China briefing: The great IPO freeze

Why are Chinese companies still fighting to join a four-year waiting list for an IPO that will likely underperform the original listing price?

In theory, Chinese entrepreneurs should have a deep aversion to the IPO. On foreign exchanges, almost all Chinese companies are undervalued – and have a dubious reputation, due to the various accounting scandals at several of them. In China, there’s a 600-odd queue (i.e. a four-year wait) for listing on a weak stock market that doesn’t offer much hope for a jackpot debut.

Last year, 57 percent of private equity-backed IPOs in China underperformed their initial listing price, according to data from Thomson Reuters. In 2011, a much stronger year for markets and deals in China, the figure was 74 percent.

Valuations suggest the market is anything but red hot. The average private equity IPO exit value fell to $167 million last year from $323 million in 2010, according to Bain & Co. figures. Other data from Thomson Reuters shows the average price-to-earnings ratio for a listed company in China during 2012 was 11.5; that’s less than India (15) and Indonesia (12.7).

Yet the Chinese entrepreneur still aspires to list his company instead of exiting via other routes. In 2012, the PRC had 83 private equity-backed IPOs (149 IPOs in total) compared to 58 trade sale exits and four secondary sales (see chart on page 50). Last year, listings were down by about half due to a regulatory freeze on the IPO process, but trade and secondary exits have been roughly the same for the past three years.

A Chinese founder may have a keen sense of risk and reward. But surprisingly, the preference for IPOs is not about the money, sources say – it’s more about cultural factors.

By listing, the founder is propelled from obscurity to become the company’s public face, which brings prestige among family and friends (and may get him on the Forbes list).

“Entrepreneurs have already made money,” says Jean Eric Salata, chief executive and founding partner of Baring Private Equity Asia. “At some point [a listing] is about your relevance, your position and power, your legacy.”

The public visibility that a listing provides is also good for business. Banks tend to perceive public companies as legitimate (or at least vetted and somewhat transparent) entities with strong cash flow, says Daiyi Sun, managing director at Jade Invest, a China-based fund of funds. Likewise, a business that IPOs goes up a few notches in the eyes of customers, distributors and suppliers.

Equally, there is sometimes a push factor involved. If a peer company lists, it becomes much higher profile than those that remain unlisted – which will likely ignite more listing applications, Sun says.


Trade sales to corporate strategics would be an obvious alternative exit route, particularly to cash-rich Japanese buyers seeking expansion offshore.

In addition, slowing GDP growth could spark some consolidation. “Most industries in China are very flat so there is an urge for market consolidation – not only [with] competitors but also up and downstream in the supply chain,” says Sun.

Yet trade sales are limited by regulatory approvals and, more importantly, generational factors.

Most founders of Chinese businesses are in the 40-60 age range, i.e. not really old enough to want to retire, explains Eric Xin, managing director of CITIC Capital Partners. Selling the business to a corporate buyer, for example, forces the founder into a life-changing decision. “He used to be the big boss of a company and is now an employee of a corporation. He is too young to retire, so what else can he do? It turns into a loss of face.”

Entrepreneurs retain a competitive spirit and want to win, adds Baring’s Salata. “They want to be the biggest; they don’t want to let someone else come in and take their business. You’d be surprised how much of a motivating factor that is. If he sells, the game is over – he gets cash and he’s done.”

Trade sales are nonetheless expected to increase as founders age – albeit gradually. Baring completed one of China’s largest trade sales in 2011 when it sold confectionary company Hsu Fu Chi to Nestle for $1.7 billion. The exit is an example of how generational change will increasingly result in exits to corporate buyers, Salata says, adding that Hsu Fu Chi’s founder was in his 60s and the children weren’t interested in the business, which had grown big and needed professional managers to thrive.

Another option is secondary sales, a relatively new concept in China’s young market. Only four secondary deals occurred in 2012, according to Thomson Reuters data, the largest being Goldman Sachs’ $2.3 billion sale of Industrial and Commercial Bank of China to Temasek Holdings. But some sources say recent market events are expected to encourage secondaries among the thousands of RMB fund managers, as liquidity and fund life pressures increase.


Last October, China’s regulators froze IPOs in order to re-check the financial data of companies on the waiting list. According to Jade Invest’s Sun, some underwriters sexed up company performance data to impress investors during the road show and approval process (which may account for some of the subsequent underperformance).

The freeze created a 600-odd IPO backlog (as of April). Funds reaching end of life are pressured to exit, though many managers continue to hold out for better times. The average holding period hit 3.9 years in 2012, up from three years in 2011, according to Bain.

At the same time, a Bain survey suggests cash return multiples are eroding. From 2008-2012, the figure for all companies surveyed was 1x-3x, while during the previous five-year period (2006-2010) nearly 40 percent had exit multiples greater than 3x.

The freeze is intended to filter out those who don’t belong: only companies with genuinely robust balance sheets will survive a rigorous re-examination of their listing application. About 160 companies have already pulled out of the queue voluntarily, and some have been served investigation notices.

Markets are cyclical and at some point, China’s public listings will come roaring back (Goldman Sachs, in a recent report, predicted 349 total IPOs this year, double the average number).

But even before then, the wisdom of pursuing various exit routes will continue to be offset by the glamour of a stock market listing, sources agreed. And because China private equity deals are typically minority stakes, the entrepreneur will have the final say on how to exit.

