It seems oxymoronic to describe a company as cautiously aggressive but these two descriptors come up most commonly when people privately discuss Tencent, a China-based, corporate venturing-backed, online media conglomerate that has this year set up the world’s biggest debut corporate venturing fund.
That, and smart, as Tencent has achieved a 5,000-fold rise in its share price since it floated in 2004, which has turned a $32m investment by South Africa-based media group Naspers’ corporate venturing unit Myriad International Holdings (MIH) into one worth about $13bn, or more.
The rise in valuation has come from Tencent’s domination of online social network services (SNSs) in China with 647.6 million active user accounts on its core instant messaging (IM) platform at the end of last year.
That China only has 457.3 million people using the internet, according to the local regulator, implies multiple accounts for some (which Tencent encourages by providing rewards for individuals to set them up).
Tencent has monetised this social networking dominance, resulting in revenues growing to RMB19.65bn ($3.1bn) last year from RMB12.4bn in 2009 and RMB2.8bn in 2006.
With net profits of just more than RMB8bn last year, a 56% increase from 2009, Tencent has become highly cash generative.
But this profitabilityis unlikely to last, the company admits in its annual report, as Tencent begins a new cycle of capital expenditure to maintain its dominance.
In his admirably clear annual report, Ma Huateng, executive chairman and co-founder of Tencent, said: "While our user base and leading internet platforms provide us with a solid foundation for capturing emerging opportunities, we do face significant challenges on a continuous basis.
"The most notable one is intensifying market competition. Another key challenge is the increasing security threat to our users.
"In view of the opportunities and challenges, we have initiated a new investment phase, during which we will be making significant investments in our existing platforms, including IM, SNS, wireless and gaming, as well as a range of new strategic initiatives, to position ourselves for future growth.
"As we will incur significant costs on these initiatives, and many of them will not generate revenue immediately, our profitability will be affected during the investment period.
"However, we believe we must take a long-term view in building our business, and these initiatives will benefit the company and our shareholders in the long run."
Given the increase in the number of internet users in China over the past decade from 20 million in 2000 to nearly half the country’s population, Ma in his annual report said: "We expect future growth of the industry to be increasingly driven by a rising level of internet usage by users and businesses, as opposed to user growth."
Tencent’s investment, therefore, is being focused on encouraging usage through a better and wider range of services and content, rather than gaining from the network effect of having new users join the internet and communicate with other people already on Tencent’s established IM platform.
It is also developing a "Tiger and Dragon" strategy to reflect its China and international strategy, respectively. Effectively, Tencent wants to maintain its local dominance using a corporate venturing fund as an important business development tool, while also trying to become one of the first Chinese companies to be successful globally through a series of partnerships built on relationships formed with other top-tier corporate venturing investors.
Being a Tiger
Founded in 1998, Tencent’s first product was an IM service called OICQ (subsequently renamed QQ – Chinese slang for cool). Tencent developed what is now QQ after Ma, who was then working in the US, saw the ICQ instant messaging product of an Israel-based peer, Mirabilis, which was acquired by US-based internet services provider AOL for $400m in 1998 just two years after launch.
Tencent is now an indirect owner of the original ICQ after Russia-based investment firm Digital Sky Technologies (DST), of which Tencent owns 10%, acquired the original IM service and its 32 million remaining users for $187.5m in April last year.
Back in China, Ma and four others set up Tencent and a year later raised $2.2m in backing from PCCW, a Hong Kong-based investment firm on behalf of Li Ka-shing, the special administrative region’s richest man, and IDG Ventures, the corporate venturing unit of American publisher International Data Group.
Tencent incorporated its IM chat service into online games, and with the creation of a virtual currency, Q Coins, to allow people to buy accessories and customise their online profilesthe company became profitable in 2001 – last year about 60% of its revenues came from people spending the virtual currency in its games.
At this time, in May 2001, Naspers acquired 46.5% of Tencent from existing shareholders, including IDG, for $32m. In an article by news provider Bloomberg Businessweek last month, Hugo Shong, founder of IDG Ventures in China, described its decision to exit Tencent as the biggest mistake of his career.
Shong declined to comment for this article, although the firm reportedly made an above-industry-average three-times return on its Tencent investment.
Naspers has yet to sell any shares in Tencent, but its stake was diluted to just more than 35% in the June 2004 flotation of the Chinese company on the Hong Kong Stock Exchange.
Underwritten by investment bank Goldman Sachs and oversubscribed 158 times, Tencent issued 420 million shares at HK$3.70 each. The initial public offering raised HK$1.56bn (then worth $200m) based on Tencent’s then-97.1 million active users generating annual revenues of RMB735m for the media company.
