The China Securities Regulatory Commission (CSRC) has put out draft rules to encourage a book building process with investors - a radical departure from past practice. Market participants have been given until September 5 to respond.
Book building is a price discovery process used by international banks to fine tune the pricing of the IPO they are underwriting. Pricing is determined over a two week to one month process during which the deal's syndicate banks hype the stock to investors and the company and its lead managers meet with institutional clients to hear their feedback. Pricing is fixed at the end of the roadshow based on the level of demand and price sensitivity garnered over a one to two week period.
How different in China, where the fund managers apply for IPOs on the basis of their existing portfolio. The price of the IPO, represented by the price/earnings ratio is fixed at 20x by China Securities Commission. Fund managers do not bid against each other for an allotment of shares since they cannot affect price under such a system.
Broadly, the bigger the portfolio the more shares they will obtain. However in order to protect the smaller fund management houses, the gains obtained for a large fund are capped at a certain point.
For years, poorly performing SOEs have been nursed through usually inadequate restructuring by their sponsors to raise money. In one case, a Henan company was encouraged to list, despite the fact it and other companies in the tanning and fertilizer industry were allegedly responsible for a huge rise in the number of cancer cases in a Henan village, now nicknamed "Cancer Village." The company listed because local and central authorities were keen to recapitalize the company to further employment, despite the high mortality rate the company was causing.
Under the new system, fund managers can signal how much they are willing to pay for an IPO. If they are deprived of their guaranteed gains and have to buy the shares according to more business-like criteria they can simply refuse to buy the issue and wait for something better to come along. That could have a major impact on the quality of listing candidates, in contrast to existing listed companies, which many fund managers describe as 'rubbish'.
On the other hand, scepticism as regards the scope of any single reform measure is usually well-founded and specialists point out that the authorities do not seem to have explicitly discussed abolishing the p/e ratio ceiling.
The proposals also contain some measures to mitigate the effect of the rule changes on retail investors, who will continue to be allocated shares by lottery. For example, fund managers will only be eligible for 20% of share offers of under 400 million shares. In return, retail investors will only be eligible for 50% of an offering for offers of over 400 million shares.
This is similar to IPO's in Hong Kong, where there are also mechanisms to protect retail investors. In Hong Kong, the retail tranche is usually only 10%, but can rise up to 50% if subscription levels exceed certain trigger points.
To discourage excessive margin buying, the CSRC is also proposing new rules that will see fund managers having to pay the full amount for the shares they subscribe to. Locking into first day gains will also be discouraged through the institution of a three month lock-up period. Sponsors will also be compelled to sell the full allotment of shares to those managers who have paid the minimum price or above, and to give a full run down of allocation - so no more sweetheart deals.
Observers comment that the authorities have always played a strange game with the stock market. Despite their quintessentially capitalist appeal, they have been used - in that eccentric way encouraged by the concept of 'socialism with Chinese characteristics' - as a disguised subsidy to the supposed legions of retail investors who gamble their life savings on the market.
The true number of these retail investors is hotly disputed, with advocates for reform claiming their real number has been inflated by fraudsters, while defenders of the system stoutly standing up for the 'man in the street'.
The CSRC has created an abundance of regulations to try to the improve the quality of listed companies, but many believe they have been a complete failure. The markets are approaching five year lows, and numerous companies on the recently launched second board have dipped below their IPO price.
Some believe this is an astonishing symptom of the bleak mood undermining the market. After all, with IPOs deliberately under priced at 20x p/e to enable first day profits in a market whose average p/e is 40%, dropping below your IPO price is symptomatic of a powerful malaise.
"Investors are beginning to turn their backs on the stock markets. That has woeful implications for what should be a fundamental financing mechanism, especially in view of the crippled banking system," says one observer.
The great hope is that by discussing pricing with fund managers, valuations will become more market oriented, forcing poor companies out and allowing good companies in. It could also lessen the CSRC's role as an IPO gatekeeper and increase the power of the market.
Many think this should be welcomed. Despite ceaseless tampering with its selection procedures, the CSRC is never far from a storm of criticism, including allegations that the members of the council who select IPO candidates have been 'nobbled'.
