In Depth: China IPO Slowdown Pits Startups Against Investors

17 Apr 2024

China’s depressed stock markets and a slowdown in IPO registration by regulators have sent a chill through the world of private equity (PE) and venture capital (VC) firms, whose funds have traditionally chosen listing as the most popular exit channel for their Chinese investments.

The market downturn has spelled trouble for many IPO hopefuls and created a rift between them and their PE/VC investors that is increasingly leading to arbitration or litigation when companies fail to follow an agreed timetable to go public and allow funds to exit.

When the promised IPO doesn’t happen, the two sides sometimes try to renegotiate their deal, but the PE/VC firm usually has the upper hand because of the nature of the original bet-on agreement (对赌协议), or valuation-adjustment mechanism. This has become a popular arrangement in China and gives investors the right to adjust the valuation of the portfolio company or to redeem their investment and receive a pre-agreed interest rate on the capital when the company’s performance doesn’t meet the conditions set out in the agreement. For Chinese PE/VC firms, the conditions usually include a deadline for an IPO.

“In the past, there were too many myths about getting rich through IPOs, with investment returns often amounting to dozens of, or even more than 100, times the original capital,” the head of investor relations at a PE firm in Beijing told Caixin. “Limited partners (LPs) only wanted to exit through IPOs and didn’t consider anything else,” he said, referring to investors in PE/VC funds. But in the current environment, LPs “are being realistic,” he said. “If an IPO is hopeless, then they opt for a buyback exit and could start by freezing the founder’s assets in court.”

Bet-on agreements help mitigate the risks and uncertainties that PE/VC investors face when they invest in a startup and incentivize company management to improve the performance of the business to help meet IPO requirements. But they also expose startups to a potential financial meltdown because most don’t have the resources to compensate investors by buying back their equity, leaving them with little alternative but to accept a large drop in the valuation of the company to compensate the PE/VC firms.

“Founders just don’t have that kind of money,” the investor relations head said. “Even if they are asked to buy back investors’ shares, they can’t afford it, so they would rather accept a lower valuation.”

Wanda wipe-out

The consequences of signing a bet-on agreement with an IPO deadline were laid bare in a high-profile deal involving an established company — Dalian Wanda Commercial Management Group Co. Ltd. (DWCM), a major subsidiary of Dalian Wanda Group Co. Ltd., the entertainment-to-property conglomerate headed by billionaire entrepreneur Wang Jianlin.

In 2021, DWCM signed an agreement with 16 investors to repay their 38 billion yuan ($5.9 billion) investment plus an 8% annual return should a subsidiary, Zhuhai Wanda Commercial Management Group Co. Ltd., fail to list in Hong Kong by the end of 2023.

On Dec. 12, 2023, as the deadline approached and Zhuhai Wanda still hadn’t completed its IPO, DWCM announced that it had reached a new agreement with the investors, who would re-invest in Zhuhai Wanda after receiving their repayments.

The new deal lowered Zhuhai Wanda’s valuation by almost 40%, and forced DWCM to transfer some of its stake in the company to investors, sources with knowledge of the matter told Caixin. Despite the loss, the new agreement was a relief for the group, which was struggling with liquidity problems amid the property market slump.

However, for the vast majority of companies with PE/VC investment who plan to go public, following Zhuhai Wanda’s example could be tough because they don’t want to swallow such a significant cut in their valuation.

IPO slump

Traditionally, IPOs have been the main channel for PE/VC funds in China to realize their investment. A report by consultancy Deloitte published in January 2023 found that among the investments exited by VC and growth funds in China, more than 90% were via IPOs. In contrast, in the more mature U.S. market, only 5% of the projects exited by PE funds used this channel, with the majority, 52%, exiting through mergers or acquisitions, and 43% through a takeover by another investor, usually another PE fund.

“Back in the days when we were managing U.S. dollar funds, bet-on agreements that stipulated IPOs were rare, with most conditional on company performance,” a source who works for an investment firm that manages both U.S. dollar and yuan funds told Caixin. That was not only because exiting an investment through an overseas IPO was easier, but also because an IPO was neither the only nor the optimal channel for exit, he said.

But the market for IPOs overseas entered a deep freeze in 2021 amid a row between regulators in Washington and Beijing over access to the auditing work papers of Chinese companies listed in the U.S. Chinese authorities’ tightened scrutiny of overseas listings due to concerns over data security fueled the decline.

In 2022, the number of Chinese companies newly listed in the U.S. dropped 62% to just 16, and the combined amount of funds raised sank 96% to $540 million, according to Deloitte’s report. The number of companies that went public in Hong Kong that year fell 15% to 82, with the amount of money raised dropping 69% to HK$102 billion ($13 billion), it said.

