Primary Market 'Sin and Punishment': A Dialogue With Founding Partner of AMG...

TMTPOST -- "No snowflake in an avalanche ever feels responsible." This quote from the Polish poet Stanislaw Jerzy in his work More Unkempt Thoughts is akin to the emotions triggered by exit that is evident in the primary market.

"Buybacks kill Chinese innovation" "500 unicorns face buybacks, a sin of investors, a disaster that entrepreneurs find hard to overcome" "The big names in VC have initiated a number of buyback lawsuits, where is patient capital?" They are some online posts about buybacks.

Once "loving" each other, the talent scouts and talents are now in a standoff in the buyback agreement, exposed under the limelight. However, do the emotional posts that are hyped online actually reflect the full picture of the primary market?

Zhang Tian is a founding partner of AMG Financial Group and the initiator of the AMG Fund's equity exit center. He has been engaged in the venture capital industry for nearly two decades, as a partner of Purple Sky Venture Capital, the legal head of Infinity Group and Pre-IPO Capital in China. He has experienced two complete fund cycles of fundraising, investment, management, and exit, handling hundreds of investment projects and fundraising, investing, managing, and exit events, assisting a large number of fund managers, LP investors, and portfolio companies to solve urgent problems.

Here is the full text of the dialogue:

Are these entrepreneurs innocent?

AsianFin: How do you view the recent debate in the industry about the trampling and run-style exit and repurchase phenomenon in the primary market?

Zhang: It is a fact, but not the whole truth. In the cases we have handled, nearly half of the projects have moral risks, not as rumored that good projects are all strangled, and the future of Chinese innovation is strangled.

In a typical fund's investment portfolio, projects that can achieve high returns are a minority, and most projects are mediocre or failed.

Equity investment is not an infinite game, nor is it a philanthropic cause; thus all market participants are dancing with chains.

Even if some project teams are good and their technology is advanced, due to insufficient marketing capabilities, insufficient ability to obtain resources, and production capacity not keeping up, they cannot convert their innate advantages into strong business performance and financial advantages within a certain time limit, which will also lead to the enterprise facing repurchase.

On the surface, it is manifested as repurchase events and repurchase conflicts, but behind it is the inevitable result of market competition, and the inevitable differentiation of various quality assets in competition, "low-quality assets" face natural elimination.

The right of repurchase is a product of a market entity that has been in a state of interest balance after decades of full interest game, and the time when the right of repurchase disappears is the time when the fate of the equity investment market closes. For the vast number of LPs, if a fund does not have a bottom line measure design similar to the right of repurchase, there will be no LP foolish enough to face the risk of an uncertain exit channel with capital entry (even if it only has theoretical certainty).

Under the law of large numbers, if there is no right of repurchase/redemption right, the domestic and foreign venture capital markets would not exist at all.

How many RMB projects without redemption rights have GPs seen, and how many USD projects do not have a redemption right? While there may be some exceptions, please note that I am talking about the inevitable interest demands of GPs and LPs in venture capital funds under the law of large numbers.

In the final analysis, the right of redemption is not a "matter of justice" as recently discussed by self-media, nor is it a purely legal issue. It is the result of a balance of interests among multiple parties, the result of market selection and natural elimination under the law of large numbers, and one of the most basic elements of the venture capital and equity investment market.

Even if the primary market were to be rebuilt from scratch, the same result would still occur.

Currently, a group of non-redemption right consumers and self-media, with strong emotions, are repeatedly jumping around to guide public opinion, trying to overturn the rationality and moral legitimacy of the right of redemption. This is sheer hypocrisy and a huge insult to the spirit of the contract, which will only make it difficult for many companies to raise funds and bring the equity investment market to face a greater crisis.

AsianFin: What specific moral risks are you referring to?

Zhang: There are three probable situations.

First, the unreasonable use of investment funds. Many founders use reimbursement, cooperation with suppliers, and other forms to embezzle and misappropriate investment funds.