“We’re getting to a point where secondaries and other alternatives end up being a bigger piece of the pie,” says Jon Parker, partner at KPMG China. “[However] more so in China than in other markets, what’s important is the mystique of being a public company, and the circles that puts you in.” n


Focus on… Regulation

China’s new leadership aims to tidy up an industry whose rapid growth has created some bad habits. By Michelle Phillips

In March, China’s once-a-decade leadership change was officially completed, as Hu Jintao handed over power to successor Xi Jinping. The new leadership has wasted no time in trying to better regulate the financial industry.

One of the first moves was last month’s replacement of the former head of the China Securities Regulatory Commission, a powerful market regulatory body, with Gang Xiao, former chairman of Bank of China.

China’s listing process has become unruly due to lax oversight. GPs have long grumbled about listing approvals hinging on personal connections with CSRC officials, while the Chinese press has reported on the lavish dinners and bribes necessary to be considered for an IPO.

In September, the situation blew up when media revealed fraud at a company approved for listing and claimed that both regulators and investors had been fooled by the group’s headline story and financials. It became a major embarrassment to the CSRC, which froze the IPO process in October.

As part of a radical clean-up of the listing process, new methods were put in place. The CSRC now makes a video recording of every one of the meetings in the IPO approval process, and has hired facial expression experts to view the tapes and ensure officials are not being bribed, according to Peter Fuhrman, chairman of China First Capital in Shenzhen.

Xiao is expected to further disrupt the status quo. Private equity firms told PEI they are hoping that his efforts will go wide and deep. Public market liquidity in China has an inordinate impact on private equity, because around 75 percent of its exit returns come from IPOs, as compared to 15 percent globally, according to Derek Sulger, partner at Lunar Capital Management.

Other private equity regulations involving institutional money and fund registration have also been emerging. For instance, China’s multi-billion RMB insurance industry was cleared for offshore private equity investment in late 2012.

Tina Wei, principal at FLAG Capital Management, thinks the insurance industry will eventually become a source of investment capital more significant than China Investment Corporation. She also believes local social security funds, smaller endowments and even Chinese pension funds will follow the lead of insurance firms.

The clean-up of private equity fund registration has been more complex. Both the CSRC and the National Development and Reform Commission, the state planning body, are competing to be the go-to agency. After the CSRC released a February regulation stating that funds must register with its offices, the NDRC released a conflicting regulation in March requiring funds to register with the NDRC branches instead.

Nonetheless, the spate of new regulations shows that China is finally trying to bring order to its domestic private equity industry, to prevent it growing wild in a loosely-regulated environment. n

Focus on… RMB FUNDS

As IPO-reliant RMB funds come to terms with the stalled exit market, the more nimble strategists are seeking new ways to thrive, write
Clare Burrows

The four year-long backlog of IPO applications in China has thousands of RMB fund managers, reliant on the country’s stock exchanges to exit, in a bind. As their pre-IPO strategy falters, and funds reach the end of their lives, they face growing pressure from LPs.

In addition, high net-worth individuals – the typical LPs for an RMB fund – are ploughing less capital into private equity. Funds raised during 2012 plummeted to RMB 41 billion (€5.05 billion; $6.6 billion), a 72 percent decrease from the RMB 149 billion raised during 2011, according to Private Equity International’s Research & Analytics division.

As a result, an estimated 2,900 of China’s 3,000 RMB fund managers are now inactive, according to Huisheng Yang, managing director of PRC-based Tiantu Capital.

But the smarter RMB managers are hoping to improve their lot. “The characteristics of RMB managers are flexibility and opportunism,” says Gerald Goh, director at Cambridge Associates China. “They have put those attributes to work in terms of thinking of a way out of what is essentially an existential crisis for the RMB industry.”

First, many GPs are extending fund lives from the typical three-year investment and two-year divestment period, in recognition of the fact that they may now need more time.

“There are a significant number of older vintage funds in the 2004 to 2005 space that have a very short duration,” Ropes & Gray partner Geoffrey Chan explains. “The most typical solution is to extend the fund life with no fee and no expense. So the GP, in order to retain the right to extend the fund life, oftentimes will have to pay for things like the books and records or auditing costs.”

But LPs tend to be sympathetic with their plight, Chan adds. Provided an LP doesn’t incur any additional costs, “If you miss your exit window, it is not the case that your LPs will force you to do fire sales.”

Fund managers have also talked about consolidating their front and back offices to help with financing, or to try and attract LPs through a ‘pledge fund’ format where they find deals before they fundraise, eliminating blind pool risk. However, there is little evidence of this happening yet.

Some forward-looking fund managers would rather evolve to the next level by adapting their business models to appeal to foreign LPs. For example, RMB fund manager Oriental Fortune Capital has solicited the services of an international placement agent to raise its first US dollar vehicle targeting $100 million, according to industry sources.

Fortune Capital, Boxin Capital and CITIC Goldstone Investments are some other RMB funds that sources say may follow. In 2011, CITIC Private Equity closed its first US dollar-denominated fund on $990 million.

Goh says that “the whole market” is showing interest in international capital, and asking how they can formulate their businesses to appeal to foreign LPs.

“Those that are most exposed to international practices and are most sophisticated [will] have done some revisionist history and [will] try to explain why [they used] their previous strategy and [begin] talking about the things that foreign LPs want to hear, such as post-investment value-addition [and] long-term holding – and [thereby] distance themselves from their more speculative, opportunistic, pre-IPO pasts.”