After a slow start to the year, the stream of Chinese companies seeking to go public through the sale of American depositary receipts (ADRs) in the US started to gather pace in the third quarter. And if the issuance keeps up, 2010 could end up being a record year in terms of the number of such IPOs. In mid-October, we brought together a group of specialists and company representatives in Beijing for a discussion about the choices available to Chinese companies wishing to list abroad and some of the issues they need to take into consideration as they start the IPO process.
Kenneth Tse, Asia-Pacific head of depositary receipts group, J.P. Morgan
Yang Diao, co-head of China corporate finance, J.P. Morgan
Wei Zhou, CFO, Charm Communications
Longgen Zhang, CFO, Jinko Solar
Robert Pu, CFO, China Nuokang Bio-Pharmaceutical
Frank Li, CFO, Standard Water
John Zhu, venture capitalist, SIG Asia Investment
Ed Job, account manager, CCG Investor Relations
Shuang Zhao, partner, Shearman & Sterling, HK
Alan Seem, partner, Shearman & Sterling, Beijing
What were the key issues you took into consideration when deciding to go the ADR route?
Wei Zhou: We are an advertising agency that primarily helps our customers to make ads and then place them on a broad spectrum of media, including TV and the internet. In the US there are other companies with business models that are similar to ours, so it is much easier for US investors than for traditional Asian investors to understand our business. The media companies listed in Hong Kong are more simple resellers. Another key reason is that we have always followed a global standard so an international listing is quite important.
Longgen Zhang: First of all, valuation. Today, domestic P/Es [in China] are higher, but whether that can last for the long term is a question. Second, if you are listing in China, the timing is not certain. You have to go through the procedures, but you also have to consider relationship issues. In Hong Kong and the US, if you follow certain procedures, you can control the timing. But most importantly, if the company’s corporate governance and business model are sound, going to the US is definitely best, because the NYSE and Nasdaq have a lot of high-quality investors that will have a positive impact on valuation.
Robert Pu: Liquidity was one of our top considerations when we considered in which market to list. We need to continuously raise capital to finance our internal R&D and in-licensing programmes in the future. Particularly, we need capital denominated in US dollars to licence drugs from the US and Europe so we can bring them into the Chinese market. It is relatively easier to raise secondary equity in the capital market in the US.
Yang Diao: In today’s environment you have a lot of consumer concept stocks getting a positive response in the US, and one of the primary reasons these issuers want to list in the US is branding. They think listing an SEC-registered company on a prestigious exchange like the NYSE or Nasdaq gives them a lot of benefits when marketing their story at home that can help them expand their consumer base.
Frank Li: While we are not a public company yet, there is a very practical reason for us to choose a certain market – the accounting principle. In our industry, US GAAP [generally accepted accounting principles] and IFRS [international financial reporting standards] are different with regard to revenue recognition which is why Chinese waste water treatment and water supply companies that have already gone public are all listed in either Hong Kong or Singapore – none of them in the US.
Longgen mentioned corporate governance, which in the US is often associated with high costs. What’s your view on this in the context of Chinese companies?
Shuang Zhao: Corporate governance and proper compliance is expensive, but I think it is very well worth it. You don’t want to fix your corporate governance when you have a class action against you, because that is really expensive. So, fixing it from the very beginning is really the right thing to do. Before going public many companies have the chairman’s relatives or someone close to the company running the books, but because of Sarbanes-Oxley they realise that they have to streamline their accounting reporting process and hire a professional CFO and other professionals in the finance department. So, Sarbanes-Oxley is a way to modernise a Chinese company. I think that aspect is really important.
Diao: US investors look at corporate governance and internal controls as a key indicator for a company’s financial strength and the robustness of its reporting system. They don’t want to see an issuer with a large number of accounting issues post-IPO or face a risk of [earnings] restatement. If you as an issuer can demonstrate really strong controls, that will give the market additional confidence that can actually help the stock performance.
When Chinese ADRs first hit New York, investors were scrambling to get a share, but today simply being a China-based company is no longer a guarantee for success. How can a Chinese company ensure it attracts the attention of US investors?
Ed Job: Over the past 20 years, the Chinese economy has been growing at double-digit rates and it is still expected to grow reasonably well in the next five to 10 years. So there is a lot of interest. But, because of some recent disappointments, and the fact that the US economy is not doing so well, investors have become more selective. There is also more to choose from, both IPOs and reverse mergers. What I see is a slight shift from growth to quality and sustainability. If investors just focus on growth, they risk investing in the wrong businesses, because despite the fact that the economy is growing, the competitive environment in China is very intensive. I think in order to address increased competition for capital, Chinese companies have to have a very strong investor relations programme to show investors how they are different, how their difference translates into a sustainable competitive advantage and that they have adequate governance and a strong management team that can navigate the competitive environment successfully.
