Xiaolei Liu[1]
Overview
In recent years, U.S.-China trade disputes and stricter U.S. investment regulations have led to the withdrawal of many U.S. dollar funds from investments in China's high-tech sectors. As many Chinese high-tech enterprises have begun to face difficulties in listing on U.S. exchanges, Hong Kong and Singapore have become alternative venues for overseas listings.
Government funds are becoming an increasingly vital source of capital in the private equity market, but two core issues—local protectionism and insufficient risk tolerance—still persist.
Policy Recommendations for the Development of the Private Equity Market: Ensure stability of IPO review standards and reopen the listing channels under the Fifth Set of Standards for the STAR Market; revise the performance evaluation criteria for local governments and government funds, incorporating support for high-tech enterprises nationwide as a key metric; reduce retail investor participation in the stock market and promote closed-end funds; clearly differentiate between fraudulent activities and normal business or R&D risks, imposing stricter penalties on the former while showing leniency toward the latter.
I. Current Status of the Private Equity Market
In recent years, U.S.-China trade disputes and stricter U.S. investment regulations have led to the withdrawal of many U.S. dollar funds from investments in China's high-tech sectors. Among domestic private equity funds, the share of government-backed investments has steadily increased. According to data from Zero2IPO Research, in the first three quarters of 2023, state-owned institutions and industrial capital accounted for over 60% of the total subscribed capital. This proportion is even higher among larger funds. Meanwhile, private RMB funds are facing significant challenges in raising capital.
Historically, initial public offerings (IPOs) have been the primary exit strategy for private equity funds, with IPO exit rates exceeding 85% in 2010. However, in 2023, this rate dropped to 54% due to increasing difficulties in the IPO process, although it remains the most common exit route. In contrast, exits through mergers and acquisitions (M&A) have risen sharply, increasing from 11% in 2010 to 30% in 2023.
II. Challenges Facing the Private Equity Market
1. IPO Exit Obstacles and Decreased Investment Enthusiasm
Private equity investments often involve long investment cycles; the earlier and smaller the investment, the longer the duration. This long-term nature requires that the safety and feasibility of future exit options be foreseeable to investors in order for them to commit to an investment.
Affected by U.S.-China frictions, many Chinese high-tech enterprises are facing difficulties in listing on U.S. exchanges. As a result, Hong Kong and Singapore have become alternative venues for overseas listings. However, these markets lack the depth and diversity of U.S. stock exchanges. For instance, the Hong Kong market is largely dominated by banking and real estate stocks, and investors generally have less familiarity with high-tech stocks.
In China’s IPO market, listing review criteria change frequently, often tightening unexpectedly, which undermines investor confidence and discourages investment. Historically, the Chinese stock market has experienced significant tightening or even suspension of IPOs, sometimes for over a year. For example, to support the biopharmaceutical sector, China introduced the Fifth Set of Standards for the Shanghai Stock Exchange Science and Technology Innovation Board (the “STAR” market) in 2018, allowing unprofitable high-tech enterprises to go public. This regulation initially boosted private equity interest in biopharmaceuticals. However, in mid-2023, these rules were suspended, rendering many investment projects halted and leaving numerous biopharmaceutical companies in a fundraising crisis.
2. Lack of Market-Oriented Mechanisms for Government Funds
Government funds have become an increasingly vital source of capital in the private equity market, but they face two major issues. The first is local protectionism, where government funds require companies to relocate or establish production bases locally to receive investments. This practice restricts efficient resource allocation nationwide. For example, once a company secures investment from one local government, it often cannot obtain funding from other regions. Given the long investment cycles and significant capital needs of high-tech enterprises, relying on a single local government's funds is often insufficient. Additionally, frequent relocations resulting from local governments competing for promising projects can lead to redundant construction and wasted resources.
The second issue is low risk tolerance. Government funds tend to have low risk tolerance. Policies aimed at preventing the "loss of state assets" impose strict accountability, which, while mitigating risk, also limits the capacity of government funds to take on necessary investment risks. As a result, some state-backed private equity investments have adopted "debt-like" structures, which do not genuinely support high-tech enterprise growth.
