In Depth: China’s PE Investors Left Empty-Handed as Cash-Strapped Startups Flout Compensation Deals

Private equity (PE) and venture capital (VC) investors in China are encountering significant obstacles to reclaiming their capital due to a downturn in the IPO market, compounded by companies reneging on compensation deals [para. 1]. Courts in China enforce agreements where companies must buy back shares and pay interest if they fail to list on time. However, business owners are often unable to fulfill these financial obligations, leaving PE/VC investors at a loss [para. 2]. Industry insiders estimate fewer than one in five companies can meet their buyback commitments after losing such lawsuits [para. 3].

Zhang Wei, an associate professor at Singapore Management University, questions the logic behind forcing struggling founders to compensate investors, especially when their companies experience growth [para. 5]. Shanghai-based law firm Lifeng Partners supported this observation, revealing that while courts favor investors in over 82% of buyback disputes, only 4.62% lead to investors getting their money back fully [para. 6].

Shenzhen Capital Group Co. Ltd. (SCGC), a prominent VC backed by local government, has issued numerous litigation-related tender announcements, with the majority involving buybacks [para. 7]. This indicates that other VC institutions may face even more challenges in exiting investments [para. 8]. Buyback problems primarily arise when portfolio companies miss IPO deadlines set in their bet-on agreements [para. 9]. Such agreements are widespread, with estimates suggesting they exist in 90% of PE/VC deals in China [para. 10].

Lifeng Partners' report estimates a challenging exit environment for around 130,000 investment projects involving 14,000 companies. Most companies will struggle to IPO on time, forcing investors to demand share buybacks [para. 12]. SCGC, having invested 109.2 billion yuan in 1,825 projects by July, exemplifies these struggles. For instance, one startup failed to list on time and only made partial payments on a substantial buyback obligation, showcasing the ongoing challenges [para. 13][para. 14].

Many PE/VC investors pursue legal actions because they are accountable to their limited partners. When one investor demands a buyback, others often follow to avoid being left with unsellable shares, which can lead to company collapses [para. 15][para. 16]. Traditionally, IPOs have been the favored exit strategy for Chinese startups due to high returns, but the IPO market has cooled significantly [para. 18].

In 2023, mainland IPOs fell by 30%, and the total raised dropped by 40%, according to KPMG China data. Listings in the U.S. by Chinese companies showed minor recovery but still paled in comparison to previous years [para. 21]. In early 2024, Chinese companies continued facing harsh IPO conditions, raising substantially less capital compared to previous years [para. 22]. Deloitte projected mainland listings in 2024 to raise significantly less capital than before [para. 24].

Supporters argue bet-on agreements incentivize company performance, though critics believe these contracts add undue pressure and can become risk-avoidance tools for investors [para. 28]. The legal landscape has toughened, making bet-on agreements less of a flexible arrangement and more a means for desperate investors to secure exits [para. 33]. Courts have recognized the potential negative impact of rigid bet-on agreements on startup growth and societal enthusiasm for entrepreneurship [para. 34].

Despite the lack of statutory provisions on buybacks or bet-on agreements in China’s revised Company Law, some legal experts advocate for judicial interpretations to address these issues [para. 37]. Entrepreneurs are also seeking to mitigate their exposure by including protective clauses in bet-on agreements, limiting their personal liabilities in cases of unsuccessful IPOs [para. 39].

In summary, China's PE/VC industry faces complex challenges, from enforcing buyback agreements to navigating a sluggish IPO market. These issues underscore the need for both regulatory reassessment and strategic adaptation by investors and startups alike.