China had its early exploration into government-guided funds (GGF) in 2002-2006. After a few trials in 2007-2008, the country gradually standardized its GGF operation in 2009-2013 and celebrated its GGF peak during 2014-2016. Even though a mild slowdown followed the peak, GGFs account for 40% of the Chinese private equity (PE) market in terms of paid-in capital, rendering them the largest limited partner (LP) in the Chinese market. That said, exit has long been a nuisance for GGFs – but Xuzhou of Jiangsu province has become an outlier to break out of the limbo and exit ahead of schedule.
An Unusual Success Story
On May 8, 2021, Xuzhou GGF cashed out from the Huaihai New Energy Vehicle Fund earlier than planned, recycling the principal and gaining returns. With total capital commitment of CNY2 billion, Huaihai New Energy Vehicle Fund actually pockets paid-in capital of CNY1.3 billion, among which Xuzhou GGF contributed CNY390 million.
Prior to that, on April 14, 2020, Xuzhou GGF also had a smooth and profitable exit from the first sub fund it has backed: Xuzhou Huaqing Optoelectronics Fund.
Traditionally, cashing out has always been one of the most demanding challenges for GGF managers. Xuzhou, however, has set up a positive example for others.
The Four Reasons Why GGFs Normally Cash Out
1. To make way for private capital: when the invested funds show encouraging momentum, GGFs will sell their fund share to the fund manager or other private sector investors at cost price or slightly higher, giving away profits. This is to incentivize private capital to fuel certain industries, following the GGFs – hence the name, government-guided fund.
2. To avoid negative outcomes: sometimes the invested funds run into worrying situations. For example, the private sector could fail to honor their capital commitment within a year, or the invested funds received capital injection from the GGF but conducted no investment in 12 months. In that case, the GGF is entitled to exit before the invested fund matures or liquidates.
3. To perform the market-oriented mechanism: government investors will transfer their fund share in advance, following the market-oriented principle.
4. To match the fund liquidation: when the invested fund reaches its date of maturity and liquidation, all investors will step out according to the contracts. When GGFs perform direct investment, then GGF exit comes after the underlying assets’ exit.
What are the Challenges?
Obviously, Xuzhou GGF here falls into the first kind. The second category, which involves a “compulsory exit”, and the fourth category, which indicates a “ruthless exit” after fund liquidation, might have left too little time or space for the GGF to guide and leverage private capital. It could have even discouraged the private sector from joining in. For the third category, the question of fund share evaluation crops up.
First of all, fund evaluation is highly complicated and expertise-intensive, given the different locations and target industries of GGFs.
Secondly, GGF evaluation faces the challenge of satisfying both sides – public sector, the seller, and private sector, the buyer. GGFs, who will be under great pressure if they cannot preserve or add value, especially when the local governments are already in debt, want a high estimated value. However, private capital will shy away and GGF exit will fall through if the GGF is overrated.
Thirdly, authorities might also want to have a say in evaluation to gain control, leading to entanglement among different parties.
Yet difficult as it might be, executing a market-oriented mechanism in the third category is widely regarded as the answer for GGFs to cash out smoothly. In this regard, GGFs have two things to do: one is to facilitate GGF trading by meeting compliance requirements, such as state-owned asset deliberation and approval; the other is to give consideration to risk tolerance and discount selling. After all, GGFs are not established for returns but for guiding private capital to certain strategically important industries, so discounting makes sense. It means giving up some profits on sunny days and bearing more losses on rainy days.
Why Is Cashing Out Important?
GGF cash out is meaningful for three reasons. First, when the GGF steps out and makes way for private capital, it is beneficial to draw a clear-cut line between public and private sector roles. Moreover, exits complete the cycle of GGF operation. Last but not least, cash out and reinvestment helps to increase the efficiency of government funds.
It is reported that Xuzhou GGF has played a great role in facilitating industrial development and deploying state-owned funds efficiently. So, no wonder Xuzhou has been setting up more government-backed funds recently.
On May 10, 2021, Xuzhou Municipal Finance Bureau and the municipal industrial fund management company of Guosheng Group jointly launched Xuzhou Municipal Government Investment Fund (limited partnership) with a total subscription of CNY4.5 billion. Having the Fund alongside Xuzhou GGF represents Xuzhou doubling down to upgrade traditional industries and develop emerging industries during China’s 14th Five Year Plan period.
In February 2021, Jiangsu province and Xuzhou government also established the Huaihai Economic Zone Investment Fund. This is the first intra-provincial but cross-regional cooperative development fund in China, thus creating a new model for government investment funds to support regional collaborative development. As of May 8, 2021, Huaihai Economic Zone Investment Fund has 4 sub funds, 4 invested projects and another 16 potential investment targets, covering high-end equipment manufacturing, integrated circuits, new energy, healthcare, green construction and modern agriculture, among others. Clearly an investment engine is humming, injecting new vitality into regional economic development.