In Episode 40 of TechBuzz China, co-hosts Ying-Ying Lu and Rui Ma talk about the new “Technology Innovation Board” on the Shanghai Stock Exchange, which formally announced its first set of rules last week. Rui and Ying-Ying explain that given its recent trajectory, this registration-based NASDAQ-style board could be launched in a few months, if not weeks — much more quickly than skeptics have assumed. With this news as the backdrop, this week’s episode serves as a quick primer into the differences between China and the U.S.’s capital markets, as well as how these contrasts may explain some of the differences in Chinese tech entrepreneurship and capital versus those in the U.S.
Rui and Ying-Ying begin by walking through a brief history of Chinese domestic capital markets, which had a total market cap of $6 billion late last year and are still really young compared with those in the U.S.; in fact, both the Shenzhen Stock Exchange and the larger Shanghai Stock Exchange were founded in 1990. Notably, prior to last fall, foreigners were unable to invest in A-shares on either exchange. Even after loosening controls earlier this year and doubling the amount foreign investors can invest, China still enforces a total quota of $300 billion, shared globally.
Our co-hosts cover a range of core questions in this episode. Listen to find out: How does the fact that the Chinese exchanges are approval-based, and not registration-based, affect listings? What role does the China Securities Regulatory Commission, or CSRC, play? Why are there only 3,500 publicly listed companies in China? Why did the Shenzhen Stock Exchange create two additional avenues for listing, in the form of the SME Board and ChiNext? How does the National Equities Exchange and Quotations (NEEQ), or New Third Board, fit into all of this? Why is it that most of China’s best internet companies are listed abroad, and how does that fact play into the new Technology Innovation Board’s intentions and potential for impact? From the perspective of a company preparing to list, what are the pros and cons of listing in mainland China versus abroad?
As always, you can find these stories and more at pandaily.com. Do let us know what you think of the show by leaving us an iTunes review, liking our Facebook page, and tweeting at us at @techbuzzchina to win some swag! Thanks also to our listeners over at our partner, dealstreetasia.com.
Special thanks to our awesome producers, Shaw Wan and Kaiser Kuo. Our intern is Wang Menglu.
Our sponsor this week is the University of San Francisco. USF’s Masters in Applied Economics combines economics training with the practical skills in data analytics that you really need to understand today’s new digital economy. To learn more, listeners can visit usfca.edu/techbuzz.
(Y: Ying-Ying Lu; R: Rui Ma;)
[00:00] R: Today’s episode is on the new “Technology Innovation Board” to be set on the Shanghai Stock Exchange, which has been in the works since last November after a big announcement by none other than President Xi himself, but which just formally announced its first set of rules last week.
[00:20] Y: Experts were mostly skeptical that a new capital markets mechanism such as this registration-based NASDAQ-style board could be launched so quickly, but now the word is that it could be launched in a few months, if not weeks.
R: That’s very fast, and not without significant risk, because China actually already has experimented with letting high-tech companies list quickly, and with both the Shenzhen ChiNext exchange and the NEEQ, results have been a pretty mixed bag.
Y: No wonder then, that most of the reactions were along the lines of, oh, this is just a distraction designed to ease tensions that have resulted from the escalating trade war. But it’s looking more and more like this is a real thing that will happen sooner rather than later.
[01:10] R: And one company in particular has been in the news for supposedly being wooed by the government to list on this new Innovation Board, which we think would be a legitimately huge deal.
Y: The biggest, actually. The company we are talking about, of course, is Bytedance, the $75Bn AI unicorn, the most highly valued private tech startup in the world, that we’ve covered back in Episodes 28 and 9.
[01:38] R: All of the companies that we have covered so far on Techbuzz, the BATs, the newly IPO’ed Pinduoduo, NIO and Tencent Music, are either listed in the US, or like Meituan, is listed in Hong Kong. The mainland Chinese stock market, however, is a completely different beast.
Y: Today is intended to be a quick primer into just how different these capital markets are and we’ll also touch on how that could explain some of the differences in Chinese tech entrepreneurship and venture capital versus the US.
