In an exquisitely renovated office in a luxury office building on Nanjing Xilu, in downtown Shanghai, Wu Meng was on the phone with his Hong Kong partner discussing an apple juice production project that they just visited.

What impressed him the most was that even though their annual income reached 200 million yuan, they still did their business in old quarters granted to the founder 10 years ago. The shabby office did not make the investment manager, who frequents five-star hotels, feel uncomfortable. On the contrary, he felt that management is practical and frugal, and responsible for the investment of the shareholders; therefore he trusts them.

"One of the biggest advantages of Chinese companies is low costs, which is their biggest selling point," said Wu, who works for the representative office set up in Shanghai by a medium-sized European private equity firm. He is charged with investing $400 million each year on the Chinese mainland.

Wu is not alone in his favorable assessment of Chinese companies, as venture capital floods into the mainland.

But with so many avenues through which to flow capital in China, there are opportunities for both use and misuse. Wu and other experts outlined how to take venture capital down the right path.

Finding the gems

Venture capital funds can be divided into two types: private equity and venture capital. Private equity targets well-performing enterprises that are either publicly listed or are preparing to go public. Compared with venture capital, private equity prefers enterprises in the midst of development, such as Xugong Science & Technology, Hayao Group, China Pacific Insurance, Focus Media and Wuxi-based Suntech Power, rather than startups. According to industry statistics, in 2005, 48 Chinese "ready-to-be-listed" companies completed IPOs after the injection of capital by private equity. The total return was over $1.862 billion, including 20 companies that produced a return of greater than 200 percent.

However, while people are talking with great interest about such cases as the acquisition of Shenzhen Development Bank, Mengniu Dairy and NetEase by billionaire international investment tycoons, little attention is paid to those small and medium-sized enterprises (SMEs) that are known to very few, but exist in large numbers and are in dire need of capital. They are the ones that are the most eager to attract investor attention.

"Projects we look into are all private businesses," said Wu. Private equity can be divided into many types. Large-size private equity companies such as the Carlyle Group, KKR and Newbridge Capital prefer big "deals" in the fields of finance, infrastructure and consumer goods. Large and medium-sized state-owned enterprises are their main targets. Medium-sized equity companies, like Wu's, tend to focus on SMEs.

However, the China regional managing director of a foreign private equity fund with a value of $20 billion said, "Normally we do not focus on private-owned enterprises (POEs) for a couple of reasons: One is the investment is too small; also we have strict controls on risk. Since the development history of POEs tends to be complicated, we do not want to get involved."

Some POEs, however, want to raise their own worth through association with big investors, which can create problems for Wu. "We had some contact with one company in Wuhan," Wu said. "It seemed like a pretty good project, and we were planning to invest, but then they said that they were talking to Morgan Stanley and asked us to wait. In the end, they did not get any investment from anyone."

Private equity companies have similar analysis methods and value assessment standards for each individual case in terms of how and how much to invest. Well-known private equity companies will not necessarily pay more for a single deal. On the contrary, small private equity companies are often more flexible in their dealings.

The fund that Wu manages belongs to a medium-sized European bank with an annual fixed investment quota. The compensation for investment managers is not related to the year-end dividend, as in large private equity companies. "Our capital size is relatively small, so we are not under too much pressure. In addition, we have been dealing with POEs for a long time, and they are our target customers." said Wu. Since entering China in 2000, Wu has successfully completed over 20 deals, all with POEs.

Ron Cao, a partner at U.S.-based Lightspeed, has chosen IT value-added business as an investment focus. Cao said that's because of three considerations: First is the fast development speed of IT companies; second, the great market potential of the IT industry; and third, the management team of IT companies possesses a high education background and professional qualities. According to Cao, when companies are chosen, the biggest worry is not that the company will fail, but that it will not grow. Lightspeed currently has two projects in China, both with overseas-experienced project teams.

Looking beyond the facade

"We have found that some companies do not understand private equity," said Wu with a wry smile. "For example, in order to show off their strength, some companies rent the best office buildings and book first class travel, just to avoid the investment manager thinking they have financial problems. We dare not invest in such companies."

Financial status can be ascertained from financial statements, but the quality and capabilities of management cannot be seen from those statements. "This so-called quality doesn't necessarily refer to education," Wu said. "Of course we want to communicate more efficiently with managerial staff. College education, even overseas education, is very favorable because it will make communication easier with local investors during a future overseas public offering. But this is not the key."

The other important factor that private equity companies consider for investment is industry prospects. "For example, one of the biggest advantages of Chinese companies is low costs, which is their biggest selling point," Wu said. Take the example of the apple juice case. If the company claims that they produce orange juice at the lowest cost, Wu would not be interested because, as everyone knows, the biggest orange producer is Brazil. China is the biggest apple supplier, which is advantageous to Chinese apple juice manufacturers.

It is known that venture capitalists in China tend to be more interested in real estate, finance, consumer goods and IT. If SMEs can find investors focusing on their industry, they can achieve a better result with less effort.

Beware of traps

Some companies that are desperately seeking capital but lack financing experience are likely to fall into the trap of fake venture capitalists.

China currently has no specific supervision standards for the operations of venture capital firms. Foreign venture capital companies have abused the registration of representative offices in China; some of them appear as "investment consulting companies." They take advantage of a lack of clarity in supervision standards.

In order to avoid fraud, SMEs should avoid channels such as advertising or introduction by friends. Wu said that most of the investment projects currently on hand were introduced by financial advisors, lawyers and accountants familiar to them. These agents normally have stable business relationships with both parties and are therefore trustworthy.