CHINA (PRC FIRMS): Opportunities and Challenges of S Funds in China's PE Secondary Market

Opportunities and Challenges of Secondary Funds in China's PE Secondary Market
中国PE二级市场S基金的机遇与困局

Private-equity secondary market (hereinafter referred to as "PE secondary market"), being different from the general primary market for the fundraising and investment of private equity funds, is regarded to be able to increase the liquidity of private equity funds, and usually refers to the market where the equity of non-listed companies and commitments to private-equity funds are traded, transferred and circulated as the subject matter thereof. Private equity secondary transactions are generally divided into transactions relating to the portfolios held by private equity funds and transactions relating to limited-partnership interests in private equity funds (referred to as "secondary share”). A secondary fund ("S fund") whose targets are the equity/assets of private equity investment funds is a professional market investor in the PE secondary market and is especially active in PE secondary transactions.
私募股权二级市场（简称“PE二级市场”）区别于一般私募股权基金募集和投资的一级市场，为增加私募股权基金的流动性应运而生，通常是指对非上市公司的股权、合伙企业份额等私募基金份额为标的进行买卖、转让和流通的市场。私募股权二级交易也可相应区分为针对私募基金所持有的直投项目投资组合的交易和针对私募基金份额的交易。S基金即指以私募股权投资基金权益/资产作为交易对象的基金，是PE二级市场中的专业市场投资者，在PE二级交易中尤其非常活跃。

Since the emergence of the COVID-19 pandemic in 2020, the prices of global financial assets have declined, which has stimulated a large amount of capital that flow into S funds and pushed up the total amount raised by S funds in the last two years. Currently, Chinese PE institutions have to face varying degrees of pressure in terms of fundraising, investment and exit.
自2020年由于新冠疫情的出现，全球金融资产价格普遍下行，这一情形促使了大量资金涌入S基金，推高了近两年S基金的募集总金额。当前，中国私募机构在募资、投资、退出环节都面临着部不同程度的压力。

In terms of fundraising, the market liquidity is tightening and the supervision on LP side tends to be more stringent and complicated, which makes fundraising more difficult. In terms of investment in recent years, the fast expansion of capital in some popular areas such as biomedicine and artificial intelligence has resulted in high valuation of projects in the market, which in turn has pushed up the cost of portfolios by funds. In terms of exit, PE funds tend to heavily rely on IPO listings, however, the downturn trend in the domestic securities market and the plummeting share prices of Chinese companies listed overseas in the last few years add further difficulty to the exit options.
在募资方面，市场流动性收紧，对LP监管趋严，募资难度加大；在投资方面，近年来资本在生物医药、人工智能等部分热点领域高速扩张而造成项目市场估值普遍偏高，进而导致基金的项目持有成本较高；在退出方面，严重依赖IPO，但近年国内证券市场低迷、且境外证券市场中概股持续走低使得退出渠道不畅。