Tencent’s shares now trade at about HK$175, giving it a market capitalisation of HK$322bn ($41bn). Naspers in its last annual report said the market value contributed by the group’s listed investment in Tencent at the end of March 2010 was R92.7bn ($12.9bn) when the portfolio company’s share price was about RMB155, or about 6% lower than at the end of August this year, excluding dividends.
The share price increase since flotation has followed Tencent’s success in attracting new and more active users and offering a broader range of services, such as a search engine, an e-commerce marketplace, two social networks, a limited-character message feed and a micro-blogging service.
John Ball, founder and managing partner of Steamboat Ventures, the US and China-focused corporate venturing unit of US media conglomerate Disney, said Tencent was a "very capable, progressive company, not to be under-estimated in its capacity to bring products to market".
This service expansion has put Tencent on course to compete against a wide range of local companies, such as Baidu in search, Alibaba in e-commerce and Sina in messaging, all from a position of strength in having a relationship with so many internet users through QQ.
Though occasionally criticised for its alleged lack of innovation of whole new ideas, Tencent has instead focused on executing better than peers on existing product ideas and localising them under licence from often foreign originators, such as South Korea.
In an interview with Bloomberg Businessweek published last month, Ma said most internet inventions sprang from Silicon Valley in the US, with its high concentration of experienced entrepreneurs and engineers, whereas the focus of Tencent, like most other technology companies in Asia and Europe, was on what he called "micro-innovation" – adding small details that make a service relevant locally.
Tencent has also been one of the most active acquirers of local venture-backed businesses. In March last year, Steamboat sold its stake in online games developer Youxigu to Tencent for an undisclosed amount.
Last year, Tencent also bought discussion forum software developer Comsenz for reportedly more than $60m from its venture investors, including search engine provider Google, and shares in Gamegoo Information Technology from its previous venture backer, Qiming Venture Partners.
Tencent is also developing its open innovation strategy this year to help findand develop new content and partnerships and also make its SNS microblog, such as Qzone, available on third-party websites.
Ma said in his annual report: "To become a stronger player in the market, we need to significantly enrich the applications and content offered to users in order to cater for their ever-changing needs in communications, information, entertainment and e-commerce.
"This is only made possible by promoting innovation and collaboration among all participants along the industry value chain. As such, we are striving to create a ‘win-win-win’ ecosystem for users, application developers and ourselves by pursuing an open-platform strategy.
"As one of the key initiatives under our open-platform strategy, we announced the establishment of the Tencent Collaboration Fund in January 2011."
The fund initially aimed to invest up to RMB5bn in minority and majority equity stakes in internet and related companies in China. In June, the fund’s size was doubled as its 10-strong investment team found a considerable number of opportunities.
The fund’s team is part of the mergers and acquisitions (M&A) department ultimately run by Tencent president Martin Lau, a former Goldman Sachs banker who joined Tencent in February 2005 shortly after helping the company’s initial public offering the previous summer.
A source said the fund was set up for hybrid reasons, both strategic and financial. He said Tencent structured the majority of its investments as minority equity stakes in later-stage companies – businesses with products and revenues – but was considering investing in start-ups – those with an idea and some product development.
Tencent has also this summer become a limited partner in the Innovation Works early-stage investment fund managed by Kai-Fu Lee, search engine Google’s former head of China.
In April, Tencent used RMB500m of the Collaboration Fund to create a film and television fund, and it is also a limited partner in the South Korea-based Capstone Partners venture capital fund investing in the local games industry.
Tencent’s investment pace in the first six months was about RMB2bn (see deals in fact box) and the source said the market timing for the fund’s launch had been good for active investing while declining to reveal the amount of the fund it had invested.
Third parties warned that though Tencent had a large fund, valuations in China were high and so the money remained smaller than the opportunity. In July, Tencent invested HK$892m buying 15.7% of security software developer Kingsoft after an attack on its service in the final three months of last year afected its reputation.
The Kingsoft deal followed Tencent’s strategic investment worth RMB450m for 4.6% of Huayi Bros Media Group, one of the biggest entertainment companies in China.
Also in May, and just a week after the Huayi deal, Tencent and US-based travel services provider Expedia invested a combined $125.6m in Chinese online travel service provider eLong.
Tencent bought 16% of Nasdaq-listed eLong for $84.4m with Expedia taking majority control with its 8% share purchase added to its existing holding.
Third parties that have dealt with Tencent’s fund said it had been sophisticated in its approach through investing in overseas peers, such as Russia-based DST, and, spawning a number of local imitations, such as TCL, Huawei and ZTE.
