Jun 26, 2012 · 5 minutes

The IPO news for China’s Internet industry keeps getting worse, but entrepreneurs and investors alike are hopeful for the emergence of a key new force that looks set to bolster and reinvigorate the ecosystem: A robust mergers and acquisitions market.

China’s Internet industry, barely 12 years old, doesn’t have a strong history of mergers and acquisitions. Dominant players Baidu, Alibaba, and Tencent have traditionally chosen to build rather than buy, squashing promising startups by appropriating their ideas, raiding their best talent, and then pushing out competing products to their vast user-bases.

Now, however, that model is starting to change. As big Internet companies mature, the market expands, and as those giants face pressure from shareholders to spend their cash, China is primed for a flurry of deal activity that could offset the pain of its flailing fortunes in IPOville.

Today, those three giants are each worth far in excess of $10 billion, while NetEase is worth more than $7 billion. The equity power, then, is now well in place for some big buys to go ahead.

“Today the scale and their size may not support the ‘build versus buy’ strategy,” says Jixun Foo, a partner at GGV Capital’s Shanghai office. “They will increasingly have to consider the ‘buy versus build’ strategy. In my mind, that’s becoming more and more apparent. We are at the beginning of the trend.”

Foo is an investor in travel portal Qunar and online video site Tudou, both of which were central to two of the most significant Internet deals in China’s history. Last June, Baidu paid $306 million for a majority stake in Qunar, valuing the company at $500 million. In April this year, leading video site Youku swallowed Tudou in a $1.1 billion acquisition to create a mega force that controls one third of China’s online video market.

Foo says those deals serve as good role models for the market, and he is optimistic for the industry’s M&A future. “Where we are right now, M&A is still the tip of the iceberg.”

At least at first glance, both those deals also appear to have addressed one of the concerns related to the M&A market here: Mollifying the founders. Under the terms of its deal, Qunar remains an independent company, run by co-founder CC Zhuang. It is still likely to be eyeing an IPO, which, according to reports, it had initially planned to file for in late 2011. Tudou, on the other hand, will move its entire management team to Youku, although it’s unclear how long CEO Gary Wang plans to stick around.

In China, it is difficult to convince entrepreneurs to stay with their companies after they're acquired. “Chinese entrepreneurs are used to either owning the company or leaving,” says Bruno Bensaid, founder of investment firm Shanghaivest. “They’re not used to being purchased and then staying on the team. It’s just not in the culture.”

Like Foo, Bensaid says the M&A sector is set to grow. Because of the anemic IPO prospects for Chinese companies, entrepreneurs now see M&A as a valid exit. “It’s going to be very good for one single reason: There is no exit on the public market.”

The latest IPO news supports that view. While companies such as AdChina and Lashou (whose CFO, perhaps not insignificantly, has just resigned) have delayed their IPOs, online education provider ChinaCast Education has just been delisted from the NASDAQ amid accusations of dodgy accounting. The embattled Mecox Lane, which is in part a victim of an overly frothy ecommerce sector, is coming perilously close to a similar fate. The public disappointment over Facebook’s IPO has also cooled the appetite for Chinese Internet companies.

Meanwhile, the big players are stocking their war chests. As of March last year, Baidu had US$1.34 billion cash in hand, compared to Tencent’s $1.71 billion. At the start of 2011, Tencent announced the creation of a $760 million venture fund, which CEO Pony Ma later doubled to $1.5 billion. In September, online game developer PerfectWorld launched a $100 million venture fund.

Aside from the Qunar and Tudou deals, big companies have made some other encouraging forays into the deal space. In May last year, Tencent paid $84.4 million for 16 percent of travel site eLong, while in August leading portal Sina paid $66.4 million for 9.05 percent of Tudou’s shares. In September, social network RenRen acquired video site 56.com (a Yokou Tudou competitor) for $80 million.

Says Bensaid: “Chinese companies on the local market are becoming aware that they need to be more competitive, and they also understand that they need to buy technology now, instead of licensing or stealing it.”

China’s market is also now at a point where growth is too fast and competition too intense for the big companies to just rely on their own resources. Few people in the industry are better placed to recognize these forces than Fritz Demopoulos, perhaps the most successful American entrepreneur in China’s internet industry. Not only was Demopoulos a co-founder of Qunar, but in 2000 he also sold sports portal Shawei to Tom.com for about $15 million.

“The big players can't do everything on their own anymore,” says Demopoulos, who also spent 18 months in the early 2000s as a vice president for business development at NetEase. “And also, to be honest, the big players are now a little bit more mature. They know how to buy companies, they know how to do partnerships.”

Baidu’s investment in Qunar was important, Demopoulos agrees, because it demonstrated the benefits for companies in looking outside their own gates for growth. “That signalled to the market that relatively larger deals could happen,” he says. “That was a testament to the maturity of the market, and also the maturity of the Baidu team.”

China is entering a new period in which buying companies or partnering with them will become widely accepted, says Demopoulos. "Overall I'm very excited about the prospects."

That must be welcome news for entrepreneurs and investors who might have been starting to think that China's Internet industry has an easy way in but no clear way out.

[Image from Shutterstock.com]