The decision to fulfill or not fulfill share buyback obligations has become a dilemma in the equity investment market.

Recently, the Shanghai Lifeng Law Firm released the "VC/PE Fund Buyback and Exit Analysis Report," which shows that in the IPO projects accepted by the Shanghai and Shenzhen stock exchanges in 2023, about 65% of companies have set buyback rights clauses in their agreements.

Due to the increased difficulty of capital market IPOs, the decline in financing functions, the underdevelopment of the existing equity transaction market, and the lag in the development of S funds in recent years, coupled with the expiration of an increasing number of funds, the enterprises that fail to go public on schedule trigger the buyback right clauses agreed upon with investment institutions, leading entrepreneurs and investment institutions to face the choice of whether to activate the buyback agreement. Data from the Mother Fund Weekly shows that in 2017, a total of 3,500 RMB funds were established in China's primary market, with a total fundraising amount of 1.67 trillion yuan. Currently, funds established in 2016-2017 are expiring one after another. If about 65% have buyback agreements, the scale of funds that may touch the buyback agreement is not small; data shows that about 130,000 projects are facing exit pressure one after another, involving about 14,000 companies.

The fulfillment of buyback clauses is currently facing a dilemma, mainly manifested in: first, the dilemma of investment institutions. Under the general lack of repurchase ability of invested enterprises and entrepreneurs, the initiation of buybacks by investment institutions may not be able to recover losses, but may instead trigger the risk of loss provision for the assets they invest in. However, not initiating buybacks faces the extreme pressure of fund expiration and LP investors demanding redemption of funds.

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Second, the dilemma of entrepreneurial companies and entrepreneurs. Entrepreneurs and entrepreneurial companies with the ability, if they do not fulfill the buyback agreement, will constitute a de facto breach of contract and face lawsuits from investment institutions. If they fulfill the agreement, it will at best affect the normal business activities of the company, and at worst lead to the liquidation of the company and the entrepreneur.

In fact, similar buyback crisis issues have existed in the equity investment market for many years. Strictly speaking, this issue began to emerge when the new regulations on asset management were introduced. Since the duration of a fund is generally "5+2" years, many funds began to enter the fund exit period before the epidemic, but the epidemic delayed the exposure of risks. During this period, the industry has explored many methods: first, exploring S funds, a type of conversion fund, to take over the assets of funds entering the exit liquidation period; second, actively seeking mergers and acquisitions, even significantly reducing valuations to increase the possibility of being acquired; third, adjusting the listing board, or choosing to list in Hong Kong to alleviate the redemption pressure of fund investors, while also temporarily avoiding triggering buyback clauses, etc. However, due to the poor liquidity and low valuation levels of the Hong Kong market, investment institutions find it difficult to obtain ideal returns.

So, what are the reasons for the dilemma faced by investment institutions and entrepreneurial companies? The direct reasons are:

First, the difficulty of domestic IPOs has increased, the capital market is not active, the financing function has declined, and a large number of entrepreneurial companies find it difficult to raise funds through IPOs, providing an exit channel for investment institutions.

Second, as the economy faces pressure from demand contraction, supply shocks, and weak expectations, as well as insufficient effective demand, the marginal return on investment has decreased. In the field of technology entrepreneurship, platform companies such as Alibaba, Baidu, and Tencent have contracted and streamlined their investment businesses. The channels that once aimed to be acquired by large companies like BAT as an exit target have almost disappeared, leading many entrepreneurial companies and investment funds to lose their direction and ability to exit and cash out. From 2014 to before the epidemic, nearly half of the so-called unicorn companies were targeting BAT rounds.The deep-seated causes of the repurchase crisis and the dilemma of exit are rooted in the entrepreneurial and innovation wave that surged around 2014, leading to a "big push and quick progress" in the private equity (PE) and venture capital (VC) market. The race to lay out tracks and grab projects continuously pushed the valuation levels of the primary market to new heights. At the same time, equity investment has long exhibited characteristics of debt investment, locking in and even shifting risks through mechanisms such as repurchase rights clauses.

This is primarily manifested in the following ways: First, since 2014, under the backdrop of mass entrepreneurship and innovation, PE and VC have ushered in a springtime of development. The trend of import substitution and cross-industry innovation has been rampant, with a flood of capital pouring into the PE and VC markets. The equity market is filled with a large amount of "easy money," exacerbating the extensive operation in this field. Many investment institutions flock to invest, and project selection is not mainly based on the growth and profitability of the project itself, but rather on whether it can enter the next round of high valuation financing. This has led to a situation where many PE and VC firms base their investment decisions on the valuations of the primary equity market, resulting in a drum-beat valuation bubble in the primary market for many enterprises.

Second, domestic PE and VC have long relied on the credit endorsement and credit enhancement guarantee models of indirect financing in their investment thinking and risk management philosophy.

However, from the perspective of risk management and risk mitigation strategies, start-up companies and entrepreneurs do not possess effective risk-bearing capabilities, nor do they have higher or more professional risk control abilities than investment institutions. Relying on entrepreneurs and start-up companies as the final safety cushion for the success or failure of investment projects is clearly a misplacement of trust in risk mitigation strategy arrangements.

To truly break this deadlock effectively, firstly, it is necessary to improve the investment environment, enhance the stability and predictability of policies at certain stages, increase the predictability of listings, and reduce the difficulty of risk pricing for investment institutions.

Secondly, it is urgent to perfect and strengthen the equity trading market, allowing PE, VC, and others to optimize their investment asset structure through equity market transactions when the IPO exit channel is not smooth due to external factors. This will reduce the risk exposure of their held risky assets and enhance the risk control capabilities of investment institutions.

Thirdly, investment institutions such as PE and VC need to abandon the extensive approach of pursuing price difference bubble transactions, continuously improve their core capabilities in professional investment and risk identification, and truly rely on the value creation ability of the investment projects themselves for investment returns. At the same time, investment institutions must move away from the price difference transaction model, focusing on how to help invested companies improve quality, efficiency, and potential, in order to maximize the return capabilities of the invested companies. After all, over-reliance on the repurchase model for risk control is destined to backfire on a large number of investment institutions, which is nothing less than another form of market clearance.

Without the drill, do not undertake the china work. Despite the many challenges of the external environment, professionalism remains the greatest treasure for financial institutions to compete in the market and is also the safe haven to navigate through risks and crises. Strengthening investment professional capabilities and allowing venture capital to return to its original intention will truly make the repurchase crisis a growth rite for China's equity investment market to break free from difficulties.