Mining The Middle Kingdom

Rivals laughed when IDG set up a VC fund in China. Now they're rushing in

When Patrick J. McGovern, chairman of the Boston magazine conglomerate International Data Group Inc., was thinking about starting a venture capital fund for China in the early 1990s, he figured it might be easier to scale the Great Wall with his bare hands. The Communist government dominated the economy. Seasoned entrepreneurs were almost nonexistent. Most challenging, with no national stock market and few private companies, it would be tough for IDG to cash out of the startups it backed. Still, lured by the potential of a rapidly evolving, billion-person market, he plowed ahead, creating the first venture fund in China in 1992. Rival venture firms thought he had lost his marbles. "They all laughed at us," says McGovern.

Now McGovern and his posse of plucky Chinese partners are getting the last laugh. The company's China venture arm, IDG Technology Venture Investment Inc., has been raking in the dough since the China market began to soar five years ago. It has earned a 42% internal rate of return on the $170 million it has put into China since its founding. Even better, its early entry and active support of Chinese entrepreneurs has given it an enviable reputation as the place to go to get financing for a tech startup. As a result, IDG has first crack at many deals in what is becoming one of the world's hottest markets. "For early-stage investment, IDG gets the best deals," says Gavin Ni, chief executive of Zero2ipo Ltd., a Beijing firm that tracks Chinese venture capital.


IDG Technology's approach is a blend of East and West. Its investments, which average just over $1 million, are typically in startups that are trying to adapt successful U.S. business ideas to the China market. It has helped create Chinese versions of (AMZN ), eBay (EBAY ), and Bloomberg, among others. Its 10 general partners, all Chinese, usually modify the business model for their own market. For example, International Ltd., an online travel agency based in Shanghai, is similar to travel site Expedia Inc. (IACI ), but it stresses phone support much more than its U.S. counterpart. The reason is that many Chinese prefer to search for flights online and then purchase tickets by phone. "They feel like the transaction is [more] secure" on the phone, says Quan Zhou, the fund's managing director. Such insights helped IDG turn its $1.6 million investment in Ctrip into $37 million.

Zhou's knowledge of the local market isn't something outsiders will pick up quickly. The 47-year-old grew up in Anshan, an industrial city he compares to Pittsburgh. During the Cultural Revolution, when he was 17, he was sent to work on a farm for three years, earning a penny a day. He later went to the U.S., earning a PhD in fiber optics at Rutgers University, and then he became a consultant on research at NASA. Yet Zhou says it's his farm experience that has proved critical in guiding his venture decisions. "When we make an investment, we think: 'What do the real people need?"' says Zhou.

That Cultural Revolution investing philosophy will be applied even more actively in the years ahead. BusinessWeek has learned that IDG Technology is opening its biggest fund yet, at $150 million, in February. Zhou says the new fund will focus on digital media, consumer Net services, and software for corporations.

Success, however, may be harder to come by in the future. Many venture capitalists, in the U.S. and elsewhere, have come around to IDG's perspective that China is the next great frontier. Indeed, 2004 was a record year for venture investing in China, with 253 deals and $1.3 billion invested, according to researcher Zero2ipo. And a host of rivals are getting more aggressive in the market, including Japan's Softbank, America's Accel Partners, regional players such as Taiwan's Acer Technology Ventures, and local Chinese firms.

IDG Technology faces not just competition but also controversy. There's a potential conflict of interest between its publishing and investing arms. While its tech publications in the U.S. and China often cover the Chinese companies that have received IDG venture money, they frequently don't disclose the financial interest. Orville Schell, dean of the Graduate School of Journalism at the University of California at Berkeley and a China expert, says these kinds of conflicts are far more common in China than in the U.S. Still, he says, such ownership should be disclosed because of the possibility that IDG publications may be overly supportive of IDG-backed startups.

The president of IDG'S publishing business in China, Hugo Shong, says the company suggests that editors disclose investments when they write features on IDG-backed companies, but it doesn't insist on it. He also says IDG publications are run as independent operations, and no favorable coverage is given to IDG-financed companies.

The story of IDG Technology's success in China actually begins with IDG's publications. After Deng Xiaoping unveiled the "open door" policy in December, 1978, McGovern flew to China and negotiated the first venture between a U.S. media company and the Chinese government. Although skeptics thought it would take years to get up and running, IDG was publishing a weekly paper within six months. By 1992, it was turning a profit in the country. That year, IDG set up its first China venture fund with $70 million and had the market pretty much to itself. "People would line up and ask for money," says McGovern. "We didn't have to negotiate with four or five other VCs."

Today, venture capitalists can bump into each other on flights to China. Still, IDG Technology has a crucial edge -- guanxi, or relationships. While most investors fly in from Hong Kong or the U. S. to prospect for deals, IDG maintains a 30-person staff spread across four offices and has a reputation for helping entrepreneurs succeed. Jian Lu, founder of Moloon International Inc., which provides games and other entertainment on cell phones, says he got offers from four venture firms to finance his company. IDG's was the lowest, but he chose to go with the firm anyway. "IDG has the strongest partner team," says Lu. These days, McGovern's long-ago bet on the China market looks anything but crazy.

By Spencer E. Ante in New York, with Dexter Roberts in Beijing

— With assistance by Dexter Roberts

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