As a New Exit Channel for Equity Funds, S-Funds Have Gradually Attracted Increasing Attention and Preference from More Institutions Due to Their Advantages Such as Avoiding the J-Curve Effect, Accelerating Cash Flow Back, and Reducing "Blind Pool" Risks. From 2014 to 2020, China's S-Fund secondary share trading market experienced significant growth. According to data from Zero2IPO Research Center, there were only a few hundred S-market trading events in 2014; by 2020, this number had soared to 1,084, with a transaction volume of RMB 103.573 billion. The S-market has gradually become an important part of asset management and investment.
With the rapid development of China's economy, China's equity investment market has also undergone three decades of rapid growth. The "Mass Entrepreneurship and Innovation" initiative in 2014 and the supply-side structural reform in 2015 both provided strong impetus for the rapid development of China's private equity market. According to statistics from Zero2IPO Research Center, the scale of newly raised funds and investment in China's equity investment market reached RMB 2.2 trillion and RMB 1.4 trillion respectively in 2021, with a compound annual growth rate (CAGR) of over 16% from 2011 to 2021. Currently, a large number of funds have entered the exit period or extension period. However, the current domestic market's exit method, which is mainly based on IPOs, has clearly been unable to meet the exit needs of fund managers and limited partners (LPs), laying the foundation for the development of S-funds.
On the other hand, the evolving domestic policy environment and adjustments to the supply-demand structure have also brought opportunities for the rapid development of S-fund transactions. In recent years, affected by the macro policy environment, the COVID-19 pandemic, and international political situations, financial institutions represented by banks and LPs represented by government-guided funds have been unable to continue capital contributions due to policy and capital issues. Private enterprises and individual investors have had liquidity needs due to economic downturns, leading to a sharp increase in fund exit demand on the supply side. At the same time, on the demand side, investment institutions pursuing safe and stable capital returns (represented by insurance funds) and institutions seeking to improve capital turnover efficiency (represented by market-oriented fund-of-funds) have created a favorable environment for the active trading of S-funds.
The combined effects of the current tightening of domestic IPO policies and the release of the Measures for the Supervision and Administration of Private Investment Funds (Draft for Comment) have continued to bring positive factors to the prosperity of the S-fund market. Despite the booming development of S-transactions in China, in terms of transaction scale and buyer trading frequency, it is a case of "more noise than action". One of the most important reasons for this phenomenon is the issue of valuation and pricing.
Currently, valuation and pricing pose a major challenge in domestic S-fund transactions. The future returns of S-funds mainly come from two sources: first, the discount obtained by the buyer at the time of the transaction; second, the value of the underlying investment portfolio at a future point in time. However, in essence, both boil down to the valuation and pricing of assets. At present, there are mainly the following types of transactions in China's domestic S-fund trading market:
The main feature of this type of transaction is that the target fund is approaching or has entered the exit period, the investment portfolio is clear, and an LP happens to transfer its subscribed but unpaid shares due to its own reasons. Typically, this type to its own reasons. Typically, this type of transaction is priced at cost, so the buyer and seller do not need to negotiate over the valuation and pricing of the underlying assets.
The key characteristics of this type of transaction are that the target fund is already in the exit period or extension period, the fund has generated a Distributed to Paid-In Capital (DPI) ratio, and the book value of the investment portfolio is relatively high. Valuation and pricing are the main challenges for this type of transaction. Since both the buyer and the seller have their own views and expectations regarding the underlying assets, it is difficult to reach an agreement on discounts and valuations. Currently, some sellers in the market sell their shares based on the subscribed shares (without considering the fund's distributed DPI), with a discount applied to the fund's book value or Net Asset Value (NAV). This pricing method highly depends on the future return realization of the fund's underlying projects.
To address the current difficulty in valuation and pricing in China's domestic S-fund trading market, the market is developing innovative trading models to resolve pricing issues and accelerate S-fund transactions:
This trading model involves the transfer of fund shares at an immediate par price or a lower price. After the buyer and seller agree on the front-end hurdle rate, they share the fund's future returns in a proportional manner. This approach resolves disputes between the buyer and seller regarding the value of the underlying investment portfolio.
In essence, this trading model adopts a debt-like approach. The buyer acquires fund shares at par and, at the same time, a ceiling and floor for returns are set, with the seller responsible for making up any shortfall. This model can simultaneously address the seller's short-term liquidity needs while allowing them to retain the intention of holding the fund shares in the long run.
This trading model is designed for scenarios where the General Partner (GP) and the counterparty cannot reach an agreement on the valuation of projects within a GP-led asset package. Clauses related to project valuation are established: if the future valuation of the project reaches a certain level, the buyer will make up the valuation difference; if not, no additional payment is required.
Overall, China's domestic S-fund sector is developing vigorously. Although valuation and pricing remain unresolved challenges, the market has gradually evolved a variety of trading models with Chinese characteristics. It is believed that in the future, with the continuous emergence of assets on the supply side, the increasing professionalism of S-fund institutions, and the gradual formation of consensus on market pricing rules, S-fund transactions will witness even greater prosperity in China.
Source: Guo Boyang, Fund Department
Review: Xue Yao
Release: You Yi
