China’s domestic capital markets are huge, important and increasingly open to foreign investors. But for many years, one thing was lacking: IPOs from China’s most famous technology companies.
When Alibaba Group turned to the US for its $21.8bn listing in 2014, it started a trend that other technology companies followed. By 2018, bankers were questioning whether the onshore market was finally becoming more attractive to Chinese tech companies. Xiaomi Corp’s decision to sell a $6.1bn IPO in Hong Kong answered that question in the negative.
At the time, it was hard to blame them. China’s traditional A-share market is not designed for growth companies. IPO candidates need to tick a number of boxes before being able to go public. The listing requirements, ranging from three consecutive years of profitability to three consecutive years of zero change in substantial shareholders, are fine for companies with long operating histories and relatively stable growth. But how many technology start-ups fit that description?
“Many of China’s outstanding internet companies went to list overseas because they had not been profitable by the time they wanted to go public,” says Wang Xinchen, a fund manager at Harvest Fund Management in Beijing, in charge of strategic placements. “It was a pity for both the regulators, and us.”
There were other problems besides the listing requirements. Even those technology companies that could satisfy the regulators still had no guarantee they would be able to list quickly.
Bankers say the long wait from the China Securities Regulatory Commission (CSRC) is a big problem when pitching onshore listings. Chinese companies typically need to wait two to three years before receiving approval from the country’s securities regulator.
When a company finally manages to overcome all these hurdles, it will face the final obstacle — a price cap.
Chinese regulations mean that listings on the country’s main boards cannot be priced at more than 23 times of earnings, another big problem for companies concentrating more on growth than profitability.
That has been good news for Hong Kong. The bourse got Alibaba’s second listing, technology unicorn Meituan Dianping and even one of mainland’s most famous restaurant chains Haidilao Hotpot, as well as the recent jumbo listing from Xiaomi.
“Because of policies such as the longer approval time and the 23 times earnings cap, the main boards in China may not always be discussed on equal ground with the Hong Kong Stock Exchange,” says Sun Lijun, co-head and a managing director of UBS Securities Global Banking, in Beijing.
Chinese regulators have often fought back. Their previous attempts, such as establishing the National Equities Exchange and Quotations OTC market and the Shenzhen Stock Exchange’s ChiNext in 2006 and 2009, did not have much impact. But in July 2019, they went one step further, launching the Star market.
That has been a much bigger success. By April 29 this year, a total of 100 companies had listed on the board and 260 companies had applied to list, according to the Shanghai bourse. The market has also seen the first red-chip company — that is Chinese companies incorporated outside of the People’s Republic of China; its first pre-profit company; and its first dual-class share structure company.
Chinese characteristics
The board offers clear advantages to technology companies. The first batch of 25 companies to list on the Star board priced at an average price-to-earnings ratio of 49.2 times. Perhaps just as important: their share prices rose to an average of 140% of their IPO prices on the first day of trading.
“China’s stock market is famous for high valuations,” says Louis Lau, a partner of the capital markets advisory Group at KPMG China in Hong Kong. “If you compare the Hong Kong market and the traditional A-share market, there is a persistent valuation gap. For companies listed on the Star market, especially in the initial first two months, the PE ratio could be as high as 100 times.”
Take Haohai Biological Technology as an example. The company has been trading between HK$27 to HK$50 for the past six months in Hong Kong. But its Star IPO was set at Rmb89 ($12.6), roughly HK$97, a share. The company was trading at Rmb77.5 when the market closed on April 14.
“A reason for this difference is that the mainland and Hong Kong capital markets are not yet completely accessible to each other,” says Sun from UBS Securities, the sponsor of Haohai’s Star debut. “If they are, then the price difference will be narrowed. As for why the Star market has higher valuations than the A-share onshore, that’s mainly because of the unique background of the Star market. Chinese investors like new things such as the Star board.”
