The Big Freeze for Chinese IPOs

Smaller deals will test the appetite of investors amid a new regulatory landscape

At the end of June 2021, Chinese IPOs were on track to post a record-breaking year. Didi Chuxing had completed the most eagerly awaited listing from China since the debut of Alibaba. Companies from the technology and healthcare sectors were flocking to NASDAQ and the NYSE, where they could bypass the long waiting list for the Mainland’s exchanges and achieve higher valuations and greater liquidity than what Hong Kong typically offered.

However, within days, the Chinese authorities had frozen new installations of Didi's ride-hailing app over data security concerns. Officials suggested that Didi had failed to secure permission before listing in America. This intervention shocked the market since, at that time, there was no formal process to seek approval for a foreign IPO.

In 2021, 50 IPOs from China raised $15.4 billion on the U.S. markets, an increase of 16% from the prior year’s total of $13.3 billion raised in 39 debuts, making it the second-best year ever. * But since July, the market has been frozen. Only two operating companies from China managed to go public in the second half of the year, and dozens of prospective IPOs have withdrawn their registration statements.

What caused the market to go from boom to bust in less than a month?

On both sides of the ocean, regulators have erected new barriers for aspiring IPO candidates. In the wake of the Didi IPO, the SEC's Chairman Gary Gensler announced in July that it would place an extended “pause” on all registration statements using the VIE structure favored by tech companies from China. Then in December, the agency published final rules to enforce the Holding Foreign Companies Accountable Act; they mandate enhanced disclosures by companies whose auditors are not inspected by the PCAOB this year and move towards delisting in 2024 if the auditors fail to comply with the inspection requirement.

China has introduced a comprehensive new system of review and approval. As many as four different government authorities will vet foreign IPOs to evaluate if they comply with relevant laws and threaten national security or data privacy. Recent muscular interventions to thwart the market power of China’s internet giants, reign in the private education sector, and persuade Didi to abandon its NYSE listing have made it clear that no company or sector is beyond the reach of the state.

Returns from last year’s crop of cross-border IPOs have been dismal, with only four of the U.S.-China names showing positive returns as of the end of January and an average drop of 57% from the offering price. These stocks swooned at nearly twice the overall U.S. IPO market rate, whose 2021 listings have fallen by 29% on average. Many of the Chinese companies listed in the U.S. were earlier-stage tech and life science companies that have yet to achieve profitability, leaving them exposed as market sentiment turned against more speculative stories.

Will the Market Window Crack Open in 2022?

While no Chinese IPOs have been consummated thus far in 2022, there have been over 20 new and updated filings by companies from the PRC preparing for a U.S. IPO since December of 2021 and a half dozen brand new filings in January alone.

But this pipeline looks very different from the venture-backed “unicorn” companies that dominated new listings in 2021. The aspiring candidates are smaller companies from lesser-known cities that operate in traditional industries — including a provider of parking lot equipment from Nanjing, a kitchen equipment manufacturer, a factoring service from Chengdu, and an insurance agency from Sichuan. Each is seeking to raise between $15 and $30 million.

In 2021, bulge bracket investment banks with a strong presence in Asia dominated new listings. Goldman Sachs led the pack with nine listings, Citigroup had six, and Credit Suisse and Morgan Stanley served as lead managers on four deals apiece. These recent China filings are headlined by smaller firms such as Network 1, Boustead, Univest, and Prime Number.

These companies and their bankers may be betting that as minor players in non-strategic industries without sizable amounts of consumer data, they may be able to fly beneath the radar of Chinese regulators. But if they proceed down the path towards an offering, they will serve as the guinea pigs for the new regulatory regime. Market participants will be observing to see if there is a broader window of opportunity for more substantial offerings.

1. U.S. Regulatory Roadblocks Easing – While the SEC put the review of registration statements from Chinese issuers on hold for several months, they have subsequently provided guidance with a “Sample Letter” covering the type of disclosure they expect to educate investors on the range of risks associated with issuers operating in China. Chinese companies are expected to prominently and exhaustively detail the risks involved in operating using a VIE structure, the risks to their business operations of actions by the Chinese government, and the risk that their decision to list in the U.S. might harm their business. The companies must also explicitly state if they are required to obtain approval from the CSRC, the Cyberspace Administration of China, and other relevant authorities and if they have been granted or denied such clearances. And they must disclose if their auditor is compliant with inspections with the PCAOB and, if not, spell out that their securities are likely to be delisted. While IPO prospectuses by Chinese issuers will be festooned with red flags, the clarity from the SEC will enable deals to move forward on a more predictable path.
2. Waiting to See China’s Review Process in Action – Far less predictable is how China’s new approval system for foreign IPOs will operate in practice. Companies outside the tech sector will likely not require approval from the Cyber Administration of China. However, they will still be required to file with the CSRC before proceeding with an IPO or follow-on offering. It remains to be seen how efficiently the authorities will conduct such reviews and what guidelines officials will apply in determining if an IPO poses a threat to China's interests. Recent comments by CSRC officials suggest that the regulators aim to reopen the channel for listing overseas. “We hope the companies would make full use of these new rules, and to resume their listing in any overseas market,” International Department Director, Shen Bing, said in an interview with CNBC. If China can implement a relatively transparent approval process, that might help quell market jitters by clearly establishing which companies and ownership structures have been cleared for ownership by overseas investors.
3. Investor Appetite for China – The final and most decisive open question is whether American investors are eager to dive back into equities from China. Over the past two decades, interest in participating in the growth of China’s economy has overcome multiple accounting scandals, trade wars, and regulatory spats. If China establishes clear "rules of the road" as to the type of companies it deems suitable to list overseas, then it is likely that its private companies will figure out how to navigate the path to tap foreign capital. How those companies will line up with the sectors that venture investors have been nurturing and that public market investors would like to own remains to be seen.

Over the coming months, the market will discover if the window for Chinese companies to list in the U.S. is cracked open. At least initially, these issuers are likely to be smaller companies outside of restricted industries without sizable amounts of consumer data. They are likely to avoid using the VIE structure and be audited by smaller, U.S.-based audit firms already inspected by the PCAOB to bypass the prospect of forced delisting a few years down the road.

The quality and performance of these early deals will be closely scrutinized. Positive returns are a warm wind that can thaw the deepest chill.

* Data based on Renaissance Capital and analysis by MBP