Hong Kong technology IPOs: Size matters

For many a Chinese entrepreneur, ringing the bell at the New York Stock Exchange (NYSE) is the pinnacle in corporate achievement. The honor of opening or closing trading, bestowed upon a newly listed company, represents the end of one journey and the beginning of another – and many founders want to have their moment on the balcony above the trading room floor, mallet in hand.

“I still get asked, ‘What is the difference between listing on NASDAQ and NYSE?’ and I say, ‘Nothing apart from the balcony,’” says J.P. Gan, a managing partner at Qiming Venture Partners. “You would be surprised how many Chinese founders pick NYSE because of the balcony.”

Hong Kong cannot match the US for razzmatazz – NASDAQ makes up for the absence of a balcony with an abundance of tickertape – as company CEOs are invited to strike a gong and take photos in a small ceremony hall. However, following alterations to its IPO regime, the exchange is better positioned to compete with its US counterparts for Chinese technology listings. 

For years, the NYSE and NASDAQ have been the default options for entrepreneurs who wanted to retain control of their companies even as minority shareholders by taking advantage of multiple-class shares that attribute more voting power to some classes than others. Having adopted the weighted voting rights (WVR) model, Hong Kong represents a viable alternative much closer to home – although for now it only wants a certain kind of company.

“We have been receiving calls from companies that were looking to list in the US and now see Hong Kong as an option,” says Hang Wang, a partner with Baker & McKenzie in Hong Kong. “But Hong Kong is not welcoming all technology companies with WVR structures. The change is aimed at successful businesses, not start-ups. They made a compromise.”

The Hong Kong approach might be described as “unicorns only.” To qualify, an innovative company – an asset-light operation based on a new technology or business model – must achieve a market capitalization of at least HK$40 billion ($5.1 billion). Alternatively, the minimum market cap can be HK$10 billion if annual revenue is HK$1 billion or more. Biotech companies get special treatment in that they can list with zero revenue, but with a separate set of safeguards.

The first company to file for a listing with a WVR structure was Xiaomi, a smart phone maker that has received substantial PE and VC funding. It is said to be targeting a $10 billion IPO at a valuation of $70-80 billion. Revenue came to RMB114.6 billion ($18 billion) last year, while the company swung from a net profit of RMB491.6 million in 2016 to a loss of RMB43.9 billion in 2017.

Should Xiaomi hit the $10 billion mark, it would be the second-largest technology offering ever seen globally, after Alibaba Group’s $25 billion IPO. The companies that follow it are likely to be of a similar size and profile, with ride-hailing business Didi Chuxing, online-to-offline services platform Meituan-Dianping among those reportedly preparing for Hong Kong offerings. 

A longstanding issue

Hong Kong’s journey to WVR started with Alibaba in 2014. The e-commerce giant lobbied regulators to permit a structure under which a group of 28 partners would retain control of the board despite holding only 10% of the equity, but to no avail. Alibaba went to New York and debate ensued as to whether Hong Kong could remain a competitive listing destination if it adhered to “one share, one vote” and refused to admit pre-profit companies. This debate has never really stopped.

Hong Kong Exchanges & Clearing (HKEx) noted in a concept paper published last year that 68% of IPOs in the US in 2016 involved pre-profit companies, up from 24% in 1980, with a strong bias towards technology and biotech. The new economy contribution to the market capitalization of the NYSE is 47%, compared to 3% for Hong Kong. 

Furthermore, while only 33 out of the 116 mainland China companies with primary listings in the US as of June 2017 had WVR structures, their combined market capitalization of $561 billion represented 84% of the market value of all US-listed mainland companies. IT-related businesses accounted for 18 of the 33.

The first sign of movement came before the concept paper was released and the consultation on creating a new board – for companies that don’t meet standard listing criteria – had begun. In late 2016, Meitu, an unprofitable business that develops photo-editing apps, completed Hong Kong’s largest internet IPO in 12 years. The company was eligible for a waiver because its revenue exceeded HK$500 million. The likes of China Literature and Yixin followed suit in 2017. 

“The exchange hasn’t published anything on this, so it isn’t opening the floodgates to pre-profit companies,” one Hong Kong-based lawyer explains. “But from the cases we have worked on, you can see it is moving in this direction. They realize a lot of new economy companies will see fast growth in the early years but might not be making any money.”

