By Prakarsh S. Jain
In the middle of the turmoil around?Twitter?s $1800 million Initial Public Offering in November 2013, it would have been easy to miss a pair of small Chinese IPOs in New York a week earlier then Twitter. Qunar, a Chinese travel-booking service company, raised $167 million, with share prices rising ~90 percent above the initial offering and the day before, 58.com, a Chinese version of Craigslist raised $187 million, surpassing the initial offering by ~50 per cent.
Do these IPOs in particular and others this year mark a wide-ranging return of Chinese cross-border listings in the States? It seems too early to voice; Qunar?s listing was the second from a reliable company in a well-known industry. These companies are among the first Chinese listings in the United States after more than 100 Chinese companies were delisted from trading on the NYSE in earlier years, which was because of fraud and accounting humiliations. The consequence of that episode, which destroyed more than $40,000 million in value, continues to vibrate through the investment community until today.
Cross-border listings play an increasingly important and valuable role for companies and investors in the global economy and in addition promote the movement of capital, competition between exchanges, and financial flexibility for businesses. Nevertheless, if they are opting again, understanding the occurrence and its lessons is important for executives and investors, if China has to avoid a repeat.
The Behind Story:
Many spectators at the time regarded the massive loss as a simple story: the companies never should have listed in the States in the first place, and stockholders were tanked-up on China?s growth during the early years of the millennium.
The real story was more multifaceted. Primary responsibility falls on the companies whose malfeasance caused such a strong reaction from investors. Yet the process got ahead of itself: companies were ill- prepared to meet the expectations of foreign markets, and the infrastructure was unrehearsed to supervise cross-border listings. Even in the 1990s, such listings were limited to a few misfortunes of corporate history, where a business had roots in many geographies. As the stock exchanges consolidated on global scale, establishments found themselves able to choose exchanges based on the characteristics of the market, availability of capital, and sophistication of investors. Regulators were and upto an extent still are structurally incapable of enforcing policy across borders and investors themselves are unaware of the fragility and weakness of their protections in cross-border listings.
The Three Waves:
When Chinese companies began to list in the United States, they came in three waves between the two decades from 1990 and 2010. The first arrived after privatization and at the direction of Chinese controllers, who recognized that the prestigious Chinese companies would benefit from the capital and governance that domestic markets could not offer. Their anticipation was that listing in Hong Kong or New York would compel transition from government departments into fully functional corporations by forming boards, imposing corporate-governance, and creating management infrastructure. NYSE at the time was highly viewed listing location, with the uppermost authority standards, and conferred a figure befitting the companies to be listed.
The second wave of listings included more state-owned titans, as well as growing number of private companies, many from China?s technology sector. These companies felt that US markets offered an environment best suited to their needs, given their attention of analysts and experience with technology listings. These first two waves in combination comprised around 100 companies with an average market capitalization of $24,000 million, representing 48 per cent of the total value of Chinese companies listed in NYSE.
The third wave of listings was larger by number, though the companies themselves were much smaller in value, with an average market capital of less than $5,000 million. Many of them, unwilling to compete for capital in the domestic markets with the larger private and state-owned enterprises, looked instead to New York. They found ready access and investors who had grown comfortable with US-listed Chinese companies and had significant appetite for the China evolution story.
NYSE still held the prestige and brand that had attracted the first wave of listings and now there was an infrastructure in place to support these offerings. All major law firms in the States and banks had presence in China, as did the smaller advisory firms specializing in reverse-merger, where an unlisted company acquires a shell that is already listed and registered with the US Securities and Exchange Commission, bypassing the more rigorous scrutiny of a standard Initial Public Offering. These tended to be much smaller and as the crisis hit, corporations listed by reverse merger had an average market capitalization of only $68 million and represented less than 1 per cent of total market cap of all NYSE listed Chinese companies. As it would turn out, this 1 per cent would cause a disproportionate amount of trouble.
?The Spinning Point:
In 2011, a series of scandals developed around companies from the latest wave of listings. Many involved fraud that presented particular problems for stockholders. Almost all involved distortions and falsifications in financial reporting that would have been missed by an ordinary audit. Many involved fabrication of the underlying documents on which audits relied, particularly bank transaction records. This could be detected only by a fraud audit or detailed hands-on due diligence, which are conducted by exception and while fraud in the most egregious cases was visible, it was not common for investors to perform this kind of diligence.
Many of the scandals involved companies that had been listed by reverse merger. By June of 2011, the authority had issued a bulletin discussing the risks of reverse mergers, citing six actions taken in the preceding months, against the Chinese companies and mere a quarter later, the median New York listed Chinese company had already lost 2/3s of its value.
?Market Reaction:
Many market observers observed the sell-off as an indiscriminate reaction against Chinese companies. Investors clearly distinguished between small and midcap companies those with market capitalization below $200 million and the better-established ones, with market capitalization over $20,000 million. Indeed, while median small and midcap companies underperformed the S&P 500 by 40 per cent between 2011 and 2013, median large-cap company?outperformed?by ~ 15 per cent. Other systematic factors such as revenue mix played no role in the change in valuations. Additionally, companies performed significantly better or worse than their size would suggest, as investors differentiated among them based on tangible company-specific news. In effect, the market decided that the size and reputation of the major companies was the only consideration they would accept.
Chinese companies listed on other foreign exchanges were not immune too. In spite of the preference for New York listings, many had also listed elsewhere. Of the 160 Chinese companies listed in Singapore, nearly 10 per cent were delisted between 2011 and 2013, collectively valued at $27,000 million.
