Venture capital falls within the category of equity investment, often taking the form of funds to invest in small and medium-sized enterprises with growth potential, and obtaining certain investment returns through equity investment. Venture capital funds are closest to risk capital VC (Venture Capital), and according to international practice, VC mainly invests in the early stages of enterprise growth, enjoying more preferential policies or support policies listed separately, and is on par with PE (Private Equity).

Venture capital funds go through four stages: fundraising, investment, management, and exit. Abundant funding sources and a reasonable capital structure are the foundation for the development of venture capital funds; strong investment project capabilities and post-investment management capabilities are the support for the development of venture capital funds; rich and diverse exit channels are the guarantee for venture capital funds to realize returns.

01 Venture capital funds face issues of insufficient funding sources and unreasonable capital structure at the fundraising end

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According to data from the China Venture Capital Research Institute, in the first half of 2024, the number of newly established venture capital funds and the amount of funds raised in China both experienced a significant decline. Specifically, 2,393 new funds were established, a 39% decrease year-on-year and a 45% decrease quarter-on-quarter. The fundraising scale was $219.5 billion, a 38% decrease year-on-year and a 15% decrease quarter-on-quarter. According to data from the Asset Management Association of China, as of the end of June 2024, there were 24,344 venture capital funds in existence in China, with a total scale of 3.26 trillion yuan.

China's venture capital funds are in the development stage, with an unreasonable fund structure and a lack of a clearly positioned and reasonably laid out group of venture capital funds. The fundraising process in the venture capital industry lacks diverse funding channels, and the capital structure is not very reasonable. At specific stages, state-owned capital dominates the equity investment market. According to data from the Zero2IPO Research Center, in the first half of 2024, investments by state-owned background investment institutions totaled 102.582 billion yuan, accounting for 57.0%. In terms of funding sources, there is a shortage of long-term capital sources, which does not match the tolerance and patience required by venture capital. Many venture capital funds are forced to exit due to time constraints or assessment pressures, and under the condition that the cycle of fundraising, investment, management, and exit has not formed a virtuous circle, situations such as forced repurchase by invested enterprises occur, which is not conducive to the survival and development of technological innovation enterprises.

02 Focus points for optimizing the capital structure of venture capital institutions at the fundraising end

Expand the fundraising channels and exit channels for venture capital enterprises, innovate various fundraising methods, follow market-oriented rules, and adopt a combination of government guidance and market operations to promote the healthy development of the venture capital industry.

(1) Activate more social capital to enter venture capital funds

Venture capital funds are an important part of equity investment. Most equity funds in China adopt a partnership system, with partners including LP (Limited Partner) and GP (General Partner), where GP is responsible for managing the equity fund. How to attract more social capital LPs to join venture capital funds is an important point in solving the development of the venture capital fund industry.

① On the capital supply side: Ensure that capital elements can obtain substantial investment returns.Capital, as a factor of production, seeks to maximize returns. The fundamental motivation for social capital to participate in venture capital investment lies in its potential for profit and development. Stable investment returns are the source of confidence for social capital and the driving force for its engagement in venture capital investment; without the expected returns, social capital would lack the basic incentive to participate in the high-risk venture capital industry. Based on this, it is essential to improve the systems for the development of the venture capital industry, allowing market mechanisms to play a decisive role in resource allocation, enabling capital to be directed to the most effective use, and achieving maximum returns.

Expand the exit channels for venture capital funds to attract social capital. Further improve the construction of the capital market system, clarify boundaries, and fundamentally promote the orderly operation of the capital market. Through dynamic optimization, allow more high-quality companies to go public and enable substandard companies to exit easily, providing more channels for the exit of venture capital funds. Support domestic enterprises in entering the international capital market to achieve a positive interaction between domestic and international capital markets. Expand the scale of the Secondary Fund (S Fund) market to further support the formation and exit of venture capital funds, guiding more social capital into the venture capital industry.

② On the demand side of funds: Ensure the continuous emergence of scientific innovation projects and entrepreneurial enterprises

An important pathway for China's high-quality development is scientific and technological innovation. Under the backdrop of supporting scientific innovation, China should focus on both the existing stock and the incremental growth of scientific innovation projects and enterprises. For the existing scientific innovation projects and enterprises, increase investment support to achieve rapid growth. At the same time, support universities, research institutions, and others in promoting the transformation of scientific and technological achievements, providing incremental support for projects and enterprises that contribute to the development of scientific innovation. Functional and market-oriented incubators and accelerators attract and cultivate more scientific and technological innovation projects or small and micro enterprises, supporting the industrialization development of these projects or enterprises. Additionally, for emerging and future industries, increase the cultivation efforts to form an ecosystem that supports these industries.

③ On the fund management side: Leverage the brand effect and guiding role of General Partners (GPs)

If a GP has impressive performance or classic cases of profitable exits from invested projects, it can win more trust and favor from Limited Partners (LPs). When a GP establishes a new venture capital fund, funds from various social levels will actively respond, actively acting as LPs to join, rapidly gathering social funds to form a new venture capital fund. Government-led venture capital sub-funds, if they can choose reputable GPs as fund managers, may attract more social capital to join, increasing the proportion of social capital through the GP's influence. Government-led funds, by participating in venture capital sub-funds, can drive more social funds to participate in the venture capital field, guiding social capital towards startups and small and micro enterprises that have difficulty raising funds, more effectively supporting small and micro technology enterprises.

