The forced postponement of Ant Group’s initial public offering (IPO), the largest ever, by the Chinese government is the latest example of the heavy-handed regulatory approach that has made it extremely costly for companies to go public in China. The high opportunity cost of going public on the Shenzhen or Shanghai stock exchanges, where the initial return from the offer price to the first unconstrained market price has averaged 170 percent during 1992-2018, has encouraged many Chinese companies to go public in Hong Kong, the U.S., or elsewhere. The high initial returns have resulted in massive oversubscriptions of almost all Chinese IPOs.
Since the creation of domestic Chinese stock markets in 1990, there have been many policy changes that we discuss in our working paper, available here. Until recently, all firms going public had to report positive earnings. In many of the last 30 years, the IPO offer price has been subject to a price-to-earnings (PE) cap. In periods when issuers are largely free to set an offer price, initial returns have averaged 60 percent. In periods where regulators have imposed either an explicit or implicit cap on the PE ratio at which a firm can go public, the average initial return has been 222 percent. From June 2014 to December 2018, when firms were not allowed to list if their PE ratio was above 23, the average initial return has been 315 percent!
The high initial returns have led both individual and institutional investors to treat applying for IPO shares as if one is entering a lottery with a small chance of winning a large prize. In most periods, there has been an institutional tranche, with bidding determining the offer price, followed by a tranche for individuals at the same offer price. Historically, investors were frequently required to place money in an escrow account for their entire order, creating an opportunity cost to applying for shares. In recent years this escrow requirement has been dropped, resulting in average subscription ratios as high as 226,000 percent for the institutional tranche and 622,000 percent for individual investors for Shanghai main board IPOs, with even higher ratios for Shenzhen ChiNext market IPOs. Using data from 2009-2012, we show that the majority of institutional investors flip their shares as soon as possible.
One strategy for minimizing the high opportunity cost of selling underpriced shares would be for an issuer to sell a small number of shares in the IPO and conduct a follow-on offering at a higher offer price. This option is not available to issuers, however, because of minimum float size requirements for the IPO.
The procedure for pricing and allocating shares in recent years for the institutional tranche has been an auction method but is often mistakenly called bookbuilding, the same method that is used for almost all U.S. IPOs. With bookbuilding, underwriters price an offering, in consultation with the issuer, after acquiring information about market demand, and then use their discretion in allocating shares to investors. With the exception of a five-month period at the beginning of 2014, however, underwriters have had no discretion in allocating shares. Instead, all investors that apply for shares with a reservation price at or above the offer price are treated equally, a mechanism that corresponds to an auction. In the restricted periods, however, the PE limit has largely eliminated the usefulness of an auction at finding a price at which supply and demand are balanced.
The Chinese equivalent of the U.S. Securities and Exchange Commission, the China Securities Regulatory Commission (CSRC), is one of the few financial regulators in the world that actively attempts to balance supply and demand. On multiple occasions, typically following stock market drops, the CSRC has imposed a moratorium on IPOs, in one case lasting more than a year. Combined with a lengthy approval process, issuers have not only been forced to leave excessive amounts of money on the table due to extreme underpricing, but they have also faced delays and uncertainty about when they can go public.
Although many firms have chosen to go public in other markets, some have chosen to do so via “the back door” by doing a reverse merger with a struggling company that is already listed. This strong demand for reverse mergers has resulted in a floor for failing listed firms. Rather than being delisted and declaring bankruptcy, they become attractive candidates for reverse mergers. As a result, and combined with an extremely low frequency of mergers between listed companies, there have been few delistings of companies after going public on Chinese exchanges.
In our paper, we examine the long-run performance of IPOs in the three years after the offering. We report that, after the big initial return, investors earn returns that are on average indistinguishable from the returns earned on similar stocks that have been listed for at least three years. The abnormal returns have been somewhat better for IPOs that went public in an unrestricted period with more modest initial returns than in the restricted periods with enormous initial returns.
We also examine the bidding behavior of different categories of institutional investors during the 2009-2012 period in which PE limits were not enforced. Mutual funds and securities firms are the two largest groups of investors in terms of bidding quantities. As expected, they also receive most allocations. The allocation ratio relative to demand is similar across investor types. We find that mutual funds have a slightly greater tendency than other categories to bid at or slightly above the offer price and thus receive allocations of shares. The differences across investor categories, however, are small. Therefore the allocation does not appear to be manipulated in an economically significant manner to favor certain investors, which is more of an issue under the bookbuilding method used in other countries.
Using proprietary data from the Shenzhen Stock Exchange, we find two striking patterns in post-IPO trading. First, institutional investors that bid in the auction tranche rarely buy on the open market, regardless of their allocation. Second, IPO investors who receive allocations sell the majority of their allocation in the first week that they can, especially if they receive a small allocation. Together the evidence suggests that investors participate in IPOs aiming for a handsome short-term return due to the huge IPO underpricing, with little interest in holding the stocks for the long run. Such an incentive discourages due diligence and hinders price discovery both at the time of the IPO and in the aftermarket.
In July 2019, the Science and Technology Innovation Board in Shanghai, known as the STAR market, opened and began to accept new listings that are not subject to either a PE limit or a positive earnings requirement. Ant Group had planned to conduct a joint listing on both the STAR market and the Stock Exchange of Hong Kong. The STAR market offerings have been at higher PE ratios, but the average initial return in 2019 was still 115 percent.
The attractiveness of the STAR market for issuers is putting pressure on the other markets to relax their listing requirements. Even if these reforms lower the opportunity cost of going public in Shanghai or Shenzhen, however, we do not expect that the attractiveness of Hong Kong will disappear for some Chinese firms going public. Hong Kong not only allows companies to reach a broad pool of international investors, but also allows companies to raise funds that are not subject to the foreign currency controls that exist on the mainland.
This post comes to us from professors Yiming Qian at the University of Connecticut, Jay R. Ritter at the University of Florida, and Xinjian Shao at the University of International Business and Economics. It is based on their recent paper, “Initial Public Offerings Chinese Style,” available here.