Exit via IPO in China The following is an excerpt from a study by EMPEA member Ergo on the prospects for private equity investors to exit their investments via IPO in China. The study draws on interviews with more than a dozen investors and capital markets experts. Ergo is a New York-based strategy consulting firm specializing in emerging markets; its clients are primarily private equity firms and corporations. Introduction One explanation for the dominance of retail investors is that they have few investment alternatives. One executive at a fund By virtue of its sheer size and incredible growth over the of funds notes that when it comes to asset allocation for indi- last decade, China presents one of the most compelling vidual investors in China, “it’s either stocks or real estate.” destinations for portfolio and direct investment. Yet for all its promise, private equity as an asset class faces a number Large household holdings of equities are expected to con- of challenges in China, particularly when it comes to exit- tinue over the next 2–5 years. As one GP based in China ing investments and realizing returns. The country’s capital notes, China’s capital markets “will develop very similarly to markets remain underdeveloped, lacking the stability of Taiwan’s but at a much larger scale.” Taiwan is “still a retail a robust base of institutional investors, and leaving them market—they like gambling,” characterized by investors inordinately prone to the whims and exuberance of China’s “like housewives and taxi drivers that engage in trading.” retail investors. Equity asset ownership by China’s households is estimated GPs face numerous uncertainties when it comes to exiting to grow from a base of US$281 billion in 2005 to US$3.8 investments via IPO—from concerns over future capital market trillion in 2014, representing an impressive 10-year CAGR developments, to trade-offs between onshore and offshore of 36%. China’s household equity holdings are forecast to listings, to opaque regulatory processes. This article sheds be the 2nd largest in the world by 2014—behind those of more light on these challenges with insights from experts in the United States—and are expected to outpace those of China, Hong Kong, Singapore, and the United States. other leading emerging market economies (e.g., India and Brazil), as well as those of leading developed countries (such Capital Market Developments as Japan and Germany). Evolution of the Markets This dominance by retail investors, notes one GP, leads to Traditionally, China’s equity markets—the main boards in “huge waves of irrational exuberance.” Cognizant of the Shanghai and Shenzhen—served as conduits for state- continued growth projected in the retail investment sector owned enterprises to raise capital and privatize their and its potential impact on volatility, the Chinese govern- operations. Within the last decade, Beijing established two ment has made the growth and development of institutional additional exchanges to catalyze the development of Chi- investors a national priority. na’s private sector: In addition to the Qualified Foreign Institutional Investor • The Small- and Medium-sized Enterprise (SME) (QFII) program launched in 2002—a program which allows Board—launched in 2004 on the Shenzhen Stock licensed foreign investors to trade A-Shares—the govern- Exchange—provides a direct means for SMEs to raise ment now allows the National Social Security Fund to invest medium- and long-term capital. It is a segment of the up to 40% of its assets in equities, and it has amended the Main Board in Shenzhen. National Insurance Law such that insurance companies can invest up to 25% of their assets in stocks. • ChiNext—launched in October 2009—is an indepen- dent exchange modeled on the NASDAQ. ChiNext is Efforts to develop a sophisticated class of long-term insti- particularly focused on high-tech, high-growth startup tutional investors, such as mutual funds and pension funds, companies. could reduce volatility while providing a ready source of demand for equities and IPOs. Exhibit 1 illustrates the growth Institutional Investor Development in China among both retail and institutional investors over the last Retail investors are estimated to account for 85% of all trad- decade, with retail investors—exemplified by the number ing activity on China’s domestic exchanges. At the end of of securities accounts—growing 3.5x from 1999–2009, and 2009, the China Securities Regulatory Commission (CSRC) institutional investors growing 34x over the same period. disclosed that there were more than 170 million registered securities accounts. According to the CSRC, securities invest- Improving Market Liquidity ment funds held 12.7% of the free-floating shares listed on While continued growth of investors in China portends the Shanghai and Shenzhen exchanges, while the 94 Quali- highly liquid equity markets, investors and industry experts fied Foreign Institutional Investors (QFIIs) held 1.4% of the point to numerous areas for improvement in the quality of free-floating shares. liquidity in the Chinese market. 