Second, erasing the redemption responsibility. Some companies are operating well, but the founders judge that the company will not be able to go public or trigger the redemption clause in the future based on market changes, and then take some measures to erase the redemption responsibility.

On the surface, it seems to be due to the pandemic, the macro market environment, and other commercial risks, but in reality, it is a human operation. Many entrepreneurs are not first-time entrepreneurs, and they have some experience in dealing with such situations.

Third, preemptively separating legal responsibility and personal property. Some founders anticipate that the company may receive a redemption lawsuit from investors, and then preemptively separate the legal responsibility and personal property that the individual needs to bear. They open their circle of friends and live a prosperous life, and investors want money, not a penny can be obtained. Among them, there are founders of star projects.

It is difficult to cover all the situations in the market with a unified index, and it is also difficult to judge with a set of standards, who is right and who is wrong. From different interest perspectives, everyone can find a bunch of evidence to prove their rationality.

Buyback = Impatience?

AsianFin: What is your view on Shenzhen Venture Capital (State-owned LP) initiating a batch of lawsuits against invested companies?

Zhang: State-owned capital has special attributes, such as state-owned characteristics. It naturally has the requirements of preserving and increasing value, and guiding the development of regional industries, and has been so for decades.

It has always existed, has always been visible and predictable, and is not a problem that arises suddenly. This is similar to how geographical location and climate affect agriculture. The climate and black soil in the Northeast can produce high-quality Northeastern rice, but not mangoes. The occurrence of outcomes is not at all surprising.

Even if they are all state-owned funds, the needs of different regions, industries, and governments directly determine that the duration, risk-bearing capacity, and equity assets that should be allocated by state-owned funds in various places are quite different.

As a professional GP, it is essential to have a clear and objective understanding of this. Raising funds from any local government and assuming that state-owned capital will not strictly enforce contracts, thinking that as long as you provide good services to state-owned capital, you will not be held accountable by state-owned capital, is a serious misjudgment of state-owned capital, and is doomed not to exist for a long time.

AsianFin: Does buyback equal impatience?

Zhang: 70% of the funds on the market have a DPI less than 1 or cannot withdraw investments, which is not a simple issue of patience or a simple issue of the duration of funds, but to a large extent, it is a "quality of assets" issue.

Most of the projects that currently trigger the right of repurchase are those invested between 2014 and 2018, among which the internet, entertainment, consumer goods, and healthcare are the most severely affected areas. Even if we wait another 3 to 5 years, it is difficult to achieve investment withdrawal.

Another category is hard technology projects. Although many projects have no problems in terms of technology, market, and trends, due to operational and market competition reasons, the performance cannot be fully released, and the financial indicators are far from the listing standards within a reasonable investment period. For these projects, the performance is largely subject to the influence of factors such as the total scale of industry capacity, downstream customers, product price changes, and the intensity of market competition. There is still a huge uncertainty whether waiting another 3 to 5 years can fully reflect the performance.

Thus, the different understandings and judgments of "asset quality" and "what constitutes a good asset" by investors in the primary and secondary markets are vividly reflected at present.

From the perspective of GPs in the primary market, if a company has a high valuation and a good development direction, there is no problem with "asset quality"; whereas from the perspective of investors in the secondary market, a company that does not fully reflect operational performance indicators, growth, financial results, and lacks a comparable valuation advantage is difficult to be regarded as a "good asset", and it is almost inevitable that the "asset quality" will be questioned.

AsianFin: What is the probability of GPs recovering money after initiating a repurchase lawsuit?

Zhang: It depends on the specific details of the repurchase clause signed. In the more than 100 repurchase cases we have come across so far, more than half of the repurchase clauses themselves have serious flaws.