R: Alright, let’s get right to it!
[02:37] R: Hi everyone! We are TechBuzz China by Pandaily, powered by the Sinica Podcast Network!
Y: Big announcement everyone: beginning this episode, we are switching to a biweekly format, and will be releasing every other Friday. But our format and topics will remain the same. We are still the show focused on giving you a peek into what’s buzzing within the tech community in China.
[03:03] R: Yup, we remain committed to uncovering and contextualizing unique insights, perspectives and takeaways on headline tech news that don’t always make it into English language coverage. So you can be smarter about the world of China tech. TechBuzz China is a part of Pandaily.com, an English language site that tells you “everything about China’s innovation.” I’m one of your two co-hosts, Rui Ma.
Y: And I’m your other co-host, Ying-Ying Lu. We’d like to acknowledge our partners- DealStreetAsia, and SupChina, creator of the Sinica Podcast Network! In addition to TechBuzz, you can also find Sinica which covers current affairs, NuVoices on women, the business-oriented ChinaEconTalk, and the Caixin-Sinica Business Brief from China’s leading business magazine. Check them out!
R: As always, if you enjoyed listening to our podcast, please leave us a review on iTunes or whatever other platform you use. Thank you for all of you who emailed in and participated in our Hongbao challenge! We loved hearing from you and it’s always great to connect with our fans!
[04:12] Y: Oh, and one more thing before we start, we want to tell you about a brand new Master’s program nearby, at the University of San Francisco. USF’s Master’s in Applied Economics combines econ training with the practical skills in data analytics that you really need to understand today’s new digital economy. Their curriculum covers skills like R and Python, machine learning, and experimental design; and topics like the economics of platforms, auctions, pricing, and competitive business strategy. Another perk is that the program is STEM-designated, so for those of you non-U.S. Techbuzz listeners, that means you’d be able to keep working in the States for three years after you graduate! To learn more and to get a fee waiver for the Fall 2019 class, please go to usfca.edu/techbuzz.
[05:13] Y: Let’s define some terms first for those of you who are new to the Chinese domestic capital markets, which by the way, is completely normal, since it was pretty much impossible to invest as a foreigner until rules changed last fall.
R: Seems like a lot of things were changed last fall.
Y: Yup, trade war and all that. But basically, foreigners were previously unable to invest in A-shares, but now we can, although there are of course still restrictions, such as limits around repatriating money.
[05:44] R: And while there were always ways to invest as an institutional investor from abroad through the QFII scheme, it wasn’t a totally free-flowing market, and even after loosening controls earlier this year and doubling the amount foreign investors can invest, that’s still a quota of $300Bn that needs to be shared by everyone from all over the world.
Y: Not a lot for a stock market that is usually second- or third-largest in the world, with a total market cap of $6Tn late last year, just after Japan.
R: In China, there are two stock markets, the Shanghai Stock Exchange, and the Shenzhen Stock Exchange, both founded in 1990. Shanghai is the bigger market, which makes sense given that it’s the financial center of mainland China, while Shenzhen, from its early days as a special economic zone, has always been more experimental and thus more friendly for small and medium sized businesses.
[06:41] Y: There are 3 different types of shares that can be issued by Chinese companies, denoted by the letters A, B, and H. A is really the only one you need to know, which is the yuan-denominated security of the company listed within China. Pretty much everyone just refers to these as A-shares.
R: B stands for foreign-denominated security within China, which is obviously much smaller than the A-share market, and H-shares are for when Chinese companies list abroad, but basically just in Hong Kong. Many state-owned enterprises, for example, are listed in both mainland China and Hong Kong, and some are even also listed in China, Hong Kong, and the US all at once, such as PetroChina.
[07:29] Y: That sounds like so much work, but probably doable when you are 4th largest by revenue in the world.
But not an option for most privately-owned tech companies in China. And by privately-owned here, just to be clear, we don’t mean private in the sense that the security is unlisted, we just mean not state-owned.
