Cornerstones weigh down Hong Kong IPOs

Cornerstone investors are painted as the foundation of solid growth but their track record on Hong Kong IPOs suggests they weigh down stock prices.

Rising wealth in China has undoubtedly had a positive influence on capital markets but data shows that the way some of those riches are harnessed in cornerstone investments is damaging the aftermarket performance of listed companies in Hong Kong.

Issuers with significant Chinese cornerstone backing — large investors brought on board before the launch of an IPO — have performed poorly compared to those with cornerstone support from global institutions such as BlackRock or Fidelity. 

Market participants say this is due to a combination of factors, and primarily stems from the quality of the issuers looking to list with Chinese cornerstone support.

More and more Chinese companies are tapping into capital markets — it is easier for them to get bank loans once they are public, plus there is a level of prestige once they get listing status in Hong Kong. Many of these companies meet with large, international long-only institutional investors during the pre-marketing process, but are turned away. This is for a variety of reasons, including worries about Chinese corporate governance or due to small size. 

These issuers then approach mainland corporates and state-owned enterprises (SOEs) in a last-ditch attempt to lock them in as cornerstones and secure the funding necessary to push the deal across the finish line.

“A few years ago, if investors didn’t like a company, there would be no deal and everyone would go home,” a senior investment banker based in Hong Kong who has been involved in raising capital for Chinese companies for over a decade told FinanceAsia. “Now, rising Chinese wealth has meant alternative pockets of funding can be found, such as cornerstones, that carry the day.”

It may get the deal across the line but it is having repercussions on the markets. Dealogic data suggest issuers with heavy Chinese cornerstone support suffered low returns post-listing compared to issuers with global cornerstone support. And many expect the trend to continue. In the long run, this could impede Chinese companies raising capital and curb economic growth. 

“What’s happened recently is IPOs in Hong Kong get corporate, state-owned enterprises [SOEs] or individuals to come in and act as cornerstones, rather than genuine institutional investors,” Philippe Espinasse, a former ECM banker and author of “IPO Banks” and “IPO: A Global Guide”, told FinanceAsia. “That enables [the issuer] to get the deal covered. Unfortunately, these are not the people whose business it is to ordinarily buy and sell shares.”

Cornerstones, also referred to as friends and family, often invest in a company pre-IPO as a favour as opposed to simply hoping for capital gains. 

Since Chinese SOEs and corporates do not typically participate in stock markets, they rarely place orders post-listing. “The deal will get covered, but it also means there will in many cases be little institutional support in the first place, and your share price will tank. There often won’t be a lot of support for the share price in the aftermarket,” Espinasse said. “It’s the wrong way of getting deals done [and is] in part why the performance of these IPOs has been disappointing.”

For example, Qinhuangdao Port, the Chinese coal-focused ports operator, relied heavily on Chinese cornerstone support — all seven of its cornerstones were from the mainland — and has performed poorly since its $562 million December 2013 IPO. It dropped 6% in its market debut, fell a further 22% six months after and is down 23% from the time of its listing up to August 28. 

Contrastingly, AIA Group, the pan-Asian life insurance business of American International Group, had a diverse range of cornerstones from around the world in its $20.6 billion flotation in October 2010. It shot up 17% in its market debut, 33% six months down the line, and finished its first year of trading up 22%. 

Evidence suggests this is not a fluke. 

According to Dealogic data, in 2013, issuers that relied on Chinese cornerstone support fell 5% in the first six months after listing, a stark contrast from companies with global cornerstone backing, which returned an average of 16%.

Similarly, in 2012, companies with significant mainland backing declined 4% the first six months after listing, compared to groups with a global cornerstone tranche, which registered gains of 3%.

The spread widened when comparing one-year returns. The Dealogic data show that companies with mainland backing fell 25% in 2013 one year after listing, against 17% for those with backing from the international cornerstones.

“In many instances, [Chinese SOEs and corporates] probably come in as a favour. Basically, the cornerstone allocations go to the wrong people. They [the issuers] can’t get the Schroders or the Fidelity’s or whoever, and go to [mainland] cornerstones instead,” Espinasse said.

There were years when issuers with Chinese cornerstones outperformed their counterparts — in 2012, companies with mainland backing returned 13% one year after the listing compared to 4% for those with global cornerstones.

This year is a mixed bag. China Cinda Asset Management, which locked in $1.1 billion worth of cornerstone support ahead of its $2.46 billion listing in December, spiked 39% in the few days following its flotation, and is up 18% up to August 26.