Diao: We have done some analysis and as of the first quarter this year, about 60% of US IPOs by Chinese issuers in the past two years were trading below the IPO price. As we have gone through the financial crisis, the market has been very demanding and most companies needed a significant IPO discount. But if you look at US IPOs by Chinese issuers year-to-date, the average performance from pricing until now [early October] is 40% above the IPO price. So we think a lot of this is market sentiment-driven. But it is also a function of when you take your company public – it has to be ready.
How effective are ADRs as a listing vehicle for Chinese companies and what alternatives are there if a company wants to list in the US?
Kenneth Tse: Once you have decided to go to the US market, you can consider the ADR route, a reverse merger [also referred to as a reverse takeover], or a listing in the form of ordinary shares. ADRs have been in the market for more than 80 years and it is a proven route both from a legal and procedural perspective. They trade in the US market in a very similar fashion to US stocks, so US investors don’t need to have a different account or find a different broker in order to trade ADRs. Someone will argue that a reverse merger is a viable way as well. I fully agree. It is a matter of whether you create a new entity and bring it to the market through an IPO, or whether you inject assets into an existing listed entity in the US and then bring it to US investors through a private placement or offering. The cost of a reverse merger is definitely lower, that’s why it has become a popular route especially with smaller companies. And it is faster. But you are also inheriting a group of investors, which may not be the investors you want, and the entity itself may have other hidden liabilities that you are also inheriting.
Job: Because a reverse merger tends to be low cost, it has attracted a lot of companies that are not ready to go public and this has created a lot of bad press and a lot of problems for the Chinese segment as a whole. With media attention focusing on governance issues and the quality of some of these names, I think there is going to be a shakeup; some of these companies will be taken private, or will just wither away, and the ones that have proven to have adequate corporate governance, a quality management team and good business models, are going to trade at much higher valuations than currently.
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Zhao: I have recently encountered many companies that after a reverse takeover are basically shopping for compliance counsel. One thing you have to realise is that many of the shell companies that you inject assets into are incorporated inside the US, they are domestic US companies for compliance purposes and are subject to the more stringent reporting requirement for domestic companies. The compliance costs for US companies are significantly higher than for foreign private issuers.
Alan Seem: Some companies look at reverse takeovers as a quick route to get listed. They merge into a shell company that is already a listed reporting company and they think their goal has been achieved. But the IPO process itself, which for a typical US IPO takes five to eight months, is very helpful to get ready for being a listed company – to start thinking about internal controls and corporate governance, to get independent directors in place, all those things. If you do a reverse takeover, it’s like hitting a light switch, you go from one day being unlisted to all of a sudden being subject to all these reporting requirements. A lot of management teams get thrown into that when they are not really prepared and find themselves unable to get their accounts done in time, for example.
Is there anything developing on the US regulatory front that Chinese issuers need to take into consideration?
Seem: Clearly there has been a huge piece of legislation recently – the Dodd-Frank, Wall Street Reform and Consumer Protection Act. It should help reform the industry and make it more transparent in terms of credit ratings and complex derivative instruments that some companies use, but I don’t think it really contains any particular things that will have an immediate impact on Chinese issuers in the US.
Zhao: One piece of SEC regulation that could potentially have an impact on foreign private issuers, especially companies in China, is the gradual adoption of IFRS instead of using US GAAP. Many issuers are concerned about whether US investors are familiar with this accounting standard and whether it will have an impact on valuation, but there will be a gradual convergence towards IFRS that will have an impact on their selection of CFOs and the IPO timetable, among other matters.
Seem: That is a very good point. IFRS is a big development and we are actually working on several IPOs that are planning to go out with IFRS accounts. I’ve been talking to some bankers about this who have said that many US investors don’t actually understand IFRS. How to overcome that is something people are looking at right now. You used to see a lot of IPOs where there’d be a standard reconciliation between US GAAP and PRC GAAP and maybe that is something companies will need to look at again for IFRS – to be able to tell investors that 'we are using IFRS, and these are the differences if we were to use US GAAP’. One of the key reasons why issuers are reluctant to use IFRS is that they don’t want to be one of the first ones and have to answer those questions on the roadshow. But we are seeing the first wave of companies trying to do this and maybe that will set a precedent.
