China IPOs: Regulatory rumblings

Though less than two years old, China’s Science & Technology Innovation Board – or Star Market – has played a significant role in the country’s deep-tech investment boom. On one hand, voracious demand from mainland investors translates into rich valuation multiples. On the other, it is China’s first registration-based listing channel, offering candidates lighter-touch regulation and a smoother path to the bourse.

In the first quarter of 2020, the Star Market underlined its rapid ascent by generating proceeds of $3.2 billion from PE-backed offerings – or 57% of the total raised by Chinese companies across all exchanges. The share subsequently dipped below 50%, but the dollar amount continued to soar, reaching $6.8 billion in the third quarter.

Since last autumn, though, progress has been curtailed as regulators cracked the whip. The Shanghai Stock Exchange terminated 37 Star Market IPO applications from January through April, compared to three in the same period last year. High-profile candidates that have withdrawn include JD Digits, the financial services arm of JD.com, display manufacturer Royole Technology, autonomous driving technology developer Hesai Technology, and speech recognition technology specialist Unisound.

It is not the number of PE-backed offerings that has decreased, rather the amount of capital they are raising – which suggests the Star Market is missing out on the kind of bumper tech IPOs it was designed to accommodate. Proceeds fell to $4.2 billion in the final quarter of 2020 and $3.7 billion in the first quarter of 2021. Its share of global Chinese listings fell below 25% as Hong Kong boomed.

After Ant Group

The debacle around Ant Group’s last-minute IPO cancellation in November 2020 is widely held to blame. It is seen as having prompted greater scrutiny of listing candidates, with 15 Star Market offerings stopped in their tracks in December, a near fourfold increase on the previous month.

“There have been significant delays because the regulatory scrutiny has increased so much. The CSRC [China Securities Regulatory Commission] is even asking US dollar fund managers to disclose their ultimate shareholders, whether that's individuals, listed companies, or other institutions,” a Hong Kong-based investor tells AVCJ. “Previously, they just asked offshore funds to confirm that they didn't have any Chinese nationals or disclosable parties. The new way could be problematic.”

This assessment is endorsed by other investors. According to one technology-focused manager in Shanghai, the regulator wants to know the identities of LPs to rule out illicit activity in its own ranks. Current and former CSRC employees are banned from investing in listed companies, and there is a renewed desire to root out non-compliance. However, many LPs are reluctant to be named as beneficial owners, the manager adds.

As such, the spate of cancellations and withdrawals amounts to a stand-off. Everyone is waiting for more details on the new policy and various discussions are taking place. Meanwhile, in the absence of further guidance, implementation follows the most stringent standards.

The Shanghai-based GP is confident the impasse will soon end because China wants technology companies to list domestically as part of its innovation agenda. One possible outcome is that disclosures will be made to sponsors – the investment banks – rather than to the regulator. But even that is too much for some LPs. “Ever since this started, companies have been withdrawing their applications,” the Hong Kong investor adds.

Deep-tech drama

The Star Market is not for everyone. It has long been acknowledged that companies in certain industries are better received in the US markets, especially if comparisons can be drawn to existing listed businesses or the business model is highly complex. William Chen, a founding partner of ClearVue Partners, observes that most of his portfolio companies are still targeting the US.

Indeed, it is arguably easier to list in New York than ever before. Management teams are not expected to travel to the US right now, so roadshows are replaced by a week of late-night Zoom calls. Industry participants note that bankers sometimes have minimal interaction with the companies they are listing and due diligence – usually conducted over the phone and by email – can be little more than a box-checking exercise.

However, China’s deep-tech awakening is being played out on local exchanges in part by necessity. Semiconductor companies have received billions of dollars in PE funding, but Hong Kong has shown little historical appetite for them and the US may not value them as highly because its semiconductor space is mature and seldom associated with rapid growth.

On top of that, the industry is a political flashpoint; a Chinese semiconductor start-up listing in the US might not please the government of either country.

