To a certain extent, the idea of setting up a policy-based continuation S fund is similar to the idea of establishing an AMC and an AIC to deal with the non-performing assets of banks.
With a large number of early government guidance funds into the exit period, it is difficult to meet the exit needs of government guidance funds by relying solely on IPO exit, and state-owned S funds have begun to be set up in various places, which will alleviate the dilemma of private equity funds withdrawing from the "dammed lake" to a certain extentThe establishment of such funds is more to assist in the continuation of their own fund shares or to assist in the withdrawal of regional state-owned assets.
The idea of setting up an S fund with this as a starting point is similar to the idea of setting up an AMC and an AIC to deal with the non-performing assets of banks. Looking back at the historical background of the establishment of AMC and AIC, we can obtain certain ideas and references for the batch withdrawal of local government guidance funds in the future.
01
Guiding the fund to withdraw from the dammed lake
According to the monthly report of the Asset Management Association of China (AMAC), as of the end of October 2023, the total scale of existing private equity and venture capital funds reached 14.31 trillion yuan. As of the end of 2022, the principal amount of private equity and venture capital funds that have been updated quarterly, completed the operation monitoring form and are in operation has withdrawn 2.2 trillion yuan. Compared with the total scale of 10 trillion plus huge industry assets, although the overall scale of the exit end shows a growth trend, it is still insufficient.
As of 2023, the mainland has set up a total of 1,557 government guidance funds, with a subscription scale of about 3 trillion yuan. And a large number of government guidance funds set up between 2015 and 2022 have expired. But the reality is that the vast majority of GPs are overly reliant on IPOs for exits, with more than half of the assets in the exit period. But this does not cover the needs of the guidance fund, and the exit is imminent.
In China, more than 70% of the projects of venture capital and growth funds are withdrawn mainly through IPOs, and the development of M&A funds and S funds is relatively lagging behind. In the relatively mature U.S. market, the top three exit paths for PE funds are: M&A exit (52%), PE secondary market takeover (i.e., S fund, 43%), and IPO (5%).
02
Deduction of expiration situation
If the equity investment fund cannot be successfully withdrawn after expiration, it usually can only face two options, namely, fund extension and compulsory liquidation of the fund, which may lead to VAM repurchase and enterprise bankruptcy, which may have a destructive effect on the development of the equity investment industry and the construction of a scientific and technological innovation system.
In addition, it is impossible for equity investment funds to be extended for a long time, and the compulsory liquidation of the fund is the final outcome. Although between extension and compulsory liquidation, extension is more favored by LPs, but the fund manager is required to convene a meeting of all partners in accordance with the contract to vote on whether to extend.
From the perspective of income, LPs know that the remaining assets of the fund have the possibility of successful listing, and from the perspective of income, it is the best choice to extend.
From the perspective of LP structure, most of the current LPs are dominated by state-owned funds, and since the state-owned LPs only clarified the duration of the fund in the early capital contribution decision-making meeting, and will not raise the issue of the extension period, therefore, in order to avoid the responsibility of voting in favor of the extension, the state-owned LPs tend to abstain from voting even though they hope for the extension, hoping that the market-oriented LP will vote in favor to reach the proportion agreed in the contract and pass the resolution, such as 67%. However, at present, the proportion of state-owned LPs generally exceeds 30%, and in many cases, it is difficult to pass the extension resolution by relying on market-based LP voting alone. If the postponement resolution is not passed and no liquidation is carried out, the market supervision and administration departments such as industry and commerce may put the fund on the abnormal list, and the industry and commerce and AMAC can only force the fund manager to liquidate the fund compulsorily.
So, in the case of the tightening of the IPO and the expiration of the fund, can the remaining assets of the guidance fund only take the road of liquidation?
At this time, the S fund came into view of the decision-makers.
03
S Fund solves the possibility of withdrawing from the dammed lake
With the vigorous development of S funds, policy dividends have been gradually released, and the policy foundation has become more and more perfect. At the same time, more attention has been paid to the supervision and compliance of the private equity secondary market, encouraging the development of venture capital and equity investment, smoothing the exit channels of private equity investment, and optimizing the functions of industrial investment funds.
