Major Policy Boost: Banks Permitted to Engage in Equity Investment to Support Sci-Tech Innovation

According to Cailian Press, Shang Fulin, Chairman of the China Banking Regulatory Commission (CBRC), stated at the second session of the 7th General Meeting of Members of the China Banking Association on the 14th that banks meeting certain conditions should be permitted to establish subsidiaries to engage in equity investment in technological innovation. By consolidating financial statements for a comprehensive overall assessment, investment returns could be used to offset credit risk losses. Shang’s remarks may signal the imminent entry of a “state-backed venture capital team.”

Since the second half of 2015, it has become a consensus that startups have plunged into a “capital winter.” With funding tightening in the primary market, most startup projects have fallen into the vicious cycle of “Series C death,” and many startups are struggling due to capital shortages.

According to data released by IT Juzi, the number of startups in the first half of 2016 decreased year-on-year. In the second quarter of 2016, the proportion of new companies receiving investment during the quarter dropped to 13%. Capital has concentrated on a few high-quality companies, while the majority of startups face severe survival challenges.

Amidst the difficulties in equity financing in the capital market, small and medium-sized enterprises (SMEs) also lack support in credit financing channels. According to the "2016 Outlook Report on China's Sci-Tech Innovation Enterprises," only 2% of surveyed companies in 2015 relied primarily on bank loans as their main source of funding.

Small and medium-sized enterprises (SMEs), particularly technology-based SMEs, largely adopt an asset-light model and lack collateral or effective guarantees recognized by banks, making it difficult for them to secure loans. Furthermore, SMEs often lack robust financial management systems, posing significant risks to commercial banks that require effective risk control and mitigation.

For enterprises, relying solely on debt financing can easily lead to excessive liabilities. In the broader context of an economic downturn, a high debt-to-asset ratio adversely affects a company’s financing capacity and ability to continue operations, with cash flow disruptions potentially causing business failure at any time. Commercial banks’ participation in equity financing can effectively supplement corporate capital and reduce leverage ratios. The entry of bank equity investment also tends to increase the equity value of science and technology innovation enterprises, attracting more investors; over the long term, this will promote the healthy development of such enterprises.

The entry of state-backed venture capital into the market is conducive to improving liquidity in the short term, gradually reversing the current “capital winter.” While nurturing a new batch of projects, these fresh funds can also alleviate financing shortages for some existing projects, with those already backed by professional investment institutions poised to benefit. In the medium to long term, the overall market recovery will drive up project valuations, achieving a win-win outcome for entrepreneurs and investors.

On April 21, 2016, the China Banking Regulatory Commission (CBRC), the Ministry of Science and Technology, and the People’s Bank of China jointly issued the “Guiding Opinions on Supporting Banking Financial Institutions in Strengthening Innovation Efforts and Launching Pilot Programs for Investment-Loan Linkage with Sci-Tech Enterprises,” announcing the first batch of pilot regions and pilot banks for investment-loan linkage, thereby officially launching the pilot work.

The so-called "investment-loan linkage" refers to a model in which banks collaborate with venture capital (VC) firms and private equity (PE) funds to combine equity and debt financing, thereby advancing the timing of credit provision. This model addresses the mismatch between bank credit supply and the financing needs of small and medium-sized enterprises (SMEs), providing funding support to SMEs in their start-up or growth stages and facilitating their development.

As early as 2010, China Merchants Bank launched the “Thousand Eagles Spreading Wings” initiative. The program aims to select and cultivate more than 1,000 innovative high-growth enterprises with the potential to enter the capital markets each year. By establishing an equity investment service platform and designing innovative debt financing products, the initiative seeks to build a financial service system that aligns direct and indirect financing. It provides tailored financial services corresponding to the characteristics of each stage of a company’s life cycle, thereby accelerating the growth of innovative high-growth enterprises.