Zhang: There are a lot of differences on revenue recognition. In real estate for example, under US GAAP you can recognise revenue as a percentage of completion, but under IFRS you cannot recognise revenue until you deliver the key to the customer. Another area is derivatives. Under US GAAP there are a lot of regulations, which affect issues like profit guarantees and share transfers between the original founders of Chinese companies and private equity investors. If you have two systems, people will always take advantage and use the one most favourable to them. That will add a lot of problems for investors, and also for analysts. If IFRS is better than US GAAP then maybe US GAAP should be phased out. You have to have one dominant system.
Diao: From our limited experience we have not seen any visible valuation differences between issuers using US GAAP and IFRS, but you probably have to consider where your comparables are traded and how they report their earnings. If they are predominantly US GAAP reporters then you probably would be taking a significant risk using IFRS, especially if there are differences on revenue recognition and other accounting issues.
Frank, you said earlier that waste water treatment companies are primarily listed in Hong Kong or Singapore and using IFRS. Would you consider changing your accounting system if you were to list in the US?
Li: We cannot. We are pretty much operating under the BOT [buy-operate-transfer] model. Under US GAAP, more than 90% of our revenues for the past few years would not be recognised. We are on the opposite side of the real estate business, as under IFRS we can book revenues using a percentage of completion, while under US GAAP, we wouldn’t be able to do that until the whole construction is completed. We have a lot of construction projects going on, but we don’t have revenue. At the same time we have invested a huge amount of money in this business, so it [revenue recognition under US GAAP] would be killing us.
Many Chinese companies get investments from venture capital or private equity firms before going public. How did these early investors play into your decision of where and when to list?
Pu: Generally speaking, in the private equity investment agreement, there is often the standard three-year redemption clause with interest on the principal, as financial investors always look for exit strategies, be it IPOs or trade sales. So this is the catalyst for the company to do an IPO. I also want to talk about where financial investors add value to the company. They certainly prepared us for being a listed company in the US, implementing month-end reporting packages, quarterly board packages, board meetings with resolutions and minutes. It is a lot of work initially, but after we listed, the whole team was already familiar with these activities. They also helped the company recruit key positions such as independent directors.
Do you feel they drove your decision to go the US?
Pu: Sequoia Capital and HBM BioVentures invested in us two years before the IPO through their US dollar funds, so certainly we needed to go somewhere other than China. And we certainly leveraged the Sequoia Capital and HBM name when we spoke with US and European funds. I don’t want to use the word ‘drive’, but that definitely helped us make our decision to list on Nasdaq.
John Zhu: One thing that distinguishes Susquehanna International Group from other private equity firms is that we are an Evergreen fund, which means we can wait and hold. We have invested in more than 40 companies in China since 2004 and have completed many IPOs, including four IPOs this year and a few more coming by the end of this year or early next year. By leveraging our expertise, we do advise a company where to be listed, with full respect of the company. Ultimately, what’s best for the company is best for us. If the capital markets aren’t good, a trade sale will allow you to get the cash immediately. But being an Evergreen fund, if the company is experiencing a temporary problem, we really prefer to help it get through the difficult times. We have demonstrated our commitment to our portfolio companies in quite a few examples.
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There have been instances over the past few years where companies have had trouble meeting the criteria agreed with their pre-IPO investors on the timing, valuation and size of an IPO. Are these agreements too restrictive?
Seem: Obviously, when the agreements get signed everybody is very optimistic, but conditions can change and then people start butting-up against the time limits or other restrictions in the agreement. A lot of the time, this will result in a renegotiation with the investors, but once you have a signed contract, obviously the investors are in a much stronger negotiating position because they have contractual rights. Investors typically want to get as much control as they can during the period before the IPO and it is very important that the management looks closely at the veto provisions and other restrictions on the company’s operations so that they don’t prevent management from doing what it thinks is necessary to grow the company and achieve its objectives. Even if the investor has all the best intentions, having to go back to the investor for approval every time you want to do something can be disruptive and have timing implications.
Zhao: I think it goes back to the value of having a qualified and experienced CFO when companies negotiate the pre-IPO terms. Investors are putting money in at a very high-risk stage and understandably they want protection. But a lot of companies, when they agree to those terms, don’t really understand that the financial results will be measured using US GAAP or IFRS and neglect to take into account certain expense items. Having a CFO come on board early will help companies to access their financial results more accurately.
