CSRC

CFC’s Latest Research Report Addresses Most Treacherous Issue for Chinese Companies Seeking Domestic IPO

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For Chinese private companies, one obstacle looms largest along the path to an IPO in China: the need to become fully compliant with China’s tax and accounting rules.  This process of becoming “规范” (or “guifan” in Pinyin)  is not only essential for any Chinese company seeking private equity and an eventual IPO, it is also often the most difficult, expensive, and tedious task a Chinese entrepreneur will ever undertake.

More good Chinese companies are shut out from capital markets or from raising private equity because of this “guifan” problem than any other reason. It is also the most persistent challenge for all of us active in the PE industry and in assisting SME to become publicly-traded businesses.

My firm has just published a Chinese-language research report on the topic, titled “民营企业上市规范问题”. You can download a copy by clicking here or from Research Reports page of the CFC website.

The report was written specifically for an audience of Chinese SME bosses, to provide them both with analysis and recommendations on how to manage this process successfully.  Our goal here (as with all of our research reports) is to provide tools for Chinese entrepreneurs to become leaders in their industry, and eventually leaders on the stock market. That means more PE capital gets deployed, more private Chinese companies stage successful exits and most important, China’s private sector economy continues its robust growth.

For English-only speakers, here’s a summary of some of the key points in the report:

  1. The process of becoming “guifan” will almost always mean that a Chinese company must begin to invoice all sales and purchases, and so pay much higher rates of tax, two to three years before any IPO can take place
  2. The higher tax rate will mean less cash for the business to invest in its own expansion. This, in turn, can lead to an erosion in market share, since “non-guifan” competitors will suddenly enjoy significant cost advantages
  3. Another likely consequence of becoming “guifan” – significantly lower net margins. This, in turn, impacts valuation at IPO
  4. The best way to lower the impact of “guifan” is to get more cash into the business as the process begins, either new bank lending or private equity. This can replenish the money that must now will go to pay the taxman, and so pump up the capital available to expansion and re-investment
  5. As a general rule, most  Chinese private companies with profits of at least Rmb30mn can raise at least five times more PE capital than they will pay in increased annual taxes from becoming “guifan”. A good trade-off, but not a free lunch
  6. For a PE fund, it’s necessary to accept that some of the money they invest in a private Chinese company will go, in effect, to pay Chinese taxes. But, since only “guifan” companies will get approved for a domestic Chinese IPO, the higher tax payments are like a toll payment to achieve exit at China’s high IPO valuations
  7. After IPO, the company will have plenty of money to expand its scale and so, in the best cases, claw back any cost disadvantage or net margin decline during the run-up to IPO

We spend more time dealing with “guifan” issues than just about anything else in our client work. Often that means working to develop valuation methodologies that allow our clients to raise PE capital without being excessively penalized for any short-term decrease in net income caused by “guifan” process.

Along with the meaty content, the report also features fifteen images of Tang Dynasty “Sancai ceramics, perhaps my favorite among all of China’s many sublime styles of pottery.



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In Full Agreement

pyramid

I commend unreservedly the following article from today’s Wall Street Journal editorial page. It discusses US reverse mergers and OTCBB IPOs for Chinese companies, identifying reasons these deals happen and the harm that’s often done.


What’s Behind China’s Reverse IPOs?


A dysfunctional financial system pushes companies toward awkward deals in America.
By JOSEPH STERNBERG

As if China Inc. didn’t already have enough problems in America—think safety scares, currency wars, investment protectionism and Sen. Chuck Schumer—now comes the Securities and Exchange Commission. Regulators are investigating allegations of accounting irregularities at several Chinese companies whose shares are traded in America thanks to so-called reverse mergers. Regulators, and not a few reporters, worry that American investors may have been victims of frauds perpetrated by shady foreign firms.

Allow us to posit a different view: Despite the inevitable bad apples, many of the firms involved in this type of deal are as much sinned against as sinning.

In a reverse merger, the company doing the deal injects itself into a dormant shell company, of which the injected company’s management then takes control. In the China context, the deal often works like this: China Widget transfers all its assets into California Tallow Candle Inc., a dormant company with a vestigial penny-stock listing left over from when it was a real firm. China Widget’s management simultaneously takes over CTC, which is now in the business of making widgets in China. And thanks to that listing, China Widget also is now listed in America.

