State Capital Backs Venture Investment, Regions Introduce Fault Tolerance Mechanisms
As the primary source of capital in China's venture capital market, how state-owned capital establishes an assessment mechanism that matches the activities of venture capital is a key point. This year, multiple regions have explored mechanisms for fault tolerance and exemption from liability to encourage state-owned capital to actively participate in venture capital activities. Interviews with journalists have revealed that most venture capital institutions sign repurchase clauses with the invested companies. Once the companies fail to meet performance requirements or face certain short-term difficulties, these repurchase clauses could become the "last straw" that breaks the camel's back.
A person from a technology company that has completed Series A financing candidly stated: "Currently, many venture capital funds operate on a model of unlimited joint liability, unlimited bottoming out, and premature exits. Venture capital has turned into 'insurance' investment, which in turn reduces the motivation of investment institutions to progress with enterprises and actively promote enterprise development through industry connections. Especially for young entrepreneurs and those who start businesses immediately after graduation, this is essentially equivalent to dissuading them."
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With the introduction of policies, industry insiders expect further improvement in the venture capital market ecosystem. Bi Ruigang, a young associate researcher at the Institute of Marxism at Fudan University and a part-time researcher at the Institute of Innovation and Digital Economy, believes that to truly "unshackle" state-owned capital through the design of fault tolerance mechanisms, allowing it to participate in the market in a manner consistent with the objective laws of venture capital, this is how a virtuous cycle of investment and innovation can be achieved.
State-owned capital LPs "carry the big flag"
On October 1, the "Guangdong Province Science and Technology Innovation Regulations" officially came into effect. The regulations propose that the provincial and municipal people's governments at or above the prefecture level should establish and improve the performance assessment, incentive restraint, and fault tolerance mechanisms for state-owned venture capital institutions, and promote state-owned venture capital institutions to increase support for technology-based enterprises in their early stages; in the assessment of state-owned angel investment funds and venture capital funds, "the preservation and appreciation of state-owned capital are not the main assessment indicators."
In addition to Guangdong, Sichuan, Anhui, Hubei, and other places have also explored fault tolerance and exemption from liability mechanisms for state-owned venture capital. This context is the General Office of the State Council's release of "Several Policy Measures to Promote High-Quality Development of Venture Capital" in June, proposing to optimize the management of government-funded venture capital funds, reform and improve fund assessment, fault tolerance and exemption from liability mechanisms, and improve performance evaluation systems.
At present, LPs with state-owned capital backgrounds have become an important force in the venture capital market. The "2024 First Half-Year Development Overview of China's Equity Investment Market" by Zero2IPO Research Center shows that in the first half of 2024, the newly raised funds in China's equity investment market were mainly small-scale funds. In terms of the state-owned capital attributes of LPs, the proportion of capital contributions from LPs with state-owned capital backgrounds (including state-controlled and state-participated LPs) has reached 79.3%, an increase of 6.7 percentage points year-on-year.
As multiple regions have introduced fault tolerance and exemption from liability mechanisms, what problems will they solve? Bi Ruigang pointed out that for a long time, state-owned capital has continued the logic of preserving and appreciating value in management, and in the specific operation process, it has been assessed for individual projects on an annual basis, which is not suitable for venture capital. This is because venture capital activities are "high risk, high return," for example, investing in 10 projects, among which only 1 project may succeed. It seems to be an investment failure, but as long as this 1 project is successful, the benefits it obtains can completely cover the losses caused by the other 9 failed projects; in terms of duration, many innovative activities of significant value often require long-term input, such as breaking through the chip neck problem, it is obviously not something that can be achieved in one or two years. If venture capital needs to be assessed every year, then enterprises supported by venture capital must also produce innovative results every year to cope with the assessment. This assessment method that does not conform to the law of innovation will seriously distort the innovative activities of enterprises, leading enterprises to only dare to carry out short, flat, and fast innovations, rather than carrying out long-term and significant value innovation activities.