Wayne Shiong, a partner at Bertelsmann Asia Investments, the China-based corporate venturing unit of German media and service group Bertelsmann, said: "Tencent is very successful and its fund is very aggressive across sectors – e-commerce, mobile, gaming and so on."
Richard Hsu, managing direc-tor of Intel Capital China, the local corporate venturing division of US-listed chip maker Intel, said: "Tencent is very smart and it has an unparallelled consumer internet distribution platform in China.
"That means its corporate venturing fund is going out with a distinct advantage.
"It could create these services itself but would spend more management effort and cost as against going out and finding them. Investing gives them a double cut of revenues as it earns from the shares but also if it is distributed on its platform it can potentially profit-share.
"The ability to distribute is a huge draw for a young company. But for Tencent it is very smart, as these third parties generate traffic and loyalty among its user base and it can offer more services.
"Tencent is a leader in the consumer internet play and its idea to build ecosystems is similar to Intel Capital.
"Intel Capital absolutely works with them, as Tencent has the consumer understanding and Intel Capital knowledge of the technology side and so we bring different value-adds to companies. For example Intel brings deep expertise on data centres that are critical to scaling the growth of internet companies."
Tencent and Intel have also signed an agreement to set up a research and development centre to focus on developing new mobile computing products.
And the ecosystem Tencent is trying to develop is global in scope, which is where its partnerships with some of the world’s most sophisticated venture investors, including Naspers, DST and Goldman Sachs, are proving helpful through the hidden wiring of guanxi – Chinese for personal connections.
Riding the Dragon
Li Dongsheng, president since 1996 of China-based electronic goods maker TCL and a non-executive director on Tencent’s board, set out a Tiger and Dragon plan for his company in 2003 to partner overseas peers (Dragons) while expanding in China (Tigers).
Tencent has taken a similar approach in taking on local tigers and foreign dragons. In December, Tencent said its QQ service was available in English, Japanese and French, and it would set up a social networking site in English this year.
Tencent already has a number of partnerships with foreign firms, such as Japan-based Gree to develop an open games development platform, Q+, in the summer.
One of its longest-established international partnerships, however, is with its largest investor, Naspers, which declined to comment for this article.
Tencent has also continued to work with its earliest investor, IDG, after both invested in Vietnam-based games developer VNG – formerly Vinagame – between 2005 and 2010.
As Tencent has grown and its world-class management team has expanded and matured – Ma, Lau and the other co-founders are all still under 40 – the role of Naspers has become more passive and relationship-orientated, according to insiders.
One that knows Naspers’ corporate venturing strategy in 127 countries round the world (see profile last year for more detail on MIH’s growth and success) said: "Naspers takes a confederation approach, where reciprocity, or soft nuance relationships, can help businesses through introductions and idea sharing. This is possible as the firmsdo not compete directly and operate in local languages and cultures.
"Tencent’s excellent managers are the masters of their own destiny and are excellent managers. The relationship has changed as Tencent has gone from its early days figuring out how to buy servers and hire coders through the corporatisation process of putting in senior managers and listing in Hong Kong. Today, Naspers holds only two out of nine board seats."
The two board directors from Naspers are Antonie Roux, who has been chief executive of MIH since April, and Charles Searle, both of whom are also on Tencent’s remuneration committee.
Roux summed up its approach to corporate venturing internationally in an interview with Brainstorm Magazine two years ago, when he said: "We made some very expensive mistakes in China in the beginning. We lost a lot of money.
"You go into the market, you don’t understand the language or the culture, and you think this will only work if you fly in expats to manage the business. Not only is this incredibly expensive, but it just does not work.
"The biggest lesson we learned is that you do not invest in a product or an income statement. You invest in a local team. Now we find the best local teams we can get, people we can trust, and then do everything we can to support them."
Part of this support has involved transferring David Wallerstein as senior executive vice-president responsible for Tencent’s operations outside mainland China after Naspers’ investment in 2001.
Wallerstein was previously the vice-president of business development of MIH in China but at Tencent he has been able to help the company expand into India and Thailand by taking minority stakes in Naspers-owned businesses.
Last year, Tencent acquired 49.9% of Sanook, a Naspers unit in Thailand, following the 2008 agreement for Tencent to buy up to 49% of MIH India’s Ibibo social network for $7.5m over a five-year period. Tencent currently owns 20%.
The most significantuse of guanxi between Naspers and Tencent, however, is their investments in DST, which is also backed by Lau’s former employer, Goldman Sachs.