Diao: It also gives a lot of credibility to the company if the CFO has joined at least one or two quarters before the IPO. It gives investors a lot of confidence.
Li: In reality though, especially in the China market, most CFOs are brought in by the PE investor, not vice versa. That’s the sad reality in China. At both the pre-IPO companies I have been working for, I was introduced by the PE investor, so when I came on board, whatever was there was already there. I was not able to change much of it.
Zhu: Overall, I think the interest of the investor is aligned with the company’s, but in some cases when their goals may be a little bit different, in particular in the case of the ratchet [performance-linked valuation adjustments]. A ratchet can be a double edged sword. On the surface, it seems that the ratchet protects the investor, but the troubles it brings may outweigh the benefits. If the company reaches its goal, then everybody is happy. If the goal is missed, we will get more shares from the ratchet. But so what? If the company is going south, what’s the point of getting more shares? This brings up a broader question of how to design a mechanism to make sure that the interest of the pre-IPO investor is aligned with the company.
Any key lessons from going public? If you had to do it again, what would you change?
Zhang: The first and most important task for the CFO of a Chinese company is transferring the private company into a public company. You have to use the IPO just as a first step. First of all, you have to follow good corporate governance. Second, and most important, as the CFO you have to restructure your departments as a US public company. You have to find a senior manager from a big four firm who can help you with US GAAP reporting. That person has to be strong and help compensate for the fact that the financial controller is often very close to the founders. He may even be the old CFO.
Seem: Another big challenge is at the board level. These days, private companies are typically set up by a founder or maybe a small group of people and it is really their baby. The board is usually very small and a founder can do pretty much anything he wants because all the board members are his family and friends and the management reports to him. When you become a public company in the US, the majority of your board has to consist of independent directors. A lot of times, those are not going to be people the founders are that familiar with – they may be recommendations from the PE fund, or the investment bankers. The founders find it very difficult to get their heads around the fact that these guys – who were just brought in – wield a lot of control over the company now, and if you want to take any major action you need to get their approval.
Pu: The market this year is better. I would have probably delayed our IPO until this year if I had known before hand [Nuokang listed in December 2009]. As a bio-pharma company we have several products in our portfolio and several candidates in the pipeline, so by delaying the IPO until this year, we would have had better visibility on several pipeline products, and with better visibility I think investors would have given us a better valuation and better post-IPO support. I would also be more conservative when talking to the sell-side analysts about our financial forecasts.
Zhou: It is important who you allocate your shares to. When the banks give you the final order book, a lot of the time, they allocate it based on their preference, to their key accounts. That may not be in favour of the company. As a CFO, you want to make sure you know what the real demand is, who your shareholders are and who is going to sell it on IPO day? Did I really meet that fund and why are they coming in? These are the kind of questions you need to ask the banks. As a CFO you are almost the last line of defence for the company at that point.
Job: As you look past the IPO you have to understand how you are going to build your IR infrastructure and what kind of metrics you are going to provide to guide your performance. You need to have a disclosure policy in place and a clear framework for how you are going to disseminate material information to investors. You want to be sure that on the first day after the IPO your employees know your status as a public company and how that restricts your communications with investors. You have to appoint key spokespeople who are going to speak on behalf of the company and make sure they understand the regulations.
Finally, Kenneth, what can we expect with regard to ADR issuance for next year? Will China continue to dominate or could we see increased interest from other countries going forward?
Tse: If I count correctly, we have seen 18 Chinese ADR IPOs already this year [as of early October] and there is still a long queue in the SEC registration process so I think we will end the year with quite a large number. Although, I’m not sure if we can beat the record from 2007 when we had 27 ADR IPOs from China. But momentum is quite strong and that will probably carry the market through Q4 and into Q1 as well. For the average money managers in the US, the percentage of exposure to developing markets is still small and if we believe that China will eventually become the largest economy in the world, their allocation to Chinese equities can only go in one direction.
Outside China, there are a couple of markets to watch as well. One is India. The Indian rupee, like the renminbi, is under pressure to appreciate because of the capital inflow into the market and the country is growing at close to double-digits. Just two months ago, we saw the first Indian ADR listing in the US in four years and I know there are a number of Indian companies working with us on ADR IPOs over the next six to nine months. Another market to watch is probably Taiwan. As long as IT expenditure remains a sizeable component of the economy, I think we will see DR issuance from the Taiwan market.
This roundtable was first published in the November 2010 issue of FinanceAsia magazine.
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