Deutsche Bank What’s next for China’s unicorns? Greater China listing reforms and implications for tech IPOs
June 2018
#PositiveImpact 1. The rise of China’s unicorns1 The tide of Chinese unicorn listings has transformed global IPO markets. Following the landmark flotation of Alibaba in 2014, a steady flow of tech-led IPOs has followed, raising over US$43 billion in proceeds and representing a combined market capitalisation of US$770 billion2. According to independent estimates, China accounts for one in three of the world’s ~260 unicorns, commanding over 40% of value in this space.3 The growth of China’s tech unicorns has been driven by a number of interlocking factors. First, China boasts the world’s largest internet market (est. 770 million users)4, which has enabled commercialization of digital business models on a large scale. Second, China‘s leading tech and e-commerce players (Baidu, Alibaba and Tencent) have built and supported a robust digital ecosystem that has transformed ‘brick and mortar’ sectors such as retail, transport and banking. Third, China’s leadership has set out next-generation technology at the heart of its economic vision, with robotics, autonomous vehicles and artificial intelligence named as strategic priorities. Investors have responded with strong demand for stakes in China’s ‘new economy’ firms. Driven by rising valuations and favourable market conditions, tech-led unicorns representing up to US$500 billion in potential market capitalisation are expected to launch IPOs over the course of 2018 – 2020.5 2. China unicorn IPOs via ADRs As China’s unicorns went global, American Depositary Receipts (“ADRs”) played a crucial role in their IPOs. Of the estimated US$43 billion raised by Chinese tech IPOs since September 2014, 74% of funds (US$32 billion) were raised through ADRs6. Chinese tech issuers’ preference for US IPOs via ADRs has been driven by a number of considerations, including access to a large pool of global institutional investors, acceptance of variable interest entity (“VIE”) structures, and established valuation benchmarks for tech peers. In addition, listed ADRs provide issuers with a flexible “acquisition currency” that could be utilized in strategic transactions. From an overseas investor perspective, ADRs confer a number of benefits. These include familiar regulatory and legal frameworks, strict disclosure standards, and greater certainty on tax treatment. Moreover, the technical qualification of ADRs as US securities enabled participation by a broad investor base, further enhancing ADR liquidity. While many of these criteria could be substantially met through Hong Kong primary listings, tech issuers saw a roadblock in the form of a long-standing ban on dual-class shares. Looking to retain broad strategic control by founders, a majority of China’s unicorns opted for US ADR listings on the NYSE and NASDAQ. The resulting embrace of US IPOs created a structural anomaly, wherein some of China’s most recognizable ‘new economy’ companies were not listed on any of its stock exchanges. As China looks to strengthen its position as a global economic and technology powerhouse, its desire for its innovation champions to ‘return home’ has risen. Hong Kong in particular is aiming to reinforce its position as a global financial hub and gateway to Greater China.
Deutsche Bank What’s next for China’s unicorns? – Greater China listing reforms and implications for tech IPOs 2
3. Listing reforms in Greater China Hong Kong listing rules7 The recently announced reforms to the Hong Kong Stock Exchange (“HKEx”) listing regime are a significant step towards attracting listings from tech and new economy issuers. Taking effect in Q2 2018, the revised listing regime introduces provisions for weighted voting rights (“WVR”) for qualifying companies, effectively enabling founders to retain strategic control even as their shareholdings dilute over time. New issuers opting to list under the WVR regime must satisfy HKEx-defined criteria for “emerging and innovative sectors” and a minimum expected market capitalisation of HK$40 billion (or a minimum expected market cap of HK$10 billion and annual revenue of HK$1 billion). In order to safeguard governance standards, these issuers must comply with enhanced disclosure and investor protection measures such as floors and caps on WVR shares. While the above provisions concern primary listings, the revised listing regime also aims to attract secondary listings of tech and new economy companies. To qualify, issuers must have an expected market capitalisation at the time of secondary listing of at least HK$10 billion. To achieve a level playing field, a secondary listing applicant with either a WVR structure and / or which is a Greater China issuer will also be required to satisfy a set of conditions that largely mirror the requirements for primary-listings under WVR. Chinese Depositary Receipts (“CDRs”)8 Looking across to the mainland, the most relevant reforms for unicorns concern the introduction of CDRs. CDR structures first took shape as part of the London-Shanghai Stock Connect, in which CDRs and Global Depositary Receipts (“GDRs”) were chosen as the main instruments to facilitate cross-listings for qualifying stocks. As a next step, China’s authorities are expanding the CDR framework in order to allow offshore (namely US and Hong Kong) listed Chinese issuers to pursue secondary listings (including equity raising) in Shanghai or Shenzhen. The government approved CDR guidelines in March 2018, with the pilot phase officially launched at the start of June 2018. Under the pilot phase, “qualified innovative companies” are split into two classes: 1) “red chip” companies with existing overseas listings, which must have valuations over RMB 200 billion (US$32 billion); or 2) non-listed companies, which must have valuations over RMB 20 billion (US$3.2 billion) and annual revenues of at least RMB 3 billion (US$500 million). Qualifying issuers could issue CDRs to either float additional shares or launch IPOs on the A-share market. Similar to the approach adopted by the HKEx, the CDR criteria sets high bars for qualification during the pilot phase. This appears driven by a desire to minimize investor risks, especially in light of the large retail investor participation in mainland stock markets. Over time, authorities may steadily expand the range of eligible companies as they look to ‘bring home’ a greater share of listings and trading activity.
Deutsche Bank What’s next for China’s unicorns? – Greater China listing reforms and implications for tech IPOs 3
4. A new phase for China’s tech issuers? It is not yet certain whether these reforms will fundamentally disrupt the IPO and listing landscape for China’s tech issuers or point towards a more gradual path that sees Hong Kong listings and CDRs complement the established ADR universe. The most immediate shifts will be seen in the destination of IPOs, in particular for “large cap” issuers that qualify for primary listings in Hong Kong under the WVR regime and the issuance of equity raising CDRs on the mainland. Based on the latest announcements, Xiaomi is expected to pursue both routes simultaneously, achieving the first dual listing under the new rules and bypassing ADRs at the IPO stage. On the other hand, any shifts by US-listed Chinese tech issuers are likely to be more gradual. As the regulatory and technical frameworks take shape, some of the most prominent US-listed ‘red chips’ have announced plans to issue CDRs in the near future. Given their significant scale and global profile, ‘red-chip’ issuers are likely to retain their US ADR listings, thereby maintaining access to their global investor base and avoiding any potential “re-listing” disruptions. While these dynamics play out with respect to ‘large cap’ IPOs and US-listed ‘red-chips’, smaller tech issuers that fall outside the scope of reforms will continue utilizing ADRs as their primary IPO instrument. Any change in this segment will depend on regulatory appetite to expand the scope of reforms in the respective jurisdictions. China’s tech-led unicorns have injected substantial momentum into the tech IPO landscape and promise to reshape regional and global capital markets in the months and years to come. Deutsche Bank will continue to foster dialogue amongst market participants and support issuers as they navigate the rapidly evolving landscape.
1 A unicorn is a privately held start-up company valued at over US$1 billion 2 Bloomberg; Deutsche Bank analysis 3 McKinsey Global Institute, “China’s digital economy: a leading global force” < https://www.mckinsey.com/featured-insights/china/chinas- digital-economy-a-leading-global-force> 4 China Internet Network Information Centre (“CNNIC”). Statistical Report on Internet Development in China.
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Deutsche Bank What’s next for China’s unicorns? – Greater China listing reforms and implications for tech IPOs 4