After a prolonged 15-month suspension, IPOs will finally be resumed as the China Securities Regulation Committee (CSRC) had just ordered underwriters to update application materials for firms waiting to list and kicked off disclosure processes shortly afterwards. Back in late 2012 when the longest-ever IPO freeze started, CSRC was aiming at cooling overheating in new share speculation and rooting-out fraudulent practices in IPO applications. To the surprise of many, it turned into a thorough reform of the IPO system. As the overhauled rules show, there will be a transition from an administrative approval-based system toward a registration-based one. This more market oriented approach shares the current administration’s spirit. Mechanisms used in developed economies for decades are being introduced to China, such as preference shares and secondary IPO offerings. In the meantime, while gradually taking their hands off tedious and tough prelisting investigations and hearings, CSRC will increase its efforts to supervise public companies.
The rigid old system created multiple, huge arbitrage gaps due to the scarcity of public companies, and as a consequence, the rapid-fire approach of private equity investments in large-scale industrial production. Through no fault of their own, GPs sometimes looked for targets that better adhered to CSRC’s standards even if they did not make business sense. CSRC is not responsible for evaluating a company’s qualifications in terms of value, and nor does CSRC have the required (inexhaustible) resources to fulfill this commitment.
As a PE professional, I would love to see this transition be effectively and efficiently executed. If the concession takes place—officials at CSRC might not like it, though—the market will play a greater role in deciding which IPOs actually make sense business-wise. Optimists believe that CSRC will digest the entire IPO pipeline of approximately 700 within 12 months, and that new applicants will witness how market-oriented the new system is.
Undoubtedly, CSRC has made the right choice, although it took so long and still has a long way to go. As the Aosaikang (an applicant company which exploited a “loophole” in the new rule) incident revealed, we will have to live with a quasi-registration based IPO approval system for a while. But after all, there is every reason to celebrate the big change.
China’s PE industry has been longing for this IPO thaw and reform for too long. Apparently many of the 700 IPO pipeline companies are PE-backed, while over eight thousand PE investments remain unexited, most of which are IPO-targeted minority deals. The IPO drought has made 2013 a tough year for China’s PE industry. Investment activity was altered correspondingly, and somewhat passively. While the total deal volume in 2013 was lower than that of 2011, the share of growth capital has declined for the fourth year since 2010. Make no mistake. Growth capital investments are largely associated with pre-IPO approaches in China.
PE firms are trying to find new targets for their money. There has been an ongoing debate regarding how the industry should respond to the death of the pre-IPO model. Some recommended switching to earlier investment stages to compete in VC arena. That did not play out well. PEs and VCs have different DNA and play in two very different leagues.
Many have been advocating for more M&A activities. It is really happening. In 2013, China witnessed a record high M&A volume at $93 billion (though modest compared to the USA’s $1.57 trillion, Dealogic) according to the research firm, Zero2IPO. Still, Chinese companies did the the majority of the volume (quite a few by SOEs). Only slightly more than one third was PE-backed deals. The typical deal structures were strategic buyers teaming up with PEs, meaning the real money deployed by PEs in M&A deals was significantly lower than one third. Questions may be raised: why wasn’t there an outburst of PE-lead (rather than backed) M&A deals? Why were there no breathtaking LBOs at all, especially when the IPO shutdown cooled the pre-IPO deals that made more dry powder available? The absence of debt facilities for buyout deals remains the primary reason. In addition, the credit cost in China is so dear that it does not make sense to use them as leverage in a typical buyout deal. Insufficient buying power also results in bogged exit routes. The strategic buyers in China are mainly limited to large SOEs and public companies. While SOEs can enjoy institutionalized preferentiality, public companies are able to raise money through secondary offerings or by acquiring targets via share swaps. If other potential buyers, including PEs, could have the access to viable leverage facilities, there would be more buying power and thus a more liquid secondary buyout market, which will reflexively boost the overall M&A activity. These problems seem like they could take generations to tackle. The most recent major relief is the first ever default case of corporate bond in China. A Shanghai based solar company, Chaori, was not able to deliver the 90mn RMB interest payment with possible principal trouble on its way. It’s merely a tiny fraction of China’s massive credit market, but it’s truly a landmark because for the first time a public bond was “allowed” to default rather than enjoy quasi-official salvation. Implicit government guarantees have always kept the credit market fully functioning. China’s current pragmatic leadership has made an effort to free the credit market, including interest liberalization (on a gradual basis) and private bank approvals. Along with the landmark Chaori incident, all of them are promising signs for a fully functioning credit market, which is good news for potential buyout players in the PE industry.
Reopening IPOs cannot reverse this important momentum. As the invisible administrative door is opened, IPO will become much easier and the scarcity of floating shares will eventually be eliminated. Companies will not enjoy ill-matched premium valuation just because they are public. Taking a company public does not guarantee profit for its PE investor anymore. Still, we cannot rule out the possibility that some private equity firms will still hold on to the quick fire IPO fantasy. There will be some room for inventory offloads but the return will not be as handsome as it used to be (loss is becoming likely). Hopes that the reopened market will spark a flood of profitable sales are nothing more than illusion. PEs will have to work harder on discovering and adding value to their targets and portfolio companies. This is what they are paid for, entrusted with, and is the most important factor that creates lucrative returns for LPs. Specifically, value adding should never be an empty promise. PEs should work closely with portfolio companies particularly in terms of corporate governance, operational talents, capital restructure, and add-on acquisitions (in the near future) rather than being hands-off and planning for a quick flip. This is also a must-have skill set if they would like to make large M&A deals in the near future. PE firms that adapt to this new environment will thrive and those who don’t will definitely be knocked out of the major league.
The equity and credit markets (as well as forex, which is not discussed in this small article) are being pushed toward liberalization at the same time. We can expect a great transition in the Chinese PE industry to embrace a more value-oriented approach. That will be one of the luckiest things for China’s hundreds of thousands of small and medium sized companies.