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Monday, 20 November 2017

ECM 2006: Moratorium over

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The China Securities Regulatory Commission has in the past months introduced various capital market reforms. Specifically, it has ended a year-long moratorium and allowed the return of A-share IPOs. This is clearly welcomed but has also sparked calls for more regulatory action on IPOs, writes Nichole Chan.

The China Securities Regulatory Commission (CSRC) last year pressed ahead with the long-mulled non-tradable share reform despite investors complaining that the reforms would kill the market. One year ago, the market fell to record lows but managed to rebound this year to trade above the pre-reform level.

At the moment, about three-quarters of the A-share market has either completed or is in the process of reform.

Seeing this, the CSRC has accelerated the pace of capital markets reforms. In the past few months it has increased the QFII quotas, allowing more foreign investors to participate in the A-share market. It has also kicked off the long-awaiting QDII, enabling domestic investors to invest overseas – although the investment is limited to money market products. In addition, it has revised the regulation of IPOs and follow-on offers to improve listing quality and transparency.

Most significantly of all, it lifted the year-long ban on IPOs and follow-ons. Equity-raising was banned after the CRSC introduced the non-tradable share reform. The PRC authorities were concerned that IPOs or follow-ons that took place during the reform process would add more complexity to the market.

Market participants in general cheered the news of the return of flotations. To domestic investors, A-share IPOs are safe bets, with the debuts usually turning in handsome gains. In the history of the A-share market, only a handful of IPOs have seen the shares close flat or below the IPO price.

Since the end of the moratorium in May, more than 20 companies have listed. So far all of them have risen sharply in their first day of trading – except Air China. Air China's A-shares opened lower than its IPO price but closed the day flat.

The disappointing debut came even after the transaction was priced at the low end of the indicative price range, the deal size was cut by about 40% and the issuer promised to buy back up to 600m shares until the end of the year. Air China finally sold 1.64bn shares at Rmb2.80 each, raising Rmb4.59bn (US$573m).

International observers might still see the flat debut of Air China as a decent result in tough market conditions, but this is not the attitude of PRC investors and regulators. The Air China IPO is only the fourth in the history of the A-share market to close at or below its public offering price on its debut, and is the worst-performing listing this year.

This was a slap in the face for the CSRC. The CSRC has long urged quality and large-cap PRC enterprises to list domestically, and Air China was one of these.

“It’s well understood the CSRC has no responsibility to ensure Air China shares will soar on debut, but the transaction does reveal certain IPO-related problems and the regulator should act on that,” one PRC banker said.

Indeed many would wonder why Air China did not change its valuation rather than simply reducing the deal size after it saw insufficient demand from institutional investors during bookbuilding. An obvious explanation would the issuer’s greed, as well as the unattractiveness of the airline industry amid high fuel costs, but some observers also point to certain deficiencies in the PRC IPO pricing process.

Early last year, China introduced initial consultation and bookbuilding into the IPO process to create a genuine market. Prior to that, pricing was set by issuers based at no more than 20 times company’s earnings.

The new regulations, however, do not seem to provide much leeway for issuer in the event of a poor response after deal launch. “It is unclear if the issuer would need to go through the initial consultation [the equivalent of pre-marketing for international IPOs] again or simply just start another round of bookbuilding with a lower range,” the PRC banker said.

Some bankers also point to the fact that the new pricing mechanism does not reflect a genuine market. “Out of the blue, the sponsor and the issuer approach you and ask you for the price range of their IPO without providing much information. We really have no clue,” said one QFII investor.

Some also suggest that more participants, especially the QFII investors, should be allowed in the initial consultation and bookbuilding processes. According to the regulations, issuers and sponsors must enquire about the IPO price range from at least 20 institutional investors vetted by the CSRC. If the offering comprises more than 400m shares, at least 50 institutional investors must be polled.

This investor also said the “consultation” status awarded by the CSRC appears to be arbitrarily granted and taken away. For example, institutions could lose their consultation status if they recommend a price range that is significantly out of kilter with other institutions.

“I guess the regulator is concerned that some institutions would deliberately indicate a much lower price in an attempt to manipulate the price, but that will also prompt investors to discuss the IPO valuation among themselves, resulting in a higher chance of manipulation,” the investor said.

Meanwhile, some domestic observers have called on the mainland regulator to limit the supply of IPO shares. The secondary A-share market was weak in July–August 2006 as investors tried to digest the heavy supply of IPOs, including the record Rmb20bn IPO from Bank of China. That stock closed up 23% in its first day of trading but has since come off by about 15%.

The CSRC is said to have considered a slow-down in the supply, but has concluded that it will allow some more time to monitor the market. Opponents of the CSRC’s market intervention welcomed the decision.

“Regulators’ duties are to ensure IPO quality and that the issuers and sponsors have met and will continue to meet the disclosure and various requirements. They should leave the market to decide if there is oversupply,” said a Hong Kong regulatory source.

But others said the PRC market is not as mature as international markets like Hong Kong and therefore needs to be regulated. “After all, in which other markets can you find irrational IPO investors like those in China?” another domestic banker said.

Domestic investors rush to IPOs without considering the fundamentals. They go after these deals simply because of the potential debut gains, and given that the gain could be up to 500% on debut, domestic investors have often heavily oversubscribed IPOs by hundreds of times, sometime even by more than 1,000 times (see accompanying table).

And the funding cost is not cheap. For an IPO with 500 times oversubscription, investors would need to put in millions of renminbi in cash upfront to get a minimum allocation of one lot of IPO shares.

A-share IPOs are split into a private tranche, which is only open to corporate and institutional investors vetted by the CSRC and is put out to a bookbuild for price-discovery purposes, and a public-offer tranche, which is available to all other institutional investors and retail investors on an internet platform.

The public-offer tranche, comprising the majority portion of the IPO (as much as 80%), is allocated on a lottery basis, with a lottery number assigned for every 500 or 1,000 IPO shares an investor applies for. If the IPO is oversubscribed, these numbers are then randomly drawn until all shares are allocated. For each lot that an investor applies for, he or she will have to have the correct money on deposit with a brokerage. Therefore, the more lots an investor applies for, the more “tickets” he or she gets in the lottery and the more money has to be on deposit.

Due to the huge sum of initial cash outlay and the lottery-basis allocation, some QFIIs opt not to participate in A-share IPOs. “But many others still see IPOs a jackpot and risk-free. The regulator should step in to educate and protect these investors,” the domestic banker said.

It is a paradox: retail investors in A-share IPOs are clearly short-term punters but they are seen as the ones who will support the future development of the Chinese equity capital market, which is seen as under-utilised. PRC enterprises have been relying heavily on bank financings. It is estimated that the total market capitalisation of the A-share markets only accounts for 19% of China’s GDP.

“To boost the market, we need the retail participation,” one PRC-focused analyst said, pointing that the Rmb1.6trn (US$200bn) deposits in the saving accounts would be the key source of demand.

"Retail investors for the moment are still opting to sit in the sidelines [after getting burned last year]. But once they have confidence in the stock market, the growth potential could be significant. The A-share market could surpass other emerging markets such as Russia," one analyst said.

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