Small companies in China are crying out for funds, and many people blame bank lending policies. But are they really the primary villains in this equity crunch?

The dilemma facing small businesses which need cash mirrors a hard truth: There is something wrong or something missing in China's financial services system. And that "something," many would argue, is a well-developed private equity sector eager to lend entrepreneurs the money to turn their ideas into reality.

Private equity firms in China, like the sector they are ostensibly supposed to be helping, are suffering growing pains. Those that do exist complain they have trouble finding qualified small firms to invest in, trouble finding seasoned professionals to guide investment decisions and trouble operating in a realm largely lacking in rules and regulations.

"In foreign countries, there are sophisticated laws and rules to govern private equity and their business partners," said Sun Lijian, a finance professor at Shanghai's prestigious Fudan University. "Also, investors abroad are usually seasoned specialists in one particular industry, who can easily identify good investments in a segmented sector."

It's been easy to overlook the private equity issue in an environment where everyone is pointing the finger at banks.

Critics say arrogant banks turn a deaf ear to the pleas of small firms needing money. In many cases, big banks demand companies put up land or heavy equipment they own as collateral. But for small firms, especially in service industries like finance, design or consulting, the only asset they possess is the brainpower of their staff.

Responding to the criticism, banks have been quick to offer lip service, pledging to do more for small and medium-size businesses. But in reality, the little guys don't have a chance against the heavyweight state-owned enterprises that banks regard as safer clients.

Lacking variety

This issue reminds me of a conversation I had late last year with Jan Noether, chief representative of the Delegation of German Industry and Commerce in Shanghai. I asked him how Germany has been so successful in cultivating small business.

Noether told me that the variety of bank sizes in Germany means there are a lot of small banks who are happy to lend to small business. Unfortunately, what would be called "small" in Germany doesn't exist among Chinese lenders. Banks here are big.

Germany and other developed economies also enjoy the benefit of private equity firms willing to take chances if they see small firms with good ideas, good management and good prospects. The concept isn't alien in China, but private equity firms here tend to ignore firms just starting out in favor of those about to go public. That's a popular channel for quick profit: Buy into a company with high valuation and dump the shares as soon as possible after listing.

There are no "angels" in the process. Whereas angel investors in the West are investment benefactors to promising young start-ups, private equity in China mostly involves venture capital that enters at a later stage of small business development.

"It is not that we are unwilling to enter at an earlier stage," said Gao Shen, a senior partner at Newmargin Ventures. "But the risks are too high, and there is virtually no means to reduce such risk in China."

Government officials are worried about the dearth of funding for small business. Small and medium-sized companies employ 70 percent of China's workers and are major contributors of tax revenue. In a sense, they form the backbone of China's commercial economy.

Early in March, Finance Minister Xie Xuren said 12.8 billion yuan (US$2 billion) will be spent to help the development of smaller firms. Structural tax reform, he said, will also help that sector by replacing the sales tax with a value-added tax to avoid duplicate taxation that often hurts small business.

"A large amount of special funding will be allocated to support technical upgrading for small companies," Xie said.

Outright government subsidies without preconditions can be disruptive to the market if they are seen to favor one group over another. There are other innovative ideas around for encouraging small business development without just pumping in cash.

The Yangpu District government has been holding quarterly showcase events in the past two years, bringing together quality start-up innovation firms with private equity investors. The most recent one was held in conjunction with the National Science Park at the University of Shanghai for Science and Technology and the California-based Silicon Valley Bank. The events aim to help small businesses with problems they encounter as they seek growth funding.

"Quite a lot of small businesses don't know how to market themselves," said Lilly Huang, head of entrepreneur services at Silicon Valley Bank. "They have good projects, but the way in which they present them is not good enough."

Silicon Valley Bank has kept a consistent and exclusive focus on providing banking services for the innovation sector for nearly three decades. It has a track record successfully funding companies like Google and Facebook, and it also has strong ties with venture capital and private equity firms, Huang said.

Filling vacuum

The National Science Park is trying to fill a vacuum. Wang Huibo, general manager at the park, told me that the park can do more than simply provide low-rent office space for small firms. "We have many roles to play," Wang said.

For example, he said, the park could be a partner of private equity companies by providing reliable information on small companies needing help.

"Some private equity firms are fearful that business performance and financial reports they receive will be deceitful," he said. "We can be an objective third party to evaluate a company, providing critical data down to even power consumption," Wang said.

The whole process of help for small businesses needs a solid framework, with involvement from the government, entrepreneurs and investment vehicles. Although some positive signs have occured, there's a long road ahead.