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  • Regulation

China IPOs: Incremental benefits

  • Winnie Liu
  • 22 January 2014
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China’s securities regulator has introduced a registration-based IPO system designed to offer greater transparency. However, this does not mean an end to intervention in public markets processes.

The reopening of China's IPO markets has not been a smooth ride.Two weeks ago, Jiangsu Aosaikang Pharmaceutical announced plans to raise RMB4.05 billion ($669 million) through an offering that valued the company at 67x its 2012 earnings, compared to an average of 55.3x for ChiNext-listed drug manufacturers.

The IPO was aborted amid concerns not only with its size, but also with the large number of shares existing stockowners intended to sell through the offering. The China Securities Regulatory Commission (CSRC), which had already indicated that it would tighten restrictions on new listings, took note.

The agency has since conducted spot checks on 13 underwriters and 44 institutional investors involved in setting the prices for share issues, including a handful of private equity firms. When it was announced in December that the year-long embargo on IPOs would end, more than 760 companies had submitted listing applications and were awaiting approval. That number swiftly fell to 697 in the wake of the CSRC's checks.

While Aosaikang Pharmaceutical's withdrawal appears to be a victory for shareholders, it is a setback for the broader objective of replacing the registration-based approvals system with one that is more market-driven. The CSRC wants its influence to wane as the market plays a more active role in vetting listing applicants, but this was classic regulatory intervention.

"In this case, the underwriters and issuers followed the CSRC's rules of law to put original shares for sale in the IPO. However, the regulator stepped in and asked the company to suspend the IPO because of the relatively high valuation given by the market," says Leo Lou, a Shanghai-based partner at law firm Fangda Partners.

It is a contradiction to be expected of a system in transition and Lou remains positive about the measures the CSRC has put in place. However, he claims to be "cautious about what the system eventually turns out to be in the reality."

Market-oriented incentive

It is too early to make definitive statements as to whether China will adopt a disclosure-based system like the US, where investors are presented with the information and participate at their own risk, or Hong Kong's merit-based approach. Nevertheless, fund managers are generally bullish on the changes, arguing that a more transparent approvals process will give confidence to investors.

The new rules suggest the CSRC will spend less time reviewing IPO applications, although prior to the review stage companies will have to meet stricter disclosure requirements. In this way it is hoped that investors be better protected while companies with strong fundamentals are able to go public with the speed - and valuations - they deserve.

"We have one portfolio company currently in the queue for IPO approval and we do not expect any material impact on its application under the new system," says Haifeng Peng, a director at Victoria Capital. "However, it is too early to say what impact the system may have on the market as a whole. Recent events indicate there may be holes in the new rules and CSRC is still working on a lot of issues. I don't think anyone would expect a transition without hiccups."

The view among managers of renminbi-denominated funds is that going forward companies must be more marketable to investors for IPOs to get off the ground.

For example, applicants from the manufacturing sector - in which some domestic private equity funds have invested heavily in the past - may get less attention if there is no clear competitive advantage or differentiation in their business model. Investors need to see that higher profit margins can be traced back to qualities such as valuable intellectual property, strong marketing and branding, and unique product design.

"In the past, the CSRC approval alone made the IPO companies attractive. Now, it's more important than ever that companies have a great story," says Chris Burch, advisor to the chairman at Shenzhen Capital Group.

With the regulator no longer taking the lead in assessing a listing candidate's profitability and investment value, China's institutional investors - which are themselves evolving - become the key constituency. The IPO road show is therefore vital in drumming up interest, and private equity investors may have to appear alongside portfolio companies to face questions.

"Institutional investors are getting more sophisticated. They are doing their own diligence and they're increasingly equipped to judge issuers' value and the potential risks of buying shares," says Zhang Xuan, Beijing-based counsel at O'Melveny & Myers.

Discouraging excess

The new system is perceived to be an improvement on its predecessor because it discourages excessive fundraising. Road shows that could run to a full year will be capped at three months, the idea being that CEOs will focus on running the business and only raise as much capital as they need. In addition, companies have the flexibility of deciding when they would like to go public within a 12-month window, rather than being allocated a specific date by the CSRC.

In another concession, management will be allowed to sell shares within six months of listing rather than being locked in for three years. Long lock-up periods have been criticized for failing to create an alignment of interest between company and management, with many mid-level executives unwilling to wait around.

