Special report initial public offeringS

China IPOs – the era of transition

After two extraordinary years for initial public offerings, is equipped to continue on its path of diversifying its listing markets and attracting high levels of capital? James C. Chapman and Wanli Xu of Nixon Peabody explain the era of transition in the nation, as it moves to bolster investor confidence and encourage domestic listings.

26 ASIAN-COUNSEL China IPOs – the era of transition

By James C Chapman and Wanli Xu, Nixon Peabody

he years 2006 and 2007 were extraordinary years the preferred exit strategy. With the attractive returns on for initial public offerings (IPOs) by Chinese investments in China’s emerging markets, many venture enterprises. According to Zero2IPO Research capital and private equity fund investors consider China as Center, in 2006, a total of 151 Chinese enterprises an integral part of their investment strategy. As a result, Tlaunched their IPO’s on both domestic and overseas China has become the world’s second largest foreign exchanges, with the aggregate amount of capital raised surging investment market. Venture capital (VC) and private equity to a record high level of US$62 billion. The year 2006 was (PE) firms generally view an IPO as the means of obtaining highlighted by the mega-bank IPOs. The IPO’s of Industrial the highest returns on their investments. and Commercial (ICBC) and the Bank of China (BOC) together raised US $36 billion on the Kong and the Stock Exchanges. These IPOs, ranked number “Going public is like standing in one and number five in the world, respectively, in terms of the largest amount of IPO funds raised in history. The year 2007 front of an X-Ray machine forever. exceeded the remarkable performance of 2006 both in the You are completely exposed. amount of capital raised and in diversity of listing markets. 242 Chinese enterprises offered US $104.83 billion worth of secu- Everything about the is in rities on the Shanghai and Shenzhen Stock Exchanges and on nine other overseas markets. Moreover, in November 2007, the public domain and in front of PetroChina’s IPO on the Shanghai valued the the competition” company at approximately US$1 trillion, making it the most valuable company in the world at the time. – Anonymous CEO

IPO’s remain the most appealing strategy for Chinese Enterprises The advantages of being a publicly traded company and Although management buyouts and mergers and acquisitions the investors’ desire for an exit through the public stock are becoming more and more common in China, most grow- markets have driven hundreds of Chinese enterprises to go ing Chinese companies still prefer selling shares to the public public on both domestic and overseas stock exchanges. through an IPO over other fund raising or exit strategies. Chinese enterprises have become key players in the IPO There are many advantages to be obtained in being a markets throughout the world. publicly traded company. The trading of a company’s securi- ties over a recognised provides the company’s Determining whether to list on a domestic shareholders a market to obtain liquidity for their investment. or an overseas exchange Publicly traded securities tend to yield higher share prices With increases in the amount of foreign investment in and thus higher valuations for the company. The company China and the number of Chinese companies conducting also has greater access to capital through the possibility of IPO’s, most major stock exchanges are trying to become future stock offerings. Being publicly traded gives the com- the destination of choices for these companies. In deter- pany ability to make acquisitions of other companies using mining where to go public, a Chinese company usually the company’s stock as currency and ability to use stock considers a number of factors including (1) the nature of incentive plans to attract and retain key employees. Being a the IPO process; (2) the annual costs of being a publicly public company listed on an overseas market also gives a traded company; (3) the price/earnings ratio that can be Chinese company global visibility which is recognised by obtained and how that translates into a potential stock price customers and strategic partners. It in turn reinforces the and benefit to shareholders; (4) the location of the company’s company’s marketplace and financial standings. Finally, pub- customers; and (5) the potential for shareholder liquidity. licly traded companies usually have a greater prestige and are For example, many domestic Chinese companies have held in higher regard than privately-held companies. elected to launch their IPO’s on domestic Chinese stock Investors of Chinese enterprises also look to IPOs as exchanges. The IPO process tends to be easier and less