Recently, a number of policies to support the development of S funds have been introduced:
In June 2024, the General Office of the State Council issued the "17 Venture Capital Measures", proposing 17 specific measures around the entire chain of investment, management and withdrawal to comprehensively optimize the policy environment.
For the exit, the "17 Articles" put forward in order to smooth the exit of venture capital, on the one hand, give full play to the main board of the Shanghai and Shenzhen Stock Exchanges, the Science and Technology Innovation Board, the Growth Enterprise Market and the Beijing Stock Exchange, the regional equity market and its "specialized, special and new" special board functions, and broaden the exit channels for mergers and acquisitions. On the other hand, at the same time, we will implement the management system for the filing of overseas listings, and smooth the exit channels for foreign currency venture capital funds.
In addition, it is worth noting that the exit policy of venture capital funds will be optimized, including accelerating the resolution of the equity exit of enterprises investing in banking and insurance asset management products; Support the development of M&A funds and venture capital secondary market funds, and optimize the business process and pricing mechanism for the transfer of private equity funds.
In May 2024, the "Several Measures for Further Promoting the Transfer and Transformation of Scientific and Technological Achievements in Guangzhou" was officially issued. Article 10 of the policy mentions: strengthen the financial empowerment of the transformation of scientific and technological achievements. Support the early investment in scientific and technological achievements and withdraw through multiple channels, set up a Guangzhou M&A and restructuring parent fund, promote the development of S fund, and smooth the virtuous cycle of "industrial investment, mergers and acquisitions, empowerment and cultivation, spin-off and listing".
In May 2024, seven departments, including the Office of the Financial Commission of the Jiangsu Provincial Committee of the Communist Party of China, jointly issued the "Opinions on Supporting the Development of Private Equity and Venture Capital Share Transfer Business in the Regional Equity Market of Jiangsu Province", which provides new opportunities for the development of Jiangsu S Fund. The "Opinions" make it clear that: support the establishment of professional private equity secondary market funds in Jiangsu; Encourage all regions to give policy incentives to newly established S funds registered in their jurisdictions and filed with the Asset Management Association of China;
On April 30, 2024, the Political Bureau of the Central Committee of the Communist Party of China held a meeting, mentioning the need to actively develop venture capital and cultivate and expand patient capital. As a fund focusing on the private equity secondary market, S Fund is an important participant in "patient capital".
On January 24, 2024, the China Securities Regulatory Commission (CSRC) approved the regional equity market in Anhui Province to carry out a pilot project for the transfer of equity investment and venture capital fund shares.
In January 2024, Shanghai issued the "Several Measures to Further Promote the High-quality Development of Shanghai's Equity Investment Industry", which pointed out that various entities will be supported to initiate the establishment of S funds in Shanghai, and the equity investment agglomeration area will establish a green channel for the new establishment (relocation) of S funds, and provide supporting policy support for the landing and operation of S funds;
On September 26, 2023, the pilot project for the transfer of shares of equity investment and venture capital funds in Guangdong was officially launched; On August 22, the China Securities Regulatory Commission officially approved the launch of a pilot project for the transfer of equity investment and venture capital shares in the Jiangsu regional equity market;
In July 2023, the promulgation of the Regulations on the Supervision and Administration of Private Investment Funds filled the gap in the upper-level law of the private investment fund industry, and the new problems faced by the domestic S market will be based on evidence.
From a policy point of view, the decision-makers do intend to promote the S fund to solve the problem of guiding funds to withdraw from the dammed lake, and as a way to solve the problem of private equity fund exit, the S fund provides a potential solution to the problem of guiding funds to withdraw from the dammed lake. However, in practice, S funds face some difficulties:
- Information asymmetry: There is information asymmetry between buyers and sellers in S fund transactions, which directly affects the valuation and pricing of the transaction. The buyer needs to have a good understanding of the underlying asset, while the seller may be reluctant to fully disclose the information for a variety of reasons.
- Lack of unified valuation standards: The valuation of the underlying assets is a complex process in S fund transactions, and the current lack of unified valuation standards and processes in the market leads to large differences between buyers and sellers in pricing.
- Complex transaction process: S fund transactions involve complex legal, tax and structural design issues, which increases the difficulty and cost of the transaction.