It’s an odd deal. The goal of a traditional IPO is to extract cash from the global capital market. A reverse merger, in contrast, requires the Chinese company to expend capital to execute what is effectively a purchase of the shell company. The company then hopes it can turn to the market for cash at some point in the future via secondary offerings.

Despite its evident economic inefficiencies, the technique has grown popular in recent years. Hundreds of Chinese companies are now listed in the U.S. via this arrangement, with a combined market capitalization of tens of billions of dollars. Some of those may be flim-flammers looking to make a deceitful buck. But by all accounts, many more are legitimate companies. Why do they do it?

One relatively easy explanation is that the Chinese companies have been taken advantage of by unscrupulous foreign banks and lawyers. In China’s still-new economy with immature domestic financial markets, it’s entirely plausible that a large class of first-generation entrepreneurs are relatively naïve about the art of capital-raising but see a listing—any listing—as a point of pride and a useful marketing tool. There may be an element of truth here, judging by the reports from some law firms that they now receive calls from Chinese companies desperate to extract themselves from reverse mergers. (The news for them is rarely good.)

More interesting, however, is the systemic backdrop against which reverse mergers play out. Chinese entrepreneurs face enormous hurdles securing capital. A string of record-breaking IPOs for the likes of Agricultural Bank of China, plus hundred-million-dollar deals for companies like Internet search giant Baidu, show that Beijing has figured out how to use stock markets at home and abroad to get capital to large state-owned or well-connected private-sector firms. The black market can deliver capital to the smallest businesses, albeit at exorbitant interest rates of as much as 200% on an annual basis.

The weakness is with mid-sized private-sector companies. Bank lending is out of reach since loan officers favor large, state-owned enterprises. IPOs involve a three-year application process with an uncertain outcome since regulators carefully control the supply of new shares to ensure a buoyant market. Private equity is gaining in popularity but is still relatively new, and the uncertain IPO process deters some investors who would prefer greater clarity about their exit strategy. In this climate, it’s not necessarily a surprise that some impatient Chinese entrepreneurs view the reverse merger, for all its pitfalls, as a viable shortcut.

So although the SEC investigation is likely to attract ample attention to the U.S. investor- protection aspect of this story, that is the least consequential angle. Rules (even bad ones) are rules. But these shares are generally held by sophisticated hedge-fund managers and penny-stock day traders who ought to know that what they do is a form of glorified gambling.

Rather, consider the striking reality that some 30-odd years after starting its transformation to a form of capitalism, China still has not figured out one of capitalism’s most important features: the allocation of capital from those who have it to those who need it. As corporate savings pile up at inefficient state-owned enterprises, potentially successful private companies find themselves with few outlets to finance expansion. If Beijing can’t solve that problem quickly, a controversy over some penny stocks will be the least of anyone’s problems.

Mr. Sternberg is an editorial page writer for The Wall Street Journal Asia.

US Government Acts to Police OTCBB IPOs and Reverse Mergers for Chinese Companies

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In my experience, there is one catastrophic risk for a successful private company in China. Not inflation, or competition, or government meddling. It’s the risk of doing a bad capital markets deal in the US, particularly a reverse merger or OTCBB listing.  At last count, over 600 Chinese companies have leapt off these cliffs, and few have survived, let alone prospered. Not so, of course, the army of advisors, lawyers and auditors who often profit obscenely from arranging these transactions.

Not before time, the US Congress and SEC are both now finally investigating these transactions and the harm they have done to Chinese companies as well as stock market investors in the US. Here is a Chinese language column I wrote on this subject for Forbes China: click here to read.

As an American, I’m often angry and always embarrassed that the capital market in my homeland has been such an inhospitable place for so many good Chinese companies. In fact, my original reason for starting China First Capital over two years ago was to help a Jiangxi entrepreneur raise PE finance to expand his business, rather than doing a planned “Form 10” OTCBB.

We raised the money, and his company has since quadrupled in size. The founder is now planning an IPO in Hong Kong later this year, underwritten by the world’s preeminent global investment bank. The likely IPO valuation: at least 10 times higher than what was promised to him from that OTCBB IPO, which was to be sponsored by a “microcap” broker with a dubious record from earlier Chinese OTCBB deals.

In general, the only American companies that do OTCBB IPOs are the weakest businesses, often with no revenues or profits. When a good Chinese company has an OTCBB IPO, its choice of using that process will always cast large and ineradicable doubts in the mind of US investors. The suspicion is, any Chinese entrepreneur who chooses a reverse merger or OTCBB IPO either has flawed business judgment or plans to defraud his investors. This is why so many of the Chinese companies quoted on the OTCBB companies have microscopic p/e multiples, sometimes less than 1X current year’s earnings.

