Choosing the Right Exchange

By Drew Bernstein on March 31, 2021
Choosing the Right Exchange
Drew Bernstein
Drew Bernstein

Chinese CEOs now have a range of IPO alternatives to navigate

In 2020, China dominated the global IPO market as never before. 565 new public companies were born through listings on China’s domestic markets, Hong Kong, and the U.S. exchanges, raking in $133 billion dollars. That is up by 51% from 2019 and compares to $78.2 billion raised by 218 operating companies on the U.S. markets during the same period. While the U.S. still led the world in capital raising last year, that was primarily due to the unprecedented 248 SPAC IPOs that raised $75.5 billion dollars. In 2021, SPAC IPOs based in Asia are taking off as experienced private equity, venture, and hedge fund investors launch their own SPAC initiatives. A SPAC merger creates yet another option for the management teams of companies from Greater China to consider in order to raise capital and obtain public status on an accelerated timeframe.

China’s ability to generate new public companies at more than twice the pace of the U.S. testifies to its success in managing the COVID pandemic and the insatiable appetite of its private companies for new sources of capital. With limited access to bank financing, public equity has long been the favored source of growth capital for the dynamic private sector that accounts for most of China’s job growth and innovation. Today a Chinese CEO or founder has a greater number of alternatives of where to list than ever before.

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Quest for Unicorns

Prior to the launch of that Shanghai STAR market in 2019, companies that wished to go public domestically had to meet strict profitability requirements and wait for years to make it through an opaque IPO approval process administered by the CSRC. The STAR market (formally known as Shanghai’s Sci-Tech Innovation Board) was designed to be China’s answer to NASDAQ and attract the kind of technology powerhouses that had previously launched in New York. STAR did away with the informal valuation guidance that had previously capped IPO pricing, allowed the market to determine trading after listing. And for the first time in China’s history, it introduced a disclosure-based registration system. Over 200 companies listed on the new market by the end of 2020, and average first day return of 187% last year has made it a magnet for aspiring new economy contenders.

The Hong Kong Stock Exchange has also taken steps to become more competitive in the quest for China’s “unicorns.” The ranks of these billion-dollar-plus venture-backed companies have swollen due to the influx of private equity investment in China, with 39% of the world’s 586 unicorns based in the PRC, according to Hurun. In 2018, Hong Kong altered its rules to allow companies with weighted voting rights schemes that enable tech company founders to retain control after they have sold down below majority ownership. And the exchange allowed biotechnology companies to list on the main board prior to generating any revenues if they had a pipeline of advanced drug candidates.

At the same time, Hong Kong is becoming ever more closely integrated with the mainland’s financial infrastructure due to the growth of the “Stock Connect” that funnels bi-lateral investment between the Hong Kong, Shanghai, and Shenzhen stock exchanges. This arrangement was recently expanded to enable institutional investors to purchase shares on the STAR market via Hong Kong and mainland investors to trade pre-revenue biotech companies listed on Hong Kong. Chinese investment banks are playing an increasingly large role in Hong Kong equity and debt deals, muscling aside the Western bulge bracket IBs. These trends are creating a unified “China stock market” around the three financial hubs, catering to the needs of different types of issuers.

The increasing depth and openness of China’s domestic markets, along with tensions in U.S.-China relations, has led to an increase in “homecoming” IPOs. This includes secondary IPOs on the Hong Kong Stock Exchange by large tech darlings like Alibaba and, as well as listings of CDRs on the STAR market by established players like SMIC and Lenovo that have their primary listing on Hong Kong. An issuer may well decide that one market is the best place to start its life as a public company and then use a secondary IPOs to take advantage of valuation arbitrage or tap into new pools of investor interest.

The fierce competition among the various stock markets for the larger "unicorns" is driven by both the business imperative of having liquid names trading on their platforms and the prestige of being associated with splashy new issues. Despite the threat of legislation that will enforce audit inspection requirements more strictly, listings by Chinese companies on NASDAQ and the NYSE had their second-best year in 2020. The boom in SPAC IPOs, which raised over $25 billion in the first month of 2021, has created another potentially attractive option for China's growth enterprises. With over $100 billion in deployable capital, these SPACs are competing for a limited number of attractive privately-owned enterprises. A SPAC merger can provide an accelerated pathway to go public and allow issuers to benefit from the expertise of seasoned capital markets players but must be carefully negotiated by management due to a range of conflicts inherent in the structure.

Choosing the Right Venue

Given these changes, it may be far less clear today what the “right” choice is for a company seeking to access growth capital and provide liquidity for existing investors. Management, founders, and private equity sponsors will need to carefully evaluate which venue most closely fits the company’s strategy, internal capabilities, and growth profile. In mapping out this decision tree, there are a number of important considerations.

