Why Hong Kong's IPO lock-up rule should go

The six-month lock-up that cornerstone investors face with IPOs hurts liquidity, deters proper screening, and distorts share prices, bankers and advisers increasingly argue.

Hong Kong’s stock market is well known around the world for its high levels of liquidity and free float of shares but the situation is worsening, at least among new listings.

The city is home to a large group of Chinese issuers from a wide variety of industries, some of which clearly have good equity stories and immense growth potential. 

Yet these shares seldom trade strongly immediately after they are listed. For a growing number of bankers and advisors, the blame for this lies with the city's regime for initial public offerings.

Much of the criticism stems from the recent unwelcome tendency by Chinese companies to lean on a select group of strategic investors before listing to ensure deals get done. That's because as a result of pre-placing a chunk of these IPOs with so-called cornerstone investors, these shares cannot be traded in the immediate aftermarket.

Unlike in Singapore, for example, Hong Kong's IPO rules require that shares placed with cornerstone investors be subject to a lock-up period of six months following the listing date. The issuer is also required to disclose details of the cornerstone investors, including their identities and backgrounds.

A high-quality list of cornerstone investors was once the best advertisement for an IPO and was regarded as a harbinger of a potential blow-out deal.

When AIA Group conducted its $17.8 billion Hong Kong IPO in 2010, syndicate bankers put together a list of five high-profile cornerstone investors that included the Kuwait Investment Authority, Malaysian pension fund KWAP, and local banking and insurance powerhouse Guoco Group.

The five cornerstone investors represented a mix of sovereign and pension funds, local institutions, and private capital as well as asset management investment. There was little doubt that the names were selected and screened by the issuer and the deal managers.

As a result the IPO was overwhelmingly subscribed and fully upsized, attracting orders that totaled as much as $130 billion -- one of the biggest order books ever accumulated by a Hong Kong IPO.

Times change

But those heady days are now over. Instead, cornerstone investment has turned into a growing performance drag for many investors in Hong Kong.

There are multiple reasons for this change.

Increased market volatility globally has made foreign investors more cautious about taking up IPO shares. On the other hand, capital is cheap and abundant in China -- perhaps too cheap and too abundant.

As a result, investment banks have started getting cornerstone investors from China to reduce the risk of an IPO transaction failing rather than as propaganda to entice smaller investors. And this has evolved into a scenario where banks no longer fully screen the list of potential cornerstone investors but rather entertain most, if not all, applicants willing to disclose their identity and accept the lock-up arrangement. 

So it is now not uncommon to find deals with a long list of Chinese-only cornerstone investors that include individuals or institutions that are barely known and companies that clearly have strong business ties with the issuer.

By doing this it would appear they are no longer trying to drum up support from the wider investment community.

Liquidity

To help overturn the situation, some bankers and advisors suggest abandoning the six-month lock-up requirement attached to cornerstone investors.

“I don’t think the lock-up rule is valid in the current market because it hampers trading and liquidity and leads to price distortion for new listings,” one head of equity capital markets at a bulge-bracket bank in Hong Kong told FinanceAsia.

Making matters worse, cornerstone investors are these days getting a higher allocation of shares to help IPOs across the finish line.

According to Dealogic, the size of cornerstone tranches as a percentage of Hong Kong IPOs reached a record high of 46.4% in the second half of 2015, compared with 15.2% five years ago. 

In effect, that can mean there are fewer tradable shares in the secondary market than the 25% minimum free float required in Hong Kong.

CDB Leasing, which is scheduled to list its shares in Hong Kong later this month, broke a notorious record when it allocated the highest proportion seen to date of a Hong Kong IPO to cornerstone investors. 

The leasing unit of China Development Bank placed nearly 80% of the IPO shares to cornerstone investors, meaning just 5% of the company’s share capital is tradable for at least six months, although the company still complies with the 25% minimum free float requirement because cornerstone investors are also regarded as public investors.

“It is hard to imagine that a billion-dollar IPO trades only tens of thousands of shares in the secondary market,” the banker said, referring to the March listing of China Zheshang Bank, which sold 57% of the IPO to cornerstone investors. “This just won’t happen in any mature market like the US.”

Stable or distorted?

Dropping the lock-up constraint on cornerstone investors would enable IPOs to return to a market-driven pricing-mechanism instead of controlled pricing.

“Cornerstone investors can impact an IPO’s pricing and valuation a lot because they are the big buyers,” said an equity capital markets banker at a Chinese bank in Hong Kong. “They determine the valuation way before the deal hits the market because they engage with the management several months ahead.”

Typically, large investors will tend to squeeze every margin in pricing, leading to little room for shares to rise in the aftermarket.

“This is not to say [that] an IPO without lock-up arrangement must perform better,” the banker at the Chinese bank said. “But it allows competitive bidding and will eventually lead to a final price that is deemed fair to most market participants, instead of one manually set by a small group of [cornerstone] investors,” he said.

Bankers said a lot of international funds are still interested in investing in Hong Kong IPOs as cornerstone investors, but many have been put off by the lock-up requirement.

“If the lock-up requirement is not in place, the issuer can have the luxury to select from a wider group of investors and thus have more bargaining power over pricing,” the first banker said.

Counter arguments mainly circle around the fact that abandoning the lock-up rule could make IPO shares more volatile in early trading and add to the work of the stabilisation agents.

But as the second banker put it, the stability of the market should never override the need for a free and liquid market with a reasonable float of shares.  

“Hong Kong’s IPO market will be very stable if it turns into an arena for club deals,” he said. “But is this what public investors want to see?” 

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