Bi Ruigang gave an example to the reporter, saying that many venture capital institutions sign repurchase clauses with the invested companies when investing, which makes the venture capital activities that should be "shared benefits, shared risks" into investment activities where benefits are shared, but risks are borne by the enterprise alone. "What's more serious is that once the enterprise fails to meet performance requirements, or faces certain short-term difficulties, these repurchase clauses may become the last straw that breaks the camel's back. The result is that these capitals not only fail to promote enterprise innovation but also accelerate the death of some potential enterprises when they face short-term difficulties."Interviewees pointed out that it is very necessary to introduce a mechanism for state-owned venture capital (VC) to tolerate errors and exempt from responsibility. Shen Jiaqing, deputy director of the Shanghai Jingyi Industrial Digital Research Institute, believes that the mechanism for state-owned VC to tolerate errors and exempt from responsibility will play a role in two aspects. On the one hand, it will improve the mismatch between the assessment of the preservation and appreciation of state-owned assets and the high-risk characteristics of the venture capital market. For a long time, the red line of preservation and appreciation assessment that state-owned VC institutions have been bearing is like the "sword of Damocles" hanging over the heads of fund managers, preventing the role of state-owned capital in nurturing and developing new quality productive forces from being fully utilized. Investing in innovation and technology inherently means an increase in risk. "Loosening the shackles" for state-owned VC is conducive to straightening out the mechanism and resolving the contradictions between the management methods of state-owned capital funds and the laws of innovation.
"On the other hand, it strengthens the leverage function of state-owned VC, which is 'four ounces move a thousand pounds', and drives investment from the whole society. Other industries needed for the high-quality development of the national economy and society, including integrated circuits, artificial intelligence, biomedicine, etc., are still in the stage of tackling difficulties, and the difficulty of obtaining excess returns has increased, leading to insufficient enthusiasm for social capital participation. 'Loosening the shackles' for state-owned VC is conducive to its better demonstration and guidance role and increases the confidence of private investment." Shen Jiaqing said.
The reporter noticed that the "Guangdong Province Science and Technology Innovation Regulations" also proposed to "promote state-owned venture capital institutions to increase support for technology-based enterprises in the initial stage". Bi Ruigang believes that, overall, state-owned capital has become the most important source of funds in China's venture capital market. However, in terms of structure, state-owned capital mainly participates in fundraising and investment activities in relatively late-stage mature enterprises, while private capital mainly focuses on relatively early-stage start-ups.
A virtuous cycle between investment and innovation
Under a series of policy supports, how investment and innovation can form a virtuous cycle has become a hot topic in the market.
"A virtuous cycle depends on the first is the success rate of corporate innovation, and the second is the acceptance of failure rates by investment financial institutions. The benefits brought by a good project, ten times or a hundred times, are enough to offset the losses of five failed projects." The aforementioned interviewed technology company person pointed out.
Shen Jiaqing also mentioned that innovation is unpredictable, so encouraging innovation "skills outside the poem", building a "tropical rainforest" type of industrial ecological circle and business environment is more important. Diversified innovation investment services, as an important part of the ecological circle, are the "screen" and "amplifier" of innovation.
Shen Jiaqing further stated that companies in different industries, regions, and resource endowments have different demands for venture capital services in the process of innovation and development. To achieve a virtuous cycle, a complete and diverse venture capital system must be established. Venture capital provides funds for projects, allowing innovative ideas to be quickly transformed into actual products or services. The technological progress brought by innovation can improve labor productivity, reduce costs, increase corporate profitability, attract and motivate more investors to invest in innovation. Having a smooth exit channel is one of the prerequisites for the logic of venture capital business, and behind it is an investment system covering the entire life cycle of enterprises, achieving full-stage empowerment of enterprises through "relay investment".
For investors, Bi Ruigang suggests that the design of a fault tolerance mechanism should be used to loosen the shackles of state-owned capital, allowing it to participate in the market in a manner that conforms to the objective laws of venture capital. First, it is necessary to clarify that the fault tolerance mechanism is not equal to no assessment, but to optimize the assessment system. Specifically, the assessment of funds should be based on the returns of the entire investment portfolio, rather than assessing each project individually. As for the tolerance for the loss rate, whether it is 40% or 80% of the principal is not important. Secondly, follow the objective laws of innovative activities and should not be assessed on an annual basis, so that state-owned capital can be more patient.
