Wall Street Blunts the “Delisting” Hype

The “delisting” narrative of Chinese companies from the US has largely not materialized. Instead, just about every other week there’s news of a new Chinese company about to IPO in New York. The next one, Lufax, may even end up being the largest fintech IPO in US history, with its high-end fundraising target at $2.36 billion.

So far in 2020, US IPOs by Chinese companies (“Chinese” here is defined as the company’s corporate headquarters being located in China as stated in its S1 or F1 filing) have raised $9.1 billion -- the most since 2014. Of course, 2014 was an anomaly with Alibaba’s IPO raising a then-record $21.8 billion.

Under all this geopolitical tension and somewhat concrete legislative action in the Holding Foreign Companies Accountable Act (HFCAA), why are Chinese companies IPOing in the US undeterred?

I believe Wall Street and the IPO business model has something to do with it.

A Chart: 2020 US IPO of China-based Companies

Before diving into the IPO business model (and its recent competitions), I first want to show you this chart I plotted. It shows all the US IPOs by Chinese companies thus far this year (not including Lufax), and the percentage change of each company’s IPO price and its opening day’s first trade price. Many of these are fast-growing, but unprofitable tech companies.

As you can see, some companies had the proverbial “first day pop”, like API (Agora) and BEKE (KE Holdings), while others’ shares started falling immediately after trading began. The median “first day pop” is 9% and the mean is 18%. Most of the companies that enjoyed a decent “pop” also raised much larger rounds than the ones that didn’t -- XPEV raised more than $1 billion and BEKE raised more than $2 billion.

The IPO Business Model

I plotted this chart, because it illustrates a key part of the IPO business model for the Wall Street bankers who facilitate them. Explained simply, an IPO is a size+volume-driven and relationship-driven business.

The size+volume part is straightforward -- bankers typically take a 7% commission based on the size of the IPO or amount raised, so the more money an IPO raises the better. Only in rare cases where the IPO company is super hot, like Facebook, does that commission decrease. And the more IPO deals that happen, aka volume, the more money bankers get to make.

The relationship part gets at the “first day pop”. Because the bankers sort of represent both sides of the table -- helping the soon-to-be public company sell shares at a good price and helping the investors looking to buy shares of new public companies at a good price -- their job is to make both sides “happy”. Bankers can make sure the company is happy by engineering a “first day pop” that produces positive headlines and a big internal morale boost, while still raising the amount of money the company wants. And bankers can make sure their investors (also clients) are happy by manually allocating these IPO shares to them -- shares that are not available to others -- so when the “first day pop” occurs, these investors can sell it for a quick, handsome profit should they choose to. In addition, there’s also the so-called “greenshoe option”, where the underwriting bankers get an additional 15% of IPO shares to sell within 30 days after the IPO day. Being able to deliver this “access” to clients makes the bankers look good and solidifies client relationships with rich investors, who would want to work with the same bankers for the next IPO. It’s a repeat-player business.

I’m glossing over many intricacies of the IPO process, but simply put, bankers want to deliver the biggest IPO possible with a “first day pop” and do as many of these transactions as possible. Doesn’t work every time, but they sure do try.

While it’s generally been a good IPO year, what makes Chinese companies especially attractive customers for New York bankers is that the alternatives to a traditional IPO -- Direct Listing and SPAC -- are not viable options for Chinese companies.

Off Limit: Direct Listing, SPAC

Even from my simple description of the IPO business model above, it’s not hard to see that the process is problematic, specifically in its “dual-agency” set up where the bankers are representing the interests of both sides of the table. Influential venture capitalists, like Bill Gurley, have been criticizing this issue for many years. Thus, both Direct Listing and SPAC (Special Purpose Acquisition Company) are gaining prominence in the last two years as alternatives. SPAC’s popularity in particular has spiked this year.

To contrast these two alternatives with a traditional IPO in the plainest way possible: a Direct Listing lets a company’s shares trade publicly without raising any money (not yet allowed to), thus only providing liquidity and price discovery, while a SPAC raises money first, then uses that money to reverse-merge with a private company, thus taking that company public.

This blog post by the VC firm, a16z , also has a good shorthand of how to compare these three options:

“If you need money, an IPO, for all its flaws, makes the most sense and is probably the best option; if you don’t, a Direct Listing may be preferable; if you need money, speed, and certainty, a SPAC may be best.”

The ongoing discussions about the pros and cons of these two new options vis-a-vis an IPO inside both Wall Street and Silicon Valley are fascinating and fierce. But they are both off limit to Chinese companies seeking to go public in the US, because:

• Direct Listing is for companies who don’t need new capital and, to trade well, should have some public name recognition, e.g. Spotify being the first direct listing back in 2018. Few Chinese companies, especially fast-growing tech companies, are profitable enough to not need new capital or have big name recognition.
• The SPAC hype is mostly an American phenomenon, and there are plenty of private companies in the US to target. It will be a long time, if ever, before American SPACs look for foreign companies to take public.

There are other “going public” options, just not good ones. With its rule change in 2018, the Hong Kong stock exchange now allows unprofitable companies to list, as does the new NASDAQ-like Shanghai STAR market. Both are trying to compete with Wall Street for business. However, the price and valuation for unprofitable companies tend to be lower, while both the higher valuation and reputational capital garnered from “going public in America” cannot be replicated. SPAC-like mergers are also available in Hong Kong, but that’s usually relegated to poor quality companies with no other options, which is the long-time reputation of SPAC in America as well until last year.

Essentially, unprofitable but promising Chinese companies need Wall Street. And Wall Street needs their business too!

Unserious Regulators

With Ant Group’s snub of NYSE/NASDAQ to opt for a simultaneous dual listing in Hong Kong and Shanghai, Wall Street will be fighting extra hard for IPO business from China.

But what about all the pending legislation and harsh rhetorics against Chinese companies? Just like the whole ByteDance ordeal, I suspect they are more for show than serious efforts to regulate a legitimate inconsistency in our capital market.

When the HFCAA first passed the US Senate back in May (and by unanimous consent, meaning every senator agreed with it, so they didn’t bother calling a floor vote to record who said “yes” and who said “no”), there appeared to be a lot of momentum behind the bill to gain approval in the House of Representatives, then to Trump for his signature. I had thought then that, given how unanimously anti-China Washington has been, legislators would fast track the bill and claim a rare victory over China.

That of course didn’t happen. The last public statement made by anyone on this bill was in August by Senator Rubio, who introduced a similar bill called EQUITABLE Act in 2019. (EQUITABLE stands for “Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges”. Yes, the Congressional acronym game remains strong.)

To be clear, I’m generally in support of the core substance of HFCAA. As I wrote in “Why Huawei Should IPO in America” back in May, it makes sense for the SEC’s Public Company Accounting Oversight Board (PCAOB), the auditor of auditors, to enforce the same standards on Chinese companies as it does to all foreign companies listed in the US. Rules are rules, and they should be applied evenly across the board. I also don’t think such a change would force all Chinese companies to delist. There are ethical, ambitious entrepreneurs from China (and everywhere) who would welcome that scrutiny, because their mission is to build a global, world-changing business and would crave the trustworthiness that comes with a higher regulatory standard. And the ones who do have problematic financial practices and shady connections will delist. It’s a self-selecting process.

Wall Street will lobby to deter or water down the HFCAA. Given its mutually-beneficial relationship with Chinese companies, that is to be expected. What is also expected, but hardly happens these days, is legislators and regulators putting their foot down and doing their job. Until that happens, Chinese companies of all shades of ethical standards will continue to list in New York, and bankers will happily continue to make money off of them.

Those “first day pops” will just keep on popping.

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