After a series of new policies (forced dividends and definite exiting system to name a couple) were initiated by the newly-appointed Chairman of the China Securities Regulatory Commission (CSRC) Guo Shuqing, the market’s call for IPO system reform has been gathering steam. Since the launch of the Growth Enterprise Market (GEM) stock market, incredibly high IPO price-to-earnings (P/E) ratios of 80 or even 100 are no longer shocking news in China. Such a high P/E ratio is understandable during a boom period, but the China A-Share market has lapsed into sluggishness since last year, with the share price in secondary markets plummeting and P/E ratios of less than 20. The huge spread between primary and secondary markets has aroused vehement debate. The IPO market has lost its magic power, delivering heavy financial blows to numerous investors. What is the root of the problem?
To tackle the question, the IPO system in China should be compared to those of more mature overseas markets:
I. Road show: One Day Vs. Two Weeks
The short road show arrangement implicitly reflects the abundant money supply of the Chinese capital market. One day is barely enough time for the pre-IPO enterprise executives to exchange business cards with fund managers and institutional investors, and not nearly enough to communicate in detail with each other. As a consequence, most funds basically rely on prospectus and brokers’ unavoidably biased research reports to make critical investment decisions.
II. Institutional investor-oriented placing: 20% Vs. 90%
An ultralow placing scale forces institutional investors to scramble for the limited shares and unconsciously drive up the offering price, whereas the remaining 80% of small-and medium-sized investors have no power of decision for the IPO price and can only subscribe new shares according to the price made by institutional investors during inquiry. Such pricing systems directly cause an overestimated new share price, especially for SMEs, and lack appropriate means of adjustment.
III. Brokers have no independent placing right
The independent placing right of brokers is critical for stabilizing a company’s share price. In mature markets, brokers are willing to place a majority of new shares to long-term investors or to help search for appropriate cornerstone investors to maintain the share price stable in the longer term. Because mainstream new share subscribers in China are small and medium investors, the share price after flotation more often than not suffers big swings, which not only increases investors’ risks and exacerbates speculation milieu, but also has adverse effects on the long-term development of the stock market.
IV. Lock-up period: new shares subscribed by institutional investors in China during inquiry face three months lock-up period Vs. overseas markets have no lock-up requirement
The intent of a three-month lock-up period is to stabilize the share price after flotation. In practice, this rule serves to embolden institutional investors who then make progressive offering prices, since no one can predict the price after three months. If the shares of institutional investors circulated along with those subscribed by small and medium investors on the first trading day, the institutional investors would probably be more cautious when making the offer. If the price is too high, most investors will sell off on the first day. Nobody wants to see red ink on the account as soon as going public.
The above-mentioned points are the driving factors for the huge evaluation gap between primary and secondary markets, and require immediate reform. The improvement of the IPO market will boost the secondary market recovery and restore investors’ confidence.
Chairman Guo’s recent comment, “Must the IPO be reviewed and approved?” reignited the intense debates about shifting the IPO approval system to a registration system. The hope is to establish a rational and healthy issuing market and a fair and transparent issuing mechanism. Investors have had enough IPO price roller coasters and black sheep in the domestic capital market, but no reform can happen overnight. The IPO issue has a long way to go, but such debates will be a catalyst to accelerate the maturity of China’s capital market, and the substantial policies initiated by Chairman Guo will not be a letdown.