The US government is finally beginning to evaluate the damage caused by this “mincing machine” that takes Chinese SME and arranges their OTCBB or reverse mergers. According to a recent article in the Wall Street Journal, “The US Securities and Exchange Commission has begun a crackdown on “reverse takeover” market for Chinese companies. Specifically, the SEC’s enforcement and corporation-finance divisions have begun a wide-scale investigation into how networks of accountants, lawyers, and bankers have helped bring scores of Chinese companies onto the U.S. stock markets.”

In addition, the US Congress is considering holding hearings. Their main goal is to protect US investors, since several Chinese companies that listed on OTCBB were later found to have fraudulent accounting.

But, if the SEC and Congress does act, the biggest beneficiaries may be Chinese companies. The US government may make it harder for Chinese companies to do OTCBB IPO and reverse mergers. If so, then these Chinese firms will need to follow a more reliable, tried-and-true path to IPO, including a domestic IPO with CSRC approval.

The advisors who promote OTCBB IPO and reverse mergers always say it is the fastest, easiest way to become a publicly-traded company. They are right. These methods are certainly fast and because of the current lack of US regulation, very easy. Indeed, there is no faster way to turn a good Chinese company into a failed publicly-traded than through an OTCBB IPO or reverse merger.


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CFC’s New Research Report, Assessing Some Key Differences in IPO Markets for Chinese Companies

China First Capital research report cover

For Chinese entrepreneurs, there has never been a better time to become a publicly-traded company.  China’s Shenzhen Stock Exchange is now the world’s largest and most active IPO market in the world. Chinese companies are also active raising billions of dollars of IPO capital abroad, in Hong Kong and New York.

The main question successful Chinese entrepreneurs face is not whether to IPO, but where.

To help entrepreneurs make that decision, CFC has just completed a research study and published its latest Chinese language research report. The report, titled “民营企业如何选择境内上市还是境外上市” (” Offshore or Domestic IPO – Assessing Choices for Chinese SME”) analyzes advantages and disadvantages for Chinese SME  of IPO in China, Hong Kong, USA as well as smaller markets like Singapore and Korea.

The report can be downloaded from the Research Reports section of the CFC website , or by clicking here:  CFC’s IPO Difference Report (民营企业如何选择境内上市还是境外上市)

We want the report to help make the IPO decision-making process more fact-based, more successful for entrepreneurs. According to the report, there are three key differences between a domestic or offshore IPO. They are:

  1. Valuation, p/e multiples
  2. IPO approval process – cost and timing of planning an IPO
  3. Accounting and tax rules

At first glance, most Chinese SME bosses will think a domestic IPO on the Shanghai or Shenzhen Stock Exchanges is always the wiser choice, because p/e multiples at IPO in China are generally at least twice the level in Hong Kong or US. But, this valuation differential can often be more apparent than real. Hong Kong and US IPOs are valued on a forward p/e basis. Domestic Chinese IPOs are valued on trailing year’s earnings. For a fast-growing Chinese company, getting 22X this year’s earnings in Hong Kong can yield more money for the company than a domestic IPO t 40X p/e, using last year’s earnings.

Chasing valuations is never a good idea. Stock market p/e ratios change frequently. The gap between domestic Chinese IPOs and Hong Kong and US ones has been narrowing for most of this year. Regulations are also continuously changing. As of now, it’s still difficult, if not impossible, for a domestically-listed Chinese company to do a secondary offering. You only get one bite of the capital-raising apple. In Hong Kong and US markets, a company can raise additional capital, or issue convertible debt, after an IPO.  This factor needs to be kept very much in mind by any Chinese company that will continue to need capital even after a successful domestic IPO.

We see companies like this frequently. They are growing so quickly in China’s buoyant domestic market that even a domestic IPO and future retained earnings may not provide all the expansion capital they will need.

Another key difference: it can take three years or more for many Chinese companies to complete the approval process for a domestic IPO. Will the +70X p/e  multiples now available on Shenzhen’s ChiNext market still be around then? It’s impossible to predict. Our advice to Chinese entrepreneurs is make the decision on where to IPO by evaluating more fundamental strengths and weaknesses of China’s domestic capital markets and those abroad, including differences in investor behavior, disclosure rules, legal liability.

