PetroChina’s (PTR.NYSE, 601857.SH, 0857.HK) infamous initial public offering from 2007 lives long in the memory. Oversubscribed and highly priced, the shares tumbled about 80% over the 12 months following the listing. Retail investors were not amused. Similarly, there have been numerous listings on ChiNext, the NASDAQ-style small- and medium-sized enterprise board in Shenzhen, that have dropped like stones after securing high valuations at IPO.
Dealing with the speculation and irregularities inherent in China’s listings business has always been a headache for regulators. Last month the China Securities Regulatory Commission (CSRC) tried – again – to draw a line under the issue, unveiling new rules intended to make procedures more transparent.
Under the proposed arrangement, the CSRC would permit more institutional investors to participate in the book-building process. Expanding the current mutual fund and securities house-dominate arrangement should ensure more realistic pricing. Meanwhile, for IPOs involving smaller companies, sponsors would able to allocate more shares to each institution involved in book-building as part of efforts to encourage them to bid more rationally.
The policy is set to “make participants more responsible, pay attention to the interest of smaller investors and enable the IPO price to better reflect market supply and demand," the CSRC said in a statement.
The draft measures, which are likely to be finalized this month, are part of a broader reform towards IPO pricing in order to protect minority investors. The listing process has long been plagued by inaccurate pricing, resulting in sharp movements once the shares started trading. In many cases this has amplified fluctuations in the equity market as a whole.
Since the establishment of China’s stock markets in 1990 though the early 2000s, companies and their underwriters usually fixed the IPO prices based on a price-to-earnings multiple of around 20 times. The sole motivating factor was to make new listings soar on their trading debuts in order to please officials and large, government-linked investors.
The rigid mechanism sparked extensive complaints that quality companies were undervalued while less promising firms were overpriced. Individual retail investors, who had no say in determining valuations, also grumbled that institutional investors were given an unfair edge in equity subscription due to their capital strength and close relationships with underwriters.
To move the domestic market in line with international standards, the CSRC introduced the book-building system for IPOs in 2005. However, the mechanism was abused by some underwriters and institutions at the expense of minority investors’ interests. Regulators have found some institutions had quoted unreasonably high prices during initial consultations with underwriters, thus driving up the price ranges, but later chose not to bid for the equity.
A dozen brokers and fund firms have been banned from taking part in the book-building in recent years due to misbehavior in pricing. But the authorities never made it clear whether there were any illegal benefit transfers between underwriters and institutions. The common sense view is that a higher price range would translate into higher commissions for investment bankers in a sell-side market.
The goal of the new policy is apparently to persuade institutions not to flip shares soon after they start trading. By offering a larger proportion of stakes in smaller IPOs to institutional investors, regulators hope to promote accountability in the price-consultation and bidding process.
Unfortunately, the initiative is unlikely to work. Many purely financial investors simply aren’t interested in becoming cornerstone investors for ChiNext IPOs – they don’t want to be tied down by lock-up periods on shares that are already so highly priced there is little upside room.
Some private equity industry contacts told me they would only get involved in the program if they found a company that really deserves long-term investment. These are thin on the ground.
The top priority for the regulator has to be creating a serious punishment system for those who abuse the IPO pricing system. Any collaboration between underwriters and institutions to artificially bloat prices must be made public and the culprits heavily fined. A retroactive policy would also be useful as it would force underwriters to take responsibility for their misbehavior even if it comes to light months after the listing.
Insider trading, market manipulation, embezzlement by major shareholders and other irregularities have taken their toll on investor confidence in China. In too few cases have the perpetrators served jail time, and even when this does happen it takes years for sentences to be handed down.
Three years ago, no one took responsibility for the collapse of PetroChina’s share price. It is time to get tough and ensure IPO pricing is transparent and reasonable. It is the only way to retain investors’ confidence and reduce market volatility.