They have continued to like the market even as prices have surged. It is still common for a Star IPO to be more than 1,000 times subscribed by institutional investors and more than 2,000 times subscribed by retail investors, Wind data shows. That has led to a different problem for regulators — having previously worried there was not enough supply of tech IPOs, should they now be concerned about too much demand?
Regulators have tried to tweak the rules to protect retail investors. Only those with more than Rmb500,000 in their trading accounts and at least two years of securities trading experience can directly invest in the Star market. But that threshold is probably not high enough. A source at the CSRC admits to GlobalCapital China that the regulator somewhat underestimated the amount of wealth of Chinese retail investors.
Nor is it just China’s hungry retail investor base driving the rise in prices. China’s institutional investors may also have a “domestic bias”, says Harvest Fund’s Wang.
But a mix of the government’s regulatory changes, exhaustion from the strong start to the market and fears about the Covid-19 coronavirus have stemmed the optimism of the market slightly — albeit only slightly.
Star board IPOs have recently been priced at PE ratios of between 40 and 60 times, still a big boost from the 20-30 PE valuations they would get in Hong Kong, says KMPG’s Lau. For now, that pricing gap looks likely to remain.
“If the companies listed on the Star market are actually high-growth companies [as they should be], then their price-earnings ratio will automatically decline as they become stable-growth companies in the future,” says UBS Securities’ Sun. “However, I don’t think the valuation premium from the offshore market will be eliminated in the short-term.”
Heavy disclosure burden
There have been some teething problems, particularly the shift from an approval-based IPO system to a fully “registration-based” system.
The time required for a company to obtain approval from the CSRC to list on the Star market — usually a few months — is already dramatically shorter than the time needed to list on the main board. But there is still room for improvement.
Under Star market regulations, companies file their applications with the Shanghai Stock Exchange (SSE) and have to answer questions from the listing committee. Their applications are then turned over to the CSRC, which will give the final verdict. An onshore fund manager says that companies often face three rounds of enquiries form the regulator, accumulating as much as 900 pages of documents — a page count that does not include IPO prospectuses.
“This is done with good intentions since the regulators want to protect investors,” says the fund manager. “However, in the long-term, regulators will not have the ability or the capacity to keep this up. Perhaps the regulators can instead roll out harsher punishments for insufficient or untruthful disclosures and improve the exit mechanisms.”
There are other areas of potential improvement, say market participants. A senior manager at a large fund tells GlobalCapital China that the current timeline for price discovery gives investors very little time to do careful research on companies before having to arrive at a valuation.
There are also questions for the securities house joint ventures of foreign banks, who appear to be getting little benefit from the rapid growth of the market. So far, only UBS Securities has sponsored a Star market IPO.
The heart of their woes is a quirky co-invest requirement. Sponsors are required to buy in 2%-5% of total shares depending on the IPO size. Their holdings will also face a two-year lock-up period, the longest among all shareholders except for the company’s owners.
Hong Kong adjusts
The growth of the Star board is not just of interest to investors and issuers. Foreign exchanges are also taking notice, particularly Hong Kong. But executives at the Hong Kong stock exchange should not panic just yet. Although the Star board may have some impact on future supply, Hong Kong’s deep pool of liquidity and strong legal framework means it is unlikely to be replaced any time soon.
The HKEX has also been shifting its focus from mainland companies to international ones, says KPMG China’s Lau. The exchange announced a three year strategic plan in February 2019, revealing its intention to expand beyond a once-reliable supply of Chinese IPOs to a broader universe of potential companies. That has already paid dividends: the exchange’s biggest listing last year was the HK$39.2bn ($5bn) IPO of Budweiser’s Asian business.
Of course, the Star board and the Hong Kong stock exchange both face the same big source of instability: the Covid-19 pandemic and the uncertain outlook for the global economy, financial markets and stock prices. The near-term damage on companies’ revenues is likely to be significant. But Sun thinks that, although timelines might be delayed, the desire to list will only be stronger than ever.
After all, companies still need financing — and Star board investors still appear hungry to provide it. GC