8 Emerging Markets Private Equity Association Exit via IPO in China, continued Exhibit 1: Growth of Retail and Institutional Investors in China 20,000 18,000 600 16,000 500 14,000 12,000 400 10,000 300 8,000 6,000 200 4,000 100 2,000 0 0 Number of Securities Accounts (10,000) 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Number of Securities Investment Funds No. of securities accounts (retail investors) (lhs) No. of securities investment funds (institutional investors) (rhs) Source: CSRC Annual Report 2009. Ergo analysis. Most observers of Chinese equity markets believe there is governance, responsible reporting, and transparency and a surfeit of liquidity, which contributes to speculation and disclosure within Chinese companies. A key component of market volatility. Chinese authorities are very concerned this includes the development of independent credit ratings with “hot money” and inflation, so much so that Beijing agencies. However, in addition to the increased standards recently limited foreigners’ access to the property market, for the private sector, several experts note that the Chinese and the government has increased the reserve requirement government itself needed to improve the transparency of at large banks to 18% (16.5% for smaller banks) in an effort its legal and regulatory system—to include a legal and judi- to contract the monetary supply and suppress Consumer cial system that fosters trust among investors, and develops Price Inflation (CPI). bankruptcy law and case law (precedents). While these issues raise concerns over market liquidity in Status: Progress toward these goals remains un-clear; the near-term, private equity and capital market experts however China Accounting Standards are gradually being see several opportunities for government intervention to phased out in favor of International Financial Reporting improve the quality of liquidity over the long-term: Standards and U.S. GAAP. A free floating currency. A move to full convertibility Increasing the number of quality companies. China’s of the Renminbi and an opening of the capital account lofty price-earnings (P/E) ratios are a symptom of too many would contribute to greater liquidity: it would facilitate the Renminbi chasing too few issues. The launch of the SME development of institutional investors, critical for stable Board and ChiNext demonstrate the government’s commit- long-term liquidity. A class of professional investors could ment to private sector development, and should facilitate mitigate market volatility. the entrance of quality companies to market. There are currently backlogs of companies wishing to launch IPOs According to Alison Nankivell, a Beijing-based Senior Port- domestically; satisfying the stringent listing requirements folio Manager for EMPEA member Export Development should provide investors with a degree of confidence in the Canada (EDC), “there’s no systematic analysis of companies quality of listed companies. on the part of investment banks. There’s nothing to sustain liquidity.” The entrance of more foreign participants could Status: Chinese regulators continue to approve compa- create opportunities for the professionalization of China’s nies for listing on the country’s exchanges. However, institutional investors. With a free float, China’s state-owned experts note that CSRC may need additional staff to pro- banks and brokerages could shift from serving as political cess applications and clear existing backlogs, and advise instruments to fiduciaries, and could catalyze a move toward that regulatory authorities may halt listings if stock prices value investing and professional portfolio management. appear overheated. Status: Given Beijing’s concerns over CPI and the poten- Legal person share reforms. The Chinese government is tial for the second round of Quantitative Easing to cascade calling for all non-tradable shares (legal person shares) to liquidity on Chinese markets, a move to a free float is not be made tradable. This reform could triple the size of the expected within the next 5 years. market in terms of tradable shares, increasing total market capitalization from approximately US$1.2 trillion to US$3.5 Improving transparency and corporate governance. The trillion. One capital markets expert notes, “downward pres- government is emphasizing the need to improve corporate sures are building up due to the fact that a vast number of Quarterly Review Vol VI Issue 4, Q4 2010 9 Exit via IPO in China, continued institutional shareholders wish to cash out.” While this may Exhibit 2: Listings of Chinese Companies create headwinds for equity prices and IPO exit multiples in 1800 200 the near-term, it should provide for a more stable market 1600 180 over the long-term. 1400 160 1200 140 Status: Legal person share reforms are on-track to be imple- 1000 120 mented by the end of 2010. 100 800 80 600 Actions taken toward each of these reforms could be self- 60 reinforcing and have cascading effects on the market as a 400 40 whole.