Look at the person, not the books – Thoughts on risk appetite and investment in China

By Therese Juda, current student of the University of Sydney Business School MBA program

The rapid pace of China’s industrialisation and resulting leaps in GDP has created a glut of capital. During our recent trip to China, one venture capitalist remarked that there is too much money, chasing too few quality opportunities.

Given the centrally-managed aspects of the financial system, varied accounting practises and challenges in exiting investments, here are some thoughts on how to understand attitude to risk in China.

Western rules don’t always apply

One of the guest speakers, a Professor in the Business Faculty at Fudan University, described a few of the Chinese’s Government’s regulations concerning bond issues and default.

He mentioned that default on bonds issued is not allowed by Central Planning Authorities, and that most investment opportunities are project-based, rather than whole of company. This presents a challenge for investors assessing the risk/return balance for a particular project as traditional modelling suggests the yield of an investment is largely compensation for the level of risk you’re taking on.

I appreciate the protective effect this regulation has on individual investors, but wonder if this provides a kind of perverse incentive to take on the highest return investments, without scrutinising the details of how viable the actual project is – driving up the returns companies need to offer to gain funding.

Look at the person, not the books

The question of due diligence Western-style, through analysis of financial statements and projections, was top of mind when our Venture Capitalist speaker described a failed investment he had personally made.

The speaker had invested personally in a project that failed, and lost the capital he had invested. The failed company was audited by local authorities who found that only 10% of funding the company had received made it to the company’s bank accounts.

Investors around the world know that this is not a situation unique to China, but what I was struck with was the speaker’s statement – ‘I am not a policeman; we do not check such things’.

As the speaker went on to describe how investment opportunities are sought through region-linked business and personal networks, I gained a new perspective on how the choice to invest is made.

The themes of interconnectedness and long-running relationships speak to the fabled ‘guanxi’, a Chinese term referring to deep personal connections built between business partners.

Before ‘guanxi’ is possible, the choice is whether to do business with this person, and this is assesed via ‘xin-ren’, a trust equation made up of both cognitive ‘head’ and affective ‘heart’ aspects (Read more in: Building effective business relationships in China).

The utilisation of these deep links to source investment opportunities spoke to me of the heart aspects – you are doing business with people who went to the same university, who move in similar circles and thus ‘get’ you, and are bound to deliver on their promises to you at a deeper level than simple contracts and liability limited companies command.

It might sound counter-intuitive to invest millions based on personal relationships, but any lenders reading this know that character trumps capacity when assessing loan default risk every time.

Gotta roll the dice to get a shot at the big time

Hearing about the importance of the character led me to wonder – if the project does fail, will the owners be able to get funding for their next venture?

The Venture Capitalist speaker seemed surprised at this question, stating that after a failed project the owners are seen as a more attractive future prospect, as ‘you have to take risks to get a chance at the big house and dreams’.

Does this mean failure is rewarded? In the context of the amazing innovations we saw at Goodbaby, a baby goods manufacturer, I realised in reality this position supports people willing to take risks to be first.

My time in China has given me a new appreciation of how nimble a company needs to be to thrive in such a complex regulatory environment, and a completely different perspective on how to assess risk and make investment decisions.

China’s economy is now moving towards innovation to sustain its growth, and will be well supported by a risk system that favours the brave – those willing to fail, in order to create something new and be first.

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