Some only signed a repurchase by the company, but after the implementation of the new company law, company repurchase involves targeted capital reduction, which requires unanimous consent from all shareholders and the signing of a capital reduction resolution. There are very few projects that can meet this repurchase prerequisite, and the general situation is that when the repurchase clause is triggered, the founder is the first to disagree.

Some signed a joint repurchase obligation by the founder, but agreed that "the founder's repurchase obligation is limited to the equity value." However, actual judicial judgments and arbitration awards often only support the founder's joint repurchase obligation, but do not recognize "the company's valuation at the time of investment or the latest round of financing valuation" as the basis for "equity value", and require a separate asset assessment and use the assessment results as the basis for calculating the equity value.

At first glance, it seems that only the asset assessment procedure needs to be carried out, but the actual equity value assessed is often dozens of times different from the equity value calculated according to the valuation. There are many cases where GPs invest tens of millions, but according to the asset assessment results, the founder only needs to bear a few million or even a few hundred thousand repurchase payments.

There is also a typical situation, which is the star projects that investment institutions flock to. Due to the large number of financing rounds, some agreements in the later rounds stipulate that "the consent of more than half of all investment institutions is required to initiate a repurchase." However, when the repurchase clause is triggered, it is often difficult to obtain the consent of more than half of the investment institutions due to different interests, different prospects of the project, different fund expiration times, different exit strategies, and different LP demands, resulting in the repurchase right being unable to be exercised.

Repurchase litigation is not a simple legal issue, involving fund management issues, early communication and preparation, evidence collection, repayment execution, LP communication, and expectation management, and a series of issues. We have accumulated a lot of experience and know-how in past exit cases, solving the difficult problems in repurchase through innovative methods.

AsianFin: How should GPs respond to the problem of exit?

Zhang: It is very normal for a fund's investment portfolio to have both good and bad projects.

However, as a GP, if you find that the DPI of the fund is facing challenges, my suggestion is to attach great importance and actively deal with it early on, and you must have both Plan A and Plan B. After all, the basic elements of the investment industry have undergone significant changes, the expectations and mentality of LPs have changed at this stage, and the judicial environment has also undergone tremendous changes. The roadmap of the past is no longer easy to lead GPs to the other side safely.

GPs should communicate with LPs as early as possible, actively, and fully transparently, and do a good job in detailed project explanation, success and failure attribution, and LP expectation management work. Do not rely solely on fund reports and partner annual meetings to avoid giving LPs the illusion that all the projects invested by the fund are very good and the future returns are very good.

After all, the final fund LPs look at the DPI, not the MOIC or TVPI reflected in the fund report. We have seen that GPs with risks often have problems with LP expectation management and communication disclosure.

Under specific disposal measures, we suggest that GPs should carry out stratified processing of their investment portfolios as soon as possible. For projects with excellent operational performance and financial indicators, mobilize internal and external resources to help them connect with the capital market; for projects that have not yet demonstrated performance but are highly likely to emerge within three years, communicate with LPs as soon as possible and mobilize LPs to find resources, capital, and customers for them together; for projects that are expected to fail to meet financial indicators after three years, stagnant development, and failed projects, it is recommended not to hesitate and quickly carry out effective disposal to avoid the risk of GP's due diligence.

It needs to be particularly reminded that the biggest challenge in the disposal phase is time. The disposal of assets generally takes more than six months, and the involvement of repurchase generally takes one or two years. GPs must reserve time margin and not harbor excessive illusions.

For GPs, many times the real threat does not come from the risk itself, but from the way GPs respond to the risk.

GPs are also sued

AsianFin: Do LPs sue GPs?

Zhang: Yes, there are about several hundred cases every year nationwide, most of which end with GPs losing the lawsuit and compensating LPs.

After the introduction of the "Nine Civil Minutes" in 2019, judicial practice has put forward new requirements for the due diligence obligations of GPs. The biggest change lies in the "reversal of the burden of proof for due diligence" and "the standard of due diligence has been raised".

