Over the past year, China's private equity (PE) and venture capital (VC) market has encountered significant challenges regarding exit opportunities. As regulatory policies tighten, the difficulty of achieving initial public offerings (IPOs) has markedly increased, resulting in a growing backlog of companies awaiting approval for listing. Concurrently, mergers and acquisitions (M&A) have not yet gained enough scale and dynamism to offer a viable alternative, coupled with pressures from fund expirations and a wave of buybacks causing exits to become a critical obstacle in alleviating the current challenges faced in the primary market.

Investors in the PE/VC sector are now increasingly cautious when evaluating exit pathways and potential returns. The dual pressures of unpredictable capital returns and liquidity risks have made finding solutions to the existing exit impasse all the more urgent.

The Pressure of Exit Channels

The Chinese PE/VC industry is experiencing overwhelming pressure on its exit channels.

The high thresholds for IPO approvals have made it increasingly difficult for companies to go public, resulting in a phenomenon akin to a "dammed lake," where numerous firms wishing to list are stuck in a queue, further increasing the count of unlisted companies and directly impeding the exit processes of PE/VC firms.

Despite ongoing efforts to foster innovation and support economic growth through reforms in China's capital markets and science and technology policies, the practicality of IPOs remains the primary exit route for most PE/VC institutions, with a relatively low reliance on alternative exit pathways. As the IPO route becomes constrained, the difficulty of exit pathways escalates significantly. Data indicates that nearly 400 companies were awaiting IPO approval in the A-share market in 2023, with the approval rate markedly declining. This suggests longer and more challenging exit avenues for investors in the PE/VC landscape, where delayed exits not only inflate capital costs but also inject uncertainty into the overall returns of funds.

While M&A stands as another potential exit route characterized by flexibility, its activity level is contingent upon the economic cycle and regulatory environment. In the context of a slowing macroeconomic backdrop, many potential M&A deals have faltered, thus limiting exit opportunities through this channel. Although the government has initiated several incentive policies, such as tax advantages and streamlined administrative approvals, more substantive measures are still required to ensure the sustained growth of M&A activity.

Recently, S-funds have come under increased attention as a noteworthy exit model. This fund type can aid PE/VC firms in achieving partial or full exits within project timelines, effectively alleviating liquidity pressures. However, the secondary market in China remains immature, with numerous restrictions on fund registration and circulation, limiting the scale and influence of S-funds. While policies are encouraging the development of this exit method, establishing a stable and liquid exit channel will necessitate multi-faceted collaborative efforts.

Underlying Reasons for Exit Difficulties

Economic and Policy Volatility Impact

The current pressures surrounding exits are closely tied to cyclical economic fluctuations. With economic growth slowing, volatility within capital markets has intensified, subsequently impacting fundraising and exits overall, leading many investment projects to delay their exit timelines. Alongside shifts in the policy environment and a relatively sluggish progress in capital market reforms, exit pressures continue to mount. Particularly in light of structural adjustments in the economy, market confidence has waned, listing demands have slowed, and these factors have directly influenced the exit expectations for PE/VC firms.

Changing Investor Expectations

Amidst cumbersome exit channels, discord has emerged between limited partners (LPs) and general partners (GPs) regarding future exit returns and timing. LPs are focused on securing higher returns and timely exits, while GPs, confronting uncertainty in the market environment, are adopting a cautious approach in both post-investment management and exits, causing a growing divergence in investment strategies between the two groups. GPs are taking a more conservative stance during post-investment management phases, resulting in an inability to promptly reflect the growth potential of investment projects, which further hinders exit performance.

Slow Progress in Capital Market Reforms

Although strides are being taken toward reforms in China's capital markets, the current market exit mechanisms remain insufficiently developed. Overreliance on IPOs has resulted in a lack of diversity in exit strategies. The relatively slow development of the M&A market, inadequacies in secondary market mechanisms like S-funds, and insufficient market transparency and information disclosure are all impediments to the implementation of varied exit mechanisms. This singularity in exit channels not only exacerbates exit difficulties but also places greater operational pressure and capital risks on PE/VC firms.

Future Prospects and Breakthroughs

Policy Benefits and Structural Adjustment Promotion

For the PE/VC industry in China, an improvement in exit channels seems possible under supportive policies. Recently, the Chinese capital market has encountered significant policy shifts. During a recent symposium, Wu Qing, chairman of the China Securities Regulatory Commission, explicitly stated an intention to gradually restore the normalization of IPOs. This move offers new hope for exits in the primary market and is aimed to enhance capital market activity while providing policy confidence to the venture capital sector as it contends with exit challenges. Moreover, ongoing encouragement for long-term capital from insurance and social security funds to engage in market investments will supply stable financial support for PE/VC firms, mitigating capital pressures upon exit.

Refinement of Diverse Exit Mechanisms

Promoting diversified exit strategies will be crucial in alleviating exit pressures. Encouraging second-hand transactions can provide PE/VC firms with flexible exit channels, especially amidst stringent IPO audit environments, making S-funds a valuable supplementary exit route. Additionally, energizing the M&A market will be one of the focal points of future policy adjustments. By optimizing M&A processes, offering tax relief, and promoting cross-industry mergers, policies can effectively enhance the flexibility of M&A exits and open more avenues for PE/VC firms.

The Return of Pricing Authority

With the gradual advancement of capital market reforms and the recovery of the secondary market—along with a gradual restoration of pricing authority—the investment exit landscape in the primary market is poised for expansion. Recent reform measures, such as accelerating the implementation of the registration system, enhancing market transparency, and optimizing information disclosure, will not only foster trust and liquidity in the secondary market but also, to some extent, alleviate investors’ cautious attitudes. Such an improvement in market sentiment is expected to boost secondary market activity and lead to more rational pricing of investment targets. For PE/VC firms, these positive transitions suggest a more stable exit environment and rational exit valuations. As secondary market valuations rebound, primary market projects will enjoy greater valuation potential upon exit, directly enhancing the performance of IPOs and M&A exits while injecting confidence into the PE/VC sector.

Conclusion

At present, the exit channels for China's PE/VC industry are facing numerous challenges; however, with policy support and improvements in market mechanisms, the future landscape of exit paths will gradually diversify. PE/VC institutions must remain agile amidst a progressively volatile market environment to adapt to cyclical economic fluctuations. Simultaneously, the industry should actively engage in investment directions guided by policy, particularly increasing focus on technological innovation and infrastructure development to seize more exit opportunities.

Looking forward, the exit channels for China's PE/VC industry are set to continually evolve. The synergy of IPOs, M&A, and S-funds is expected to create a stable and sustainable ecosystem for exits, injecting new vitality into the industry’s continuous growth.