(2) Support more long-term capital to enter venture capital funds

Strengthen top-level design, improve and standardize the systems and mechanisms for long-term funds to enter venture capital funds. Under the premise of following market rules, allow and guide long-term capital to enter the venture capital field, such as guiding insurance institutions, social security funds, and commercial banks with investment functions, and other long-term capital to participate in venture capital funds according to market rules.

Regulatory authorities allow and even encourage these institutions to enter the venture capital industry, but whether these institutional investors participate, when they participate, and how much they invest, these decisions need to follow business logic and market laws. Each institution makes decisions based on its own development layout and makes judgments on investment risks.

Strengthen the market-oriented operation mechanism of state-owned venture capital funds. When state-owned capital establishes venture capital funds or state-owned enterprises establish Corporate Venture Capital (CVC), the most important thing is to establish incentive and restraint mechanisms for state-owned capital venture capital funds. It is necessary to guide state-owned capital to support venture capital funds while preventing potential agency problems, achieving a balance between incentive and restraint mechanisms. Under clear boundaries, ensure that long-term capital truly implements market-oriented allocation. For venture capital funds with state-owned capital participation, GP managers will be very cautious in investing, paying great attention to the safe return on investment, and will only choose projects with relatively lower risks. According to data from Zero2IPO Research Center, state-owned capital investment institutions place more emphasis on the preservation and appreciation of state-owned capital, mainly investing in mature and expansion stage projects. The incentive mechanism mainly encourages state-owned capital venture capital funds to make decisions and invest according to market-oriented mechanisms, achieving a virtuous cycle of fundraising, investing, managing, and exiting. If there is a lack of incentive mechanisms, investment decision-makers do not achieve profit-sharing and risk-sharing, and state-owned capital's venture capital funds lack vitality. The restraint mechanism mainly restrains certain behaviors, sets boundaries, and prevents agency problems. If there is a lack of restraint mechanisms, the characteristics of state-owned capital determine that agency problems may occur.Improve the performance assessment mechanism for state-owned capital venture investment. The assessment rules reflect a mechanism design, and an appropriate mechanism can achieve incentive compatibility, which is both in line with the interests of state-owned assets and provides incentives for investment decision-makers. The state-owned venture capital fund adopts a co-investment and penalty system for investment loss of project investment decision-makers, truly achieving shared interests and shared risks. The evaluation system determines the direction and whether the fund can play a role in supporting start-up enterprises. An appropriate assessment system can bring out the initiative of investment fund managers, while an inappropriate assessment system may lead to a "lying flat" strategy of not investing and not withdrawing by fund managers. Improve and implement a fault tolerance mechanism, conduct periodic comprehensive performance evaluation according to the investment laws of the fund and market principles, and do not assess the profit and loss of specific single sub-funds or individual projects, finding a balance between increasing the tolerance for state-owned capital investment failure and the appreciation and preservation of state-owned capital. In addition, simplifying the exit procedures for state-owned capital equity investment and expanding the scope of application based on the pre-agreed exit process, and implementing an exit model with the filing of the off-site transaction supervision agency is also an important measure to enhance the enthusiasm of state-owned capital participation in the venture capital industry.

(3) Improve the linkage and docking between domestic and international venture capital institutions.

In recent years, the reality of geopolitical challenges and the weakening of internet dividends has led to a shift in the direction of the dollar funds that once played an important role. The mutual rush between dollar funds and technology companies is difficult to continue, which has had a certain impact on China's venture capital industry.

Improve the system, further expand and improve the QFLP (Qualified Foreign Limited Partnership) pilot, support qualified foreign limited partners to convert foreign exchange into RMB and participate in the establishment of equity investment funds in China after qualification approval and foreign exchange supervision procedures. Qualified foreign investors include foreign natural persons, enterprises or other organizations, which can be sovereign funds, pension funds, charitable funds, insurance companies, banks, securities companies, and recognized foreign institutional investors.

The main goal of the QFLP pilot is to attract foreign capital to carry out equity investment in China in the form of RMB funds, with RMB funds mainly focusing on the equity of domestic non-listed companies. Expand the introduction of international capital and achieve the joint development of social capital both domestically and abroad. International venture capital institutions each have their own characteristics and positioning, most of them have already laid out in China, and have twenty years of experience in the Chinese venture capital market. The shift of dollar funds to RMB funds can provide support for the development of China's RMB fund venture capital industry.

The expansion of the QFLP pilot has laid a policy basis and policy support for international venture capital institutions to enter China's venture capital market. The Shanghai Municipal Government's "Several Opinions on Further Promoting the High-Quality Development of Shanghai Venture Capital" proposes to deepen the QFLP pilot, support international professional investment institutions and teams to set up RMB funds in China, and explore the pilot of one-time settlement and sale of foreign exchange for foreign institutional investors to participate in RMB funds, laying a policy basis for international professional investment institutions to enter China's venture capital market.

Under the partnership system, QFLP can set up foreign GPs in China or rely on domestic GPs to manage the fund. Specifically for a certain fund, partners can be all QFLPs, or some domestic LPs and some QFLPs. Under certain conditions, domestic capital and international venture capital institutions can work together to promote the healthy development of the venture capital industry.

At the current stage, more funds reduce the investment in new projects and focus on relatively mature invested projects, supporting the stable operation of invested projects. How to guide and encourage QFLP to participate in China's venture capital funds, especially Shanghai's venture capital funds, requires the formulation of corresponding policies for guidance and support, follow market rules, make QFLP profitable, achieve a win-win situation of shared interests, and invest more in technology innovation enterprises in the early stage.