China IPOs: Star attraction

It has long been accepted that China’s US dollar and renminbi-denominated funds exist in different worlds. Currency controls naturally lead the former to take portfolio companies public in overseas markets while the latter focus on domestic IPOs. Different exit paths and regulatory systems have nurtured distinct investment styles.

“US dollar funds are more aggressive. They have more money, they chase big deals, and they bet on future giants. They are tolerant of loss-making portfolio companies. In contrast, renminbi funds are cautious. They are profit-oriented and want to diversify the risk,” says Liyong Zhou, a general manager in the VC unit of Shanghai STVC Group, one of China’s earliest state-backed LPs in venture funds.

Even when managed by the same GP, US dollar and renminbi funds differ in strategy, preferred investment stage, and target industries.

However, the boundary is now blurring as an increasing number of US dollar GPs pursue domestic IPOs. On one hand, the US is less appealing as the Luckin Coffee scandal has heightened regulatory scrutiny and trade tensions have lawmakers clamoring for the complete exclusion of Chinese companies. On the other, the Science & Technology Innovation Board – also known as the Star Market – has proved a smooth listing route.

The Star Market is everything China’s other bourses are not: friendly to tech start-ups; willing to overlook losses among candidates of a certain scale; and governed by a registration-based rather than approval-based listing system. The Star Market is obliged to respond to applications within five days of receipt, although there is the option of launching lengthier reviews.

“It only takes four months from application to listing on the Star Market compared to at least two years for the traditional review process,” says Shiduo Xu, a Beijing-based partner at law firm Zhong Lun. The regulator announced in April that the registration-based system would be introduced on ChiNext later this year.

Path to riches?

A total of 110 companies have debuted on the Star Market since it opened last July. This helped the Shanghai Stock Exchange become the world’s most popular listing destination in the first half of 2020 with proceeds of RMB110.5 billion ($15.8 billion) from 72 offerings. Valuations are the big draw as local investors gorge on IPOs. Even biotech start-ups, which typically receive a warm welcome on US exchanges, want to call the Star Market home.

SinocellTech, a drug developer backed by Qiming Venture Partners, nearly trebled in value on its Star Market debut despite being several years away from profitability. The company is currently trading at a 250% premium to its IPO price. Qiming has listed two more companies on the same bourse in the past five months; both command a strong investor following. As of mid-June, the average price-to-earnings (P/E ratio) on the Star Market was 85, with more than half the stocks doubling in value capitalization since making their debuts.

“Starting this year, many US dollar funds are talking to us about domestic listings. If the company has already achieved a red chip offshore structure, including a VIE [variable interest entity, which allows foreign investor participation in restricted industries], it could consider listing directly onshore," says Mulong Gong, a Beijing-based managing partner at law firm King & Wood Mallesons (KWM).

For all the excitement around a new path to liquidity, investors must be patient on realizations. The Star Market – like other Chinese bourses – prevents them from selling any shares until a year after the IPO. Investors that bought in less than 12 months before the offering are subject to a three-year lock-up period. Once these restrictions have lapsed, only about 1% of a company’s total issued shares can be offloaded each quarter through regular sales by significant shareholders.

Jade Invest, a Shanghai-based direct investor and manager of US dollar fund-of-funds, still holds a 20% of Shenzhen-listed Sangfor Technologies even though the listing was more than two years ago. “The exit is lengthy, but we are sitting on a 200-300x return,” says Dayi Sun, a managing director at Jade Invest. “This single investment could pay back half of our entire fund.”

US dollar managers should also be mindful of capital control and exchange rate losses, although some investors play down these risks. “Profit repatriation is a standardized process these days. It may take longer, maybe half a year, but it’s not a difficult procedure,” says Nisa Leung, a managing partner at Qiming, which has generated about 70 exits through A-share listings and domestic M&A.

She adds that, as a VC investor, potential exchange rate losses seldom come under consideration. It might be different if Qiming’s returns were closer to interest rate margins.

