HONG KONG (Financial Times) -- The Chinese search giant Baidu raised $1.9bn in April by selling the equivalent of 60 per cent of its financial services business.
But investors, including TPG, Carlyle and Taikang Insurance, were not buying simple equity, they were selling a form of debt that may in the future convert into equity.
Baidu needed cash to narrow the lead that Alibaba and Tencent have taken in China's financial services market, but whether it can pull off the strategy is unclear. So investors limited their downside. They can redeem the security at a guaranteed 10 per cent return.
Much venture financing in Chinese start-ups involves convertible debt rather than equity, and it has often worked out happily for both sides.
In 2015, for example, Silver Lake Partners invested $330m in convertible notes in the online travel agent Qunar. Only months later, Qunar merged with Ctrip, its main rival. Silver Lake converted its debt into equity and more than doubled its money.
When Alibaba sold convertible debt in 2012, investors were given the right to swap them for common shares at a discount to its 2014 IPO price.
While the conversion price for investors has always been hotly contested, there has often been an assumption that the valuations of Chinese tech companies would rise so rapidly that they need not worry about actually repaying their debt.
But beginning with the lacklustre Hong Kong listing of the mobile phone maker Xiaomi in July, which has seen its share price dip from over HK$22 to HK$13.6, the appetite from investors appears to have dimmed. This has knocked on into the private market.
And as valuations fall, the amount of convertible debt held by tech companies suddenly matters. Several tech companies that have come to market are trading at below their IPO price. Investors may start to want their money back at maturity because companies have not hit their conversion price.
The Indonesian gaming and ecommerce group Sea Ltd, for example, sold $775m of convertible debt to Hillhouse Capital, Tencent and several other investors in 2017 with a three-year maturity. The company started trading at $16.26 a year ago, but its share price has since fallen to just under $13.
By definition, start-ups do not generate much cash and, unless they are in the hardware business, they generally have few hard assets. For many start-ups, their value lies in their data and there is little or no free cash flow to repay their debt. Investors may end up writing off bets that once looked sure-fire.
Some blue-chip investors, such as Sequoia Capital's China arm, declined to accept debt from their entrepreneurs. One investor who declined to participate in the capital raising for Baidu Financial Services Group noted that if the business went sour, the only asset the company would have would be the money it was lent.
"In many cases, if things don't work out for the company, you end up putting the deal to yourself since the only asset the firm may have is your money," said the investor.
"When you negotiate these structures, you need to look at the underlying credit. In many cases the sense of security is totally false," the investor added, speaking generally.
In some cases, there remains a healthy appetite from investors. When ByteDance, the news aggregator and mobile video app, began talks over $3bn of new funding, half the amount was in convertible debt.
The drone manufacturer DJI is in the middle of raising convertible debt and equity and has retained the right to decide if debtholders can convert into equity. The ride-hailing app Didi Chuxing has imposed similar conditions.
But with the mood darkening, many smaller companies may have to do more capital raising rounds than they expected, just to repay earlier investors. And the mood may yet get darker still.