China’s stock market is driven by individual investors. Volatility tends to be higher than in Hong Kong and the US, where most shares are owned by institutions.

One factor that is equally important for either domestic or offshore IPO: an SME will have a better chance of a successful IPO if it has private equity investment before its IPO. The transition to a publicly-listed company is complex, with significant risks. A PE investor can help guide an SME through this process, lowering the risks and costs in an IPO.

As the report emphasizes, an IPO is a financing method, not a goal by itself. An IPO will usually be the lowest-cost way for a private business to raise capital for expansion.  Entrepreneurs need to be smart about how to use capital markets most efficiently, for the purposes of building a bigger and better company.


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ChiNext: One Year Later, Celebrating a Success

Zhou dynasty from China First Capital blog post

This past Saturday, October 30,  marked the one year anniversary of the founding of the ChiNext (创业板) stock market. In my view, the ChiNext has been a complete and unqualified success, and should be a source of pride and satisfaction to everyone involved in China’s financial industry. And yet, there’s quite a lot of complaining and grumbling going on, about high share prices, high p/e multiples,  “underperformance” by ChiNext companies, and the potentially destabilizing effect of insiders’ share sales when their 12-month lockup period ends.

Let’s look at the record. Over the last year, the board has grown from the original 28 companies to 134, and raised a total of 94.8 billion yuan ($14bn). For those 134 companies, as well as hundreds more now queuing up for their ChiNext IPO, this new stock market is the most important thing to ever happen in China’s capital markets.

Make no mistake, without the ChiNext, those 134 companies would be struggling to overcome a chronic shortage of growth capital. That Rmb 94.8 billion in funding has supported the creation of thousands of new jobs,  more indigenous R&D in China, and provided a new and powerful incentive system for entrepreneurs to improve their internal controls and accounting as a prelude to a planned ChiNext IPO.

China’s retail investors have responded with enthusiasm to the launch of ChiNext, and support those high p/e multiples of +50X at IPO. It is investors, after all, who bid up the price of ChiNext shares, and by doing so, allow private companies to raise more capital with less dilution. Again, that is a wholly positive development for entrepreneurship in China.

Will some investors lose money on their investments in ChiNext companies? Of course. That’s the way all stock markets work. The purpose of a stock market is not to give investors a “one way bet”. It is to allocate capital.

I was asked by a Bloomberg reporter this past week for my views on ChiNext. Here, according to his transcript,  is some of what I told him.

“For the first time ever, the flow of capital in China is beginning to more accurately mirror where the best growth opportunities are. ChiNext is an acknowledgement by the government of the vital importance of entrepreneurial business to China’s continued economic prosperity. ChiNext allocates growth capital to businesses that most need and deserve it, and helps address a long-standing problem in China’s economy: capital being mainly allocated to state-owned companies. The ChiNext is helping spur a huge increase of private equity capital now flowing to China’s private companies. Within a year my guess is the number of private equity firms and the capital they have to invest in China will both double.”

A market economy functions best when capital can flow to the companies that can earn the highest risk-adjusted return. This is what the ChiNext now makes possible.

Yes, financial theory would argue that ChiNext prices are “too high”, on a p/e basis. Sometimes share prices are “too high”, sometimes they are “too low”, as with many Chinese companies quoted on the Singapore stock market. A company’s share price does not always have a hard-wired correlation to the actual value and performance of the company. That’s why most good laoban seldom look at their share price. It has little, if anything, to do with the day-to-day issues of building a successful company.

Some of the large shareholders in ChiNext companies will likely begin selling their shares as soon as their lock-up period ends. For PE firms, the lock-up ends 12 months after an IPO. If a PE firm sells its shares, however, it doesn’t mean the company itself is going sour. PE firms exist to invest, wait for IPO, then sell and use that money to repay their investors, as well as invest in more companies. It’s the natural cycle of risk capital, and again, promotes overall capital efficiency.

There are people in China arguing that IPO rules should be tightened, to make sure all companies going public on ChiNext will continue to thrive after their IPO. That view is misplaced. For one thing, no one can predict the future performance of any business. But, in general, China’s capital market don’t need more regulations to govern the IPO process. China already has more onerous IPO regulations than any other major stock market in the world.