3. Fundraising Difficulties for Market-Oriented Private Equity Funds
Private equity funds that are not affiliated with the government can invest across the country and optimize resource allocation. However, these funds have faced increasing fundraising challenges in recent years due to several factors. First, the exit obstacles mentioned earlier have made it difficult for private equity funds to attract investors. Second, private investors are increasingly concerned about policy stability. The recent regulatory changes in the education sector have not only directly affected private equity funds investing in that industry but also heightened concerns about potential regulatory uncertainty in other sectors—while some regulatory changes may be necessary, they should be implemented strategically to allow industries sufficient time to adapt. Additionally, poor stock market performance has reduced the number of profitable exits from the secondary market, further exacerbating the shortage of private equity funding.
III. Recommendations for Promoting the Development of the Private Equity Market
1. Ensure Stability of IPO Review Standards and Re-Open Listing Channels for High-Tech Enterprises
The Fifth Set of Listing Standards should be reinstated promptly to enable unprofitable high-tech enterprises, especially in the biopharmaceutical sector, to raise capital through A-share listings. Future changes to IPO review standards should be approached cautiously, with careful consideration of their impact on private equity.
2. Revise the Performance Evaluation Criteria for Local Governments and Government Funds, Incorporating Support for High-Tech Enterprises Nationwide as a Key Metric
Local government funds should prioritize national economic development rather than focusing solely on regional interests. Using quantitative methods, the impact of government funds on high-tech enterprise development and key patent applications can be measured and incorporated into local government performance evaluations.
3. Reduce Retail Investor Participation in the Stock Market and Promote Closed-End Funds
A healthy secondary market is essential for private equity investments. Currently, around 220 million retail investors participate in China’s stock market, representing about 15% of the population. Although large in number, retail investors contribute only a small proportion of the total investment capital. According to the 2019 China Household Finance Survey, the median annual income of retail investors was 130,000 yuan (around USD 19,000), with the 25th percentile earning 76,000 yuan (around USD 11,000). Given that retail investors made up only 5.7% of the population in 2019, it is likely that their current income levels are even lower. These income constraints limit retail investors’ capacity to take on risk. Numerous academic studies show that, as a result, retail investors tend to focus excessively on short-term stock market performance.
China's stock market has long aimed for stable, steady growth with narrow fluctuations (commonly referred to as a "slow bull" market), with strict exit requirements to protect retail investors. However, these guidelines often conflict with the stock market’s fundamental logic, limiting its healthy development. While investor education can resolve some issues, the most effective solution is to entrust retail funds to professional institutional investors. In short, professional tasks should be handled by professionals.
Closed-end funds should be further encouraged, as they permit only the trading of shares on the secondary market and prevent investors from redeeming shares during the closed period. This would enable liquidity for investors while giving fund managers the freedom to focus on long-term investments, reducing the pressure to achieve short-term results. By shifting from stock trading to fund trading, this approach separates retail investors from direct involvement with companies and reduces the influence of investor sentiment on policy decisions.
4. Differentiate Between Fraudulent Activities and Normal Business Risks
On one hand, stricter penalties must be imposed for illegal activities such as financial fraud and deception. Although the revised Securities Law has raised the maximum fines for securities violations, the penalties for serious offenses like financial fraud still need to be further strengthened.
On the other hand, we must accept the normal risks associated with research and development (R&D) and business operations. Some believe that the recent suspension of the Fifth Set of Standards for the STAR Market was due to poor performance by some companies listed under these rules. Yet, high-tech enterprises inherently face significant risks, and failure does not necessarily indicate fraud. We must accept the inherent risks that high-tech enterprises face during R&D and provide them with the necessary space and support to drive innovation.
IV. Conclusion
In conclusion, to promote the development of China’s private equity market, it is recommended to adjust local government and fund performance evaluation criteria to incorporate support for high-tech enterprises nationwide as a key metric. Additionally, ensuring stability in IPO review standards, reinstating the Fifth Set of Standards, and promoting the growth of long-term institutional investors in the secondary market while encouraging the use of closed-end funds to reduce retail investor participation will further stabilize both the private equity and stock markets.
[1] Author Affiliation: Guanghua School of Management, Peking University.