R: OK, so while we don’t care about B or H shares, we don’t actually really care about A-shares either, at least not for the purposes of this episode. That’s because there are strict requirements to list as an A-share company, most of which don’t make sense for tech startups.
[08:07] Y: There’s a bunch of rules around net asset ratio, operating history, growth, and shareholder equity, but the one rule that pretty much prevents most unicorns we know of from listing is the one around profitability. For both exchanges, there are very specific cumulative or last few years’ net profit requirements for the company. That would pretty much eliminate almost all tech startups globally, I think.
R: Which is why, of course, Chinese tech companies often IPO abroad, because the US and Hong Kong markets have no such rules.
Y: But beyond that, it’s just difficult as heck to get listed, because the other key difference is that the Chinese exchanges are approval-based, not registration-based. I know we have lots of investor listeners so this is going to come across as super elementary for you guys, but bear with us while we explain to our non-investor audience what that means.
[09:04] R: We are over-simplifying a bit here, but basically, if you are trying to list in the US, you file with the SEC, or Securities and Exchange Commission, and they do a thorough review, and make sure you’re disclosing all the right things and you aren’t trying to defraud investors and all that, but once you pass this process, you can go on and sell securities, and it’s all just the free market at work, pretty much.
Y: In China, however, the equivalent regulatory body, the CSRC, or China Securities Regulatory Commission, does a lot more than that. You also have to file a bunch of forms with them if you want to IPO, but unlike in the US, where if you clear the process, you can list, meeting the requirements for listing in China doesn’t guarantee you an IPO.
[09:49] R: Far from it, because the CSRC actually curates the stock market offerings. This means that they can greenlight qualified companies from certain sectors or geographies or whatever characteristic and not approve other companies, who also meet the listing requirements, based on their interpretation of market conditions and just whatever else they think the Chinese stock market needs.
Y: Yeah, like for a bit they approved companies from Tibet and other developing regions on accelerated timelines because, well, they thought that would be good for the economy. They can also have periods where they just don’t approve any listings whatsoever, which has happened multiple times. There’s really nothing you can do when that happens, kind of like when if you guys remember gaming approvals just stopped happening in China last year. The government will do what it does, and it’s not always transparent.
[10:46] R: Even on “accelerated timelines” though, we are talking about close to a year to get approvals, if you are lucky enough to be in the category of company that the government is hoping to promote at the moment. Most companies have to wait two to three years to get listed, and approvals are by no means certain. For example, if your business deteriorates while you are waiting in line? Guess what, you can probably kiss your IPO goodbye.
Y: Which is why, if someone tells you that they own or control or represent a 上市公司, or publicly listed company in China, it’s supposed to mean that they have listed A-shares … it actually means something, because getting listed is no easy feat.
R: And that’s why even after almost 30 years in operations, there are only about 3500 publicly listed companies in China, roughly a third of them in Shanghai, which tends to have the larger companies, and two-thirds in Shenzhen, which is mostly smaller market cap companies. And these two main boards continue to be dominated by traditional industries such as real estate, finance, and industrials.
[11:55] Y: But obviously, this is not an efficient process, especially for tech companies who are high growth, capital hungry, and mostly unprofitable. And so the Shenzhen Stock Exchange created two additional avenues for listing in the form of the SME Board, and ChiNext.
R: SMEs are for small and medium enterprises, just like the name suggests, and ChiNext, or 创业板 was the exchange’s attempt to mimic NASDAQ and get more high-tech companies listed. The first companies began trading in late 2009, but even with significantly lower requirements, companies still need to demonstrate two years of profitability and accumulated profit of no less than $1.45mm.
[12:40] Y: Again, that doesn’t work for a lot of internet startups. So China updated the rules to its Over-the-Counter OTC system, named it the National Equities Exchange and Quotations, or NEEQ , although no one really calls it that, everyone calls it the New Third Board, or 新三板.
R: The New Third Board, which is owned by the Shanghai and Shenzhen exchanges and began operating in Beijing, expanding service nationally in 2012, is super light on requirements because it’s not technically a stock exchange. But it did have some rules around how long the business needed to have been operating — two years as a corporation — and required audited financials. Most notably though, it does not require profitability unlike all the other markets in China.