It is generally perceived that PE secondary transactions could be a way-out to relieve the exit trouble in the PE market. As for the Chinese market, the following four factors have jointly brought new development opportunities to domestic S funds: (1) LPs that participated in early RMB PE funds in the period from 2009 to 2011 are facing the problem that these funds will expire within these two years and are difficult to be liquidated in the short term; (2) a large number of government guiding funds that entered the market in the period from 2013 to 2015 have entered or are about to reach the exiting stage, which are subject to the provisions of their respective administrative measures and the funds have a strong need to exit. Due to those funds' "guiding nature", they have certain advantages in terms of exit price, often accompanied by relevant "concessions to surrender profits"; (3) after the promulgation of the Guiding Opinions on Regulating Asset Management Business of Financial Institutions in 2018, some asset management products with multi-level nesting, term of fund mismatching and capital pooling problems are requested to be tidied up and exited in an orderly manner; (4) the global grain, energy and other bulk commodity markets fluctuate greatly due to the slowdown of the world economic recovery, coupled with the frequent occurrence of domestic epidemics, market players are struggling financially and economic circulation is constrained. The downward pressure adds on the funds. Some LPs of funds, especially the ones such as listed companies and private institutions, are facing liquidity problems and are unable to pay up their subscribed contributions in time and some are required to achieve full or partial liquidity on their fund interests so that they can cash out to support their main business as soon as possible, which further increases the demand for secondary transactions.
市场普遍认为，中国私募股权投资市场退出难题亟待PE二级交易缓解，我们认为对于中国市场而言，以下四个层面的因素共同为国内的S基金带来了新的发展机遇：（1）2009-2011年期间早期参与人民币私募股权基金的LP面临该等基金在这两年即将存续到期、但短期内仍难清盘的困扰；（2）2013-2015年期间大量进入市场的政府引导基金类资金，已经或即将进入退出期，这些政府引导基金类资金受限于其各自管理办法的规定退出需要强烈，基于其“引导性质”在退出价格方面也具有一定的优势，往往可以附带有相关的“让利优惠”；（3）自2018年《资管新规》出台后，部分存在嵌套和期限错配、资金池等问题的资管/理财资金亟待有序清理退出；（4）受世界经济复苏放缓，全球粮食、能源等大宗商品市场大幅波动，国内疫情近期多发，市场主体困难明显增加，经济循环畅通遇到一些制约，新的下行压力进一步加大，部分基金的LP（尤其是上市公司、民营机构等机构主体）出现了资金流动性问题而无法按时缴付其认缴出资额，或要求尽快处理退出投资收回已投资金用于其主营业务的需要，进一步增大了对于基金二手份额的交易需求。

On the other hand, S funds, in comparison with primary private equity funds, offer great advantages on investment opportunities to investors due to its inherent nature: Firstly, since the investment target is the limited-partnership interests of an existing fund with shorter remaining duration, the transferee of a secondary transaction can turn the capital around much quicker than other funds. Secondly, S funds can enhance the predictability of investment returns and reduce the risk of blind pool portfolio. Before investing in secondary shares of a private fund, the transferee may judge the investment quality of such private fund by observing the portfolio of such fund. Making an investment when the underlying fund is exiting or approaching the expiry time of the investment period will be better timed and its return better predicted than investing into private equity funds which are at the early stage of initial fundraising. In addition, an S fund tends to obtain opportunity to receive price discount when it accepts the transfer of investments or fund shares, which can further secure a better return rate. Given that the original investors of private funds sometimes have to transfer their shares of private fund due to some objective needs such as turnover of capital and expiration of a term, the transferee will have strong bargaining power and it is possible to acquire such shares of the private fund at a low discount.
另一方面，S基金的天然特性相对于其他私募股权基金的投资机会对投资者而言具有极强的优势：首先，由于投资的是经转让的私募基金份额，该等私募基金已存续一段时间，因此剩余存续期限较短，受让方能在相对较短的时间内退出，提高资金的利用率。其次，S基金可增强投资收益可预期性，降低盲池风险。在选择投资于私募基金转让份额之前，受让方可以通过观察该等私募基金的已投项目，判断该等私募基金的投资质量。通常在该等标的基金已进入退出期或接近投资期届满时投资，相较于在私募基金初始募集时参与投资，对预期收益的判断更为准确。此外，S基金受让项目或基金份额时通常都会有机会享受价格折扣，则可以进一步提高回报率。鉴于私募基金的原投资者往往是出于资金周转、期限届满等客观需求而不得不转让其持有的私募基金份额，此时受让方就获得了较强的议价能力，有可能以较低的折扣受让该等私募基金份额。

