China's OTC market: The shortcut

JD Capital rose to prominence in China under a different name - Jiuding Capital - as arguably the preeminent pre-IPO shop, listing companies seemingly by the dozen. It has now established itself as an early mover in another space, becoming the first Chinese PE firm to complete a public listing itself.

JD Capital's parent company - Beijing Tongchuang Jiuding Investment Management - is trading on the emerging over-the-counter (OTC) platform, known as the New Third Board. A total of 131 LPs exchanged their interests in JD's funds for interests in the GP. It is, unsurprisingly, an exit strategy: once gridlocked because underlying portfolio companies are unable to list, these LPs' fund positions suddenly became liquid.

"The key driver for the listing is to ease pressure from LPs to cash out," says Dayi Sun, managing director at China-focused fund-of-funds Jade Invest. "The GP has raised a number of renminbi funds over the last few years, which usually have a three-year fund life. LPs are now increasingly looking for exit but it's hard, given that the normal IPO process has been slowed."

Another option is to have portfolio company founders buy back positions, but this is unappetizing when valuations are low. A GP listing offers the prospect of a quick exit and a more attractive valuation. JD Capital raised RMB3.54 billion ($567 million) by selling 5.8 million shares sale at RMB610 apiece.

Other managers are expected to follow suit and take advantage of the OTC system. But the bourse's primary use to PE and VC firms is still likely to be as a mechanism for exiting portfolio companies, especially if it becomes possible to transfer to the A-share main boards or ChiNext.

However, there is no timetable for introducing such an option. And the faltering development of New Third Board over the past few years hardly inspires confidence.

Humble beginnings

The Third Board, initially known as the share transfer system, was launched in 2001 as a pilot program enabling small- and medium-sized high-tech private enterprises in Beijing's Zhongguancun technology hub to raise funds. Two years ago the State Council allowed the program to expand into more cities, including Shanghai, Tianjin and Wuhan.

The China Securities Regulatory Commission (CSRC) introduced further reforms last year, uniting all the OTC markets and establishing the National Equity Exchange and Quotation (NEEQ), or New Third Board. The listing requirements are less stringent than for other bourses: companies must simply have a clear shareholding structure and two years of financial statements.

Despite the measures, the New Third Board is hindered by low trading volumes and inactivity. None of the more than 40 companies on Jiangsu province's OTC market raised capital last year.

This is partly attributed to high investment thresholds. Participation is restricted to institutional investors or high-net-worth individuals with assets of RMB50 million that can be traded in listed stocks. The absence of a market maker system is also a problem; it means every transaction is based on direct negotiation between the investor and listed company.

"You could price listed companies at a sky-high price-to-earnings ratio and push the share price even higher by buying shares yourself. But no other investors are willing to pay for those shares, given that more than a half companies listed on the board have poor financial performance," says Sanshou Huang, president of domestic IPO advisory firm Heading Century.

As of the end of March, a total of 660 firms were listed on the New Third Board, doubling the number at the end of 2013, according to China Private Equity and Venture Capital Association (CVCA). Listed companies raised RMB610 million in early April, compared to RMB1 billion fundraising during 2013 as whole. Interestingly, 212 companies have previously raised capital from private equity investors.

"From a financial point of view, it's not an ideal venue for PE fund managers to exit portfolio companies if they are hoping for high returns," says Huang. "A lot of VC-backed enterprises are under pressure to exit because they agreed to a valuation adjustment mechanism with PE investors several years ago. As listing on the main board becomes more difficult, the New Third Board seems to be a visible option."

Upwardly mobile

Although the board is at a nascent stage, the government is taking steps to encourage activity. A market maker system is expected to be introduced next month and the State Council is encouraging qualified companies on the New Third Board to apply to listings on the main board, even in the absence of formal rules.

The financial disclosure requirements imposed on listing applicants already represent a stepping stone to the main board. Given that financial statements must be properly audited the documentation could be seen as a preliminary IPO prospectus.

"The role of the New Third Board is as a testing ground for how a registration-based listing system could work in practice, which is one of the government's main policy objectives," says Shoushuang Li, a senior partner at Dacheng Law Firm, who helped structure JD Capital's New Third Board listing. "Board transfer rules will eventually be launched because the State Council wants them."

JD's trading price and volume are the currently the highest ever seen on the New Third board. So far only one other manager - CSC Group - is preparing to list but others will follow if it proves beneficial to the overall franchise.

"Chinese fund sponsors could improve their visibility by listing on the board," says Serena Tan, an associate in Debevoise & Plimpton. "It will improve investor confidence as the sponsors would have to disclose certain information to the public. Transparency may then help the sponsors in future fundraisings, since investors are likely to know them better than unlisted ones."

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• Topics
• Exits
• Greater China
• Expansion
• China
• Exit
• IPO
• Growth capital