Startup redemption angst, Chinese banks as venture capital funds, mortgage refinancing rumors, "housing pension fund" - Week in Review #25

Hi folks, every week I try to do a review of events that I think have a lasting impact beyond news cycles in China. Sometimes, when events in the previous weeks or months start to form a common theme, I will also review those earlier events as well.

This is one such week. This week’s review will heavily center on China’s VC and entrepreneurship. A lot has happened over the last few weeks. (Again, for who I am and what unique value I can bring to the table, please read here.)

(Also for those of you who are interested, I just wrote a short rundown of China’s top internet names’ key drivers, debates, and our non-consensus views at Baiguan this week, covering names such as Alibaba, Tencent, PDD, and Meituan.)

#1 Startup share redemption angst

A few months ago, in my article about VC’s demise in China, I specifically mentioned that many startup founders are required to provide personal guarantees now in order to get venture funding. This unique situation, combined with the de facto freezing of IPO clearances in the onshore A share market, the valuation depression in the HK market, and the fact that China has no personal bankruptcy law (which the 3rd Plenum has addressed), represents a looming train wreck for China’s VC-backed entrepreneurs and their backers.

As Johnny of

MJFinance’s Newsletter

has pointed out, 2025-2027 will be the peak of startup redemptions, as those startups that got a lot of funding during the 2019-2021 VC craze will either have to be IPOed, bought out, or trigger investor redemption clauses. Many companies will likely either fail to be IPOed, or as IPO valuation may be much lower than the original private valuation, some later-round investors will block the IPO from even happening.

At the same time, those investors have their own fiduciary duty to their investors (the limited partners, or LPs), so their most rational choice, individually, is to call for the redemption of their original investment as fast as legally possible, before anyone else. The recent batch of redemption lawsuits launched by Shenzhen Capital Group (SCGC), a top-tier government-owned VC company is just the beginning.

But collectively, it will be a lose-lose situation. Like SCGC, every investor will scramble for an exit, causing a stampede. This is not a bank run, but a “startup run”, destroying underlying businesses in the process, and putting an unpayable debt burden on the many startup founders who have provided personal guarantees, and it’s doubtful if those VC investors are even able to recoup any losses through this.

Sensing a looming disaster, it’s interesting to observe that many players who have skin in the game are making very public statements on the matter now.

One notable article was written by Mr. Kuang Ziping邝子平, founding and managing partner of Qiming Venture, a top China VC fund. In the article, Mr. Kuang pointed out that those redemption clauses, although borrowed from the US venture capital industry and laws in the Cayman Islands, have been abused in China (translated by Claude-3.5 and curated by myself):

Let's first discuss redemption clauses. A redemption clause refers to the right of investors to require the company to buy back their investment a certain number of years after the investment, typically five years or more. The redemption price is usually the principal plus interest. The redemption clause is automatically canceled if the company goes public or is acquired. However, an often overlooked legal provision under Cayman law is that shareholder redemption can only be executed if it does not harm the company's normal operations. This is why, despite being an imported concept from U.S. dollar funds, the frequency of shareholder redemptions in Silicon Valley investment practices is quite low.

Later, when this clause was applied to RMB funds, two changes occurred. The first change was that when we initially tried to include the redemption clause in RMB fund investment terms, lawyers cautioned that there was significant legal uncertainty in China regarding companies using their own funds to repurchase shareholders' equity. As a result, investment institutions made an adaptation, requiring founders to make repurchase commitments. The industry view at the time was that although founders likely didn't have the ability to repurchase, this clause could still serve a purpose by encouraging founders to work diligently. Since this obligation fell on individuals, in scenarios where investments were made in Cayman corporate structures, the premise of not harming the company's operations was naturally overlooked.

The second change occurred in recent years. As repurchase clauses became increasingly common, lawyers believed that courts seemed to be more accepting of companies as the repurchasing entities. As a result, more and more investment institutions began to shift the repurchase obligation from individuals to companies, with some even requiring joint and several liability from both the company and the founders. However, when the repurchasing entity changed back to the company, a crucial issue arose: in the redemption clauses of RMB fund investments, or in Chinese company law, the premise of not harming the company's normal operations was not reflected.

What Mr. Kuang’s article amounts to is a fundamental attack on whether those redemption clauses should exist at all, by looking at their historical roots and showing they have been wrongly applied. Mr. Kuang’s argument in short is: this is wrong. (Although, just as Johnny has pointed out, Mr. Kuang himself has strong vested interests in this matter, and has an unspoken motive to use such kind of article to dissuade peers from front-running his funds.)

While, another notable article, by Lifeng Partners礼丰, a domestic law firm, is an interesting attack on the redemption clause’s utility. Lifeng did a comprehensive analysis of all the redemption lawsuits that have already taken place and concluded that redemption actually brings back little value. They basically say, this is useless:

However, based on our sample statistics of hundreds of judicial cases, the execution effectiveness of redemption cases that entered judicial procedures is not optimistic. The average execution recovery rate is only 6%. Among redemption cases that entered the execution procedure, only 4.62% achieved 100% recovery and full execution. In terms of time, from the filing of the initial trial to the final judgment, the average duration is about 1 year. Adding 3-6 months for execution time, it takes an average of a year and a half to complete all litigation procedures.

Therefore, there is a saying in the investment community that "there are no winners in redemption litigation." While this statement may not be entirely rigorous, it does reflect, from one perspective, that exiting the domestic investment market through redemption litigation often leads to "devastating" results.

Clearly, something has to be done about this. But it’s just amazing to see so many ecosystem participants trying to help themselves with so many views and studies covering different angles. As those articles are widely read and shared, it’s almost certain they are also getting circulated in the policy deliberation circles. With this lively discourse, it’s not impossible as 2025-2027 redemption flood looms large, some kind of solutions will appear soon.

[For the paid section of this post below, you will find further discussion related to this topic, including a new drive at creating venture capital arms of state-owned banks, a local government deprioritizing asset safety in VC investments, and complaints about IPO freeze. I will also discuss 2 important pieces of news about real estate.

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#2 Venture capital arms of state-owned banks