China’s equivalent of the Nasdaq stock exchange is failing to attract some of the country’s most innovative companies. ChiNext was supposed to anchor local high-tech businesses on home soil with a secure source of funding, but foreign investors have proven to be stuck in their ways.
It has been evident that foreign venture capital investors prefer to take their firms public on US exchanges. Chinese internet and technology giants such as Renren (the Facebook of China), Jinko Solar (a major solar product manufacturer), and iSoftStone (a leading IT services provider) are among those that blanked ChiNext and went for an initial public offering (IPO) in the US.
ChiNext was launched with high hopes as a Nasdaq-style board of the Shenzhen Stock Exchange in late 2009. Since then it has been an active market for IPOs, attracting more than 350 Chinese firms. However, it is clear which companies ChiNext is failing to attract. And the impact is clear too: Chinese tech firms which listed on ChiNext in the two and a half years after launch had average total assets of less than USD$50 million. That compares to Chinese tech firms listing in New York during the same period which had average assets of about USD$140 million.
Our recent study shows that only a tiny proportion of the firms that went public on ChiNext had foreign venture capital backing. By contrast, the vast majority of Chinese technology firms that went public in the US since the launch of ChiNext were backed by foreign venture capital firms.
So why is it then that ChiNext and Chinese stock exchanges in general are not attractive venues of exit for foreign firms?
Red tape, red lines
At any time, there is a long queue of firms waiting to go public in China. When the China Securities Regulatory Commission (the main regulator of securities exchanges in China) published the full list of IPO applicants for the first time in early 2012, the list contained more than 500 firms, around 200 of which were waiting for the CSRC’s approval to go public on ChiNext.
The approval system is heavily regulated and is not free from political bias. There is anecdotal evidence that firms backed by domestic venture capitalists are favoured over those backed by their foreign counterparts. One study notes that foreign-backed firms, as a result, may have no choice other than finding strategic buyers or conducting “a listing on a foreign exchange such as the Nasdaq”. Another study mentions that if the government is worried about foreign dominance in the venture capital industry it will continue to act in a way that is “supportive of local venture capital vis-a-vis foreign firms”.
For a long time, entrepreneurial Chinese firms struggled to go public in China due to strict listing requirements imposed by the main boards of Shanghai and Shenzhen Stock Exchanges. This has hindered the development of the venture capital industry as well, since firms who make initial investments struggle to sell out through a public listing in China. The launch of the Small and Medium Enterprise Board of Shenzhen Stock Exchange in 2004 was a step in the right direction, but the board did not fully meet the needs of the venture capital industry.
When ChiNext was launched in late 2009, it offered less stringent listing requirements and promised more as a venue for venture capital firms to cash out their investments. However, there is one crucial listing requirement at ChiNext which helps to dissuade foreign investors: it requires firms to be profitable before they apply for a listing. In the US, this is not the case for many technology firms, and it is understandable that foreign venture capitalists head for the US rather than waiting for their companies to move into the black.
It is a fairly basic part of venture capital strategy that they want to sell their stakes in a liquid market to make sure they get the full value of those shares. And it has been an equally established fact that US exchanges offer better liquidity than their relatively youthful Chinese peers. It is also fair to say that Chinese exchanges, and especially ChiNext as a new market, are subject to high levels of speculation from traders, leading to unnerving volatility in prices for foreign investors.
Both regulators and exchanges in China are aware that Chinese retail investors are relatively inexperienced in trading and they can easily fall for speculation and exhibit herding behaviour. Many of such investors buy up shares during an IPO, not to become long-term investors, but to earn a quick profit when the shares start trading.
Of course, there are reform efforts ongoing to improve the application process and increase transparency. It is also fair to say that as Chinese stock markets become more mature and liquid, foreign investors will have more confidence in taking their firms public in China. Easing the listing requirement on profitability would be a crucial step.
The fact remains though, that some of the country’s most prestigious high-tech firms prefer to go public outside China, and that is unsettling for the local high-tech industry. Even though these firms begin their life cycles as start ups in China, once they receive foreign capital, the chances are that they will end up going public in the US at which time they will bid farewell to Chinese capital markets. The risk is that this route becomes habit-forming, making it harder for Chinese investors to invest in successful Chinese companies, and harder still to foster a genuinely Chinese high-tech industry with firms born, grown – and listed – in China.