investments have also come down from more than $1bn in 2000 to an estimated $2llm this year.

Essentially, the pool of funds available for VC investment has stagnated around $6bn recent years. As Taiwan's economic powerhouse has mainly rested on the hi-tech sector - particularly semiconductors and electronics equipment - the global tech wreck of recent years has inevitably taken its toll in Taiwan investments also. While Taiwanese venture capitalists blame many of their troubles on the government's decision to repeal the tax credit as well as restrictions on where the funds can invest, the causes go deeper. Opportunities at home and the US are not what they were ten years ago, and Taiwanese investors seem ill at ease investing in other Asian countries.

The government's position
Last year, the government revoked the 20 per cent tax credit on venture capital investments. Ho Mei-Yueh, vice chairman of the Council for Economic Planning and Development, Executive Yuan, was among the co-authors of the tax incentives passed in 1987. Believing that venture capital represented a necessary but risky economic priority, investors received a 20 per cent tax credit for actual investment in emerging technologies. But the government's position has always been that venture should be encouraged, but not at the expense of the island's overall strategic goals.

Ho points out that during the peak investment period (1995-2000), many funds manoeuvred through a loophole, which effectively enabled their shareholders to circumvent the tech-driven venture criteria. As a result, the government eliminated the credit.

The government, however, has taken steps to address other complaints from the venture community. In Taiwan, the corporate sector provides more than 70 per cent of venture funding. To broaden the funding base, the government will lift restrictions on pension fund investment. Ho reports that government pension fund officers have already agreed to the change. Another potential source is the labour unions. Union leaders, however, have not shown the same willingness as their government counterparts to support the venture capitalists.

Restrictions on investing in the PRC
Regulations on investing in the PRC have also created friction between the two. ‘There are only restrictions on a few items,' says Ho, and Taiwanese investors have already put close to $50bn into the PRC, mostly in joint ventures and direct investments. But the restricted areas represent Taiwan's real strength - technology –and the government shows little if any sign of relenting in such ‘sensitive technology' as ICs. ‘Our core competence cannot be exported,' Ho emphasises. Other investment related to heavy capital equipment, eg, large petrochemical plants, is currently not allowed, but in a few months should be permitted, she adds.

One way to get around the regulations, however, is to join a group of foreign investors. A number of prominent Taiwanese names, for example, are among the shareholders in Richard Chang's Shanghai-based SMIC. Ho gets to the nub of the issue when she observes that: ‘We should loosen the restrictions but have more effective controls, that is establish criteria agreed to by a broader consensus. Who really represents society is difficult to say because only a few people present their ideas' she says.

Investment opportunities
But government regulations are only part of the story. Fortune Venture Investment Group chairman James Chew points out that domestic opportunities exist, but in far fewer numbers than in the past. ‘Telecom is no longer in vogue,' he says. ‘Having followed an internet model emphasising market share, these companies were unable to generate enough revenue to survive.' As for Taiwan's very critical semiconductor foundry business, both TSMC and UMC announced that Q3 revenues were down. The LCD flat screen will replace the CRT screen in the PC market, but only slowly. ‘Media/entertainment has spawned the DVD and will continue to grow,' says Chew, as will the packaging/testing industry which has centred on the further need to miniaturise the laptop.

Asia's hometown high-tech hero?
Given Taiwan's domestic success in high tech, Taiwan's VCs should be exporting capital and talent to the rest of Asia. That has not happened: Taiwanese investment has stayed home, selectively entered China, and flowed into Silicon Valley. Chew offers some explanations.

Qualifying for the tax credits was contingent upon investing in high tech. In many Asian countries, there's no high tech, he says. Japan has been hostage to a stubborn economic recession since the early1990s. With little growth and a serious cash outflow, the market hasn't been attractive. On a personal level, Chew thinks the younger Taiwanese lack the older generation's connections. Most have opted to stay away rather than spending the years necessary to develop connections in Japan's tightly knit corporate culture.

Taiwanese investors have built wafer fab plants in Singapore, but only at the insistence of customers' who were worried about the aftershocks of another earthquake. Lying along East Asia's geo-physical fault line, Taiwan is prone to periodic earthquakes, with the last one a few years ago shutting out electric power to the island's hi-tech industry.

Cross-straits politics
Even if the government, industry, and VCs were to agree on a common strategy, Taiwan's leaders must come to grips with a political certainty that will track the country's evolving economic union with the mainland. If 16 diverse European nations that have been at each other's throats for two millennia can do it, resolving a civil conflict that has lasted a mere 50 years should be easy.

And, if Taipei is to grow into an international gateway, then the city's future as a temporary camping ground for Nationalist forces awaiting the call to march on Beijing must be revisited. City Fathers must not only expand the urban infrastructure but the cultural foundations for overseas managers to live and work comfortably.

Self-improvement
All the above factors are vital to the survival of Taiwan's venture industry, but the ultimate answer lies with the community's ability to compete on a global and regional level. The Taiwan Venture Capital Association lists some70 different firms, with 181 different funds. Only a handful has attained national recognition. Says one industry leader, ‘Consolidation is the only answer.'

With the government easing restrictions on domestic funding sources, the onus lies on Taiwan's VCs to produce the returns and reporting to attract funds from both government and labour.

Fund structure is also an issue. In the late1990s, the Ministry of Finance ruled that VC funds had to be organised as evergreen funds. Thus, they share the personality of a corporation rather than a partnership, even reporting their earnings on a per-share basis. Funds cannot be listed. Corporate structures have rarely if ever worked, if only because limited partners don't appreciate being taxed twice on their returns. The VCs are eager to change this structure, and the government seems willing to go along.

All roads lead to China
And, finally there's China. The mainland clearly provides one-stop shopping for the industry's ailments. Just how important is Chinese investment? Recent statistics suggest that 35-38 per cent of Taiwanese GDP is tied up with the mainland.

The largest potential lies in the manufacturing area: labour and land on the mainland are cheap, while the provincial governments offer tax incentives to attract business. Corporations are able to control revenues throughtransfer pricing.

Financial services in China also hold promise, but widespread investment lies many years in the future. There are still no exits. Says Chew, ‘Taiwanese securities firms have all gone to China. They have to be there, but they should keep their burn down.'

A source from one of Taiwan's major VC firm, which has made investments in China, points out that it will take China a few years to fully get its legal framework in order and make corporate law enforcement transparent. As for Taiwan's restrictions on hi-tech investments in China are concerned, they could also be eased as China's communist regime becomes more tolerant. Only after that would private equity, especially from Taiwan, start flowing into China in greater amounts, says the source. He goes on to add that fuller economic cooperation must precede a political thaw.

By then, even other emerging Asian economies such as India, Singapore and Malaysia would have climbed up the ladder of hi-tech, making the flow of large-scale Taiwanese venture capital easier.

Copyright © 2002 AVCJ

Daniel M Schwartz is chairman of the AVCJ.

This article first appeared in the Asian Venture Capital Journal, November 2002.

The Asian Venture Capital Journal is the region's leading publication on private equity and venture capital. With readers worldwide, AVCJ provides monthly coverage of fund raising, investments, exits and the people behind them. For more information please visit www.asianfn.com