The objective of a stock market is to let  investors, not regulators, decide how much capital a company should be given.  If a company uses the capital well, its value will increase. If not, then its shares will certainly sink. This is a powerful incentive for ChiNext company management to work hard for their shareholders. The other reason: current rules prohibit the controlling shareholders of ChiNext companies from selling shares within the first three years of an IPO.

The ChiNext is not a path to quick riches for entrepreneurs in China. It is, instead, the most efficient way to raise the most capital at the lowest price to finance future growth. In the end, everyone in China benefits from this. The ChiNext is, quite simply,  a Chinese financial triumph.


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How PE Firms Can Add – or Subtract – Value: the New CFC Research Report

China First Capital research report

CFC has just published its latest Chinese-language research report. The title is 《私募基金如何创造价值》, which I’d translate as “How PE Firms Add Value ”.

You can download a copy here:  How PE Firms Add Value — CFC Report

China is awash, as nowhere else in the world is,  in private equity capital. New funds are launched weekly, and older successful ones top up their bank balance. Just this week, CDH, generally considered the leading China-focused PE firm in the world, closed its fourth fund with $1.46 billion of new capital. Over $50 billion has been raised over the last four years for PE investment in China. 

In other words, money is not in short supply. Equity investment experience, know-how and savvy are. There’s a saying in the US venture capital industry, “all money spends the same”. The implication is that for a company, investment capital is of equal value regardless of the source. In the US, there may be some truth to this. In China, most definitely not. 

In Chinese business, there is no more perilous transition than the one from a fully-private, entrepreneur-founded and led company to one that can IPO successfully, either on China’s stock markets, or abroad. The reason: many private companies, especially the most successful ones, are growing explosively, often doubling in size every year.

They can barely catch their breath, let alone put in place the management and financial systems needed to manage a larger, more complex business. This is inevitable consequence of operating in a market growing as fast as China’s, and generating so many new opportunities for expansion. 

A basic management principle, also for many good private companies, is: “grab the money today, and worry about the consequences tomorrow”. This means that running a company in China often requires more improvising than long-term planning. I know this, personally, from running a small but fast-growing company. Improvisation can be great. It means a business can respond quickly to new opportunities, with a minimum of bureaucracy. 

But, as a business grows, and particularly once it brings in outside investors, the improvisation, and the success it creates, can cause problems. Is company cash being managed properly and most efficiently? Are customers receiving the same degree of attention and follow-up they did when the business was smaller? Does the production department know what the sales department is doing and promising customers? What steps are competitors taking to try to steal business away? 

These are, of course, the best kind of problems any company can have. They are the problems caused by success, rather than impending bankruptcy.

These problems are a core aspect of the private equity process in China. It’s good companies that get PE finance, not failed ones. Once the PE capital enters a company, the PE firm is going to take steps to protect its investment. This inevitably means making sure systems are put in place that can improve the daily management and long-term planning at the company. 

It’s often a monumental adjustment for an entrepreneur-led company. Accountability supplants improvisation. Up to the moment PE finance arrives, the boss has never had to answer to anyone, or to justify and defend his decisions to any outsider. PE firms, at a minimum, will create a Board of Directors and insist, contractually, that the Board then meet at least four times a year to review quarterly financials, discuss strategy and approve any significant investments. 

Whether this change helps or hurts the company will depend, often, on the experience and knowledge of the PE firm involved.  The good PE firms will offer real help wherever the entrepreneur needs it – strengthening marketing, financial team, international expansion and strategic alliances. They are, in the jargon of our industry, “value-add investors”.

Lesser quality PE firms will transfer the money, attend a quarterly banquet and wait for word that the company is staging an IPO. This is dumb money that too often becomes lost money, as the entrepreneur loses discipline, focus and even an interest in his business once he has a big pile of someone else’s money in his bank account.   

Our new report focuses on this disparity, between good and bad PE investment, between value-add and valueless. Our intended audience is Chinese entrepreneurs. We hope, aptly enough, that they determine our report is value-add, not valueless. The key graphic in the report is this one, which illustrates the specific ways in which a PE firm can add value to a business.  In this case, the PE investment helps achieve a four-fold increase. That’s outstanding. But, we’ve seen examples in our work of even larger increases after a PE round.

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The second part of the report takes on a related topic, with particular relevance for Chinese companies: the way PE firms can help navigate the minefield of getting approval for an IPO in China.  It’s an eleven-step process. Many companies try, but only a small percentage will succeed. The odds are improved exponentially when a company has a PE firm alongside, as both an investor and guide.