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expensive than in the United States. Similarly, the annual private Chinese enterprises. The Shanghai and Shenzen costs of legal and regulatory compliance required of public Stock Exchanges were formed in the 1990’s as arms of the companies is much lower in China. In addition, in 2006 and Central government, not as places where sources of capital 2007, the dramatic rise of stock prices on the Shanghai and could meet users of capital in the standard equity market Shenzen stock exchanges provided shareholders with sense that western investors understood. The exchanges handsome returns on their investments. Finally, many cus- were created to list State Owned Enterprises and sell shares tomers were located in China or at least in Asia making an to outside investors thereby raising the value of the govern- IPO in China a beneficial undertaking. ment’s stake in these companies. To date, approximately, Notwithstanding the above, overseas stock exchanges, two-thirds of the shares among domestic stock exchanges’ particularly the (NYSE) and listed companies are owned by the state. The securities regu- National Association of Securities Dealers Automated latory system lacked clear rules and the enforcement mecha- Quotation System (NASDAQ) in the United States, nism was highly inconsistent. In addition, the investment remain attractive to most Chinese companies. These culture was immature. Western concepts such as return on exchanges have a long history with sophisticated institu- equity, price earnings ratios and the like did not command tional investors. They tend to have better liquidity and mind-share among Chinese investors. less volatility. The entire public offering infrastructure is In recent years, however, Chinese domestic stock more mature and functions at a higher level. The require- exchanges have started to become more competitive with ments for full disclosure, transparency and corporate overseas stock exchanges which have historically domi- governance reduce investors’ risks and are seen by nated world-wide capital markets. In 2007, 124 domestic sophisticated investors as very beneficial. Chinese IPO’s raised US$65.09 billion and averaged US$524.91 million, exceeding the 118 overseas IPO’s by The emergence of China domestic stock exchanges Chinese enterprises which raised US$39.745 billion. Out- Recent explosion of domestic IPO’s pacing overseas counterparts, the domestic Chinese mar- In their brief history, China’s domestic stock exchanges kets attracted six IPO’s with offerings of US$25.35 were not initially an attractive financing option for most billion or more. Even Chinese companies backed by for- eign VC/PE had an explosive IPO growth in the domestic Chinese stock markets. Compared with the ten IPO’s listed during 2006, the 33 domestic IPO’s of VC/PE- backed companies generated a 230 percent growth rate, and yielded about twice the return of overseas IPO’s in 2007. Goldwin Science & Technology for example, debuted on the Shenzhen SME Board generated over a 30 times investment return for its investors. West Mining – the only VC/PE backed IPO on during 2007 brought its lead investor a return of 26.96 times the investment.

Regulatory efforts to improve the domestic Chinese capital markets This explosive growth in IPOs on the domestic Chinese stock exchanges has largely resulted from Chinese government’s regulatory efforts to keep such finance transactions ‘onshore’ and to maintain ‘control’ over Chinese companies. On one hand, the Chinese government has enacted a series of measures making it much harder for Chinese com-

28 ASIAN-COUNSEL China IPOs – the era of transition

By James C Chapman and Wanli Xu, Nixon Peabody

panies to establish offshore holding companies and dis- procedures for issuance, formation disclosure, supervision couraging Chinese companies from being listed on foreign and other matters. Growth ventures, start-ups in high-tech stock exchanges. VC/PE financings for Chinese compa- parks, securities companies and their direct investment nies have traditionally been structured offshore, using branches and various investors have been optimistic Cayman and other offshore holding companies as financ- regarding the launch of the GEM. Most analysts envision ing vehicles. State Administration of Foreign Exchange that China will see a growth in domestic IPO’s after the (SAFE) Circular 75 and subsequent regulations made the promulgation of the final rules by the CSRC. use of such offshore holding companies very difficult. Similarly, historically, IPO’s of the best Chinese compa- “Although management buyouts and nies have occurred in or the United States. This paradigm has been changed by the Regulation on mergers and acquisitions are becoming Merger and Acquisition of Domestic Enterprises by For- more and more common in China, most eign Investors (the 2006 M&A Rules) which deters Chi- nese companies from restructuring for the purpose of growing Chinese companies still prefer conducting offshore offerings. These regulatory barriers selling shares to the public through an make overseas listings much more difficult and the trend is to continue to limit such listings. IPO over other fund raising or exit A parallel development is the effort of the Chinese strategies” Government to implement a national strategy of building James C Chapman, Partner mature and multi-level capital markets. From the middle of 2005 to mid-2006, China imposed a moratorium on new Nixon Peabody domestic IPOs during which the domestic stock markets were restructured to convert non-tradeable shares into tradeable shares. Since the lifting of the moratorium, Chi- Apart from the GEM, the launch of an ‘over-the- nese domestic listing activity has exploded (over 100 new counter’ (OTC) market and a market for trading corpo- listings) and until the recent correction, the domestic rate bonds are also underway. The State Council has indexes have hit all time highs. approved the establishment of the OTC market in Tian- Furthermore, recent regulations provide an incentive jin, which will also provide more access to the capital for more foreign investors to structure their investment markets for smaller private companies. vehicles as RMB dominated domestic private equity funds. The improvement of the approval process for listing on Current challenges facing Chinese stock exchanges domestic stock exchanges should make it more convenient Although the viability of the Chinese Stock Exchanges has for VC/PE firms to sell their investments. Foreign private dramatically increased, there are still significant challenges in equity investors are now looking at Chinese domestic going public on a Chinese stock exchange. Foreign VC/PE IPO’s as a possible exit rout. IDGVC, SAIF, and other firms still see an IPO on a Chinese domestic exchange as prob- investors have achieved high returns on investments on the lematic. Issuers, investors and intermediaries expect more A Share market when certain of their portfolio companies transparency for publicly traded companies. Foreign investors went public on the domestic A Share market. still face problems with foreign exchange and significant tax The imminent launch of China’s Growth Enterprise challenges. In addition, current requires investors Market (GEM) after nearly nine years of preparation also to lock-up their shares for a significant period of time. Accord- may create additional opportunity for domestic Chinese ingly, the Chinese stock exchanges still do not meet the needs companies. On March 21, 2007, the China’s Securities of foreign investors which provide the majority of capital Regulatory Commission (CSRC) released Initial Public for Chinese private companies. Offering and Administration Measures on Enterprises List- In addition, recently the domestic Chinese stock ing on Growth Enterprises Market (draft rules) on its web- exchanges have suffered a major correction and values have site. The draft rules for the GEM stipulated the conditions, dropped 45-50 percent. As a result, the IPO activity has