In recent years, commercial banks in China have been actively exploring the "investment-loan linkage" business, primarily forming the following three models:

1. Commercial banks collaborate with venture capital firms, with the former responsible for lending and the latter for investment.

For startups that have been or are about to be invested in by venture capital (VC) firms, banks provide loan support and other financial services, such as advisory and settlement services, through methods like equity pledges or option-linked loans. Among these, an option-linked loan refers to a arrangement where the bank signs an option agreement with the startup when issuing the loan. This agreement stipulates that the bank has the right to subscribe for a certain number of shares at a predetermined price within a specified future period, with the shares held in trust by the VC firm. The agreement also includes provisions for profit sharing, allowing the bank to capture part of the equity premium when the startup goes public or is acquired. Currently, this investment-lending linkage model is widely adopted by banks in China.

Banks such as Shanghai Pudong Development Bank, China Minsheng Bank, and China Everbright Bank all offer investment-loan linkage services through this model. The advantages of this approach include fewer policy restrictions and strong operational feasibility, making it the most widely applicable model. Commercial banks leverage the expertise and investment capabilities of venture capital firms to effectively control risks and enhance customer service, thereby gaining new investment opportunities. However, a drawback of this model is that banks and venture capital firms, as two types of independent legal entities, differ in their operational philosophies, risk appetites, and profit motivations and distribution mechanisms. These differences lead to redundant business processes, lower investment efficiency, and insufficient trust and closeness in their collaboration.

2. Banks achieve investment-loan linkage through their investment subsidiaries.

Currently, the China Development Bank (CDB) is the only bank in China holding a license for RMB-denominated equity investment. It can conduct direct equity investments through its subsidiaries, CDB Capital and CDB Securities, to facilitate investment-loan linkage. Other banks, such as the four major state-owned commercial banks and China Merchants Bank, adopt an indirect approach by establishing overseas subsidiaries with direct investment capabilities, while their domestic branches coordinate to carry out investment-loan linkage businesses.

This model fully leverages the group’s advantages, shortens the decision-making chain, and reduces communication costs. However, as the relevant investment teams within the banking group are heavily engaged in channel-type businesses, fixed-income businesses, and secondary market investment activities derived from substantial bank assets, they exhibit limited enthusiasm for equity investment projects.

3. Banks collaborate with asset management institutions to achieve investment-loan linkage.

Currently, commercial banks in China can collaborate with asset management institutions such as securities firms, trust companies, and fund companies through their private banking divisions to issue wealth management products based on equity income rights or equity investments in non-listed companies. These products raise funds from high-net-worth clients to acquire stakes in target enterprises and generate equity returns.

The advantage of this model lies in the bank’s ability to achieve profit-sharing and resource integration for investment-loan linkage through the issuance of asset management products. Meanwhile, this model offers greater flexibility and market-oriented mechanisms in terms of risk premium and performance incentives. The drawback is that risks arising from the bank’s investment-loan linkage activities may spread to the group company, thereby posing a threat to the bank’s prudent operations.

Earlier this month, Premier Li Keqiang presided over a State Council executive meeting to discuss policy measures for promoting the development of venture capital. The meeting proposed encouraging localities with appropriate conditions to establish venture capital guidance funds, supporting state-owned venture capital firms in carrying out mixed-ownership reforms, and backing state-owned enterprises in establishing or taking equity stakes in venture capital firms and fund-of-funds.

Following the encouragement of local governments and state-owned enterprises to participate in the venture capital industry, further deregulation allowing bank capital to enter the venture capital sector is highly likely to signal the comprehensive entry of state capital into this field. Against the backdrop of a "capital winter," the national team in venture capital is expected to inject substantial incremental funds into the financing market, helping startup projects as a whole to emerge from the capital downturn.

In line with policy directives, bank funds are being channeled into equity investments in technological innovation. As national strategic emerging industries, sectors such as big data, the internet, integrated circuits, chips, and nanotechnology are poised to be the first to attract bank capital.