“It is better to have a relatively clear benchmark. US investors may not appreciate the value of a company without a benchmark,” says Hao Li, a managing director at Lighthouse Capital. “And frankly speaking, Chinese companies developing core technologies can hardly pursue US IPOs. That may create some issues regarding Sino-US relations.”

Megvii Technology knows how it feels to be targeted by US regulators. In August 2019, the China-based company, which specializes in artificial intelligence-enabled facial recognition software, filed to list in Hong Kong. Two months later, Megvii was blacklisted in the US for alleged human rights violations, which meant it couldn’t purchase components from US suppliers without government approval. The Hong Kong IPO went nowhere.

In March, the company applied to list on the Star Market, but the process has proved laborious. Megvii’s response to a first round of inquiries from regulators ran to 560 pages. It is unclear if and when the company, which has received around $1.5 billion in private equity funding, will go public.

Of China’s four so-called AI dragons, only SenseTime has yet to file for an IPO. Yitu Technology’s Star Market application was accepted last November, but the company withdrew in March, claiming that it was taking too long “to implement rules and regulatory verification requirements” regarding its VIE structure. CloudWalk received the green light in December and responded to the first round of regulatory inquiries in March. The process is ongoing.

Bad actors

While the beneficial ownership disclosure issue is a widely stated reason for IPOs being withdrawn, delays and cancellations are often a response to sub-quality companies or sub-quality information disclosure. In January, regulators issued on-site inspection rules and quickly selected 20 listing candidates at random for disclosure checks. Sixteen voluntarily withdrew their applications.

Chuan Xiong, a partner at Zhong Lun Law Firm, notes that some companies simply rushed their documentation. “Some financial data is inconsistent; some companies apply a template without disclosing the key information; some provide documents comprising hundreds of pages of advertising content, and after reading it, you may not even be able to figure out what the company does; and some consciously or unintentionally omit important related parties,” he says.

There are also cases in which companies are rejected because of the nature of their business. Last week, the Shanghai Stock Exchange turned down Xuyu Optoelectronics, a Shenzhen-based LED packaging devices producer, after questioning whether its self-designation as a manufacturer of new electronic components and equipment and a next-generation IT company was justified.

Doubts were also expressed as to Xuyu’s R&D capabilities and talent base. The company’s R&D investment amounted to only 5% of operating revenue over the past three years – Star Market candidates are expected to reach at least 15% – and 80% of employees had no tertiary education.

Additional requirements have been put in place to catch out would-be tech companies, such as R&D personnel accounting for at least 10% of the workforce. There is also a negative list intended to restrict IPOs by financial technology, real estate and investment-related businesses. JD Digits’ withdrawal might be connected to this new rule.

Manufacturers trying to reposition themselves as technology companies is not the only red flag. Hesai terminated its Star Market application in March. No reason was given for the move. However, Hesai had been embroiled in a patent dispute with a US peer that resulted in it agreeing to pay license fees.

“If you claim to be an innovative technology company but then you have to pay third parties large sums in patent licensing fees, and then every time you sell a product you are paying royalties, people will doubt on your originality,” says a third investor.

Quality vs uncertainty

To numerous industry participants, the drop in IPOs is necessary – even desirable – if it reinforces the quality and reputation of the Star Market. “The registration-based system does not mean non-review. The regulator just no longer judges your business substance, but it keeps the door open to check the quality of your information disclosure,” says Zhong Lun’s Xiong.

And it is not the only recent directive in what remains a highly regulated market. For example, in February, the CSRC fired a warning shot to pre-IPO stock flippers by stressing that investors who buy into a company less than 12 months before a listing will be subject to a 36-month lock-up starting from the date of their investment.

As ever in China, the unpredictability of regulatory intervention – even if it is to tweak the implementation guidelines for existing policies – remains a concern. “Is it a temporary requirement or will it continue into the future?” one lawyer asks regarding the beneficial ownership disclosure issue. “It's really not easy to foresee.”

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• Topics
• Greater China
• Regulation
• IPO
• China
• regulation
• CSRC