With all the pros of S funds stated above, does it mean S funds are the perfect solution to exit difficulty of private equity funds? Considering the status quo of the S fund market in China practically, there is still a gap between theory and reality, and the development of the S fund market still faces the following challenges: The first problem is how to balance the relationship between the S fund and the S strategy. How to define an S fund in practice? How to distinguish a general FOF fund adopting S strategy from an S fund? Is it possible for an S fund in the market to exclusively invest in secondary shares of funds? As is known to many, the private equity transactions are featured with specialism, fortuitousness and confidentiality due to low liquidity, inaccurate valuation and opaque information in such market. Provided a fund, which is originally designed to focus on S strategy, runs short of suitable S trading opportunities but encounters a hard-earned investment opportunity to commit to a new PE fund, will it invest in the fund as an initial LP?
基于S基金上述的优点，那是不是意味着S基金就是解决私募股权基金退出难的完美方案？基于目前国内S基金的实际现状，理论和现实依旧存在一定的差距，S基金仍旧面临以下困局。第一，首先面临的就是S基金与S策略之间的平衡问题，从实操中来看究竟该如何定义S基金，引入S策略的一般FOF基金和S基金如何区分，市场上的S基金真的能实现只投资基金二手份额吗？众所周知，私募股权投资市场因其流动性差、估值不准确、信息不透明等多方面因素，其交易环节本身就是具有强烈的专业性、偶发性和私密性，如果一支原本定位于专注只做S策略的基金，但在市场上并没有那么多合适的S交易机会、或其难以及时获得优秀的S交易机会的阶段，又遇到了比较好的初始私募基金投资机会，那么是否会作为初始LP对子基金进行投资呢？

Secondly, since no large-scale and market-oriented trading platform of the secondary shares has been established, the channels to acquire trading information of secondary shares are very limited. When an opportunity of acquiring secondary shares of a fund emerges, GPs tend to first inquire with the existing LPs of the fund to gauge their interest in the shares. If such fund performs very well, the secondary shares of such fund will naturally be in high demand. If it is a market-oriented S fund without any connection with any existing LP or GP of the underlying fund, it will put this "outsider" in a disadvantageous position in competition with existing LPs or S funds affiliated to the GP. Therefore, it it noted that the opportunity of obtaining secondary shares of a fund with excellent performance in the domestic market only becomes available to a potential investor when it has managed a certain size of FOF fund, or has extensively invested in sub-funds of a certain size or has strong information acquisition capabilities and has established a very close relationship with the leading GPs in the market.
第二，国内并未建立起大规模、市场化的基金二手份额的交易平台，信息渠道非常有限，对于出现的基金二手份额机会，GP一般也会首先面向该只基金的现有其他LP征询受让意向。如该只基金表现非常好，该基金的二手份额也会炙手可热，但如果仅仅是一只与标的基金现有LP或GP并无任何联系的市场化S基金，其作为“外人”在现有LP或与GP的关联S基金面前将显得毫无竞争力。因此，我们注意到，目前国内市场中能够获取市场上这样表现优异的基金二手份额机会的，是需要基于已经管理了一定规模的FOF基金，已经广泛布局了一定规模的子基金，或基于其信息获取能力极强、与各市场头部GP建立了非常紧密合作关系的机构。

Thirdly, in terms of the trading process of secondary shares, there is a balance to be found between the non-public nature of private funds and the requirement of information disclosure by purchasers. How could the seller manage to publicise secondary shares information to more potential investors whilst still in compliance with the applicable law and regulations? The same issue is seen in the due diligence of the underlying fund and its investment portfolio. A target fund usually is financial investors of its own portfolio companies and therefore may not mandate the portfolio companies to provide all due diligence information requested by an S fund in such a detailed manner as what a fund direct investment would require. It is very difficult to obtain data for such due diligence and the amount of data collected is limited. How to solve the conflict between S fund as the purchaser's requirements for the authenticity and timeliness of underlying investment information and the practical challenge in penetrating the underlying portfolio investment of the target fund has become a key issue for S funds when pitching to their own investors and demonstrating the reliability of their investment strategies in the fundraising process.
第三，对于二手基金份额的交易过程而言，也面临着私募非公开属性与买家信息公开度的要求之间平衡的问题，卖方如何在确保非公开募集合规的情形下在将转让信息需求进行尽可能让更多买家看到以便获取更多有竞争力的报价。类似的问题也存在于对标的基金及其投资组合尽调的过程中，标的基金在投资组合层面往往为参股型的财务投资人，亦可能无法要求相关投资组合按照基金直接投资项目的标准提供S基金作为买家所需要的全部详尽的尽调资料，获取数据的难度很大，收集的数据量也有限。如何解决S基金作为买方对于底层项目信息真实性和时效性的要求与��层项目穿透尽调的难度之间的矛盾，也成为了S基金募集过程中说服其自身投资者进行投资、论证其自身投资策略可靠性的重要关键问题。