- Lack of professional team: S fund investment requires a professional team to conduct asset evaluation, transaction structure design and post-investment management, etc., and there is a relative shortage of professionals in the field of S funds in China.
- Policy and regulatory support: The development of the S fund market needs corresponding policy and regulatory support, including preferential tax policies and the clarification of trading rules, etc., which need to be further improved.
- Exit channel dependence: The exit of domestic private equity funds is overly dependent on IPOs and mergers and acquisitions, while the exit of S funds also needs to consider a variety of channels, including but not limited to IPOs, mergers and acquisitions, share transfers, etc.
- Special considerations for state-backed funds: Funds with state-owned backgrounds need to consider compliance issues in S transactions, as well as the complexity of the pricing and approval process, which make it difficult for S funds to operate.
Solving these problems is not achieved overnight, and it requires long-term market cultivation, improvement of laws and regulations and other infrastructure to achieve the purpose of guiding the withdrawal of the dammed lake through the S fund.
All in all, it is unlikely that the exit problem of the guidance fund will be solved through the market-oriented S fund, but the solution to the problem may be implied by the continuation of the S fund.
04
Continuation of S Fund
The GP of the surviving fund or its affiliates shall establish a new S fund, i.e., a successor fund, which will be used to acquire all or part of the underlying assets of the surviving fund or to acquire shares of the surviving fund. The GP and Fund S (the buyer) jointly set up a new fund (i.e., the successor fund) to acquire all the underlying assets of the GP's existing fund, and the original LP can choose to exit the fund or transfer the equity into the new successor fund through this transaction. For fund managers, the continuation fund breaks the limit of the fund term, continues the manager's management of the underlying project, and is also an important way for the manager to strengthen its dominant position in the segment with a long cycle.
Through the transaction transfer model, we know that the successor S fund can take over the original shares of the existing fund, and if the LP and GP of the successor S fund are the same as the existing fund, it is equivalent to extending the term of the existing fund in disguise. If the final transaction price is priced according to the cost price or quasi-fixed income price, the transaction of this kind of fund shares is more policy-oriented than market-oriented.
Is there a similar precedent for this kind of policy deal in China's economic development?
The answer is yes, AMC and AIC.
05
Historical background of AMC and AIC
1. AMC, a major asset management company
In the 90s of the 20th century, driven by the reform and opening up and the promotion of market-oriented economic reform, China's economy ushered in rapid development, however, the loan scale of the four major banks of Bank of China, Agricultural Bank of China, Industrial and Commercial Bank of China, and China Construction Bank increased sharply, but its asset quality was not good. To this end, the four major AMCs were "ordered to solve the problem of non-performing assets of the four major banks".
Due to complex reasons such as the transformation of the economic system, the lag of state-owned enterprises in reforming the external environment, the lack of domestic demand, and the Asian financial crisis, around 1997, the efficiency of the mainland's state-owned enterprises first plummeted, and then they lost money as a whole, which became an important factor plaguing the mainland's national economic development. Due to the special relationship between state-owned enterprises and state-owned banks, the risks of state-owned enterprises will inevitably be transferred to the banks, which will be reflected in the balance sheets of banks, which is the spread of the "bad debt economy."
After the outbreak of the Asian financial crisis in 1997, the whole society realized the devastating impact of systemic financial risks, and in 1999 China accelerated the progress of negotiations to join the World Trade Organization (WTO), and at the same time, after joining the WTO, the domestic banking industry will face challenges and competition from foreign banks, and it is unknown whether the four major banks, which are burdened with a large number of non-performing assets, can withstand it.
In order to solve the "gray rhinoceros" of non-performing assets of state-owned banks as soon as possible, maintain the steady operation of the economy, and let the four major banks travel lightly. In 1999, the Financial Asset Management Corporation (FAMC) came into being and undertook the historic mission of disposing of the non-performing assets of state-owned banks. Four state-owned AMCs, Cinda, Dongfang, Great Wall and Huarong, have been established one after another, with a duration of 10 years, and the policy of receiving 1.4 trillion yuan of policy-related non-performing loans divested by the four major state-owned commercial banks and the China Development Bank.