  • Valuation & Liquidity – Valuation is undeniably a decisive factor when considering an equity offering, as it directly impacts the cost of capital. Depending on the industry, valuations can vary wildly between China’s onshore and nearshore markets and comparable companies in the U.S. When investors fall in love with a particular stock or sector that tends to create an appetite for new issues with a related “story.” Investment bankers advising the company should present detailed analysis showing not only what levels comparable companies are trading, but what key metrics analysts base their valuation models on in different markets. Liquidity is equally important, since a stock that is thinly traded is subject to price disruptions if existing investors decide to exit. In 2021, $722 billion of shares are expected to hit the market in China, following the expirations of mandatory lockups held by insiders and underwriters on the STAR market, providing that venue’s first real test of the ability to absorb sustained selling.
  • Ongoing Capital Needs – While the IPO may be viewed by some as the defining event in corporate development, more sophisticated management teams recognize that it is just one leg of a marathon in building a dominant industry franchise. One advantage of a U.S. listing is that companies are able to execute overnight follow-on offerings of equity and debt securities so long as they deliver on their business plans and maintain active trading. The ability to tap the capital markets at will can be decisive advantage in funding internal growth, making acquisitions, and investing in new ventures. Several of China’s leading internet companies have been able to make strategic investments in companies that then launched IPOs of their own, creating a network effect of businesses clustered around a common platform infrastructure.
  • Policy Alignment – Given the heightened strategic tensions between China and the U.S., policy considerations have become increasingly important factor in market selection. The STAR market was explicitly intended to promote companies that strengthen China’s “strategic technology power” and enable it to develop autonomous supply chains for advanced industries. To qualify, a prospective issuer must fit in one of the sectors viewed as key to China’s future – next-generation information technology, biomedicine, new energy, environmental protection, high-end equipment, and new materials. If a business does not fit in one of these buckets, it is out of luck. The U.S. IPO markets have been receptive to a wider cross section of innovative Chinese companies, in sectors ranging from consumer goods to education, real estate, healthcare, and electric vehicles. But given the recent moves to blacklist U.S. investment in companies with ties to China’s military or security forces, companies that have Chinese government entities as major customers or shareholders might be best advised to list at home. The decision of AI-based facial recognition company Megvii to list on Shanghai’s STAR market after a failed effort on Hong Kong is a telling example.
  • Global Ambitions – A company whose revenues and future business strategy are primarily focused on China’s domestic market may have very limited need for foreign currency. But issuers with ambitions for global expansion may find it highly advantageous to list in Hong Kong or the U.S. where they can access dollar-denominated funding. In addition, an overseas listing is likely to increase a company’s brand recognition and open the door to securing overseas technology partners. In addition, founders and private equity sponsors may find it more advantageous to hold convertible assets in offshore vehicles given China’s stringent limitations on currency flows.
  • Depth of Analyst Coverage – Industry expertise tends to cluster around certain markets, pooling sell-side and buy-side analysts and investment bankers with the qualifications to accurately evaluate a company’s prospects. For example, since Hong Kong now has 28 listed biotechs since allowing IPOs by pre-revenue biotechnology companies in 2018. The U.S., by contrast, has hundreds of public biotech names, which may make it easier to maintain an analyst following through the ups and downs of the drug approval process. In other cases, brands or products that are very well established in China may enjoy no name recognition whatsoever with American investors. These businesses may be better served listing close to home where they have an automatic following. Retail investors continue to be a dominant force in China’s domestic stock markets, with another 18 million new accounts piling into the market in 2020, bringing the mainland’s army of individual traders to 178 million. Historically, retail investors have accounted for just 10% of trading in U.S. stocks, although that has soared in 2020 with the advent of Robinhood and other online trading platforms to as much as 25% of turnover. The balance of institutional expertise and potential for retail exuberance can be another factor in choosing the right market.
  • Listing Costs – When it comes to the most significant cost of going public, the underwriters’ discount, Hong Kong remains a clear bargain with average fees of 2.4%, as compared to an average of 5.6% for NASDAQ and 6% for the STAR market. Lead underwriters on the STAR market are required to purchase 2-5% of the public offering and hold those shares for two years. Regulators hope that this will create a positive incentive to enforce accurate disclosures and select quality names to go public. To get an accurate sense for the full costs of going public, management should budget for all the associated costs, including audit, legal, stock market listing fees, printing, and other costs. That said, the cost of an initial listing is usually minor as compared with the impact on the cost of capital going forward.

While all of these factors are important, choosing a listing venue also means committing to expectations of being a public company. From that point forward, your management team will be locked into a defined schedule for financial reporting and standards of corporate governance. While going public can bring heightened visibility for a company’s successes, it also means that every decision and setback will be scrutinized and dissected.

Farsighted management teams will view the rigors of being a public company as an opportunity to strengthen their core systems and hone their strategy to a fine edge, rather than as a burden or necessary evil. This will determine if the current boom in Chinese IPOs results is an investment fad or reshapes the global financial landscape in the years to come.

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