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dramatically decreased. Compared to the number and (SESDAQ), London Alternative Investment Market (AIM), size of IPOs in the first quarter of 2008, the second quar- (TSE) and Korean Securities Dealers ter appears to be dramatically down. This is especially Automated Quotation (KOSDAQ). In 2007, the TSE, MOTH- true for VC/PE backed companies. ERS, and KOSDAQ attracted Chinese IPO’s for the first time expanding the financing venues for Chinese enterprises. The use of foreign stock exchanges for Chinese IPO’s HKMB’s leading role Despite the impressive transactions that China has listed Due to its proximity and shared historical ties, the HKMB has domestically in the past few years, the market value of Chi- been the first choice for the IPO’s of most Chinese enterprises. nese companies listed on overseas stock exchanges is still In 2007, HKMB continued to outpace other overseas stock larger than the market value of the companies listed on the exchanges both in the amounts raised and numbers of IPO’s. In Shanghai and Shenzhen stock exchanges. Notwithstanding 2007, 52 companies conducted IPOs on the HKMB raising an the obstacles imposed by the Chinese Government, overseas aggregate of US$31.127 billion. The large offerings in 2006 and IPO’s of Chinese companies continue to increase. In 2007, 2007 demonstrated that HKMB had become a global player there were 118 IPOs of Chinese companies on overseas stock among major stock exchanges. For the first time in 2006, exchanges This is a substantial increase over the 2006 figure HKMB ranked as the number 1 exchange among world stock of 32 IPOs, and the 2005 number of 37. Compared with exchanges for total proceeds (US$46.1 billion raised). 2006, and excluding the two mega-IPO’s of the ICBC and BOC, the amount of capital raised in 2006 was substantially United States stock exchanges scoring higher than in 2005. in the Chinese IPO competition The United States stock exchanges have had the advantages of The increase in competition among having the best liquidity and transparency, proper disclo- overseas stock exchanges sure requirements, straightforward accounting rules and All nine major overseas capital markets attracted qualified Chi- other positive traits. As of the end of 2006, 41 Chinese nese IPO’s, including NASDAQ, NYSE, Hong Kong Main companies were listed on NASDAQ. For China venture- Board (HKMB), Hong Kong Growth Enterprise Market backed technology companies, NASDAQ is still the (HKGEM), (SGX), Stock Exchange of preferred option for an IPO. US institutional investors Singapore Dealing and Automated Quotation Systems are very knowledgeable and are comfortable with tech-

