Since the Chinese regulator thundered out the New Asset Management Rules (New AMR) in 2018, Chinese private equity (PE) and venture capital (VC) firms have been deprived of a major capital source from banks. Covid-19 has only exacerbated their fundraising dilemma, with total raised capital dropping from CNY1.8 trillion ($277.0 billion) in 2018 to CNY1.2 trillion ($184.7 billion) in 2020. With the transitional period ending in 2021, both banks and PE/VC firms are making last-ditch efforts to find an opening in the sealed door.
Xie Dong, CPPCC member and director of Shanghai Municipal Financial Regulatory Bureau, recently suggested that commercial banks try a business pilot similar to venture debt in Shanghai.
Wang Tianyu, a representative of the National People’s Congress and chairman of the Bank of Zhengzhou, also had a recommendation. He suggested that the venture capital plus venture debt pairing for which 10 banks are currently eligible could be lengthened. In the venture capital and venture debt pairing, venture debt-lending banks can either set up asset management subsidiaries to provide also venture capital or cooperate with PE/VC firms to provide only venture debt.
But that’s thinking too much of the pilot itself, which has struggled to show results.
Headwinds for the Pilot
Chen Li (pseudonym), a high-ranking staff member from one of the 10 eligible banks who wishes to remain anonymous, spoke bluntly about the pilot.
“The bank started the business pilot in 2016 and only signed agreements to invest in about 20 target firms selected from a group of 300. The bank’s head office was happy to take the initiative to open a subsidiary, but soon regulation became strict, and the business was shelved.”
Consequently, not only did the selected targets slip away, making the due diligence research a complete waste of time and energy, but also the subsidiary lost all its talents. The innovative business pilot had failed to match people’s expectations.
The Law of PRC on Commercial Banks stipulates that no commercial banks may, within the territory of the People’s Republic of China, invest in non-banking financial institutions or in enterprises, except where otherwise provided for in the regulations of the State. However, in April 2016, 10 banks, led by Bank of China and state policy lender China Development Bank, were granted access to the mainland’s PE/VC markets following the removal of a legal bar on banks holding equity in non-financial companies they lend money to.
But in the past 5 years, the pilot has gone less smoothly than people wished. As Wang Tianyu laments,
“The pilot provided an innovative model to let nominated commercial banks hold equity in and lend debt to non-banking financial institutions while abiding by the Law on Commercial Banks. But the pilot didn’t deliver many concrete results, and only China Development Bank of the 10 appointed banks was approved to establish its subsidiary that performs investment.”
Banks have made efforts, though. China Merchants Bank, one of the 10 pilot banks, tried this model in June 2010, before the pilot program, via partnering with PE firms to hold equity in targeted firms.
Another of the 10, Bank of Beijing, signed a strategic cooperation agreement in 2013 with The Garage Cafe, a staging ground for innovative entrepreneurs. The bank was to provide tailored financial services for the start-ups there, such as venture debt and special credit product. Its loans have helped more start-ups receive bigger checks from seed investors or PE/VC houses.
Venture capital from PE/VC investors combined with venture debt from commercial banks has been the more popular model of the venture capital and venture debt pairing.
Lu Jue, the President of SVB Asia and SPD Silicon Valley Bank (SSVB) praises proposals by Xie Dong and Wang Tianyu:
“They are conducive to attract more resources from indirect to direct financing markets, improve financial market structure and financial services, support sustainable development of excellent VC institutions, and thus help China’s sci&tech innovation develop better and faster.”
Banks Busy Dealing with the New AMR
Existing venture debt focuses on underlying firms, though general managers (GP) in fundraising difficulty have also desired long-term funds from banks. In his proposal, Xie Dong pointed out that venture investors are in a capital shortage and venture debt-like loans tailored to the fund, the GP and the limited partner (LP) are all needed.
Zero2IPO data proves a year-on-year fundraising decrease of 3.8% and that more than 40% of fund managers couldn’t even secure CNY100 million ($15.4 million) in fundraising. The capital drought has become so serious that the industry cannot turn a deaf ear. “Sci&tech companies in their infancy are inevitably dependent on equity investment funds, while the latter are largely hindered by limited capacity or channels to raise funds. This in turn has inhibited industrial development,” explains Xie Dong.
“We have long cried for fund-focused bank loans, which will be very useful if put into practice,” says a bank president in Shanghai. However, Chen Li is pessimistic about the demand because such loans will ultimately flow into the equity investment market, which will be problematic if the regulatory system is not established beforehand.
What’s worse, even after a 3-year transitional period from 2018, banks have not handed in their test paper yet in the New AMR exam, which requires them to gradually reduce rule-breaking assets and formulate rectification plans.
“Banks still need to divest some existing assets, and no capital outflow shall be expected for the time being,” says a primary market investor. When the central bank extended the transition period of the New AMR for one year in 2020, banks’ divestment of assets was also part of the reason.
Non-traded equity/industrial funds, credit bonds, non-performing assets and capital replenishment vehicles of commercial banks are the top 4 hard-to-digest asset classes. The first kind is often connected with national infrastructure projects, which take years to mature. Thus, it’s hard for banks to launch new wealth management products and find investors who would like to take them over; also digesting such assets implies credit risks that are 4 to 12.5 times higher than corporate debt.
It’s lucky for banks that the central bank has extended the transition period of the New AMR to the end of 2021, which allows them to take their time divesting. However, people in the space hold that small- and medium-sized banks cannot meet the deadline even given one more year.
Secondary Funds: The Hidden Tunnel
The Law on Commercial Banks is looming, the New AMR deadline drawing near, and the venture capital-venture debt pilot held up. But Shanghai Pudong Development Bank has stirred the water nonetheless. It helped China Reform Holdings Corporation (a PE house) raise CNY500 million ($76.9 million) in Feb 2021. The raised capital will be deployed to underlying assets of investment funds managed by China Reform Holdings Corporation.
“According to disclosed information, this is a secondary fund,” reckons a market analyst. With 90% of underlying assets running well and the remaining 10% clearly targeted, the wealth management product sold out quickly: only 3 days after the CPC Central Committee and the State Council issued the action plan for building a high standard market system on January 31st, 2021. The action plan encourages banks and their wealth management subsidiaries to partner with venture capital funds or industrial investment funds.
Previously, a wholly owned subsidiary of ICBC carried out strategic cooperation with PE players such as Hillhouse Capital and Legend Capital, and launched the sci&tech innovation private equity product in June 2019.
In December 2020, Taizhou Urban Construction and Investment Development Group established a CNY1 billion ($153.9 million) equity investment fund, half of which was backed by banks’ wealth management products. At present, ICBC, BOC, BOCOM and Postal Savings Bank of China all have wealth management subsidiaries that have established equity investment funds targeting nonpublic enterprises.
Some Final Words
Under current regulatory restrictions, both banks and PE/VC fund managers in China are seeking the opportunity for greater cooperation with each other. After all, long-term funds from banks and insurance companies are necessary for a mature equity investment market – if taking a lesson from Western countries. However, considering the early development stage of the country’s financial market, this still has a long way to go in China.