When China unveiled its own version of NASDAQ more than a year ago, many people hailed it as the long-awaited opening of a new investment channel – a means of accessing growth companies with the ability to deliver potentially high returns.
ChiNext launched in a blaze of high valuations, but these have not translated into equally strong corporate growth. The exchange now lags the main boards in Shanghai and Shenzhen. An index tracking 100 companies listed on Shenzhen-based ChiNext has only gained 6% during the June-October period, compared to a 17% increase in the benchmark Shanghai Composite Index.
And things could go from bad to worse: ChiNext faces the possibility of an equity glut. Large tranches of shares held by founding investors – including venture capital and private equity firms and company managers – are poised to flood the nascent market once lock-up periods expire.
In total, US$6.9 billion in shares are due to become tradable in the fourth quarter, which amounts to 36.6% of the value of all outstanding shares available. There are concerns that this flood of equity could ruin future fund-raising by start-up firms.
The average price-to-earnings (P/E) ratio on ChiNext is more than 60. This compares to 40 on Shenzhen’s small- and medium-sized enterprise (SME) board and less than 20 for the CSI300 index, which tracks the top 300 mainland-listed companies by market capitalization.
ChiNext’s average price-to-book ratio of 11.4 times is also considerably higher than those for the SME board and the CSI300. Yet estimated earnings growth for the 100-plus ChiNext-listed firms averages 39% for this year; for the SME board, it’s 46%. Similarly, net income for ChiNext firms grew 26% in the first half of this year compared to 42% for main board companies in Shanghai and Shenzhen.
Worries about a potential ChiNext capital crunch prompted regulators in November to put new limits on share sales by senior management – an attempt to prevent executives from exploiting a loophole by quitting their jobs in order to shorten the lock-up periods on their shareholdings.
Previously, top executives who were awarded shares as part of an initial public offering (IPO) were subject to a 12-month lock-up period, after which they could sell no more than 25% of their total holding each year. However, those who left their posts were entitled to sell 50% of their shares 6-12 months after the IPO, and then exit fully once the one-year lock-up period ended.
As of the end of October, executives at 37 ChiNext-listed firms – including general managers, board members and chief financial officers – had left their jobs since the companies they worked for went public, according to a report by Huatai United Securities. Departed executives at 21 of those companies own shares worth a combined US$752.2 million.
Under the new arrangement, senior executives who quit within six months of a listing will be unable to sell stock for at least 18 months after their departure.
Rules for other shareholders haven’t changed. Controlling shareholders are prohibited from selling shares for three years after the IPO while pre-IPO individual investors like private equity firms are subject to a 12-month lock-up period.
Ultimately, these limits on the share disposal won’t help ease selling pressure. As long as the market is volatile and features high valuations for IPOs, pre-IPO investors will sell as many of their shares as possible after the company starts trading. Everyone wants to exit on a high – and with Chinese equities, there is always the risk of an incredible low.
So what does this make ChiNext – a place for people to invest or just a platform for founders of start-up firms to realize their fortunes and for underwriters to boost their revenues?
The bubbles on ChiNext are unlikely to match those seen on NASDAQ between 1996 and 2000. But in both cases, individual investors pay the price when bubbles burst. These are the people who are left high and dry holding largely worthless shares long after the senior executives responsible for creating the firms have crept away with their profits.
The other big winners are of course the underwriters. Fees for working on ChiNext listings average out at 5.14% of the proceeds, more than double what is paid for first-time sales on the main board in Shanghai. ChiNext offerings have so far generated US$778.3 million in fees, according to Bloomberg. This comes without ever having to ride out lock-up periods on a potentially volatile secondary market.
No wonder domestic investment banks lobbied so hard for the creation of ChiNext.