At present, if LPs initiate a lawsuit against GPs for accountability, GPs will bear the burden of proof and prove that they have made the utmost effort to take all feasible measures of due diligence.

It seems reasonable, but in law, it is a substantial challenge for GPs, and there are not many GPs who can fully prove their due diligence without any flaws.

AsianFin: Before fundraising, did GPs not have a reasonable prediction of the lawsuit?

Zhang:This question is related to the development history of the industry.

Between 2014 and 2018, a number of fundraising intermediary institutions emerged in the market. Although they played a certain role in promoting the industry, their work and core interests were to complete the fund-raising and close the accounts to receive their commissions, with a sales-oriented approach. As a result, many LPs who did not have sufficient risk-bearing capacity were introduced into venture capital funds.

On the other hand, under the expectation of a booming macro-level at that time, everyone believed that tomorrow would be better, ignoring the inherent uncertainty of investment itself. Everyone thought that as long as they could raise money and invest, if a few companies could go public, the whole fund could make money, and all problems could be solved.

However, it is not the case for the real capital market.

Looking at the global market, truly successful fund managers not only run fast but also need to live long. Living long is not an easy thing, which means controlling leverage, controlling investment risks, the ability to obtain different types of funds and LPs, highly specialized asset allocation capabilities, and also requires an objective and calm view and judgment of macro and micro factors, not being disturbed by favor or disgrace, which is very demanding for fund managers.

Back to the current reality, GPs need to clearly understand that after the expiration of the fund, state-owned LPs will be handled by different departments and management lines within the local governments according to their own management requirements and rules, and will not "grasp everything at once", and will not relax the requirements for DPI because of the completion of the return investment, investment attraction and other goals.

At the same time, it is also necessary to recognize the serious consequences that GPs will face if they are held accountable by LPs, so GPs must have both Plan A and Plan B.

AsianFin: Recently, many new state-owned funds have emerged. What is the difference between them and the ones launched in 2014-2018?

Zhang: In recent years, the mother funds and large guiding funds established in China have many new changes in organizational structure and operation mode, but there is no substantial difference from 2014-2018 in terms of state-owned capital sources, asset allocation structure, and risk-bearing capacity.

Recently, many GPs feel very frustrated. I want to tell everyone that this may be inevitable, but it is also normal. The prosperity cycle will not be the norm.

Investment institutions are sailing across the Drake Passage, and everything has just begun. For many GPs, they need to be prepared to face fierce impacts. The mentality of GPs will go through the Kubler-Ross change curve, which is: shock, denial, anger, bargaining, depression, and acceptance. This is the inevitable path for the vast majority of market-oriented GPs, unless the DPI of the funds under their management is above 1, otherwise it is hard to avoid.

The current primary market situation is very intense in expression, manifesting as a sudden liquidation. This liquidation is not only aimed at invested companies but also at the existing state-owned LP funds and GPs.

As the proportion of state-owned capital in the primary market increases, we predict that after the new round of state-owned capital funds expires, the current situation will reappear, and it may be even more fierce.

As a member of the industry who has experienced the impact, I hope everyone can view from a long-term perspective and deal with the current situation. It is meaningless to discuss optimism or pessimism now, GPs need to be realists, and handling the current problems is the key to whether they can finally come out.

AsianFin: What is the essential difference between the dot-com bubble from 1995 to 2001 and the current difficulty in exiting consumer/technology projects?

Zhang: The industry characteristics, LP structure, and capital form are completely different.

Firstly, the risk-return characteristics of the funds are different. The natural marginal cost advantage of the internet business and the smooth exit channels of overseas capital markets made it relatively easy for internet funds to break through DPI 1 at that time. Even if 99% of the projects died, as long as one or two projects could go public, the whole fund would make money.

In the hard technology track, due to the widespread involvement in the production and manufacturing process, industrial involution, and the adjustment of capital market policies, etc., new challenges have been put forward to GPs. GPs need to have a deep accumulation in the industry, be sufficiently diligent, correctly grasp the capitalization window period of the industry, and have enough luck to achieve a fund DPI of 1.