China Everbright Bank meanwhile, another financial that secured significant mainland funding before its $3 billion December listing, fell 6% in the few days after its market debut, and is down 9% up to August 26.

Harbin Bank, which relied on Chinese friends and family for its $1.1 billion IPO in March, was flat on its debut and is only up 2% year-to-date up to August 26.

Confidence in mainland banks has been low largely due to concerns about Chinese banks’ bad debt levels, and has likely contributed to China Everbright and Harbin Bank’s returns. 

Still, more often than not, the data show that issuers with strong Chinese cornerstone backing have underwhelmed post-listing, and few say this is purely a coincidence.

The fact remains that Chinese cornerstones allow smaller, poorly managed companies to find new sources of funding that permit them to float their shares, which affects aftermarket performance for all listed companies.

Another senior ECM banker in Hong Kong, who has been involved in Asian IPOs for ten years, noted that in the past few years, a number of banks have focused on getting cornerstone investors to come into a deal and pay the top of the range, as opposed to starting off with an attractive valuation.

“[Some banks] focus on getting [cornerstones] to pay the absolute maximum price,” the second senior banker told FinanceAsia. “Often, cornerstones come in as a side arrangement with the [issuing] company. [But] it gets everyone invested and pulls in other [Chinese cornerstones], and destroys the price-discovery process.”

The second banker noted that, ideally, deals should start out with a decent valuation at the low end, and then build momentum during the bookbuilding process among institutional investors. This should lead to decent aftermarket performance and allow the company to tap capital markets for future fundraising efforts via placements. When Chinese cornerstones get involved, often global institutional investors avoid the deal fullstop. 

“A lot of them think the deal is pre-wrapped with a bunch of strangers paying a high multiple with side arrangements,” he said. “There is a misunderstanding and mis-selling of the benefits of cornerstones by weaker banks, which ruins [the price discovery and performance].” He added: “All of the best deals I’ve done have been without cornerstones.”

Rocky markets
Cornerstones are a crutch in volatile markets. Having financial support locked in for six months is the only way to get deals done amid tanking stock markets and low investor confidence.

“It’s there’s a high level of market volatility, it will obviously be beneficial for issuers to secure more cornerstone investors,” said Nick Johnson, head of equity capital markets, Asia-Pacific, at JP Morgan. “If it’s an awesome company in a constructive market, whether you have cornerstones or not may not be a major issue.”

Still, when markets are volatile, syndicates wind up rushing to get the books covered as quickly as possible, and if books are still not covered on the last day of the bookbuild, the shares will likely price at the bottom. “Then, more often than not, it will tank in the aftermarket,” Espinasse said.

Some say the cornerstone issue in Hong Kong could be solved by changing the lock-up requirements. Cornerstones in the city are locked up for six months after a company lists, whereas Singapore and Malaysia have no lock-up restrictions in place. 

“What should happen in Hong Kong is [the regulator should] change the rules to mirror the practice in Singapore and Malaysia and lift the lockup restriction. That would provide a strong incentive for quality institutions to come in,” Espinasse said. “Unfortunately, I don’t think that’s going to happen.”

The city’s regulators do not make changes overnight, and Espinasse points out that the exchange is quite conservative. “Getting things changed in Hong Kong is quite difficult,” he noted.

To be sure, market participants maintain that the poor performance is not solely a result of having Chinese cornerstone support. There are a number of factors to consider. Most agree the lousy performance stems from the fact these companies should never have listed in the first place, rather than the fact they had Chinese cornerstone funding.

“There are now a significant number of relatively smaller companies looking to go public but do not have the size or growth potential to attract really big institutional investors,” said Mark Chan, partner at law firm Berwin Leighton Paisner. “They rely on Chinese cornerstones. However, the Chinese cornerstones are not the key reason they’re not doing well.”

He argues there are other things impacting post-IPO performance, such as the inability to grow the business as planned, or lack of investor confidence. Meagre performance could also be a result of incorrect pricing or sector volatility.

“It could be because the marketing timing is off, the pricing is off or the sector is off. I suspect it’s [more likely] a transaction does not perform well for those reasons [as opposed to Chinese cornerstone support],” said a third senior ECM banker in Hong Kong. Still, he noted that generally speaking, “piling in friends and family is a sign of a weaker deal.”

The long-term impact is unclear. Hong Kong remains one of the most liquid markets in Asia outside of Japan, and there will always be demand for quality issuers with sensible valuations and transactions. “[What is clear] is that cornerstone rules hinder the bookrunners’ work when it comes to more challenging offerings or market conditions,” Espinasse said.

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