Profitability requirements are also becoming more realistic in order to cut down on fraudulent accounting. "The former listing rules required a company to have at least three sequential years of growing profits. As every business observer knows, things don't always work out that way. So, to meet this artificial requirement, many companies resorted to creative accounting, shifting sales to other periods, sandbagging in certain years, and so on," one China-based fund manager explains.

For companies that are unable to meet CSRC criteria - usually because they don't have three years of growing profits - back-door listings have become a popular option. The phenomenon really took root during the embargo on new listings, with many PE mangers under pressure to exit investments and give back return to LPs. The regulator has responded by proposing new rules under which back-door listings would be subject to the same standards as IPOs.

Finally, the number of public listings is expected to increase, the removal of scarcity value making valuations more rational. Deloitte projects that 200-230 companies currently under review can go public in 2014, raising RMB150-170 billion between them. In 2012, the A-share market saw 154 IPOs with cumulative proceeds of RMB103.4 billion.

If the listing process falls short of accepted standards, including on pricing, the brokerages, accountants and lawyers working on the offering will be held accountable.

This is the first time that the CSRC has said intermediaries should be punished. It will inevitably make these groups more careful in choosing the applicants they work with, and ultimately more professional in how they address the process.

"Markets with a viable disclosure-based systems, such as the US, tend to have mature, self-policing intermediaries that perpetuate a compliance culture and perform a critical gate-keeping function for the market," says Zhang Ying, Hong Kong-based counsel at Fangda Partners. "The rule of law is slowly taking hold in the Chinese market, but it's not quite there yet. This is clearly a step in the right direction but I don't expect the CSRC to venture far down this path until the market is ready."

SIDEBAR: The IPO reforms in detail

At the beginning of 2014, the China Securities Regulatory Commission (CSRC) resumed approvals of new share listings by firms on the Shanghai and Shenzhen bourses, ending the year-long IPO lockdown. These offerings are subject to new measures intended to shift the market from an approval-based system to a registration-based system. These changes are designed to control the "three high" problems - high prices, high price-to-earnings (P/E) ratios, and high subscription funding.

Approvals:

• The CSRC and IPO committee shall only examine IPO applications and documents according to their legality and their accordance with regulations. They won't make judgments on the issuer's profitability and investment value

• The CSRC should make decision on whether to allow a company to launch an IPO within three months

• The effective date of IPO approval has been extended to 12 months. Companies are free to issue shares any time within this period but should update their financial documents time-to-time and make sure there are no significant changes to their structures

• Companies awaiting IPO approvals are encouraged to issue corporate bonds first or secure a mix of debt and equity financing

Pricing:

• Issuing prices should be set by the issuers and underwriters. The prices should be disclosed in the IPO prospectus

• The number of inquiring investors should be between 10 and 20 for an offering of less than 400 million shares. If the offering is above 400 million shares, the number of inquiring parties should be between 20 and 40

Issuance:

• 40% of shares issued offline should first be allocated to mutual funds and social security funds

• At least 60% of the issuance should be rationed offline for offering s of less than 400 million shares. For offerings in excess of 400 million shares, at least 70% should be rationed offline.

• An offline-to-online clawback mechanism will set the ratio at 20% of the total issuance, if the online subscription multiple is above 50x but less than 100x the initial allocation. If the online subscription multiple is above 100x, the clawback ratio will be set at 40% of the shares offered in the IPO

• Original shareholders that have held unrestricted shares for 36 consecutive months may sell them to the public. However, there can be no change in actual control of a company

Disclosure:

• Shareholders with at least a 5% interest in a company should disclose whether or not they intend to retain their shares after the IPO. If they plan to reduce their holding, they have to give at least three trading days' notice

• The issuer and lead underwriter should publish special risk alerts for three weeks ahead of an online subscription if the proposed P/E ratio exceeds the average of its listed peers

Supervision and punishment:

• Intermediaries may be punished for negligence. Underwriters may be barred from underwriting for 12-36 months for actions including underwriting without permission, incorrect disclosure, leaking information, engaging in unfair competition, or violating the issuance plan or the provisions of writing the investment value report

• Random inspections will be carried out on companies during book-building and road shows. If an issuer and lead underwriter are found to have used information other than what is disclosed in the prospectus, the CSRC will stop the IPO and penalize the parties involved

 

 

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