Overseas IPO events and offer amount by market (from 2005 to 2007) 2005 2006 2007 Market Offer IPO Average Offer IPO Average Offer IPO Average Amt (US$M) Events (US$M) Amt (US$M) Events (US$M) Amt (US$M) Events (US$M) HKMB 19012.72 37 513.86 41284.14 39 1058.57 31127.38 52 598.60 NYSE 395.70 1 395.70 480.55 3 160.18 4490.51 18 249.47 SGX 201.83 20 10.09 1336.79 24 55.70 1987.84 26 76.46 NASDAQ 718.84 7 102.69 527.07 6 87.85 1469.10 11 133.55 HKGEM 74.74 8 9.34 227.49 6 37.92 255.58 2 127.79 TSE 0.00 0 0.00 0.00 0 0.00 191.09 1 191.09 AIM 62.09 2 31.045 130.42 6 21.74 135.43 5 27.09 MOTHERS 0.00 0 0.00 0.00 0 0.00 41.78 1 41.78 KOSDAQ 0.00 0 0.00 0.00 0 0.00 31.52 1 31.52 SESDAQ 23.94 6 3.99 11.55 2 5.78 14.56 1 14.56 Total 20,490.32 81 252.97 43,997.99 86 511.60 39,744.79 118 336.82

Source: Zero2IPO-China VentureDatabase Illustration: Johnnie Au

30 ASIAN-COUNSEL China IPOs – the era of transition

By James C Chapman and Wanli Xu, Nixon Peabody

nology investing. Such sophistication lessens volatility the vast majority of the shares of the publicly traded com- and improves liquidity. The NYSE historically has been pany. The most common exchange used for this technique has the exchange in the world and lists many been the Over-the-Counter-Bulletin Board (OTCBB). Once of the world’s largest companies. It has the highest list- listed on the OTCBB, successful companies seek to build a ing standards and its corporate govern- liquid market in their and move ance rules are the toughest. “Many domestic to a higher quality stock exchange such United States stock exchanges have as NASDAQ. Over the past five years, worked hard to attract more Chinese Chinese companies There has been a tremendous resur- IPO’s in the past two years. NASDAQ have elected to gence in reverse mergers in the US as has Chinese-speaking staff in Shanghai institutional investors began investing and Beijing and is waiting for approval launch their IPO’s on in companies that become public to open a Beijing office. In late 2007, domestic Chinese through reverse mergers. the NYSE received separate approval The SPAC is a company with no stock exchanges. The from Chinese regulators to open a repre- assets or business that conducts an sentative office in Beijing. Most Chi- IPO process tends to IPO. Investors are willing to pur- nese companies looking to raise capital be easier and less chase the shares of the SPAC based in overseas stock exchanges are mid- upon the reputations of the founders sized and looking to grow rapidly. They expensive than in the of the SPAC and its purpose. Once often find US stock exchanges as the United States” the IPO is completed and funds best alternative for not only attracting raised, the SPAC seeks to purchase US capital but global capital as well. Wanli Xu an operating business. Currently, Whether it is because of the size and Nixon Peabody there are a number of SPACs which reach of the NYSE or the expertise with have been formed to acquire pri- technology companies possessed by vately held companies located in NASDAQ, US exchanges are often being selected for China. The acquisition is usually completed as a share IPO’s over other foreign alternatives. exchange and the holders of the Chinese company end Outside forces have also driven Chinese companies to up owning shares of the publicly traded company. US stock exchanges. Many institutional investors prefer a listing on the US stock exchanges. Mainland firms hope that Conclusion listing in a market known for tough regulations and strin- The Chinese domestic stock exchanges have matured gent oversight will give them credibility with both global greatly in the past three years. Regulatory reforms, the intro- and domestic customers and business partners. duction of new products and the Chinese Government’s efforts to discourage IPO’s on foreign exchanges, have all IPO Alternatives in the US bolstered the Chinese stock exchanges. Overseas stock The US stock markets have not only been successful at exchanges continue to attract Chinese companies with attracting Chinese companies interested in IPOs, but they better liquidity and a more mature investment culture. Each have had success in attracting Chinese companies interested of the stock exchanges discussed in this articles have advan- in alternative methods of going public. Currently, there are tages and disadvantages. In this era of transition, Chinese two major IPO alternatives available in the US. These companies should carefully evaluate the best exchange for include the ‘reverse takeover’ or ‘reverse merger’ and the their IPO’s and plan far in advance. Careful analysis and special purpose acquisition company or ‘SPAC’ as it is com- thoughtful planning can make the difference between a monly referred. hugely successful IPO and failure. A reverse merger is a transaction in which an operating company mergers with a publicly traded corporation that [email protected] has no business. By means of a share exchange or merger, [email protected] www.nixonpeabody.com the shareholders of the operating company end up owning

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