[13:36] Y: Well it opened to much hype in the beginning, with pretty much every startup I knew thinking that they could just fundraise from “the public” quickly without dealing with VCs. And indeed while many companies did do so, it’s mostly turned out to be a failure. Although there are almost 11,000 companies on the board as of late 2018, weekly turnover is only about $150mm and the total market cap is only about $500Bn. That means on average each company is just $45mm or so in value. Illiquid value, that is. That’s barely a Series B valuation.
R: Yeah, these companies are for the most part dinky and just not very good. Basically, there is no liquidity. And the requirements are actually somewhat high for individual investors to participate, ostensibly to protect them from these risky assets. So if you are working with a company that claims to be listed on this exchange, know that it basically carries no weight.
[14:48] Y: I mean, I think that if Pandaily were willing to eat the tens of thousands of dollars required to hire a securities firm and law office to list, as well as the annual costs of maintaining the listing, we could probably do so. Pandaily wouldn’t even be that small compared to the other companies. Only about 10% of 新三板 companies have profits of $5mm or more.
R: That’s not to say it’s all been bad. One of the main reasons for starting this exchange in the first place was to provide small companies a place to raise capital to fuel growth. In the first half of 2018, 160 NEEQ companies delisted. Most of the delistings were voluntary, save for a few cases of fraud, and most of these instances were because they were seeking to re-list on a larger board.
[15:41] Y: I think it’s pretty clear that both ChiNext and the New Third Board came nowhere close to becoming China’s NASDAQ, because the former was still too restrictive and the latter, being just an over-the-counter exchange, was way too lax. And that’s where we are today, with the Shanghai Stock Exchange’s Technology Innovation Board, or 科创板 being the latest attempt to create China’s NASDAQ.
R: And a lot of people are very excited. Now that you understand the difference between registration and approval based exchanges, this new one is supposed to be registration-based, so that IPO timing is much more in the control of the company, as it is in the US, versus in the hands of regulators.
Y: It’s also going to allow pre-profit companies, which is huge, but beyond that, it’s also supposed to allow for different weights for shares, like the dual-class structure that tech companies love to use, and it’s going to decrease lockup periods for key personnel from three years to one, although they still will only be able to sell a quarter of their holdings annually after the lockup period expires.
[16:50] R: Individual investors though, will be subject to verification that they have at least $75K in assets in their account and over two years of investment experience before being allowed to purchase securities on the board. The argument is that this still leaves 3 million eligible investors so there should still be enough liquidity, especially after you add in all the institutional investors. Basically investors responsible for 70% of the transaction volume in the A-share market should be able to participate here as well.
Y: Funds are hungry for new investment opportunities and over 20 submitted applications so far despite there being no exchange yet and no companies even announced for listing. Some people are concerned that this could lead to a bubble, which I think is going to be difficult to avoid because again, both ChiNext and New Third Board were super bubbly when they launched.
[17:46] R: I don’t know, I think investors should be prepared for a ton of volatility. This new Technology Innovation Board will also allow for 20% changes in prices before trading is halted, unlike the 10% that is typical for other Chinese exchanges.
Y: Still, it does seem like the rules are trying to be as tech-friendly as possible. It’s rumored that the government has already approached Bytedance and a few other large tech startups for listing on this Board.
R: No surprise there, because as noted, most of China’s best internet companies are listed abroad, where they are enriching foreign investors at a much greater scale than domestic ones. So that’s definitely on the government’s mind.
[18:30] Y: But while this board might be considered really new-fangled for China, most of its rules are really playing catch-up to the rest of the world. Even next door Hong Kong, after many years of resistance, is aggressively trying to woo more tech companies as well by allowing for pre-revenue biotech companies and dual-class share structures.
R: Don’t forget it also has a pretty fair lock-up period of six months, whereas China has controlling shareholders under a 3 year lockup and all other shareholders under a 1 year lockup period.
