The CSRC Disciplines the IPO Process in China
By turns mysterious, unpredictable, overextended yet under-experienced, byzantine in its complexity and frustrating for all who deal with it, the CSRC (“证监会”) comes in for a lot of criticism. The Chinese stock market regulator makes and enforces the rules for all 3,200 public companies traded on the Shanghai and Shenzhen stock exchanges. Though modeled after the US Securities and Exchange Commission, the CSRC’s remit is far broader. It alone decides which companies will be allowed to IPO. It plays gatekeeper, not just referee.
To win CSRC approval, it is by no means enough, as it usually is in the US, to have an underwriter and a few years of audited financials. All of the seven hundred IPO aspirants waiting in the queue for CSRC approval have these. Only a small minority will manage to jump through all the CSRC hoops and win approval for an IPO. The CSRC makes its own judgment about a company’s business model, future prospects, management caliber, shareholder structure, customer concentration, competitive position, planned use of IPO proceeds, the cleanliness of any outside investor’s money, related-party transactions, the appropriate IPO valuation, even the marital status of a company’s founder.
In effect, the CSRC is doing its utmost to take the “caveat” out of “caveat emptor”, by detecting ahead of time any taint that could damage a company’s post-IPO process. The CSRC can of its own volition forbid companies in an industry to IPO, as it did recently with real estate developers and private steel companies.
The purpose is to starve them of capital. It can also, just as suddenly, reverse its prior course and allow once-blacklisted industries to access public markets. It seems to be doing this now with Chinese companies in the restaurant industry. It can also play favorites. Companies from China’s restive Xinjiang region are currently given special priority, and shown more leniency, in approving IPOs.
The CSRC’s approach to IPO screening is not dissimilar to the way Goldman Sachs chooses companies to underwrite. Each is trying to select “sure bets”, companies that won’t prove an embarrassment a few year’s down the road. Goldman does it to make money and keep its high reputation, the CSRC to avoid social upheaval. Keeping China’s stock markets scandal free is a matter of paramount national importance. So far, the CSRC has succeeded at this.
Accounting and disclosure scandals have become commonplace for Chinese companies quoted in Hong Kong and the US. Not in China. Credit the CSRC’s thorough IPO filtering. The CSRC also keeps a tight lid on the supply of IPOs each year to prevent new issues from weighing down overall market valuation.
There is another overlooked benefit to the CSRC’s stringent IPO approval process. It weeds out the flim-flammery, hype and exaggerated salesmanship from the IPO process. Any company approved by the CSRC for an IPO is all but guaranteed a successful closing. The underwriters have it easy. They barely need to break a sweat.
The same is most definitely not the case in the US and Hong Kong, for example. There, regulatory approval is the first and simplest step in an expensive, tightly-choreographed, quite often unsuccessful effort by underwriters to drum up investor interest and get them to bite. It involves a fair bit of hucksterism. In the US, IPO underwriters are salespeople. In China, they are order-takers.
Chinese underwriters have limited discretion over IPO pricing. For one thing, the CSRC is watching, and can deal severely with underwriters who seek what the CSRC decides are “overpriced” valuations. It seems like everyone in China knows where IPO valuation multiples are at any given time. At the moment, they are around 35 times last year’s net income for smaller companies listing on the Chinext, and around 25 times for larger companies. The CSRC has grown increasingly vocal in criticizing big first day gains for newly-IPO’d companies.
The CSRC does not approve IPO applications of companies that don’t have at least two years of profits or ones that have huge numbers of users, but comparatively light profits. That is to say, no Facebook, Groupon or Linkedin types are allowed. This, too, removes a lot of the investment banking sales wizardry seen in the US during the IPO process.
One positive result of this is that underwriters in China are limited in what they can promise companies to win an IPO mandate. Good, bad or indifferent, an underwriter is likely to get just about the same price for shares it sells in an IPO. So, basically, winning mandates in China comes down to a lot of wining and dining, Karaoke and cartons of expensive cigarettes.
Since the CSRC’s approval process can drag on for up to two to three years, underwriters also have little, to no, say over IPO timing. The risk in the IPO process in China is, overwhelmingly, the risk of rejection by the CSRC. The CSRC rules mean underwriters and company are in it together. The underwriter needs to be active throughout the long process, and present at many meetings with the CSRC. The underwriters put their neck on the line by providing guarantees to the CSRC on the soundness of a company’s financials and pre-IPO disclosure.
Having seen the process from both angles, ten years ago as CEO of a US company during part of its IPO process, and now in China, working with clients seeking CSRC approval, my view is that the CSRC’s method has a lot to recommend itself. It puts far more focus on the company and less on its investment banker. An IPO in China is not so much a test of an underwriter’s marketing prowess and placement network, but more state-directed capital deployment to companies deemed by the CSRC to be most suitable and fit to receive a slice of the public’s savings. Who the underwriter is and how they operate are basically afterthoughts.
This may offend against the market principles of a lot of financial professionals, that the only real IPO test a company should need to pass is if an investor will send a check to buy its shares. But, “safety first” seems a good principle for China at this stage. Private companies have only had access to China’s capital markets, in a substantial way, for two years, with the opening of the Chinext (创业板）board.
The stock market is now –and will remain — the lowest-cost way to finance the growth of private enterprise in China. Everyone stands to lose if confidence is badly shaken, or a scandal takes down one of these once-private now-public companies. For this reason, though many investment professionals are mystified by its decisions and sudden about-faces, the CSRC earns my support and respect.