While there is no new board, the amendments to existing regulations regarding WVR include safeguards to protect minority investors. WVR shareholders must hold at least 10% of the underlying economic interest in a company and at most 50% of the voting rights, while the voting power of a single WVR share cannot be more than 10 times that of an ordinary share. Moreover, these rights can only reside with founders and do not transfer in a share sale.

Certain issues, such as changing articles of association and shareholder rights, removing independent directors, and replacing auditors, are still subject to one share, one vote. Minority shareholders also have the right to convene shareholder meetings. Enhanced governance measures include establishing a corporate governance committee and retaining a compliance advisor on a permanent basis, which most companies only do for one year after listing.

“I think the current safeguards reflect the exchange and the Securities & Futures Commission’s careful evaluation of different models and measures in the context of Hong Kong’s regulatory regime and the level of sophistication of the market and investors,” says Irene Chu, head of new economy and life sciences at KPMG China.

This view is not shared by all. The Hong Kong Corporate Governance Association (AGCA) believes that the accommodation of WVR globally is “resulting in a regulatory ‘race to the bottom’” that will undermine the integrity of the Hong Kong market. In a letter to HKEx, it posed questions on a range of issues, including a perceived reliance on case-by-case assessments rather than clear rules under the new regime and the exchange’s ability to enforce the safeguards.

Some of these concerns are shared by others in the market. “We don’t know how the exchange is going to implement these rules,” one industry participant observes. “Companies will set up committees to monitor governance, but to what extent will they be Mickey Mouse committees?” HKEx has said that companies can set up their own rules and procedures regarding the role of this committee.

Not for everyone

At the same time, Hong Kong will not be regarded as an optimal listing venue by all Chinese technology companies, even if they do qualify. “It comes down to how you maximize your valuation. If you are worried that Hong Kong doesn’t know how to value an unprofitable company, then you would choose the US,” says Hans Tung, a managing partner at GGV Capital. 

The implication is that Hong Kong’s investor base is generally biased against unprofitable companies, while the US has more institutional players that are familiar with technology and receptive to niche business models. For example, several Chinese peer-to-peer payment (P2P) companies went public in the US last year, following in the footsteps of local counterpart Lending Club. 

“If you list in the US and the model is like that of a successful US company it is easier to explain to investors,” says James Mi, a founding partner at Lightspeed China Partners. “However, if the model is unique to China and there isn’t necessarily a comparable in the US, it is not as easy to explain. Intrinsically there is an advantage to listing in Hong Kong, but right now the institutional investor quality is not up to the standard of the US market.”

Xiaomi is seen as a classic example of a Chinese technology company that is suited to the Hong Kong market. It has wide brand recognition in Asia but sells few mobile phones in the US; its business model is relatively straightforward; and the nearest US comparable is Apple. GGV’s Tung suggests that live-streaming and gaming companies are also among those likely to favor Hong Kong due to local familiarity with their products.

In some cases, the personal preference of the founder helps decide the listing location. According to investors, Meitu opted for Hong Kong in part because its founder had experience with listings in the territory and he was more comfortable conducting a roadshow in Chinese than in English. WVR wasn’t available at the time, but Meitu had raised relatively little outside funding so management still held a sizeable stake.

Perhaps more telling, though, was the expectation that the company would benefit from the Stock Connect schemes Hong Kong has with the Shanghai and Shenzhen exchanges through which mainland Chinese investors can more easily buy Hong Kong stocks. Meitu has seen a lot of trading activity out of the mainland, notes Gan of Qiming, an investor in the company.

“Even with currency controls, mainland Chinese retail investors can buy and sell Hong Kong stocks. That is really changing the dynamic of Hong Kong,” adds Li Hang, head of Greater China equity capital markets at CLSA. “Although they cannot buy during the IPO phase, after the listing they are free to trade. This introduces more money flows to the Hong Kong market and it can help offset the valuation differential between Hong Kong and the US.”

Starting point

Opinion is divided as to whether NYSE and NASDAQ are in danger of losing their status as the gold standard for Chinese technology companies. Some investors argue the innate excitement of a US listing will be difficult to dislodge, while others claim that prestige is no longer an issue, pointing out that Hong Kong-listed Tencent Holdings has roughly the same market capitalization as Alibaba.

