Lack of IPO Opportunities Intensifies Distortion in Equity Investment (AI Translation)

【周刊提前读】IPO无门加剧股权投资异化 “起诉退出”让谁尴尬？

Over the past seven or eight years, China's private equity (PE) market has expanded aggressively, resulting in buyback agreements that are now causing significant issues in the form of "litigation exits" [para. 1]. These agreements often contain valuation adjustment mechanisms, including equity repurchase and monetary compensation, intended to mitigate risks for investors [para. 3][para. 4]. However, these earn-out clauses, initially meant to manage uncertainties, have evolved into tools for transforming high-risk equity investments into near-debt investments with principal protection [para. 5]. This has led to a large number of disputes, as more than 90% of investment projects include repurchase rights, yet only a fraction successfully fulfill the obligations when legal challenges arise [para. 8].

Since the start of 2023, Shenzhen Capital Group Co., Ltd. (SCGC) has issued 41 litigation-related tenders, with 35 pertaining to compensation claims for unfulfilled buybacks due to invested companies failing to go public as scheduled [para. 2]. This scenario reflects the dire exit situations for many institutions amid tighter IPO regulations by the China Securities Regulatory Commission (CSRC) since August 2023 [para. 14]. SCGC, having managed nearly 500 billion yuan in assets and invested in 1,822 projects, exemplifies the current struggles faced by PE firms in China [para. 13].

The number of initial public offerings (IPOs) has sharply declined, hitting a five-year low for both the number of IPOs and the amount of capital raised [para. 15]. As of July 31, 2024, 359 companies were under review for A-share IPOs, indicating a significant backlog [para. 16]. Even with alternate overseas listing destinations like the Hong Kong Stock Exchange, many companies face extended delays, averaging 201 days for filings [para. 17][para. 18].

Repurchase agreements are heavily scrutinized as they often impose severe obligations on company founders, sometimes even extending to joint liabilities for their families [para. 9][para. 20]. Many founders find themselves in precarious situations, compelled to agree to repurchase clauses under the pressure of needing immediate financing [para. 11][para. 21].

There have been efforts to mitigate the negative impacts of these agreements. For instance, some suggest that state-owned capital should lead by extending investment horizons and wagering periods to alleviate pressure on startups [para. 25]. However, the feasibility of mandating such changes remains questionable due to the complexities involved [para. 27].

There is a need for a re-evaluation of repurchase agreements given the changing market environment. Legal experts argue that the industry should enact new judicial interpretations to address the commercial needs resulting from bet-on agreements [para. 29]. Moreover, separating repurchase obligations from personal liabilities is increasingly recognized as a necessary evolution to foster a healthier investment environment [para. 28]. This separation aims to ensure that founders are not personally devastated by the failure of their businesses, maintaining their ability to innovate and contribute to the economy [para. 24].

Despite these complexities, the equity investment landscape in China remains fraught with risks of litigation and unmet financial obligations. The situation underscores the necessity for institutional reforms and pragmatic legal frameworks to restore a balanced, sustainable investment environment [para. 30].