Photographer: Anthony Kwan/Bloomberg

The Magical Transformation of Hong Kong’s Listed Companies

  • Regulators battle reverse takeovers by mainland businesses
  • Shell companies can be worth HK$600 million, analysts say

Chinese investors buying listed companies in Hong Kong reached record levels, prompting officials to look at ways to curb the practice amid concerns of market manipulation and volatility.

Hong Kong’s Securities and Futures Commission is investigating the link between wild share price moves and such so-called backdoor listings after a survey found that between 2013 and 2015, 56 companies saw their market value jump more than 1,000 percent within a six-month period, even though 39 of them were losing money.

Exchange officials say the swings and change of direction often associated with the reverse takeovers can distort the market and also allow buyers to circumvent hurdles and scrutiny required for an initial public offering. Last year, a record 45 Hong Kong-listed companies completed a change of ownership through majority equity sales, according to data compiled by Bloomberg.

“What a backdoor listing is in its worst incarnation is an opportunity to get a listed business, which wouldn’t be able to go through the front door,” David Graham, the chief regulatory officer and head of the listing division at Hong Kong Exchanges & Clearing Ltd., said in an interview.

Acquiring a company solely to gain a listing for a business that wouldn’t otherwise meet the exchange’s criteria is against the rules, as is taking a company public just so it can be sold. But in either case intent can be hard to prove, and with almost 900 companies waiting for an IPO in China, it can be a lucrative business to provide ready-made traded units.

When Allied Cement raised HK$145 million ($19 million) in its IPO in January 2012, the money was earmarked to pay down debt and for working capital, according to a prospectus.

Twenty-two months later and the firm’s controlling shareholder was negotiating the sale of a 56 percent stake to a consortium led by China Health Management Investment. Soon after completing the HK$533 million deal, China Health replaced several board members, while saying it planned to stay in the cement business.

In January this year, just as the lockup period restricting new owners from changing a company’s business model expired, Allied Cement announced a HK$346 million deal to buy a majority stake in a mainland Chinese health-care firm partially owned by its controlling shareholders. The deal was part of a move into medical, health-care, and elderly care services, the firm’s directors announced in a filing. 

Last month Allied Cement said it plans to change its name to Tongfang Kontafarma. At its peak in June last year, the stock was up more than 1,000 percent from its debut. It has since dropped 63 percent.

None of the changes are in any way illegal and Allied Cement hasn’t been accused of breaking the rules.

Allied Cement did not respond to telephone and e-mail requests for comment

Exchange Regulations

The exchange has rules to try to prevent people listing companies just so they can sell them quickly as a shell for another business. IPO applicants must show three years of profit and at least HK$500 million a year in sales. The bourse also made cash injections more difficult and has a two-year look-back period after a company raises capital in the market or changes ownership to see if its business has changed substantially.

A typical shell doesn’t raise a lot of funds during an IPO and has a profitable, asset-light operation with some cash flow, said Graham. Often a majority shareholder will sell their holding soon after the lockup period. In some cases a buyer is already lined up even before the IPO, according to people familiar with arranging such deals.

Officials are considering tightening regulations further, saying proposed IPOs will be scrutinized more closely and companies will be asked to outline their long-term plans. The look-back period may be extended to longer than two years, they said.

Even so, it can be hard to discern whether a company was bought simply as a shell for a new business, or is changing direction as the new owner looks for other opportunities.

Shell companies are “quite a difficult theme to define” said Graham. “You have to find the balance between allowing genuine commercial transactions to happen and basically regulating the market appropriately.”

Magnum Party

Night club owner Magnum Entertainment Group threw a celebration party in 2014 after its $100 million IPO. Individual investors oversubscribed their allocation of the deal by 3,559 times.

Four months after a one-year lockup period on the sale of the shares ended, Magnum shareholder Yip Mow Lum, 64, sold his 69 percent stake to a British Virgin Islands-registered firm controlled by mainland household appliance magnate Zheng Jianjiang. Magnum was renamed Aux International Holdings and is now looking at investments in health care, according to filings.

A spokesman for Zheng said he wanted a Hong Kong-listed company with strong cash flow and few receivables or machinery, as these were harder to value. Magnum was recommended to Zheng after it listed and it wasn’t a reverse takeover because no assets have been injected into the business, the spokesman said.

Zheng, chairman of Ningbo-based Aux Group, will make a decision in a month or two regarding new sectors to expand into, though it is unlikely the company will open more nightclubs, the spokesman said.

Yip, chairman of Bright Smart Securities and Commodities Group, wasn’t available for interview or to respond to e-mailed questions about the sale, a spokesman for the group said.

Magnum’s shares halved in value within three months of its IPO, then jumped more than 300 percent over the following year and have since dropped 43 percent. Neither Zheng nor Yip has been accused of breaking any exchange rules.

The exchange and the SFC said they don’t comment on individual companies. They said they are generally concerned that some ownership changes are fueling a lucrative market in listed companies.

“It’s legal for shareholders to change their businesses under different considerations,” said Gary Cheung, vice chairman of Hong Kong Securities Association, an industry group representing more than 70 percent of the city’s brokers. “Hong Kong is a free market.”

A shell with a primary exchange listing is worth about HK$600 million and some brokers are collecting “huge fees,” said Francis Lun, chief executive officer at Geo Securities Ltd. in Hong Kong. He estimates there are at least 100 shell companies out of the 1,900 listed securities in Hong Kong.

The Hong Kong exchange “barely has any effective measures to prevent shareholders selling the listed company as a shell and making a profit,” said Castor Pang, head of research at Core-Pacific Yamaichi. “If this situation continues without the rules tightening, the Hong Kong market will be left with a lot of bad stocks.”

Looser Rules

Cheung said one way to deal with the problem might be to loosen IPO rules rather than tighten them. That would make it easier for Chinese companies to have their own IPO.

More stringent regulation targeting reverse takeovers also makes it harder to sell public companies that have genuinely failed and are trying to claw back some residual value, Cheung said.

The Hong Kong stock market isn’t the only one affected. A similar practice by some Chinese companies in the U.S. has drawn increased scrutiny from American regulators, and reverse takeovers are common on the Chinese mainland.

Given the demand for listed companies and the challenge of finding a balance that doesn’t deter genuine businesses from going public, Graham at the Hong Kong exchange says the practice of trading in shell companies is unlikely to end.

“They are a phenomena in our market and they are probably here to stay,” he said. “We need to decide how to regulate them.”

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