Exit Via IPO in China

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 independent 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. Private equity itself may be a driver of these market 200 20 Number of Companies (A-Share) improvements. EDC’s Nankivell notes that “private equity 0 0 Number of Companies (offshore) 1999 2001 2003 2005 2007 2009 investors—people who want to see successful exits—will 2000 2002 2004 2006 2008 probably create more pressure on the regulatory system to No. of onshore listed companies [A-share] (left axis) be acting in a more professional way, and that probably No. of offshore listed companies (right axis) will accelerate the pace of professionalization of the key players.” Source: CSRC Annual Report 2009. Ergo analysis.

The Chinese government is believed to be cognizant of the reforms required to develop stable and liquid capital mar- Exhibit 3: Breakdown of Offshore Listings kets, however capital markets experts agree that reforms will be gradual, making a float of the Renminbi unlikely 1H2010 within the next five years. 2009 Pieter Bottelier, a seasoned observer of China’s financial sector, captures a prevailing sentiment among Western experts 2008 consulted for the study: “Ultimately it’s a political question. Year All the technical people in the government know these issues 2007 well; but in the end, it’s the Party that determines the direc- tion, pace and scope of capital market reforms.” 2006

IPO Exits: Chinese vs. Global Exchanges 2005

The listing preferences among Chinese companies are clear: 0% 20% 40% 60% 80% 100% they overwhelmingly prefer to list domestically on the Proportion of Listings A-Share market, rather than listing in Hong Kong (H-Shares) or New York (N-Shares, or ADRs). Exhibit 2 shows the domi- n Hong Kong Main Board n NASDAQ nance of A-Share listings while demonstrating the desire n Hong Kong Growth n New York Stock Exchange Enterprise Market among some Chinese companies to list offshore. In 2009, n Singapore there were 10 times as many A-Share listed companies as Source: Zero2IPO Research Center. Ergo analysis. offshore listed companies. For the 11-year period from 1999 to 2009, the number of A-Share companies grew at a CAGR of 6.7%, while the number of companies listing off- Exhibit 4: VC/PE-Backed IPOs (2007–2009) shore grew at a CAGR of 13.2% 100% Among offshore listings, Hong Kong is by far the pre- 90% 12 ferred exchange for Chinese companies. Exhibit 3 provides 80% 22 a breakdown of the exchanges Chinese enterprises have 70% 61 selected for offshore listings since 2005. The listing prefer- 60% ences of Chinese companies gel with those of private equity 50% investors in China. Rebecca Xu, Co-Founder and Managing 40% Director of Asia Alternatives—an Asian Fund of Funds with No. of IPOs 23 offices in Beijing and Hong Kong—and member of EMPEA’s 30% 36

Asia Council, notes “China’s domestic markets will become Proportion of IPO Activities 20% 33 an important exit venue in the future.” 10% 0% In the short- and medium-term, notes Xu, the domestic 2007 2008 2009 market will be coming up from behind. Hong Kong and n Overseas IPOs n Domestic IPOs NASDAQ will continue to play a very meaningful role for IPO exits, but companies will increasingly choose to list Source: Zero2IPO Research Center. Ergo analysis.

10 Emerging Markets Private Equity Association Exit via IPO in China, continued

Exhibit 5: Exit Multiples: Average Return on Book Value of VC/PE-Backed Chinese IPOs