While taking PE investment is not technically a prerequisite, in practice, it operates like one. The most recent data I’ve seen show that 90% of companies going public on the new Chinext exchange have had pre-IPO PE investment. 

In part, this is because Chinese firms with PE investment tend to have better corporate governance and more reliable financial reporting. Both these factors are weighed by the CSRC in deciding which companies are allowed to IPO. 

At their best, PE firms can serve as indispensible partners for a great entrepreneur. At their worst, they do far more harm than good by lavishing money without lavishing attention. 

The report is illustrated with details from imperial blue-and-white porcelains from the time of the Xuande Emperor, in the Ming Dynasty.


 

Shenzhen The World’s Most Active IPO Market So Far in 2010

Jade object from China First Capital blog post

 

Shenzhen’s Stock Exchange was the world’s busiest and largest IPO market during the first half of 2010. Through the end of June, 161 firms raised $22.6 billion in IPOs on Shenzhen Stock Exchange. The Shanghai Stock Exchange ranked No.4, with 11 firms raising $8.2 billion.

Take a minute to let that sink in. The Shenzhen Stock Exchange, which two years ago wasn’t even among the five largest in Asia, is now host to more new capital-raising transactions than any other stock market, including Nasdaq and NYSE. Even amid the weekly torrent of positive economic statistics from China, this one does stand out. For one thing, Shenzhen’s Stock Exchange is effectively closed to all investors from outside China. So, all those IPO deals, and the capital raised so far in 2010, were done for domestic Chinese companies using money from domestic Chinese investors.

The same goes for IPOs done on Shenzhen’s larger domestic competitor, the Shanghai Stock Exchange. In the first half of 2010, the Shanghai bourse had eleven IPOs, and raised $8.2 billion. That brings the total during the first half of 2010 in China to 172 IPOs, raising $31 billion in capital.

The total for the second half of 2010 is certain to be larger, and Shenzhen will likely lose pole position to Shanghai. The Agricultural Bank of China just completed its IPO and raised $19.2 billion in a dual listing on Shanghai and Hong Kong exchanges. Over $8.5 billion was raised from the Shanghai portion.

One reason for the sudden surge of IPOs in Shenzhen was the opening in October 2009 of a new subsidiary board, the 创业板, or Chinext market. Its purpose is to allow smaller, mainly private companies to access capital markets. Before Chinext, about the only Chinese companies that could IPO in China were ones with some degree of state ownership. Chinext changed that. There is a significant backlog of several hundred companies waiting for approval to go public on Chinext.

So far this year, 57 companies have had IPOs on Chinext. The total market value of all 93 companies listed on Chinext is about Rmb 300 billion, or 5.5% of total market capitalization of the Shenzhen Stock Exchange. On Shenzhen’s two other boards for larger-cap companies, 197 companies had IPOs during the first half of 2010.

The surge in IPO activity in China during the first half of 2010 coincided with the dismal performance overall of shares traded on the Shanghai and Shenzhen stock exchanges. Both markets are down during the first half of the year: Shanghai by over 25%  and Shenzhen by 15%. 

The IPO process in China, both on Shanghai and Shenzhen markets, is very tightly controlled by China’s securities regulator, the CSRC (证监会). It’s the CSRC that decides the number and timing of IPOs in China, not market demand. One factor the CSRC gives significant weight to is the overall performance of China’s stock market. They want to control the supply of new shares, by limiting IPO transactions, to avoid additional downward pressure on share prices overall.

So, presumably, if the Chinese stock markets performed better in the first half of 2010, the number of IPOs would have been even higher. Make no mistake: the locus of the world’s IPO activity is shifting to China.

Navigating China’s Treacherous IPO Markets

Song plate from China First Capital blog post

How do you say “Scylla and Charybdis”  in Chinese? Thankfully, you don’t need to know the translation, or even reference from Homer’s The Odyssey, to understand the severe dilemma faced by China’s stock exchange regulator, the China Securities Regulatory Commission (CSRC)

Scylla and Charybdis were a pair of sea monsters guarding opposite sides of a narrow straight. Together, they posed an inescapable threat to sailors’ lives. By avoiding one, you sailed directly into the lair of the other. 

The CSRC has been trying to navigate between twin perils over the last months, since the October launch of ChiNext , the new Shenzhen stock exchange for smaller-cap private companies. They have tried to stamp out the trading volatility and big first day gains that characterized earlier IPOs in China. But, in doing so, they’ve created circumstances where the valuations of companies going public on the ChiNext have reached dangerous and unsustainably high levels. 