Secondly, the structure of LPs is different, and their understanding of risk, tolerance for losses, and handling methods after expiration are all different. During the internet period, market-oriented LPs were the majority, and they generally could accept a certain degree of loss, and the flexibility of fund expiration extension was also larger. In the new cycle, state-owned LPs are the main body, and due to the inherent attributes of state-owned capital and strict management requirements, the duration of state-owned funds, the requirements for the speed of exit, the depth of understanding of venture capital, and the tolerance for losses are all quite different.

Thirdly, during the Internet cycle, both domestic and international macro fundamentals are very favorable. GPs, LPs, and founders all have a strong drive and high risk tolerance. They believe that if this attempt is not successful, there will be another chance, and they unanimously think that tomorrow will be better. However, in the current recession period, no matter which role, there is little room to get a second chance after a failure.

Fourthly, during the Internet cycle, with the increasing network effect and decreasing marginal cost, leading companies can build a moat and create wealth. But in the hard technology investment cycle, the investment targets have undergone fundamental changes. Most enterprises need to be implemented in production and manufacturing, and in terms of "increasing production capacity," under the background of large-scale investment attraction in various parts of China, the difficulty is not high.

Now, these industry competitors can easily enter quickly, and the cycle from shortage to surplus in the market has been greatly compressed. Many companies have not yet had the opportunity to release their performance and have already faced the state of internal competition within the industry. The corresponding wealth effect, the requirements for project execution ability, and the challenges of the business model are completely different.

Goodbye to the "Last Era"

"VCs will only exist where the cost of capital is extremely low but the growth rate is high. The existence of VCs depends on the external environment. When the external environment changes, the shrinkage of the VC industry is an objective law. There is no need to be anxious or struggle. Just wait for the next low-interest, high-growth cycle," said Chen Yuetian of Huofeng Capital.

In 2014, during the mass innovation and entrepreneurship wave, without a team or a product demo, with just an Idea, investors spent a lot of money for a cup of coffee, and entrepreneurs easily obtained seed and angel financing. That was an era of abundant capital, dreams, and innovation without talking about asset quality.

"It is better to invest in ten wrong ones than to miss a potential unicorn" seems to have become the default belief of the investment circle. They travelled through the Zhongguancun Entrepreneurship Street, the road showed site of various incubators, and the first thing they did every day is to check the business plans in the mailbox. In 2014 and 2015, ZhenFund received about 300 business plans every day, invested in nearly 200 projects in two years, and the team quickly expanded to nearly 40 people.

At that time, the myth of raking in dollars by listing on NASDAQ in 3-5 years of entrepreneurship attracted countless entrepreneurs, and for a while, they couldn't distinguish whether entrepreneurship was for ideals or wealth.

One side provides funds to invest in the future in exchange for a hundred or a thousand times the return on funds, and the other side uses dreams, character, and experience as collateral to exchange for the realization of dreams and personal value. This itself is a transaction.

When transactions fail to deliver satisfactory results, the balance among entrepreneurs, GPs, and LPs is disrupted.

In 2022, the number of Chinese companies supported by VC/PE that went public was 352, and in 2023, it was 267, nearly halved compared to the 432 companies that went public in 2021. It is worth mentioning that IPOs remain the main exit channel for VC/PE.

"Whether it is the change of tracks, the shift in policy environment, investors and entrepreneurs should learn to be responsible for the funds and for every business decision they make, after all, no one's money comes from the wind," said investor Jack.

What seems to be a dispute triggered by the repurchase clause is actually the lifting of the veil of the primary market, facing the value investment, facing the quality entrepreneurs, and facing the "asset quality" of hard technology companies.

Under a fallen nest, no egg remains intact. The "crime and punishment" in the primary market concerns all participants.