What can be said with greater certainty is that moves to anoint Hong Kong as a hub for technology IPOs are premature. The reception Xiaomi receives from investors will be important in terms of setting a tone for the market, allaying concerns other companies have about pricing and valuation, and encouraging wider participation. Even then, though, the changes represent a pragmatic and gradual loosening of a regime, not its overthrow.

The regulations as they stand are described by many advisors as a starting point. “They considered additional measures in the consultation paper, but there is a need for balance; the attractiveness of the WVR structure might be lessened if ringfencing measures are too onerous,” says Baker & McKenzie’s Wang. “After one or two years they may issue new guidance and change some things.”

Adjustments will not only be driven by developments in the market, but also by the regulator becoming more comfortable with the system. While this could result in a further relaxation in the rules, it should not be interpreted as a change in mindset. 

Hong Kong is still far removed from the US approach where zero profit and WVR are accepted on the proviso of full disclosure – and a trail of class-action lawsuits emerges as shareholders seek recompense for alleged misdemeanors. Regulation is proactive, with an emphasis on identifying and neutralizing potential problems. And this will likely remain the case as long as retail investors are a meaningful presence in the market.

“In practice, the regulator in Hong Kong tends to adopt a more paternalistic approach,” says Li-Chien Wong, a partner at Kirkland & Ellis. “They feel highly responsible for the quality of the companies they allow to list in Hong Kong and the vetting process reflects that. They do have the discretion to decide whether a company is suitable for listing. The market is evolving, and the regulators are adapting to the market changes in a managed, organized way.”   

 

SIDEBAR: A biotech awakening

Ascletis has generated negligible revenue in the past two years while net losses exceeded RMB138 million ($21.7 million). But its financial position might be about to change. The company’s first drug, a treatment for chronic hepatitis C, is set to go on sale in the autumn and a 145-person team has been assembled to handle commercialization.

Ascletis is the first candidate to file for a Hong Kong IPO under new rules that allow for listings by zero-revenue biotech companies. Investors, underwriters and regulators will likely take comfort from that the fact that the business appears unlikely to stay zero-revenue for long.

“A lot of companies that were preparing for US listings have now changed direction to focus on Hong Kong, but I don’t think every biotech company can go for an IPO. It will only be those that are successful, with good products and high visibility,” says Wei Fu, CEO of C-Bridge Capital, which first backed Ascletis in 2014 and remains the largest outside shareholder.

The exchange has taken care to ensure only high-quality companies make the cut. Candidates must have a minimum market capitalization requirement of HK$1.5 billion ($191 million), enough working capital for at least 12 months, and secure the backing of a sophisticated investor – such as a PE firm specializing in healthcare or a major pharmaceutical player – at least six months before the IPO. 

The consensus view is that at present no more than a dozen Chinese biotech companies can consider a Hong Kong listing. They include cancer drug developer Kintor Pharmaceuticals, which has one treatment in phase three trials, another in phase two, and three more in phase one. 

“Companies need to have well-rounded management teams and attractive pipelines with strong visibility on commercialization, which usually means at least one program in phase three,” says Steven Wang, a founding partner at HighLight Capital, which is an investor in Kintor. “A lot of companies, despite raising significant capital, get stuck in phase one or two. The data aren’t good, or the product isn’t attractive – and then competitors surpass them with other options.”

At the same time, assessments shouldn’t be based on the progression of clinical trials alone: much rests on the kind of disease a drug is treating and the size of its market potential. This underlines the challenge presented in valuing companies. 

HKEx has established a committee to advise it on biotech IPOs and the exchange is said to be trying to hire people with experience in this area. Similarly, investment banks are looking to deepen local analyst coverage of biotech. Li Hang, head of Greater China equity capital markets at CLSA, admits that talent is limited. “It’s not like consumer where most people understand business models,” he says. “With pharmaceuticals, you need to have deep knowledge on everything.”

As such, no one is expecting a mad rush of biotech listings in Hong Kong, but investors are happy to have another option to listing in the competitive US market. “Having a timely supply of liquidity drives the growth of healthcare in China,” Fu says. “This move by Hong Kong fills in the last gap – the whole financing chain is now in place for the industry.”

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• Topics
• Greater China
• North America
• IPO
• Regulation
• Technology
• Healthcare
• Hong Kong (China)
• USA
• Exit
• Xiaomi
• Alibaba Group
• KPMG
• GGV Capital
• Lightspeed Venture Partners
• C-Bridge Capital
• HighLight Capital