Monsters to the left, monsters to the right. The regulators at CSRC deserve combat pay. 

Based on most key measures, ChiNext has been a phenomenal success. So far, through the end of 2009, 36 companies have IPO’d on ChiNext, raising a total of over $2 billion from investors. That’s more than double the amount these 36 companies were originally seeking to raise from their IPOs. Therein lies the Scylla-Charybdis problem. 

Before ChiNext  opened, the CSRC was determined to avoid one common problem with Chinese IPOs on the main Shanghai and Shenzhen markets – that the price on the first day of trading typically rose very sharply, with lots of volatility. A sharp jump in the price on the first day is great for investors who were able to buy shares ahead of the IPO. In China, those lucky few investors are usually friends and business contacts of the underwriters, who were typically rewarded with first-day gains of over 20%. These investors could hold their shares for a matter of minutes or hours on the day of the IPO, then sell at a nice profit. 

But, while a first-day surge may be great for these favored investors, it’s bad news for the companies staging the IPOs. It means, quite simply, their shares were underpriced (often significantly so) at IPO. As a result, they raised less money than they could have. The money, instead, is wrongly diverted into the hands of the investors who bought the shares at artificially low prices. An IPO that has a 25% first-day gain is an IPO that failed to maximize the amount the company could raise from investors. 

Underwriters are at fault. When they set the price at IPO, they can start trading at a level that all but guarantees an immediate increase. This locks in profits for the people they choose to allocate shares to ahead of the start of trading. 

The CSRC, rightly,  decided to do something about this. They mandated that the opening price for companies listing on the CSRC should be set more by market demand, not the decision of an underwriter. The result is that the opening day prices on ChiNext have far more accurately reflected the price investors are willing to pay for the new offering.

Gains that used to go to first-day IPO investors are now harvested by the companies. They can raise far more money for the fixed number of shares offered at IPO. So far so good. The problem is: Chinese investors are bidding up the prices of many of these new offerings to levels that are approaching madness. 

The best example so far: when Guangzhou Improve Medical Instruments Co had its IPO last month, its shares traded at an opening price 108 times its 2008 earnings.  The most recent  group of companies to IPO on ChiNext had first-day valuations of over 80 times 2008 earnings. Because of the high valuations, these ChiNext-listed companies have raised more than twice the amount of money they planned from their IPO. 

On one hand, that’s great for the companies. But, the risk is that the companies will not use the extra money wisely (for example by speculating in China’s overheated property market), and so the high valuations they enjoy now will eventually plummet. Indeed, valuations at over 80x  are no more sustainable on the ChiNext now than they were on the Tokyo Stock Exchange a generation ago. 

Having steered ChiNext away from the danger of underpriced IPOs, the CSRC is now trying to cope with this new menace. They have limited tools at their disposal. They clearly don’t want to return pricing power to underwriters. But, neither do they want ChiNext to become a market with insane valuations and companies that are bloated with too much cash and too many temptations to misuse it.   

CSRC’s response: they just introduced new rules to limit the ways ChiNext companies can use the extra cash raised at IPO.  CSRC is also reportedly studying ways to lower IPO valuations on ChiNext. 

The new rules restrict the uses of the extra cash. Shareholder approval is required for any investment over Rmb 50 million, or more than 20% of the extra IPO proceeds on a single project. The CSRC also reiterated that ChiNext companies should use the additional proceeds from their IPOs to fund their main businesses and not for high-risk investments, such as securities, derivatives or venture capital.

The new rules are fine, as far as they go. But, they don’t go very far towards resolving the underlying cause of all these problems, of both underpriced and overpriced IPOs in China.

The problem is that CSRC itself limits the number of new IPOs, to try to maintain overall market stability. Broadly speaking, this restricted supply creates excessive demand for all Chinese IPOs. Regulatory interventions and tinkering with the rules won’t do much. There remains the fundamental imbalance between the number of domestic IPOs and investor interest in new offerings.

Faced with two bad options, Odysseus chose to take his chances with the sea monster Scylla, and survived, while losing quite a few of his crew. The alternative was worse, he figured, since Charybdis could sink the whole ship.

The CSRC may well make a similar decision and return some pricing power to underwriters, to bring down ChiNext’s valuations.  But, without an increased supply of IPOs in China,  the two large hazards will persist. CSRC’s navigation of China’s IPO market will certainly remain treacherous.  