Hong Kong was one of the notable exceptions in this case. Chinese companies there represented ~40 per cent of the exchange?s total capitalization, with an aggregate market capitalization of $1.1 trillion.?Yet the decline in Hong Kong?s ?red chips? was only 40 per cent as big as that for US-listed mainland companies (Calculated from median decline in P/E ratios in Hong Kong red chips versus US-listed Chinese companies).?Why? First, reverse-merger listings are relatively uncommon their and so most companies go through the scrutiny of an IPO. Second, the city?s securities industry developed around listings from mainland China and has decades of experience in them. The investment community also has a much stronger network and is better able to spot leading indicators of problems.
The Regulators:
Regulatory protections failed to prevent this crisis from happening, and once it chanced, they failed to cure it though through no fault of their own. While the exchanges promptly suspended companies? listings when evidence of fraud emerged, US securities regulators could not themselves take action against the companies, whose assets were typically in China. Suits against them would end up in Chinese court, where judgments would be hard to impose. Instead, the regulators focused on the advisers who allegedly misled investors. Here, too, the hands were tied. Like many other countries, China confines provision of professional services to companies incorporated and licensed locally, which typically means that US listed Chinese companies are audited by the Chinese subsidiaries of the Big Four audit firms. These subsidiaries are licensed by the Chinese not by a US-based accounting-oversight board. These subsidiaries resisted releasing their working papers for audits on delisted companies, maintaining that they were covered by China?s extremely broad state-secrets laws.
In July 2013, China?s regulators offered to release audit working papers to the SEC on a case-by-case basis. This is an improvement, but it?s a small one. It enables the SEC to prosecute long after the event and only after negotiating to get the materials, it needs. It does not give the SEC any automatic rights to inspect the auditors? work, to take action against them without regulators? support, or to take effective legal action against the companies.
?Companies Reaction:
In the aftershock, few companies saw their valuations recover, despite efforts to convince investors of their honesty. Some tried to bolster their share prices with more frequent and comprehensive investor communications, but no amount of communicating could assuage the market?s wariness. Others explored bringing in a credible new strategic investor whose extensive diligence, managers hoped, would demonstrate reliability. One such deal was Pearson?s acquisition of Global Education and Technology. Still others opted for take-private deals, announcing or completing 27 of them in 2012 and 12 through November 2013.
Comments from the Chinese executives of delisted companies are illuminating. Even before the sell-off, many Chinese executives felt US investors did not understand them and they were too distant to grasp China?s risks and opportunities. Others felt US investors? analysis was colored by their familiarity with mature companies at home, where the drivers of growth and profitability were often radically different. After the sell-off, in retrospect, most also felt that they had been poorly prepared for listing in NYSE to begin.?Many acknowledged to have had little awareness of the regulatory burden it would carry or the challenges of investor relations.
Although most of the companies, mentioned they had no immediate need for fresh capital, but all planned eventually to relist, preferably in China, either on Shanghai?s or in Hong Kong if they needed foreign capital. This preference was partly economic, but they also felt that investors there would better understand and be able to value them.
?The Teachings:
For such listings to work, there needs to be a regulatory framework that provides transparency and protects investors, a professional-services ecosystem that provides effective quality control for listings, and an investor base with the knowledge and capabilities to understand the businesses properly.
An equity market is more than just an exchange.?Investors rely on a broad ecosystem of professional advisers, equity analysts, brokers, and regulators who perform quality control on the companies that list there. The dangers come when the ecosystem takes on issues that it is not prepared to evaluate. In the major global equity markets, investors take the high standards of this ecosystem for granted, when in fact relying on audited financials and company representations is insufficient in many markets.
The companies involved in this case happened to be Chinese, but the elements that led to fraud there are visible in many other emerging markets, as well as in some developed ones. The lack of quality control is especially concerning with regard to companies originally listed by reverse merger, since this route to market continues to be used. Indeed, on US exchanges, there have been nearly as many reverse mergers per year involving companies after January 2011 as in the preceding five years. That there were far fewer Chinese companies should give investors little reassurance. They need to be aware of the shortcomings of reporting and find ways to fill the gaps, whether through informal channels or through analysts doing investigative diligence.
The SEC doesn?t face a problem just with Chinese audit firms but potentially with any audit firm outside its regulatory purview and it is not the only regulatory agency facing this problem, since every other major market could face the same experience, particularly given the growing competition among stock exchanges. To close the gap between US and Chinese regulations satisfactorily, the countries? two regulatory agencies must collaborate; both sides urgently need this to happen. The solution offered by the Chinese regulators falls far short of genuine cross-jurisdiction cooperation. Hence, US investors are still forced to take on faith the content of audit reports, and neither they nor regulators have timely mechanisms to take action against frauds.
A company?s choice of listing location must be more thoughtful.?It is a strategic decision that most companies will only make once. They and their advisers must be less driven by emotive factors and prestige and more driven by economics. Although the top-tier equity markets are increasingly similar on liquidity, costs, and valuations, significant differences remain in specialization and ability to understand different types of companies. US markets are still comfortable with larger and better-known Chinese companies, many of which are significant on a global level, but they are not confident with smaller, less-well-known ones, and valuations reflect this.
Cross-border listings will continue to be valuable for companies, investors, and exchanges alike. The lesson of the Chinese delisting debacle is that each must be more circumspect in their approach and take concrete steps to avoid a repeat.
Prakarsh Jain is a graduate in Commerce from Jai Hind College, post-graduate in Master of Global Business-Investment Banking & Wealth Management from S P Jain School of Global Management and a Chartered Accountant (CA). Currently, Mr. Jain is working with Mizuho Securities, a wholly owned subsidiary of Japanese investment Bank in Corporate Advisory team. From an early age, Prakarsh has been actively involved in various competitions & debates at national/international level and in recent time has represented UAE at the KPMG International Case Competition (KICC 2013) held in Spain. In addition, he has also acted as a delegate at the World Islamic Banking Conference: Asia Summit held in Singapore.
