China Unleashes Market-Based IPOs on STAR Market

On Monday China burned the rulebook that has guided its IPO market up till now. The result, unsurprisingly, was fireworks.

The 25 technology companies that listed on the new Shanghai STAR Market leapt by an average of 140%, with one company, Anji Microelectronics, surging 400%. Trading was so fast and furious that prices tripped market circuit breakers at several points, before churning on. With state media relentlessly promoting the new market and retail offerings 1,700 times oversubscribed on average, frothy trading was not unanticipated.

But market players were still stunned as these mostly untested, early-stage companies swelled to a collective valuation of $77 billion.

What’s Different About STAR?

The STAR Market, operated by the Shanghai Stock Exchange, sharply diverges from the paternalistic, centrally controlled approach that China has taken to the capital markets in the past.

Up until now, all IPOs needed to be approved as suitable by China’s securities regulator, the CSRC. While intended to ensure quality, the process was subject to political influence, plagued by allegations of corruption, and resulted in a years-long waiting list to go public. Valuations are set at an unofficial benchmark of 23 times earnings, ensuring a nice pop in value for those who receive IPO allocations, but limiting the amount of capital a company can raise.

China’s stock market rules reflect a historical distrust of the speculative tendencies of the 148 million Chinese investors who account for 80% of trading volume on the domestic market. While feverish trading can send shares soaring, it is feared that the inevitable bursting of the bubble will lead to social unrest. So daily price changes are capped at 10% and officials have a tendency to suspend stock trading if the market falls too quickly.

The STAR Market introduced some radical changes for qualifying companies.

• It uses a disclosure-based system that removes CSRC’s gatekeeper function and enables companies to go public in months, not years.
• It eliminates the requirement for three years of profitability, allowing money-losing tech companies to go IPO.
• The IPO price is set by the company and the underwriter and there are no restrictions on stock price movement for the first five days of trading, with a 20% daily limit thereafter.
• It allows dual-class shares and weighted voting structures that enable founders to retain control.

Many of STAR’s “innovations” are lifted straight from the U.S. markets. But some of them, like the 3-year lock up for founders’ shares and requirement for underwriters to buy a 2-5% ownership stake in their deals and hold it for two years, might be advisable for the U.S. to consider importing for early-stage tech IPOs.

Aside from creating a few more overnight Chinese billionaires, the STAR Market serves important policy purposes by enabling China to experiment with market-based capital allocation and price discovery on a limited basis before potentially rolling out similar reforms to its mainline stock markets. China’s stock market is now the second largest in the world and promises to become more international after MSCI quadrupled its index weighting earlier this year. But its policy framework and infrastructure are creaky.

The new market also provides a means to direct badly needed growth capital to companies aligned with the government’s industrial policy. It’s no accident that the sectors that are approved for listing on the STAR Market — next generation IT, smart manufacturing, aerospace, new materials, renewable energy, biotech — sound a lot like the sectors highlighted in the Made in China 2025 plan to make China self-sufficient in high technology.

This is not China’s first experiment in stock market reform. ChiNext, which was launched as China’s NASDAQ in 2009, melted down in 2015 and has never really recovered. And China's OTC Market, the “New Third Board”  that launched in 2013, is not famed for the quality or transparency of its listings.

Perhaps the biggest difference from those past experiments is that the STAR Market enjoys the direct sponsorship of President Xi Jinping, who first announced the initiative in November of 2018. This means that regulators and market officials have moved with unprecedented haste to launch the new market. And underwriters may exercise more care in picking the companies they choose to sponsor.

What Comes Next?

The biggest winners from Monday’s spectacular debut were Chinese tech CEOs, who now have another quality IPO venue that removes many of the tortuous obstacles to listing domestically. This is particularly valuable for companies that work in sensitive industry sectors or provide technology to Chinese government security or military clients, where listing overseas is not a viable option.

Will Shanghai’s STAR Market replace New York and Hong Kong as the destination of choice for China’s tech unicorns?

CEOs and private equity will undoubtedly be watching carefully how long the heady valuations of the first day's trading can be sustained. A pipeline of 140 companies have reportedly already filed to list.

But despite the reforms, an overseas listing offers many advantages that are not available in China, including the ability to tap billions of dollars of institutional capital, the flexibility to do multiple equity and debt offerings over time, and the liquidity for founders and private equity sponsors to sell part of their holdings while not being subject to currency controls. For all these reasons, STAR may not be the first choice for China’s largest and most high-profile tech companies to go public.

At least, not yet.