SPECIAL REPORT INITIAL PUBLIC OFFERINGS China IPOs – the era of transition After two extraordinary years for initial public offerings, is China 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 stock 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 Bank of China (ICBC) and the Bank of China (BOC) together raised US $36 billion on the Hong Kong and the Shanghai 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 business 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 Stock Exchange 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 stock market 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 MAY 2008 27 SPECIAL REPORT INITIAL PUBLIC OFFERINGS 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 New York Stock Exchange (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 Shanghai Stock Exchange 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 Hong Kong 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.