A Sino DR boom?

Specialists in the depositary business are predicting a boom in DR issuance thanks to China.

Not excited by ADRs from China? It's not surprising. Regional investors are accustomed by now to the routine issuance of American depositary receipts (ADRs) by Chinese companies. The process is a familiar one: a Chinese company carries out its main listing in Hong Kong, but a portion of the issuance is earmarked for the US market.

But take one scenario that is being bandied about by DR specialists and you could soon be looking at a flood of issuance with a far greater significance than you have seen so far.

The driver in this process could well be China. Despite listing some solid companies in Hong Kong, the country's stock markets are looking into the abyss. With the government desperate to dump its enormous shareholding overhang in domestically-listed SOEs, stock investors have fled the market. That's a logical reaction.

That's where ADRs or GDRs (Global Depositary Receipts listed in London) come in. In order to restrict the number of shares pouring into the domestic market, depositary receipts (DRs) could be issued abroad based on the underlying shares.

Although ADRs are rarely mentioned in the Chinese media, their role in regional privatizations has already been prominent.

"ADRs have been used in a number of Asian countries, and especially in Greater China, as a major component of the privatization process," says Chris Kearns, vice president of the Hong Kong office of Bank of New York, a specialist DR Bank with a 64% market share world wide, and a 70% share in Asia.

Indeed, one of the largest ADR programs coming out of Asia was based on the $1.5 billion 2003 privatization of Chunghwa Telecom, for which ADRs were actually the principal instrument, points out Kearns.

Adds David Russell, head of the Citigroup DR business in Asia, increasing the investor base for huge issuances is one of the main attractions of the share class:

"The price of shares is obviously determined in some measure by the amount of supply. Indeed, that's exactly why we recommend DR issuance to our clients in the first place. By expanding the range of potential investors you are expanding demand which ought to result in a positive impact on the share price for the right company," he comments.

As Russell indicates, the key is finding the right company. Many sceptics would argue that most A share companies are poor and that finding a good company off which to issue DRs would be tricky.

In fact, DRs might in themselves help to improve Chinese companies. Even if China's best companies were to get a hammering in the US in the initial stages, they would be exposed to the rigours of mergers and acquisitions, ultimately leading to improvement in their performance.

That's already happening. Like children at a kindergarten, overseas-listed Chinese companies, often staffed by technically-skilled, overseas-educated Chinese, are beginning to compete. Keen to use the techniques of their US peers, corporate leaders such as those at Shanda Interactive Entertainment, are already carrying out raids. Remember the games company announced earlier this year that it has quietly built up a 19.5% interest in one of China's major ISPs, Sina. That led the latter to mount the first ever 'poison pill' defence by a Chinese company.

Many of China's companies would be natural candidates for DR issuance since they operate in the manufacturing and commodities sector - precisely those areas which respond to global economic trends and for which global comparisons are readily available, notes Russell.

Another feature of the DRs is that it would sidestep the issue of opening up China's domestic markets to foreign money. As the examples of Southeast Asian countries shows, money can withdraw as fast as it comes in. Under the DR scenario, the Chinese government could benefit from foreign money without the downside of such instability. Nor would DRs require any change to China's politically-sensitive unofficial currency peg to the US dollar.

Nor are ADRs incrementally expensive, notes Bank of New York's Kearns.

"You don't pay anything extra for ADRs, you pay what you would pay for a normal IPO, around 7% in the case of a Nasdaq listing," he says.

The possibility that DRs could solve one of China's most pressing financial problems simply demonstrates the effectiveness and versatility of this instrument, argue its supporters.

They point out DRs can be useful even in less spectacular transactions, for example when they feature in the Hong Kong IPO of a mainland red chip or H-share. Indeed, 2004 was a record year for Chinese companies issuing ADRs, says Kearns.

The advantages of issuing DRs are numerous: from the issuer's point of view, it can access a market which may not be as natural to the company as its home market. That market may be bigger and attract a different and possibly superior class of investors. In addition, the issuer can trade alongside his peers, facilitating analyst and media coverage.

From the investor's point of view, they can broaden their portfolio by buying into foreign stocks which trade in the same format (ie in terms of reporting and currency) as the domestic components of their portfolio. For the US investor, buying DRs removes the problem of different timezones and dealing with foreign brokers with very different reporting standards.

The mechanics of issuance are equally uncomplicated. DRs are not new shares. They are issued in proportion to the number of shares issued in the issuer's home stock market, with the ratio determined in such a way that the pricing of the shares reassures US investors. (Nobody wants to be perceived as a penny stock.)

Leading DR issuers such as Citigroup, Bank of New York and JPMorgan become designated depositary banks for the issuer. Through their worldwide network they work with local custody banks. These local custody banks are the units which interface directly with local brokers to buy and sell the shares, off the back of which DRs are issued. These shares are then passed on by the local custody bank to the international depository bank.

An example of the versatility of a DR programme is the route that Chinese technology and internet companies have followed. They have incorporated themselves offshore, issued shares, and then issued DRs based on the underlying shares. Unusually, the underlying shares are not listed in a home market such as Hong Kong.

Kenneth Tse, head of depositary receipts at JPMorgan, points out that this technique enables the Chinese company to avoid the lower price to earnings multiple awarded to tech companies in Hong Kong and gain the higher values accorded tech companies in the US. It also provided tech companies with higher visibility and arguably a more expert investing public and analyst coverage.

That's clear enough. But why bother with the whole DR programme in the first place? Why not just list directly in the US to take advantage of the US's immense capital resources and technological expertise?

There are some good reasons for this also, says Tse. "By listing their shares as DRs, the issuers retain the right to later list their shares on the home market," he explains.

Indeed, despite the attraction of the US markets, the true capital markets home of Chinese companies is currently Hong Kong.

There is a clever bonus to this strategy, since by the time they come to list back in Hong Kong, their prices will be trading at the higher US levels, and this should logically follow through onto a Hong Kong listing.

According to Citigroup's Russell some companies do try to join the benefits of the US markets with their home markets by listing their ordinary shares separately in different markets. But he warns that this ends up being a much more complicated operation than issuing DRS.

"The advantage of DRs is not some big conceptual thing, it's really because the nitty gritty of back office issues becomes much more simple thanks to the role of the depositary bank," he notes.

There are examples of big players who have ignored the DR route for a dual listing.

Deutsche Bank, for example is listed in Frankfurt and in New York. But the shares are different and are listed in two separate share registries. They are kept within a similar price range through price arbitrage. But liquidity has to slosh over from one quite different market into another.

"In contrast, when DRs are issued, the DRs that trade on Nasdaq or the NYSE and the ordinary shares that trade in the home market will be entirely fungible via the depositary bank as the conduit that links the two markets," points out Tse.

Tse also believes that there is no overwhelming philosophical necessity to DRs - they just make life a lot easier.

"The depositary bank handles all the administrative tasks such as proxy voting, annual reports, dividend payments and so on, relating to the DRs in the US market. And the issuer can deal with his depositary bank in his own timezone, removing all the hassle of being listed in a foreign market," he concludes.

Given the usefulness of ADRs, it would seem they could act as the perfect bridge between Western financial engineering techniques and China's economic potential. All that's needed is a final dash of political courage. But that, as in any country, could be the ingredient most hard to find.