[19:02] Y: Yeah, exactly. So what’s this new board’s main advantage? What are the pros of listing in China?
R: Well, in one word, valuation. There is good reason to believe that Chinese companies will enjoy much richer valuations in China than abroad. For one, there’s just the simple fact that local investors will be much more familiar with a local business and probably more excited about it.
Y: Yeah, everyone in China uses Alibaba and Tencent services and probably daily but a very small percent of US investors will. That really affects retail investors more, but it’s not nothing.
R: Nope, not nothing. But more importantly is just the difference in valuation. While the Chinese stock market has mostly had a bear run for the past few years, especially 2018, and the Shanghai Composite has a current P/E in the mid-teens, actually much lower than the S&P’s 20 plus, Shenzhen Composite’s P/E ratio is still nearly 30, and tech companies are still doing OK. Or more than OK. Specifically, I’d like to point to the example of Qihoo 360, which went private and delisted from the NASDAQ in a $9.3Bn transaction in late 2015.
[20:21] Y: Qihoo, if you guys remember from an earlier episode on Tencent, specializes in anti-virus software and is one of the largest internet companies in China. After going private, it re-listed last year in Shanghai via a backdoor listing, and at one point was worth $65Bn.
R: Sure, two years have passed since their delisting from the NASDAQ but the business has actually been pretty stagnant since then. In fact, fiscal first half of 2018 revenues and 2015 revenues were basically the same, and mobile users are actually down sharply. And even though the stock “crashed” shortly after the re-listing, the company today is still worth $27Bn, three times its takeover price and with what is widely regarded as a much worse growth outlook.
[21:19] Y: We aren’t cherrypicking examples here, there was also Focus Media, delisted for less than $4Bn and relisted soon thereafter for more than $7Bn, and a bunch of other companies who have tried to do the same, although not all have re-listed, but we think Qihoo is probably the best example because it’s large enough to be compared to some of the unicorns these days, and also it’s a pure internet software play.
R: Many reasons exist for the change in valuations, including just a different investor base, different markets of course, but also there’s just less high growth tech stocks in China, because they’ve all listed abroad. People are starving for this kind of investment opportunity, which makes it extra bubblicious. If Bytedance were to list in Shanghai … I don’t know, but there is a good chance it would go public at a much higher valuation than in the US.
[22:14] Y: Yeah, very likely, I’d say, just because of the lack of high quality tech companies people can get their hands on. But besides becoming, say, three-times the multi-billionaire that he could be here in the US or in Hong Kong, Bytedance CEO Zhang Yiming probably has other considerations as well right? There is the lockup, for one. Whether one or three years, that’s significantly longer than the typical six months abroad.
R: And not just him, but remember, all execs with technical know-how core to the business, are locked up for a minimum of three years, and if the company is loss-making at IPO, that lockup, which extends to controlling shareholders, directors, and senior executives, could be as long as five years. Five years is an eternity in the markets! But most especially in the internet sector.
Y: Don’t forget that and he will have a very different, much less sophisticated investor base to work with in China versus the US. Individual investors make up 80% of the trading volume in China, whereas they are a very small amount in the US.
[23:21] R: And not everyone is as bullish that the government really will be as hands-off and the new board as fully “registration-based” as has been announced. After all, it has a record of saying one thing and doing another, often stepping in to stabilize the market when volatility gets too high for comfort.
Y: And even if the exchange does come into being as promised, there are still some weird rules native to the Chinese market that companies will have to deal with. Freezing or halting trade is something that happens often, and the regulators could step in and do that, although some companies also instigate it themselves to stop falling prices, so that could be a net positive.
R: I don’t know, it seems like these cons are pretty significant. As for Bytedance, it seems that it’s not as focused on going public as it was before after this latest cash infusion from Softbank, but I’m sure that won’t stop every major exchange from knocking on their doors. And it might be very hard to say no to the Shanghai Stock Exchange to be the poster child for an initiative announced by the President himself.