At this stage, the source of funds for the acquisition of non-performing assets is the central bank and the commercial banks themselves, and the asset companies are acquired at the original book value of the bank's assets, and the losses from the disposal of non-performing assets are actually borne by the AMC and the treasury.
At this stage, the four AMCs mainly recovered funds through debt collection and collateral sales, but the disposal results were not satisfactory. Since the AMC industry is still in the exploratory stage, the regulatory and incentive system has not yet taken shape, and the task period is only 10 years, there are many problems in the disposal process, such as false auctions, related party transactions, arbitrary evaluations, and administrative interventions, resulting in the loss of a large number of state-owned assets.
In order to cooperate with the restructuring and listing of large state-owned industries such as Bank of China, China Construction Bank and Industrial and Commercial Bank of China, the four major AMCs once again carried out large-scale divestment of non-performing loans of commercial banks. After March 2004, the four financial AMCs began to try to transform into commercial market-oriented acquisitions, and gradually acquired non-performing assets from financial institutions other than the four major banks. In 2004, Cinda acquired the wholesaler qualification of 278.7 billion yuan of doubtful non-performing assets of Bank of China and China Construction Bank at a price of 50% of the book value. Unlike in the past, AMC's divestiture of non-performing loans of state-owned banks was not acquired at a 1:1 price, but adopted a commercial discount acquisition model, so the divestiture was positioned as a "commercial divestiture", and the transformation of the four major AMCs to commercialization was "initially eyebrow-up".
From 2004 to 2005, CCB divested 56.9 billion yuan of loss-related non-performing assets from Cinda; Bank of Communications divested 65 billion yuan of doubtful non-performing loans to Cinda; ICBC divided 450 billion yuan of doubtful loans into 35 asset packages and sold them to the four major AMCs on a package-by-package basis, while ICBC also entrusted 246 billion yuan of loss loans to Huarong for disposal.
In 2006, the relevant departments issued a document to further clarify the basic principles, conditions and directions for the transformation of AMC into a modern financial services industry. Since then, asset management companies have begun a market-oriented transformation, and the target of acquisition has also expanded from bank non-performing assets to non-bank financial institutions.
2. Local AMC
Similar to the background of the establishment of national AMCs, local financial institutions in China were also facing serious asset quality problems at that time, and the first batch of local AMCs were born around 2000 in order to resolve financial risks in their jurisdictions.
In 2012, the regulator issued a notice allowing the provincial people's government to set up a local AMC, which can participate in the batch transfer of non-performing assets within the province after filing and approval by the CBRC, ushering in a round of expansion of local AMCs.
3. AIC, a financial asset investment company
The Financial Assets Investment Corporation (AIC) was established against the backdrop of a new round of market-oriented debt-to-equity swaps. In December 2015, "deleveraging", as one of the five major tasks of "three removals, one reduction and one supplement", was proposed for the first time at the Central Economic Work Conference. In October 2016, the State Council officially issued the Opinions of the State Council on Actively and Prudently Reducing the Leverage Ratio of Enterprises and the Guiding Opinions on Market-oriented Bank Debt-to-Equity Swaps, officially launching the market-oriented debt-to-equity swap.
Compared with the disposal of existing non-performing loans through collection, restructuring, write-off, transfer, etc., market-oriented debt-to-equity swaps can alleviate the liquidity pressure and potential risks of enterprises through leverage reduction in a more timely manner, and at the same time enhance the medium- and long-term development resilience and competitiveness of the invested enterprises, which is conducive to economic transformation and upgrading and the optimization of the country's industrial layout, which is not only conducive to reflecting the in-depth service of finance to the real economy, improving the efficiency of social resource utilization, but also conducive to the forward-looking and proactive management of non-performing loans by commercial banks.
However, under the original market structure dominated by financial AMCs and banking supervision rules, the advance and retreat of market-oriented debt-to-equity swaps will face the problem of low willingness of commercial banks to participate.
On the one hand, if commercial banks independently carry out debt-to-equity swaps, which means that loan assets are converted into equity assets, the scale of banks' risk assets will increase significantly under the regulatory framework of capital adequacy ratio, resulting in a greater loss of capital.
