Article by Simon Fong (方三文), Founder & President of Snowball Finance, iChinaStock’s parent company.
Why do so many good Chinese companies go public in foreign markets rather than let domestic investors share in the profits of growth?
Chinese investors often complain about why would “good companies”, like Tencent (0700.HK), Baidu (NASDAQ: BIDU) and Sina (NASDAQ: SINA), choose to list in the US and Hong Kong instead of on the Chinese A-shares market.
There are four main reasons:
- If a ‘Chinese’ company takes foreign investment using a VIE structure, it can only list abroad
- Many companies don’t meet the strict financial standards for a Chinese listing
- China’s listing process is lengthy and opaque, a torturous examination compared with America’s speedy registration
- China’s regulatory agencies perpetually overregulate, rather than letting the market decide
1) If a ‘Chinese’ company takes foreign investment using a VIE structure, it can only list abroad
The core reason is simple. These companies aren’t at all eligible to listed on the Chinese A-Shares Market, which restrict the overseas-funded enterprises severely.
Note: This explanatory section was added to the original article for the benefit of international readers.
To receive foreign investment, a great number of Chinese companies set up an elaborate corporate structure called the VIE or Sina structure, because some industries such as internet info & services and financial services are restricted or even prohibited in foreign-funded investment. This structure is especially common for technology companies that raise financing early and often, frequently from foreign investors.
Under a typical arrangement, a Cayman Islands company (or some other offshore destination), sometimes via a 100%-owned Hong Kong subsidiary, then owns a wholly-owned foreign enterprise (WFOE) in China. That WFOE, in turn, via a series of agreements controls a local Chinese company that holds the licenses necessary to operate the business in China.
State-owned enterprises aside, most ‘Chinese’ companies in the US are not legally Chinese at all. They’re Cayman Islands, British Virgin Islands, etc. companies that control Chinese entities.
Chinese regulators have raised the idea of allowing foreign companies to list on the A-Shares Market, but at present that’s still speculative.
A worry for foreign investors is that the entire VIE structure, which largely serves to circumvent Chinese laws barring foreign ownership, has been called into question by Chinese regulators in recent months.
2) Many companies don’t meet the strict financial standards for a Chinese listing
In August 2005, when Baidu (NASDAQ: BIDU)_listed in US, Chinese asked this very question. Let us review.
Baidu didn’t reach profitability until 2003. When it went public, it had been profitable for just 2 years. The company’s profit was only $300,000 (2.4 million RMB) in the quarter prior to its IPO.
This is a far cry from the minimum IPO criteria for the Chinese Small and Medium Cap A-Shares Market, where “net profit in the recent 3 fiscal years must be positive and the sum exceeds 30 million RMB; aggregate cash flow from operational activities in the recent 3 fiscal years exceeds 50 million RMB, or aggregate operating revenue in the recent 3 fiscal years exceeds 300 million RMB.”
Baidu didn’t even live up to the standards for listing on the Chinese Growth Enterprise Market: “Profitable for the previous 2 years, with aggregate net profits of not less than 10 million RMB and consistent growth” or “profitable in the previous year, with net profits of no less than 5 million RMB, revenues of no less than 50 million RMB, and a growth rate of revenues no less than 30% over the last two years.” Nor may capital be less than 20 million in the year prior to the IPO.
And Baidu was far from the worst! When Sina (NASDAQ: SINA), Sohu (NASDAQ: SOHU) and Netease (NASDAQ: NTES) went public in the US, they couldn’t even claim profitability or clearly state their revenue model, let alone meet the minimum listings standards for the Chinese A-Shares Market.
3) China’s listing process is lengthy and opaque, a torturous examination compared with America’s speedy registration
Even if they manage to meet the standard of A Shares, many would still choose to go public in another country probably because of the investment structure there. More importantly, it could be the process, feeling and implicit cost of the IPO.
After a company goes public, it sells part of equity to those who are willing to buy. This couldn’t be a more ordinary matter of business. Yet I’m not sure since when, but it has became one of the most difficult things in China.
Going public is like going through a round of torture. In the prolonged process of waiting for review, these companies feel deeply the role of “Party B” that they are playing. They have not only to be upset by countless uncertainties, but also incur high costs off the balance sheet.
The regulations were originally set up to protect Chinese investors and provide strict reviews for each public company, but they have now mutated into a monster that does not know its master. For those who list on a foreign market, except for the Chinese part of the review process, they clearly feel they are “Party A.” The exchange is there to serve them, not vice versa.
Moreover, if they want to conduct a secondary offering of stock or set up warrant incentive policy, they have to go through a process similar to the torturous IPO one. But in foreign markets there is no such issue.
4) China’s regulatory agencies perpetually overregulate, rather than letting the market decide
The Chinese A-Shares Market has an amorphous definition of “misappropriation” that is frequently cited to justify regulation.
After a stock market crash, for example, many investors asked for a halt on IPOs to prevent “capital from being diverted.” Unexpectedly, regulatory agencies showed their goodwill and put a hold on all IPOs.
But companies need to finance after all. So, during that period, well-performing state-owned enterprises, such as Chinese National Petroleum Corporation (CNPC) and China Mobile went to Hong Kong to finance and later also issued ADRs in the US.
This tells us that Chinese regulatory agencies are actually most concerned about investors. They fear that investors will buy low-quality stocks and they therefore spare no efforts to set up strict review processes for IPOs. They are also concerned about investors losing money in the secondary market and therefore set up “protection measures” like downward limits and upward limits and make adjustments to the “IPO rhythm” to stabilize the secondary market.
But these ‘good intentions’ only end up leading everybody astray from the original market intention.
The quality of companies listed on the A-Shares Market is far from satisfactory, while most of the companies with the best growth potential and highest returns to investors list abroad. Moreover, the A-Shares Market remains one of the capital markets with the largest fluctuations in the world!
The conclusion should be fairly simple: regulatory agencies should not and cannot be held responsible for a company’s quality through an IPO review. The operational risk of a company does not move in lock step with static indicators like financial data. Regulatory agencies should not and cannot be responsible for the fluctuations in the secondary market. Fluctuations of the market can never be contained by up or downward limits, nor can the regulator effectively set the “IPO rhythm.”
Chinese companies will continue to list abroad, despite sky-high A-Share Market valuations
To be fair, under the elaborate care of regulatory agencies, A-Shares do have their own magic, that is, a super financing power. Especially in the fiery Growth Enterprise Market over the last year, PE ratios frequently shoot up to 100x. Every single listed company has been overjoyed to get more funds than planned.
With such “stupid wealthy people” circ*mstances, will companies still want to list in foreign markets?
I believe so.
Again, there are many companies that will never meet the standards of the A-Shares Market. For growth companies that really desperately need funds, even the listing threshold of the Growth
Companies that list abroad don’t have to worry that investors will criticize them for a broad definition of “misappropriation.” For them, going public is not just a one-time IPO sale, but also a sustainable financing platform.
In Conclusion
To sum up, the pre-IPO review and post-IPO trading have made A-Shares Market a different ecosystem from foreign markets. It is hard to say which is better. But companies themselves have preferences.
Therefore, I don’t think fewer companies will list in foreign markets despite the high valuations of A-Shares. It’s hard to tell if “quality Chinese companies” will give A-Share investors a chance to invest.
Article by Simon Fong (方三文), Founder & President of Snowball Finance, iChinaStock’s parent company. The original Chinese article was published in the October edition of The Founder.
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