In July last year, Naspers injected its 39.3% stake in Mail.ru company and an additional $388m in cash, in exchange for a 28.7% stake in the enlarged DST group, which was subsequently renamed Mail.ru Group and listed on the London Stock Exchange.
Through Mail.ru, Naspers has a very small exposure to US-based internet companies Facebook, Zynga and Groupon – the bulk is held by DST Global, the offshore investment entity controlled by DST founder Yuri Milner and his partners.
Naspers’ investment followed Tencent’s $300m purchase of 10.26% of DST, now Mail.ru, in April, partly to gain greater access to Mail.ru’s games developer, Astrum.
Neither Naspers nor Tencent has any exposure to DST Global. DST declined to comment for this article.
Roux, in an interview with news provider Economist, said: "This international presence allows the firms to apply lessons they have learned in one country to another. We spend an enormous amount of time on sharing knowledge."
This is "geographical arbitrage" – looking at a country’s gross domestic product and internet connectivity relative to its peers to gauge the size of opportunity and then building a media business based on free communication tools and other services and virtual goods, such as in games or e-commerce for the real world, developed in other countries but tailored for the local culture in the new market.
But while Naspers has no other investments in China to avoid potential conflicts with its largest external investment, DST has co-invested with Tencent in local retailer 360 Buy.
Tencent has also subsequently partnered DST’s Groupon and Zynga portfolio companies to help them expand in China. In July, Zynga said it would launch its first game in mainland China, Zynga City, in partnership with Tencent.
While based on the US firms most popular game, CityVille, Zynga City will use Chinese architecture, references to Chinese pop culture, as well as events and contests in the game that will be linked to Chinese holidays and news after the company acquired local developer XPD Media last year.
Zynga’s use of local developers through acquisition has been followed by Tencent – the Chinese company invested in US-based games group Riot Games in September last year before deciding on a full acquisition in February for a reported $400m enterprise valuation.
Riot Games, which continues to work independently of Tencent, has reportedly expressed interest in hiring several hundred employees, including publishing managers, in other emerging markets, among them Russia, Brazil, Thailand and Indonesia, according to one analyst at Goldman Sachs quoted by news provider Financial Times.
But with more than 1,000 Groupon-type local companies already in China, transplanting the DST portfolio company through the Tencent joint venture, Gaopeng, has been difficult,with reports in news provider Wall Street Journal that staff were being laid off.
As well as Groupon and Tencent backing of Gaopeng, there is Yunfeng Funds, a private equity fund established by Jack Ma, president of local e-commerce company Alibaba Group, and Shi Yuzhu, president of New York-listed games developer Giant Interactive Group.
Giant and Tencent had already worked together for the release of the Dragon Soul online game.
The challenges faced by Gaopeng, and the rise and relatively slow increase in ICQ, reflectthe difficultyof maintaining a domestic advantage let alone in expanding internationally and maintaining relationships with finacially-focused investors.
One of DST’s backers, hedge fund Tiger Global Management, was the lead investor in Tencent rival Duowan’s latest $100m round at the start of the year (see case study).
But it also reflects the rise of non-US investment power centres in emerging markets, sometimes called the new conductors. As one blog, Amplify, wrote when Tencent acquired a stake in DST: "This is not about China and Russia owning Silicon Valley [the world’s biggest centre for venture investing], but about the rise of emerging economies collectively as an independent centre-of-gravity in the online world."
As one insider to Tencent’s plans said: "Overseas, Tencent is being cautious partly as the China market is so big and also because so few Chinese companies have been successful overseas, so they are developing gradually, certainly compared with US firms way of doing business, which is to go into a market and tell how it should be done."
It is an investment and development strategy that asks to be judged on actions and results rather than hype.
Fact box:Tencent
Revenues: RMB19.65bn
Net profit:RMB8.1bn
Tencent Industrial Collaboration Fund
Founded: January 2011
Assets under management: RMB10bn
Team: 10 investments professionals
Key people
Ma Huateng (Pony): co-founder and chairman
Lau Chi Ping (Martin): president
Zhang Zhidong (Tony): co-founder
Chenye Xu (Daniel): co-founder and chief information office
Yidan Chen (Charles): co-founder and chief administration office
Zeng, Liqing (Jason): co-founder and adviser emeritus
David Wallerstein: senior executive vice-president
Qing Ji (Judy): senior director of M&A
Shaohui Chen: senior director of M&A
York Chen: senior director of M&A
Tencent’s deals in 2011
Name Stake (%) Amount (RMBm)
17u.com 30 50-60
Huayi Brothers Media Group 4.6 450
eLong 16 540
Kingsoft 15.68 730
OKbuy n/a n/a
360 Buy n/a n/a