On the other hand, if a market-oriented debt-to-equity swap is carried out with a financial AMC, although the debt can be off-balance sheet and the loss of bank capital can be reduced, it is difficult for the bank and the financial AMC to reach an agreement on the transfer value, which will affect the efficiency of the market-oriented debt-to-equity swap.
Against this background, it has become a core part of the market-oriented debt-to-equity swap work to allow commercial banks to set up subsidiaries (i.e., financial AICs) that specialize in market-oriented debt-to-equity swap business and internalize the comprehensive income of debt-to-equity swaps, so as to remove obstacles for commercial banks to participate in debt-to-equity swaps on a larger scale.
In 2017, the former China Banking Regulatory Commission (CBRC) issued the Administrative Measures for the Implementation of Debt-to-Equity Swaps by Commercial Banks (for Trial Implementation) (Draft for Comments) to encourage state-owned commercial banks to set up financial investment companies (AICs) to undertake market-oriented debt-to-equity swaps. Subsequently, CCB established its first AIC, CCB Financial Assets Investment Co., Ltd., in Beijing. In June 2018, the China Banking and Insurance Regulatory Commission (CBIRC) promulgated and implemented the Measures for the Administration of Financial Asset Investment Companies (for Trial Implementation). In May 2019, the executive meeting of the State Council decided to further promote market-oriented and law-based debt-to-equity swaps, support financial asset investment companies to initiate the establishment of asset management products, and allow investment in insurance funds and pensions. In April 2020, the China Banking and Insurance Regulatory Commission (CBIRC) further issued and implemented the Notice on Relevant Matters Concerning the Asset Management Business Carried out by Financial Asset Investment Companies, clarifying that financial asset investment companies can carry out asset management business through the issuance of debt-to-equity swap investment plans, providing important policy measures to further promote market-oriented and law-based debt-to-equity swaps.
In addition, in line with the national financial development strategy, relevant departments are also actively exploring the expansion of the business scope of financial AIC. In February 2020, the People's Bank of China and other departments issued the "Opinions on Further Accelerating the Construction of Shanghai International Financial Center and Financial Support for the Integrated Development of the Yangtze River Delta", which proposed to support qualified commercial banks to set up financial asset investment companies in Shanghai in accordance with the principle of commercial voluntariness, pilot qualified financial asset investment companies to set up professional investment subsidiaries in Shanghai, and participate in the construction of the Lingang New Area and the economic restructuring, industrial optimization and upgrading and coordinated development of the Yangtze River Delta. Equity investment, direct investment and other businesses have greatly expanded the business scope and development space of financial AIC.
From the development process of AMC to AIC, it can be seen that there is a certain tendency of "packaging and batch processing" in China for the treatment of large batches of state-owned assets.
So, can mature equity fund assets be treated as non-performing credit assets?
As can be seen from the comparison table, the maturity share of the guidance fund cannot be completely equated with non-performing credit assets. But the two also have a lot in common, making it possible to centralize processing.
The four major AMCs and AICs correspond to the non-performing assets of state-owned banks, and the local AMCs correspond to the non-performing credit assets of local governments. The local government guidance fund is also established in response to the local government. Therefore, it is also more reasonable to set up an institution similar to a local AMC to centralize the handling of the remaining assets at maturity of the guidance fund. The Continuation S Fund is a ready-made legal and compliant financial product, which does not need to formulate laws, regulations and regulatory measures from scratch, and only needs to be slightly modified and improved according to the actual situation.
Historically, credit non-performing assets and maturing fund shares have required a professional team to manage and operate. At present, the ability of most local state-owned equity investment platforms is more concentrated in the link of "investment", and the ability of "management" and "withdrawal" is a shortcoming. Therefore, the use of the Continuation S Fund to concentrate on the maturity of the guidance fund is not only a temporary solution to the maturity problem, but also a good opportunity for the local government to cultivate an equity operation processing team.
To sum up, policy-based continuation S funds are more inclined to alternative 'transfer of state-owned assets' and the integration of state-owned assets. At present, there is no precedent for this kind of S fund, and the root cause is that most of the government guidance funds are still in a deferred state and are not facing liquidation problems. However, combined with the actual situation, it is not difficult to deduce that it is very likely that this kind of similar S funds will bloom everywhere in the future.