25 n Q4 ‘09 n Q1 ‘10 n Q2 ‘10 n Q3 ‘10

15 Multiple 10

0 Singapore NASDAQ Hong Kong New York Stock Shanghai Shenzhen– Shenzhen– Main Board Exchange SME Board ChiNext

Offshore Exchanges Domestic Exchanges

Source: Zero2IPO Research Center. Ergo analysis. in Shanghai or Shenzhen. Other offshore exchanges (e.g., listings may offer potential for outsized returns, but GPs Singapore and London) will play a minor role, and will be and their portfolio companies will be subjected to an targeted mainly by Chinese companies seeking to grow opaque IPO approval process. their market share in a specific geography or industry. While GPs may not drive the decision to list onshore versus The data for VC/PE-backed IPOs bear out Xu’s analysis. offshore, they must manage the tradeoffs involved, balanc- Exhibit 4 shows a clear shift of PE-backed IPOs away from ing the need to maximize returns while satisfying the needs offshore and toward onshore listings; Exhibit 5 provides a and objectives of their LPs. simple explanation for this shift: exit multiples. The IPO Approval Process—A Black Box While the potential for more attractive exit multiples domestically certainly plays a role in the decision on where Private equity investors in China point to the opacity of the to list, a number of benefits of listing offshore also fac- regulatory process for IPO approvals as the most vexing tor in, such as access to a broader range of investors and aspect of exiting in China—more so than concerns about shorter lockup periods, outlined in Exhibit 6. Onshore capital markets development or convertibility of the Ren- minbi. Practitioners in China believe that regulators, when given a choice, may approve domestic-owned companies Exhibit 6: Advantages to Listing Offshore for listing before foreign-owned companies. • Diverse investors: Access to a broader range of investors so Two notable Chinese legal experts disagree. Bai Yanchun, as to diversify the company’s capital base. a founding partner of King & Wood in Beijing, has worked with over 150 corporations seeking listing approval, and • Prestige: The prestige associated with an international listing was appointed to the CSRC in 2008 as one of the mem- can confer an implied level of trust and corporate governance. bers of its stock issuance approval body. Bai notes that • Avoiding capital controls: Listing in Hong Kong or New York circulars issued by the State Council demonstrate that “at frees up investors to deploy capital more freely. a policy level the Chinese government is tending to encour- age investors to list domestically…but in reality, most of • Shorter lockup periods: Sponsors face a lockup period of three the FIEs [Foreign Invested Enterprises] are not enthusiastic years—and investors a lockup of 12 months—on Chinese exchanges about doing domestic listings.” versus a typical lockup of 6 months for offshore exchanges. Bai notes that the detailed regulations “do not contain any- • Ease of listing: The registration and listing requirements in thing that could be prejudiced against foreign investors. Hong Kong, Singapore, and the Western bourses are much Regulators are providing equal treatment…but companies less stringent than those in Mainland China. This efficiency is must read the regulations closely…the conditions and stan- true not only for the IPO, but also for secondary placements dards at CSRC are harsher here for an IPO in the domestic and subsequent capital raises. market [than in other exchanges such as Hong Kong].”

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Yu Yongqiang, a Partner of Jun He Law Offices in Beijing One foreign GP based in China adds that political support— and a specialist in securities transactions, shares Bai’s view at both the local and the national levels—may be vital to that China encourages foreign companies to launch IPOs in receiving approval. With long waiting lists, this expert China. He adds that the process can be “quite complicated,” believes the bigger, nationally branded domestic compa- and that CSRC and the National Development and Reform nies and SOEs are moved to the top of the list for approval. Commission (NDRC) “focus a lot of attention on the use of the proceeds from the listing.” EDC’s Alison Nankivell agrees with this analysis, adding that non-strategic companies that don’t have any govern- However, a partner in a leading international law firm’s ment involvement may find it difficult to receive approval. office in Beijing notes that while the Chinese government is “There’s going to be a policy spin to why certain compa- open to foreign investment in pre-IPO and post-IPO companies will get favored treatment,” notes Nankivell, “and nies in China, an examination of the details of transactions until there are transparent criteria—and until they are reveals, “CSRC is not very willing to approve foreign-con- honored—it will not be possible to have any confidence trolled companies in IPOs.” This lawyer adds, “These days, where you’ll sit in the IPO approval ranking.” Moreover, political issues are key to IPOs. If you have shareholders municipal governments are now getting involved with with certain backgrounds, that could raise issues…There’s Renminbi-denominated funds, creating another wrinkle for no sound practice for approval, and there are no clear foreign-invested companies seeking opportunities to list on guidelines for how to interpret certain rules.” domestic exchanges.