[24:32] Y: But we aren’t the only skeptics. Plenty of Chinese experts have pointed out that there are already many channels to “go public” in China, and this new proposal overlaps with existing exchanges creating competition when there may not be enough liquidity to go around as it is.
R: The conclusion by most people is that the US stock market is still by far the most robust, although it’s definitely a multi-step process to get from where China is today to where the US is. Looking and behaving more like Hong Kong might be a more realistic goal.
Y: Yeah, Hong Kong seems to be OK, and it’s more of a hybrid system where the regulators do make a decision on the investment worthiness of the stock, and engages in valuation as well, both of which the SEC takes no part in. So most people believe that even at best, the new Board will still be sort of “approval based,” just probably not as egregious as the A-share market.
[25:31] R: Oh for sure, because the just released rules had a special invitation for companies with VIE structures, which is basically the way Chinese internet companies are linked up with offshore entities and therefore are able to receive foreign investment and easily list overseas.
Y: Companies with VIE structures would definitely include Bytedance, Didi, and a great bunch of Chinese unicorn startups. If you expect to have a market cap of over $1.5Bn USD at IPO, or expect to only reach half of that but have annual revenues of $75mm, then you are eligible to apply to be on this new Board.
R: So basically, unicorns and near unicorns. Fairly strong signal that only awesome companies need apply. Will it work? What do you think, Ying-ying? Wait, before we go there, what did we learn today?
[26:27] Y: Well, we learned that the US and Chinese stock markets work very differently, and one of the biggest differences is that the US is registration-based, meaning that the SEC doesn’t decide whether or not you are worthy of being listed, how much you might want to list at, and can’t control when you list, whereas in China, the authorities can and do do all of those things.
R: Which means that it can take a really long time to go public, and we are talking about the process taking several years here, versus weeks in the US. There are stringent lockup requirements afterwards as well, also several years long, and all these things, you have to remember, are to reduce volatility and increase stability in the markets.
Y: Which are definitely good things to do because let’s face it, the Chinese capital markets are still really young compared to the US, with both Shenzhen and Shanghai Stock Exchanges just in their 29th year. And while the government has tried to give tech companies and small businesses more of a chance, so far their experiments, known as ChiNext and the New Third Board, have not been very successful.
[27:27] R: Thus the push for this new Technology Innovation Board in Shanghai, which removes profitability as a requirement for listing, among other things. Based on the newest rules that have been announced, and which are still subject to change, it looks like they’re targeting unicorn level startups, and of course Bytedance has been mentioned as one of the companies they are wooing.
Y: We then went over some of the pros and cons of a company like Bytedance listing in Shanghai, with really one main pro: higher valuation, and lots of cons: such as a long lockup period, we are talking about up to five years here, unsophisticated investors, and uncertainty that the regulations won’t change, etc.
[28:11] R: So from our perspective, it’s not some piece-of-cake decision, as the tradeoffs are quite serious, and I think if it were me, I’d probably list abroad. That lockup period is just killer.
Y: But if everyone thinks like that, then the market will never change. It’s going to take multiple steps to get to a real NASDAQ in China. At least it’s a positive sign that this initiative exists, and this is definitely a leap in the right direction.
R: We’ll see how others in the region, including domestic competition ChiNext and the adjacent Hong Kong Stock Exchange, react to these rules. I’m still betting that Bytedance and the other decacorns trying to go public this year or next all go abroad.
Y: What do you think, Techbuzzers? As always, feel free to write us via email or Twitter and let us know!
[29:08] Y: OK, that’s all for this week folks! Thanks for listening. As a reminder, episodes will now be available every other Friday. We really enjoyed putting this together, and we are always open to any comments or suggestions. You can find us on twitter at thepandaily, at techbuzzchina, and my personal Twitter account is GINYGINY.
R: And my Twitter is spelled RUIMA. TechBuzz China by Pandaily is powered by the Sinica Podcast Network. Pandaily.com is an English language site that tells you “everything about China’s innovation.” Our producers are Shaw Wan and Kaiser Kuo. Our intern is Wang Menglu!