Caixin Weekly | Wave of Litigation Exits in the Primary Market (AI Translation)

财新周刊｜一级市场“起诉退出”潮

Seven or eight years ago, during China's private equity market boom, buyback agreements between investment and financing parties flourished. These agreements, often seen as "time bombs," are now leading to a surge of “litigation exits” in the primary market. Since early 2023 alone, Shenzhen Capital Group Co., Ltd. (SCGC) has issued 41 litigation-related bids, primarily involving buyback compensation due to investees failing to meet their IPO commitments. Despite widespread market discussions, this information has now been hidden. [para. 1][para. 2]

Buyback agreements, or valuation adjustment mechanisms (VAM), exist to mitigate future uncertainties of a company. For investors, these agreements reduce valuation discrepancies; for startups, they facilitate financing by signaling confidence. However, these agreements have morphed from risk control measures into debt-like instruments, essentially requiring startups to guarantee returns. This has made private equity investments resemble risk-free fixed-income products, burdening startups with the brunt of the risk. [para. 3][para. 4][para. 5]

High repurchase obligations have forced numerous businesses into ruin and left founders liable, often even personally. A concerning 90% of projects in China include buyback rights but less than 20% manage to fulfill these obligations if disputes advance to legal action. This has made some General Partners (GPs) go to court mainly to pacify Limited Partners (LPs). However, this approach pressures invested companies, diverting them from business operations and innovation. [para. 6][para. 7][para. 10]

Between tightened IPO processes and the current economic environment, the primary market has cooled significantly. The "8·27 New Policy" by China Securities Regulatory Commission (CSRC) nearly halted IPOs, making it difficult for companies aiming to go public. IPOs worldwide by Chinese companies dropped by 56.31% year-over-year in the first half of 2024. The Hong Kong stock market, often the secondary destination for Chinese companies, also saw its lowest IPO financing since 2003. [para. 14][para. 15][para. 18][para. 19][para. 26]

Historically, buyback agreements like these were absent in Silicon Valley, where the redemption clause was used sparingly and often with a longer obligation period. In China, these mechanisms have evolved and abuse is rampant. Notably, buyback provisions are now present in about 90% of China's private equity projects. Many investors now prioritize securing buyback rights over due diligence on the companies, creating a risky investment climate. [para. 28][para. 29][para. 30][para. 31]

Founders, who cannot guarantee their company’s future, risk their personal and family wealth due to these binding agreements. Historical instances like Pegasus Media’s disputed buyback, where liabilities extended to a founder’s widow after his death, illustrate the severe personal consequences. Industry insiders believe that personal liability clauses seen in domestic agreements are not standard practice overseas, highlighting the unique stringency of Chinese agreements. [para. 60][para. 61][para. 63]

Efforts are underway to redesign frameworks to mitigate these pitfalls. Suggestions include extending the lock-up period for state-owned LPs' investments to alleviate the immediate pressure on GPs. However, practical implementation faces resistance, and state intervention may be challenging due to varying stances among LPs. [para. 69][para. 71][para. 72][para. 73]

In summary, the buyback mechanisms in China’s equity investment market reveal critical flaws. Widespread reliance on these agreements creates a detrimental impact, leading to numerous lawsuits and financial strain on startups. Structural reforms and coordinated efforts are necessary to align the industry's expectations and operations with a healthier economic environment. [para. 76][para. 77][para. 78][para. 79]