Specific factors regulators are believed to be considering A Chinese expert on the country’s capital markets suggests include a company’s ability to demonstrate competency in that while traditional economic stalwarts such as Guang- a core business, rather than diversified operations (spe- dong and Shanghai may enjoy some privileges when it cifically for ChiNext listings); the absence of material comes to listing, the central government is “increasingly changes (e.g., to assets, ownership or the business) during and sharply under pressure to grant more policy favors to the previous three years; and shareholder continuity and the less developed inland regions.” Thus, while the central related-party transactions. government remains the most crucial in the process, local political issues are germane to the approval process.

Exhibit 7: Typical A-Share Approval Process

Step 1: Only a joint stock limited company (JSLC) is qualified as an issuer and a limited company (LC) shall be Restructuring altered to a JSLC 1–3 months

• Improve corporate governance; establish internal control Step 2: • Train directors, supervisors, senior management, and 5% shareholders Coaching • Special issuers (e.g., banks, securities co.) must obtain supervisory opinion from regulatory authorities 3 months (CSRC, CBRC) • Submit Sponsor Letter to CSRC after coaching

• CSRC determines whether to accept the application within 5 days of filing Step 3: • CSRC questions local government and the NDRC, and comments on the application documents; Filing & Hearing issuer shall pre-disclose prospectus within 5 days after responding to CSRC comments approx. 3 months • Public Offering Review Committee (PORC) hears the application

Step 4: • Public offering made within 6 months of obtaining approval Offering & Listing • Disclosing prospectus and pricing based on road show within 6 months • Application to stock exchange for listing • Sponsor shall continue to monitor issuer for more than two years after listing

Source: Partner, Chinese law firm based in Beijing.

12 Emerging Markets Private Equity Association Exit via IPO in China, continued Looking Forward—Implications for LPs Regardless of the timeframe, GPs’ portfolio companies and GPs will need to be in full compliance with CSRC’s regulations, to include the clear identification of uses of proceeds Given Beijing’s increased concerns over frothy property mar- from an IPO. GPs will ultimately need to conduct stake- kets and CPI inflation, IPO exits onshore could be a dicey holder analyses to ensure their portfolio companies have proposition in the near-term. Several experts note an alarm- the support of local governments (through job creation, ing level of uncertainty in global capital markets, which could tax revenues, etc.) and are aligned with national policy suppress appetites for IPOs on offshore exchanges as well. priorities. Unfortunately, the latter could be prone to unexpected shifts, and portfolio companies could become Looking ahead 2–5 years, experts anticipate greater stabil- hostage to policy debates. ity in the equity markets and ample demand for IPOs. Over the next two years, China likely will continue its financial The competition for listing on China’s exchanges likely will sector reforms and create a more favorable environment remain stiff, and the increased municipal involvement in for foreign-owned portfolio companies to list on domes- private equity will add complexity for foreign GPs and LPs. tic exchanges. The addition of an international bourse in Renminbi-denominated funds could have advantages over Shanghai, expected to launch within the next 1–2 years, their foreign currency peers, and LPs may want to identify could contribute to a more favorable IPO environment for GPs likely to have an array of Chinese co-investors. Ultimately, foreign-owned portfolio companies. savvy GPs who have a keen understanding of the local political and economic conditions should be able to maximize the Beyond 2012, however, it is unclear whether capital market returns to themselves and the LPs that fund them. liberalization will continue. There will be a change in government during the 18th Party Congress at the end of 2012, and To obtain a copy of Ergo’s full study, please email Michael the outcomes of the election could dramatically affect private Casey at [email protected]. Members can also download equity investors. GPs and LPs alike should begin assessing a copy from the members-only section of the EMPEA potential impacts that a shift toward a less reform-minded website. government might have on their exit prospects.

EMPEA proudly announces its newest members joining its Board of Directors:

Arif Naqvi Jean Eric Salata Founder and Group CEO Founder and CEO Abraaj Capital Baring Private Equity Asia

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