Directed Improvisation - the growth of venture capital in China

Yuen Yuen Ang has described China's growth model as one of "directed improvisation", which combines top-down direction with bottom-up improvisation. Instead of dictating precise plans, the central government guides and incentivize adaptive responses within the system. This included flexible policy signals, concrete definition of success, high-powered incentives at all levels, promotion of regional niches etc. The local officials figure out local solutions to local problems. 

She builds a three-step framework to explain development that followed from "directed improvisation". 

Harness weak/wrong/backward institutions to build markets > emerging markets stimulate strong institutions > strong institutions preserve markets. This three-step sequence of development presents a fundamental corrective to the conventional wisdom, which traditionally has insisted that it is either “good” institutions (such as rule of law and formal property rights) that led to economic growth, or the other way around. China’s experience demonstrates that the first step of development, paradoxically, is to re-purpose “weak/wrong/backward” institutions to create new markets. Taking this first step, however, requires directed improvisation as an organizational prerequisite.

Sebastian Mallaby's book on the rise of venture capital, The Power Law: Venture Capital and the Art of Disruption, has an excellent description of this approach at play in the development of China's venture capital financing and startup ecosystem

The Chinese government forbade foreign ownership of a broad swath of Chinese businesses, including ones that ran websites. This meant that U.S. venture investments into companies like Alibaba were on their face illegal, as was the listing of Chinese internet stocks on America’s Nasdaq market... To breathe life into China tech, the U.S. VCs and their lawyers came up with a series of workarounds. To begin with, the Chinese internet companies they backed were incorporated in the Cayman Islands. Cayman law allowed for every variety of stock: common shares for the startup founders, share options for employees, preferred shares for the investors. Further, a Cayman outfit could accept investment capital from a non-Chinese VC: Goldman Sachs was forbidden to invest in an internet startup in Hangzhou, but it could buy shares in its Cayman parent. Finally, the Cayman shell could easily be listed on a non-Chinese stock exchange such as the Nasdaq, providing a way around the blockage of China’s primitive markets. 

Once the Cayman company had been established, the next task was to use its venture dollars to build a business in China. To get around the prohibition on foreigners owning equity in a Chinese internet venture, the Cayman dollars were pumped into a parallel Chinese-owned operating company in the form of a loan. Then, to give foreign investors the sorts of rights that they expected from venture deals, Silicon Valley’s lawyers invented what amounted to synthetic equity. They executed a series of side contracts between a China-based subsidiary of the Cayman company and the Chinese-owned internet operator. The Chinese internet company granted control rights to its foreign creditors, simulating the influence that comes with an equity stake. The Chinese company also agreed to pay interest on its foreign loan in amounts that varied according to the success of the business: in effect if not in law, the foreigners received dividends. Finally, to cap off these arrangements, all parties agreed that disputes would be resolved under New York law. Chinese officials refused to bless this Silicon Valley confection. But, to be fair, they tolerated it.

The improvisation at the local level and the officials turning a blind-eye to the legality of these structures is instructive. This structuring was permitted to happen in a de-facto regulatory sandbox. Once it got refined, it got adopted as the mainstream mode for foreign investment in China through the so-called "variable interest entities (VIEs)". 

This example also illustrates the problems with the conventional wisdom that countries can attract foreign investments only if their regulatory environment is enabling and welcoming. China has consistently disproved this ostensibly sacrosanct principle in attracting foreign investment. There are several accounts that show that its domestic policy and operating environment, and that too not in recent years but even in its development phase, have been deeply uncertain. Investors have sought to overlook this and invest in the country.

The American influence was deep

China’s technology boom was forged to a remarkable extent by American investors, and the Chinese VCs who emerged alongside them were themselves quasi-American—in their education, professional formation, and approach to venture capital. They had studied at top U.S. colleges, worked at U.S. companies, and carefully absorbed the U.S. venture playbook: equity-only funds, stage-by-stage financing, sleeves-rolled-up involvement, and stock options for startup employees... In short, U.S. capital, legal structures, and talent were central to the development of China’s digital economy. Without this American input, companies like Alibaba could not have gotten off the ground, and today’s Chinese dominance of technologies such as mobile payments would not have been likely either.