"In addition to the guiding funds established at the national level, many places have also established many frontier industry investment funds. The support and investment behavior of these funds are often tied to local investment promotion requirements, sometimes easily distorting and violating the laws of industrial development, leading to some chaos." Shen Jiaqing suggests innovating the system and mechanism, encouraging industry funds that meet the requirements, with the help of regional integration, to weaken local attributes, and adopt a large-scale, branded, and cluster development model, from outputting capital to outputting management, concepts, and models, to achieve high-quality development of state-owned venture capital.The State Council's executive meeting held in September pointed out that venture capital is crucial for technological innovation, industrial upgrading, and high-quality development. It is essential to quickly unblock the bottlenecks and choke points in the "raising, investing, managing, and exiting" stages, support qualified technology companies to go public both domestically and internationally, vigorously develop equity transfer and merger and acquisition markets, promote the pilot of physical distribution of shares, encourage social capital to establish market-oriented merger and acquisition mother funds or secondary market funds for venture capital, and promote a virtuous cycle in the venture capital industry. Efforts should be made to make state-owned capital a more responsible long-term and patient capital, and improve relevant policies and measures for state-owned capital investment, assessment, fault tolerance, and exit.
Looking ahead, China Merchants Securities (600999.SH) noted in its research report that China's patient capital is still insufficient at present. Subsequent policies to strengthen patient capital could consider three aspects: supporting state-owned capital to play a leading and exemplary role, establishing a systematic guarantee for long-term funds to support sci-tech innovation companies, and creating an atmosphere where state-owned capital leads investments and various social funds follow; building an evaluation system around "patience," accelerating the improvement of the state-owned capital's fault tolerance mechanism, strengthening the assessment of medium and long-term performance, and comprehensively and reasonably determining assessment targets from multiple aspects such as economic benefits, social benefits, risk control, and industrial support; optimizing the investment environment of the capital market, removing institutional barriers that hinder the entry of medium and long-term capital, allowing institutions to carry out market-oriented competition, and better serving technological innovation.
This year, many places have introduced due diligence exemption and fault tolerance mechanisms:
In May, Dongcheng District of Beijing issued the "Dongcheng District Government Investment Guidance Fund Management Method (Draft for Comments)", proposing that relevant departments and staff of the guidance fund management institution, who meet six conditions such as following the actual situation to perform investment decision-making procedures and not seeking improper benefits for themselves, others, or other organizations during the performance of their duties, can be exempted from responsibility according to laws, regulations, and disciplines.
In July, Chengdu High-tech Zone issued a full life cycle capital support service system covering "subsidy—seed—angel—venture capital—industrial investment—mergers and acquisitions", setting a fault tolerance rate from 80% to 30% for policy funds such as seed, angel, venture capital, industrial investment, and merger and acquisition funds, aiming to solve the state-owned capital's "afraid to invest" dilemma, thereby better playing the role of investment funds in promoting technological innovation and cultivating new quality productive forces.
In August, Yangzhou City, Jiangsu Province, issued the "Implementation Measures on Supporting Industrial Science and Technology Innovation and Encouraging Initiative (Trial)", supporting a focus on industrial science and technology innovation to provide front-line services and take the initiative, and mistakes and errors that occur in the process of promoting industrial science and technology innovation can be given "fault tolerance exemption" after identification.
In September,The Hubei Provincial State-owned Assets Supervision and Administration Commission (SASAC) has introduced the "List of State-owned Enterprise Fault Tolerance and Exemption Matters," establishing a "1+N" fault tolerance and exemption work system and proposing various types of "exemption" situations.
In September, Zhengzhou City, Henan Province, issued the "Zhengzhou City Angel Investment Fund Establishment Plan," which requires adherence to the laws of angel investment, reasonable tolerance of normal investment risks, and not using normal investment risks as a basis for accountability. When the fund is liquidated, if the investment loss rate does not exceed 40% of the investment principal, the fault tolerance procedure should be initiated in accordance with laws and regulations. A comprehensive performance evaluation should be conducted based on the overall evaluation principle, without pursuing accountability for losses in individual or several direct investment projects, single or few sub-fund investments in individual or several projects, or individual project annual phased performance results. An evaluation mechanism oriented towards the transformation of scientific and technological achievements and technological progress should be established, tolerating investment losses, etc.
In October, the "Guangdong Province Science and Technology Innovation Ordinance" came into effect. The ordinance proposes a series of related measures around the equity investment support needed for scientific and technological innovation, including extending the duration of existence, differentiated assessment, and exit. It explicitly states that in the assessment of state-owned angel investment funds and venture capital funds, the preservation and appreciation of state-owned capital should not be the main assessment indicator.