Red-Hot Web in China Richly Rewards Foreign Investors

SHENZHEN, China – It is one of the best investments of the digital age.

In June 2001, a South African media company called Naspers paid $34 million to acquire a big stake in a struggling Chinese start-up. Today that start-up — Tencent — is an Internet colossus worth nearly $120 billion, far more than web pioneers like eBay or Yahoo. And Naspers is $40 billion richer because of its well-timed bet.

Foreign investors like Naspers have emerged as some of the biggest winners in this country’s sizzling Internet market.

Yahoo and Japan’s SoftBank could score a total of $75 billion on their shares in Alibaba, the Chinese e-commerce giant that filed its plans on Tuesday for an initial public offering. The venture capital firm Draper Fisher Jurvetson owned nearly a third of Baidu, the Chinese Internet search engine, when it went public in 2005; its shares rose 354 percent on its first day of trading. The I.P.O. this year of an Alibaba rival, JD.com, the company formerly known as 360Buy, will rain profit on a host of foreign investors, like the American investment firm Tiger Global, DST of Russia and Prince Alwaleed bin Talal of Saudi Arabia.

“It’s really the law of big numbers,” said Stuart Schonberger, a partner at CDH Investments, a private equity firm focused on China. “With China, when it goes right, it’s just amazing.”

Foreign investments in this country’s Internet sector have been so large and lucrative that some analysts worry that China could further tighten its existing restrictions as a way to ensure its control over one of the most dynamic and sensitive parts of the economy, as it has with banking, telecommunications and aviation.

But so far, the Chinese government has shown no overt concern. Regulators have not pressured foreign shareholders to reduce their stakes or tried to prevent Chinese companies from listing overseas. Perhaps that’s because Beijing’s influence in this sector is more subtle, analysts said. The biggest Internet companies are managed by Chinese entrepreneurs who have allowed the government to closely monitor their websites and censor at will — and foreign investors have largely taken a passive role.

“If the government needs to regulate Internet companies, it won’t matter if they’re owned by foreign companies,” said Hong Bo, a Beijing-based analyst who follows China’s information technology industry.

China’s top leaders have praised Alibaba and Tencent as examples of innovative Chinese companies. China’s official news agency even published a commentary a few weeks ago hailing the rapid development of the Internet sector, without mentioning that virtually all of the major companies got significant funding from foreign investors.

“Twenty years after the world’s most populous country gained access to the Internet, China has been fundamentally and irreversibly changed, but not in the way some Western prophets had expected,” the Xinhua commentary said. “Instead of bringing collapse, the Internet in China is becoming more commercially robust and innovative.”

This system of foreign ownership is rooted in the late 1990s, when Chinese entrepreneurs were desperately seeking capital to finance their Internet start-ups, many of which were modeled on companies in Silicon Valley. Because there were few Chinese venture capital firms, many Chinese start-ups turned to foreign capital.

There was just one problem: The state restricts foreign investment in areas deemed sensitive.

So clever bankers and lawyers quickly found a solution. They proposed registering a holding company offshore that would control the assets of a start-up. The holding company would then be linked to onshore entities owned by Chinese residents, who would hold the Internet business license.

This complex investment structure — known as the variable interest entity, or V.I.E. — proved to be a regulatory loophole that allowed Chinese web entrepreneurs to tap foreign funding. It also set the stage for the companies to list overseas.

“There were no viable exits for Internet companies in China,” said Gary Rieschel, co-founder of the venture capital firm Qiming Ventures, which operates in China. “To list in Shanghai, they had to show three years of profits. And none of the companies could do that.”

Foreign venture capital firms rushed to take advantage. In addition to Draper Fisher Jurvetson, Silicon Valley outfits like Integrity Partners, GGV Capital and Sequoia Capital all bought early stakes in some of China’s hottest start-ups, including Sina, Sohu, Baidu and NetEase.

A handful of strategic investors, companies with longer investment horizons, also bought big stakes. In 1999, SoftBank made the first of several investments in a fledgling Chinese business-to-business website called Alibaba.com with $20 million. SoftBank’s chairman, Masayoshi Son, told colleagues at the time that he intended to get a foothold in China’s Internet market with the aim of holding for years.

“Masa’s a very unique guy, an operations guy with a strategic vision,” Chauncey Shey, executive managing partner at SB China Venture Capital, a SoftBank affiliate, said of Masayoshi Son. “He usually doesn’t need to exit. He thinks long term.”

Yahoo, founded by the Stanford classmates Jerry Yang and David Filo, has also struck gold with Alibaba. In 2005, local competitors were outmaneuvering Yahoo’s China website. So Yahoo’s top executives that year announced it would cede control of its Chinese-language website to Alibaba. As part of that deal, Yahoo agreed to invest $1 billion in what had become the Alibaba Group in exchange for a 40 percent stake in the company.

That investment now looks like a brilliant stroke. Soon after the two sides signed the deal, Yahoo began to falter in the American market, while its Alibaba investment took flight with the explosive growth of the Chinese company’s e-commerce platforms, Taobao and Tmall. Yahoo’s stake in Alibaba is now worth about $35 billion, even after it sold a chunk of its shares two years ago for $7 billion.

Analysts say one reason so many foreign investors have succeeded in China’s Internet market — and have avoided scrutiny from the Beijing authorities — is that they have taken a largely passive role in the start-ups. They tend to assume board seats but allow the Chinese founders of the companies to manage day-to-day operations and develop their own business strategies.

That has been the model for Naspers’s relationship with Tencent.

Founded in Johannesburg in 1915 as a publisher of newspapers, Naspers later expanded into pay TV and Internet services and began searching for deals in China. The company, which maintains a low profile, entered the country in the late 1990s. In 2001, in its first major deal, Naspers bought a stake in Tencent, which had been started by a group of engineers enamored with beepers and instant messaging.

At the time, Tencent’s prospects were grim. The company, which was based in the southern Chinese city of Shenzhen, was struggling to make a profit with its free instant messaging service, OICQ. And AOL, which had acquired an instant messaging company called ICQ, had just filed suit in the United States against Tencent alleging trademark infringement.

Then, in the middle of negotiations with Naspers, the dot-com bubble burst in the United States, deflating the hopes of the young Chinese entrepreneurs.

Despite the challenges, Naspers valued Tencent, which soon changed the name of its instant messenger to QQ, at about $80 million and agreed to pump more money into its operations. Naspers acquired nearly half the company’s shares from Tencent’s two major foreign investors, the Boston-based IDG and the venture capital arm of PCCW, which is controlled by the son of the Hong Kong billionaire Li Ka-shing. The two firms, which had put just $2.2 million into Tencent in 1999, sold their stake to MIH, a division of Naspers, at a huge profit.

“IDG and PCCW like to invest in start-ups. But when we needed money for further development, they were not able to help,” Pony Ma, Tencent’s chairman and co-founder, once said in an interview. “MIH had a lot of capital so it was a better guarantee.”

After the investment, Naspers stepped back and let the founders set the direction of the company. Building off its instant messaging business, Tencent transformed into an online gaming and social networking powerhouse — one that is now listed on the Hong Kong Stock Exchange.

Venture capital firms have rarely held on long enough to make more than $10 billion by investing in an Internet start-up. But Naspers, which seldom grants interviews about its investments in China, held on for years, and its stake now reaches about $40 billion.

In an email this week, Charles Searle, one of the Naspers executives who led the company’s investment in Tencent, said: “We have not sold a single share.”