Attracting overseas-listed tech giants back home
Beyond IPO listing requirements, the board will also welcome “red chips” – Chinese companies that are incorporated internationally and listed on the Hong Kong Stock Exchange. These companies can list back home via issuing Chinese Depositary Receipts (CDRs), which are securities issued by a depositary in China that represent the rights and interests to these underlying shares of issuers outside of China. This way, red chips can still list in China without having to overhaul their overseas corporate structure. Should these companies list back on the mainland, Chinese investors can also have a share in these companies’ gains.
This would not be the first time that China is proposing the CDR structure to woo overseas-listed companies back home. In March 2018, the CSRC announced a pilot CDR scheme that covers companies in advanced technology or “strategic and emerging industries”.7 But the plan has since been put on hold as negotiations with overseas-listed Chinese tech firms remain deadlocked and macroeconomic issues came to the fore. We wait for more details on the CDR scheme for the Sci-Tech Innovation Board to assess its feasibility.
Another Sci-Tech Innovation Board breakthrough is in weighted voting rights, or WVR. These rights are often in the form of dual-class share structures, where there are unequal voting rights on all or specific matters that are subject to shareholder approval. Technology companies like the WVR structure, as it allows founders and management to maintain control over the strategic direction of the company. This way, a young start-up can focus on the long term instead of generating immediate financial returns. It also is a bulwark against unwanted takeover attempts.
The openness of American bourses to WVRs were a major reason behind Chinese technology firms wanting to list there, and it prompted some soul-searching among exchanges in Asia, most notably in Hong Kong and Singapore where the two economies have been making a strong push to grow their high-tech sectors. The Sci-Tech Innovation Board’s acceptance of WVR will allow Shanghai to compete better with Hong Kong and New York in terms of attracting technology companies. We expect that some of the overseas-listed Chinese tech companies will return to the mainland to list in the near term.
Concerns linger over execution
These proposals, while groundbreaking, also raise concerns over stock prices, the evolution of China’s investment landscape, and the capabilities of China’s brokerage and asset-management sectors in supporting the Sci-Tech Innovation Board’s development.
Share prices may be volatile
A key concern would be how volatile share prices will be. Removing price limits in the first five trading days and increasing the price-limit trading band to 20% thereafter may cause stock prices to fluctuate greatly.
However, we think that the expected volatility will only be temporary. The above-mentioned proposals to overhaul the IPO mechanism, and also allowing margin financing and short selling of stocks on the Sci-Tech Innovation Board will allow the pricing of shares to be more market-oriented; supply and demand will be more balanced. This should be beneficial for China’s capital markets in general.
Levels of sophistication a concern
This brings us to the next question on whether China’s capital market is sophisticated enough to ensure that the Sci-Tech Innovation Board is a success. China’s equity market remains sentiment-driven with retail investors making up the bulk of turnover. In 2017, individual investors accounted for 82% of the turnover on the Shanghai Stock Exchange.8
The dominance of retail investors can lead to big swings in prices for newly-listed shares. For retail investors, floats can be winning tickets to double-digit returns, as current controls on IPO pricing suppresses listing prices. With a 44% first-trading-day gain cap in place, and a lack of new names to invest in due to the low number of approved IPOs, retial investors are eager to invest in any new stock that makes it to the board.
We think that limiting who can be a qualified Sci-Tech Innovation Board investor should mitigate some of these concerns. Contrary to the other main boards, the Sci-Tech Innovation Board is expected to have tighter rules on who can trade on it: individual investors must hold a minimum 500,000 yuan (US$74,500) and two years of trading experience in order to be eligible. Other requirements also include a two-year lockup period for sponsoring brokerages, and three years for senior management and core technology personnel. These rules underscore the Sci-Tech Innovation Board’s preference for professional or institutional investors, which should lower the likelihood of sentiment-driven stock-price fluctuations happening.
Corporate governance is another concern. The board’s listing framework favors smaller companies, but Chinese SMEs are not known to be rigorous in corporate governance. We believe that investment managers and brokers that forge deep relationships with SME management can understand these companies better and therefore more likely to avoid any governance risks that may arise.
There are also worries that a successful Sci-Tech Innovation Board would draw liquidity away from other boards. Some richly-valued tech companies on other boards could come under pressure as investors refocus on Sci-Tech Innovation Board stocks. We think that the Sci-Tech Innovation Board will in fact help uncover the true value of tech stocks in China, and thus be beneficial for similar stocks on other boards.
Regulatory risks may also affect the Sci-Tech Innovation Board’s pace of development. Many of the above-mentioned proposals are not new, and some have even been tested out previously. But for a multitude of reasons, they have not persevered to become a permanent fixture in China’s A-share landscape. For example, as illustrated above, authorities put attempts at CDR on hold after much fanfare. There may be a concern that short-term pain may result in reforms being reversed.
Brokerages and fund houses must step up
Brokerages will also have to get up to speed for the Sci-Tech Innovation Board’s launch. The new IPO framework essentially eliminates government guidance in floating companies. Brokerages must now set IPO prices by calculating fair market value for a company that is pre-profit while measuring that against market sentiment and expectations. This may be a challenge for domestic agencies that have not had much experience in this area. For example, if the final valuation resulting from book building differs greatly from the preliminary appraisal value, the company may have to give up listing.
At the same time, fund managers would need more focused research platforms to look at the key sectors preferred by the boards. Investment processes would have to be improved upon in terms of calculating volatility and pricing. There may be a need to come up with new risk parameters, especially for Sci-Tech Innovation Board-only funds.
Sci-Tech Innovation Board a step in right direction
Overall, keeping in mind that these are still early days, we think that the proposals are a big step in the right direction for China’s capital-market reforms and growth of its technology sector.
Even though the proposals made are specific to the Sci-Tech Innovation Board, several of them address concerns that have been raised before by the private sector. If successfully executed on the Sci-Tech Innovation Board, we anticipate that authorities will also want to have them be in place for other boards. This should set China’s equity market – and capital markets as a whole – on a path towards being more market-oriented, and ultimately matching New York’s and Hong Kong’s bourses in their efficiency.
At the same time, we think that these proposals benefit China’s technology sector and should inject a big boost of confidence into tech companies with regards to their prospects. For example, we anticipate that proposals such as allowing pre-profit companies to list will open up more financing options for start-ups, including making them more attractive to venture-capital investors; introducing WVRs should answer tech firms’ concerns over shareholding rights and allow Chinese tech firms to focus more on long-term projects and research, rather than having to deal with investors’ day-to-day concerns. This is even more so when China’s equity market is overwhelmingly dominated by retail investors.
China has been committed to transforming its economy with technology advancement as one of its key drivers of growth. The central government has been keen on enabling this change, and we view the Sci-Tech Innovation Board as one of its key efforts at this.
At the same time, China’s growing global economic clout means that it needs to have a well-functioning equity market to allow individual investors to partake in the economy’s growth, while continuing to provide companies with capital to grow, which in turns ensure economic health and retain foreign investors’ confidence. While these are still early days, the proposals we’ve seen so far are a good step in the right direction to ensure the continued development of its capital market.
Ahead of the board’s launch, we reiterate that execution and faith in market dynamics are key to the success of the Sci-Tech Innovation Board, and China’s capital markets. We remain cautiously optimistic of the potential that may arise with the board’s launch.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Ruiwen Yang is Deputy CIO of Active Equity and Fund Manager at Invesco Great Wall. Cheng Zhan is Fund Manager at Invesco Great Wall.
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^2 Rules on registering for initial public offering on the Science, Technology and Innovation Board, CSRC, published Jan. 30, 2019, accessed on April 10, 2019.
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