Meanwhile, Victor Zhao, a managing director at Hina Capital Partners, is among those who expect the valuations and overall liquidity of China’s domestic markets to be superior to those overseas in the next 5-10 years. This will tempt even more US dollar funds to the Star Market. Indeed, some firms no longer pursue distinct exit strategies for US dollar and renminbi vehicles. 

“We have a very simple philosophy: we identify the best companies and invest in them through both funds,” says Chengbin Li, a partner at Loyal Valley Capital. “In the interests of fairness, we try to make it half and half.”

Modes of entry

The easiest way for a US dollar fund to make a renminbi-denominated investment is through a Sino-foreign joint venture structure. Advisors observe that these entities are becoming increasingly popular. However, they are not always the optimal route.

For example, some companies prefer to be supported by renminbi funds. AIpark, a Beijing-based smart parking management solutions provider, recently closed a RMB300 million ($42 million) Series C round led by Gaorong Capital. Jun Yan, the company’s founder, tells AVCJ that he has only raised renminbi because he is targeting a domestic IPO.

There are good reasons for this approach. First, a JV structure involves a lot more administration work because approvals are required from onshore and offshore regulating entities. It could take months for these to be processed, especially given the delays created by COVID-19. Second, due diligence standards are stricter for US dollar funds.

Third, once US dollars are raised, they must be held in overseas accounts. Bringing the capital onshore involves making a strong use-case to Chinese regulators. The State Administration of Foreign Exchange (SAFE) is loath to allow companies simply to hold cash in onshore accounts where it could easily be channeled into financial products, notes Hina’s Zhao. For an investment in marketing or R&D, a contract would have to be produced.

Moreover, the presence of a JV could restrict the scope of a company’s future commercial activities. Sensitive areas such as the military and certain internet-related assets remain strictly off-limits to entities supported by foreign capital.

“Say you are a software company that has nothing to do with internet and you set up a JV structure. You might want to offer a SaaS [software-as-a-service] platform or something else that relies on the internet and suddenly the JV becomes an impediment,” explains KWM’s Gong.

If a JV is unworkable, there is always a VIE. This structure – typically an onshore vehicle that operates in parallel to a wholly foreign-owned enterprise (WFOE) but is controlled by a Chinese national and contractually tied to the WFOE – has been a feature of China’s investment landscape for 20 years. It is responsible for giving foreigners exposure to internet assets that are normally beyond their reach, underpinning US listings for scores of start-ups.

However, rising appetite for local IPOs has revived a trend, last seen in 2015, of removing VIEs. "Some secondary investors focus on this business, using renminbi vehicles to acquire positions from overseas LPs. US dollar funds might even stipulate in their agreements that if a portfolio dismantles its VIE to become a domestically funded, it is guaranteed an immediate withdrawal,” says Xing Ji, a managing partner at Lighthouse Capital.

CDR solution

Even here, though, the Star Market now offers an exit route. Companies have the option of selling Chinese Depository Receipts (CDRs), which are similar in nature to the American Depository Receipts (ADRs) used by non-US businesses to list in New York. In these situations, VIEs can be retained.

Last month, electric scooter manufacturer Segway-Ninebot became the first foreign-registered enterprise with a VIE structure to win approval for a CDR offering. The company hopes to raise more than RMB2 billion, which would provide a liquidity event for offshore investors such as smart phone maker Xiaomi, Sequoia Capital China, Intel Capital, Shunwei Capital, and Singapore’s GIC Private.

To qualify for a CDR offering, a company with a VIE structure must generate revenue of at least RMB3 billion and achieve a valuation of more than RMB20 billion. However, Zhong Lun’s Xu notes that regulators are willing to be flexible. Rapid revenue growth, independent R&D capabilities, and global leading technologies all count in an applicant’s favor.

This amenability says everything about the ultimate motivations of the CDR initiative: to get high-quality start-ups that might otherwise generate windfalls for overseas retail investors to list at home. VC and PE players willing to ride the regulatory gauntlet stand to benefit. 

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• Topics
• Greater China
• IPO
• Regulation
• Technology
• China
• TMT
• Qiming Venture Partners
• Loyal Valley Capital
• Jade Alternative Investment Advisors