Shenzhen’s New Growth Enterprise Market: Getting it Right, Right From the Start

 

China First Capital blog post -- Ming Dynasty jade bowl

 

“Manage people’s expectations. Then, exceed them.” That’s not a bad rule to live by, or management principle to apply in regulating China’s fast-moving capital markets. This past week, China Regulatory Securities Commission, the nation’s stock market regulator, moved one step closer to opening trading in the new, Shenzhen-based, Growth Enterprise Market. It’s been ten years in the planning. The names were finally announced of the first companies that will list on the new market when trading begins later in October. All are private SME, and several had pre-IPO private equity funding.

The total amount of capital this first crop of IPOs will raise is well above most earlier estimates. The original stated plan was for smaller companies to list on the GEM, which, in turn, suggested the GEM market would be only a marginal contributor of growth capital for private SME. The minimum requirement was set at just $1.5mn in aggregate profits over the last two years. Even at high Chinese multiples, firms of that size would struggle to raise more than $10mn in an IPO.

But, in something of a surprise, CSRC chose larger companies to be in the first group to list. It now looks like that the ten companies will raise a total of over $400mn when their IPOs close, or an average of $40mn each. This, in turn, points to a cumulative market capitalization for this first group of around $2 billion. That bodes well for the market’s long-term future. A larger market capitalization means more liquidity and so less volatility in the share price. This will help attract more capital to the new Shenzhen market, and to subsequent future IPOs there.

Bravo, I say! The CSRC may well get the formula right, and so prove that these smaller-capitalization “growth stock markets” can work, both for companies and investors.

Elsewhere, these growth stock markets have mainly failed in their stated purpose to create an efficient platform for smaller companies to attract investors and raise capital. Germany’s Neuer Markt shut down soon after it was created. The small-cap markets in Singapore and Hong Kong have been disappointments. Small-cap companies stayed small-cap companies, which is entirely contrary to the purpose of a “growth board” like this. The granddaddy of them all, America’s OTC Bulletin Board, has become an all-purpose dumping ground for shady American firms, stock manipulators, and, sadly, several hundred once-strong Chinese SME who listed there after taking very bad advice from self-interested advisors and brokers looking to make a quick buck.

It’s anybody’s guess how many companies will list on Shenzhen’s GEM this year, or next. There is a backlog of at least 100 that have applied, and been provisionally accepted by CSRC. One thing we know: each IPO in China will get its final approval as part of an orderly process that takes into account the performance of companies already listed on GEM, and stock prices trends overall.

The Shenzhen GEM shows every sign of beginning to fill a very large, very important funding gap in China. Assuming, as I hope, that CSRC continues its preference for companies able to raise at least $30mn-$40mn in a public listing, these IPOs will channel capital to companies who would otherwise find it very hard to come by. Most of the private equity and venture firms that we work with don’t write checks that large. They generally invest around $10mn-$25mn in pre-IPO equity capital to own 20%-30% of a private Chinese SME. These investments are done at valuations of around eight times last year’s profits. So, a GEM listing could become the best source of growth capital for an SME that already has achieved some success, has profits of over $10mn-$20mn a year, but is still too small for a main board listing, in China or outside.

The public markets have two big advantages over private equity financing: they offer much higher price-earnings valuations, and give shareholders a liquid market to trade their shares. On the other hand, for Chinese SME, staging an IPO in China always has a level of deep unpredictability. The CSRC makes all the decisions about which companies can IPO and when. So, SME can wait two years or more to apply, get approval, and then put the IPO proceeds in the bank. If that SME is now growing quickly, has outsized opportunities near-to-hand with a high rate of return, but can’t finance its growth internally or with bank debt, a round of private equity will almost certainly be the best route to follow.

Done right (see my earlier blog post, on Foshan Saturday ‘s IPO) a company’s market capitalization, when it eventually completes its IPO, can be at least three times larger than it is at present. That means the laoban gets richer (nothing wrong with that), and investors are happier, too, because of the increased liquidity and stability from the higher market cap at IPO.

I’m extremely positive about the role the GEM will play in helping to build even stronger private Chinese SME. The CSRC and Chinese government have taken over ten years to plan this new stock market, and learn from the mistakes of others. All signs now are that they have done so, and the GEM will gradually create a group of publicly-traded private companies that will go on to achieve far more impressive results in the future.