The Chinese mainland IPO environment also cooled in 2023 as the stock market slumped and the China Securities Regulatory Commission (CSRC) suggested in August that it would limit the number of new listings as part of a package of measures to arrest the slide. The number of IPO registrations has slumped since then.

For the whole of 2023, the number of mainland IPOs and the total amount raised dropped 30% and 40%, respectively, according to data compiled by KPMG China. Listings in the U.S. by Chinese companies showed some signs of recovery in 2023 after almost grinding to a halt in July 2021, with 37 new IPOs raising $827 million, according to data compiled by Deloitte and published in December. But that amount of funds pales in comparison with 2020, when 35 Chinese companies raised $13.7 billion through U.S. IPOs, a December 2020 report by Deloitte shows.

That year, IPOs by Chinese companies in the investment portfolios of PE/VC firms made up just 54% of total exits, compared with 62% in 2022, according to data compiled by Zero2IPO Research, a Beijing-based service provider for the industry.

Bet-on agreements have become a prerequisite for many PE/VC investors, especially state-backed ones, lawyers at Zhong Lun Law Firm said in an article published in August.

And the terms have become increasingly stringent, with shorter timeframes for IPOs and higher interest rates on repayments from portfolio companies if they fail to list within the timeframe.

The annualized interest rates in bet-on agreements usually range from 8% to 10%, with some as high as 20%, industry insiders told Caixin. Buybacks are sometimes priced against the company’s valuation in the latest round of funding.

“Unless the project is excellent or the founder is particularly assertive in negotiations, many LPs insist on signing bet-on agreements, especially given that fundraising has become more challenging in recent years,” a source who works in an investment institution focusing on the consumer goods sector told Caixin, noting that this is especially true for local government-backed funds.

In earlier days, bet-on agreements were more like “gentlemen’s agreements” and weren’t usually enforced, the source whose firm manages both yuan and dollar funds said. That has changed because the industry is facing more difficulty, and investment firms desperately need to be able to show successful exits in order to raise new funds, he said.

Some investors used to talk about long-term investment and partnerships with portfolio companies, but as soon as it becomes likely the IPO deadline can’t be met, they immediately demand repayment, said a Beijing-based lawyer who specializes in solving transaction disputes.

Ticking time bombs

For many startups, bet-on agreements have turned into a ticking time bomb since the CSRC, China’s top securities regulator, vowed to slow the pace of IPOs to help prop up the slumping stock market.

Companies that signed bet-on agreements have found themselves in a dilemma where they can’t fulfill the IPO requirement on time but don’t have enough capital to buy back shares from their PE/VC investors.

Adding to entrepreneurs’ plight, bet-on agreements in China usually obligate both the company and its founding shareholders to pay for buybacks when IPO conditions can’t be met, according to a 2022 report by Han Kun Law Offices.

Many PE/VC firms are increasingly turning to litigation to exit their investments. Keyword searches on China Judgements Online, a database containing judgment documents from Chinese courts, show that in 2023 alone, there were hundreds of rulings containing the keywords “IPO,” “buyback” and “bet-on.” These rulings show that in most cases, investors win their claims for repayment.

In 2017, Smartisan Technology Co. Ltd. signed a bet-on agreement that stipulated that should the smartphone-maker fail to complete an IPO in five years, it would have to buy back its equity from investors and pay them interest. The agreement also stipulated that founder Luo Yonghao, who is also a media personality, had liability for repaying investors should the company be unable to.

After the IPO deadline was missed, Zheng Gang, the founder of one of Smartisan’s investors, Shanghai Purplesky Capital Co. Ltd., started a public spat with Luo in early 2023. Zheng claimed that Luo wanted to swap the repayment set out in the agreement for shares in Luo’s new venture without proper communcation, while Luo fired back that investors had the choice to accept or refuse the new plan.

In September, Zheng said he would initiate arbitration proceedings, screenshots of his social media post show.

Bet-on agreements have been abused in China, a source who used to work in the regulatory sector told Caixin. Many investors blindly bet on projects, and hope to either exit through an IPO and make a fortune, or use bet-on agreements as a form of hedging against investment risks, the source said. They aren’t conducive to the innovation and development of small and midsize companies, he added.

There are growing calls for clauses in bet-on agreements that contain IPO conditions to be scrapped. Bai Lituan, a senior partner with Shanghai-based DeBund Law Offices, put forward such a proposal in a recent article.

“Investment is inherently an act of sharing profits and bearing risks together,” he wrote. “Clauses that condition repayment on IPOs essentially get transformed into a form of risk-free fixed-income investment, which deviates from the essence of investing and should be considered invalid.”