Tycoons Usurped by SOEs in China IPOs as Returns Tumble

In December, China Machinery Engineering Corp., a builder of power stations, went public in Hong Kong thanks to five Chinese government-owned companies that bought almost a third of the $575 million offering. The stock has since fallen 24 percent.

China Machinery is among a growing number of state-owned enterprises forced to rely on so-called cornerstone investments by other state firms to get initial public offerings done, as wealthy individuals like Li Ka-shing stopped investing. The results haven’t been stellar.

These IPOs have dropped on average 8 percent within their first six months of trading compared with a gain of 15 percent for all Hong Kong IPOs worth at least $500 million in the last decade, according to data compiled by Bloomberg. The weak returns reflect how investors increasingly view the presence of SOEs as a sign of a less-desirable offering. The trend threatens to stifle an already weak market for Chinese IPOs by diminishing investor appetite.

“If a deal is half-filled with SOEs, yes, it may get done, but it’s probably not going to trade up,” said Philippe Espinasse, former head of equity capital markets for Asia at Nomura Holdings Inc. and author of “IPO: a Global Guide.” “This creates a spiral: deals don’t trade well and even fewer people want to take part in IPOs.”

Hong Kong rose to become one of the world’s top IPO markets in the last decade as some of China’s biggest companies, such as Industrial & Commercial Bank of China Ltd., went public employing cornerstone investors. These investors receive guaranteed stock in an IPO in return for holding the shares for at least six months.

Tycoons Wary

At first, cornerstones tended to be large institutions or wealthy individuals, their presence meant to signal that the issuer was sound and that a stable base of investors would undergird the stock.

“Originally, they brought in the tycoons because when you had Li Ka-shing coming in, everyone said it must be a good deal,” said David Norman, a Hong Kong-based equity capital markets lawyer at David Norman & Co., referring to Asia’s richest man.

As Hong Kong’s benchmark Hang Seng Index fell 9 percent since the start of 2011 and IPO returns worsened, billionaire businessmen like Li cooled to such deals. Accustomed to reaping almost guaranteed profits on IPOs, they now faced little upside, said Chee Keong Low, associate professor in corporate law at the Chinese University of Hong Kong, who was a member of the Hong Kong exchange listing committee from 2006 to 2010.

China Hongqiao Group Ltd., Far East Horizon Ltd. and MGM China Holdings Ltd., which went public in the first half of 2011, were the last $500 million-plus IPOs to feature wealthy individuals as cornerstone investors, among them hedge fund manager John Paulson, who bought $75 million of MGM China stock.

Returns Trail

To fill the void, Chinese SOEs started making more cornerstone investments, typically purchasing shares in other state-controlled companies going public. They accounted for a record average 73 percent of cornerstone buying in $500 million-plus Hong Kong IPOs in the past 12 months, according to data compiled by Bloomberg.

Yet over the past decade, their deals returned less than other IPOs, based on a Bloomberg review of offerings of at least $500 million in Hong Kong. The analysis covered performance in the first six months of trading, the typical lockup period for cornerstone investors.

Political Motives

The 13 IPOs where Chinese SOEs purchased more than half of the cornerstone tranche posted an average drop of 8 percent, according to the data. By contrast, the 14 offerings where non-Chinese companies or funds were the main cornerstones returned an average 41 percent, the data show, while the 19 deals dominated by wealthy individuals returned 11 percent.

The average six-month gain for all 88 IPOs of more than $500 million in the last decade was 15 percent, according to the data.

The low returns may reflect how Chinese SOEs are buying into IPOs without a strategic reason, said Binay Chandgothia, fund manager at Principal Global Investors in Hong Kong, where he helps oversee $280 billion. That may affect the quality of the deals and raise doubts among investors about the companies’ long-term growth, he said.

Top executives at state-owned companies going public may not be especially disturbed by the poor stock performance, said Hu Xingdou, a professor of economics at Beijing Institute of Technology. They are often appointed by the government, he said, and see a completed IPO as a stepping stone to bigger positions in politics or at other SOEs.

“To Chinese SOEs, the success of an IPO is often more important than their returns,” said professor Low of the Chinese University.

Why Invest?

In some cases, state-owned companies did reciprocal cornerstone investments to help IPOs get completed.

People’s Insurance Company (Group) of China Ltd. bought $50 million worth of shares in China Machinery’s December IPO, while two weeks earlier the parent of China Machinery bought $75 million of shares in PICC Group’s $3.6 billion IPO, according to prospectuses for the two share sales. PICC Group’s share price is little changed since it started trading in December.

“There’s no law against it but you wonder why machinery makers invest in insurance companies,” said Norman of David Norman & Co. “It’s the sort of things that raise eyebrows of the stock exchange.”

Strategic Rationale

China Machinery decided to have Chinese cornerstone investors based on long-term strategic considerations, the company said in an e-mailed response to questions.

“Chinese cornerstone investors often pick stocks based on the synergy between the upstream and the downstream of an industrial chain, with views on strategic and financial cooperations,” the company said.

Three calls to the Beijing-based press office of PICC Group seeking comment weren’t answered.

Hong Kong’s stock exchange has signaled concern that the cornerstone structure is being used for purposes other than investment gains, undermining the credibility of IPOs.

Guidance Letter

In February, the bourse warned underwriters and issuers against cutting side deals with cornerstone investors in return for buying shares in IPOs. In a so-called guidance letter, the exchange said it considers it “misleading to the public” to offer incentives such as a waiver of brokerage commissions or an option to sell shares back after listing.

“At the end of the day, cornerstone investors have to make money out of it, whether the return is hard cash or soft favor,” professor Low said.

Alibaba Group Holding Ltd., the Chinese e-commerce platform considering an IPO, may be one company strong enough to go public without cornerstone investors, according to equity capital markets bankers who asked not to be identified because Alibaba hasn’t decided when and where to sell shares. An IPO by Alibaba could raise about $HK$100 billion ($12.9 billion), Ernst & Young LLP said last month.

“Cornerstones are not a prerequisite for listing if it’s a good company with a good story, well-known, well-governed and with the right valuation,” said Ian Long, head of China equity capital markets at Deutsche Bank AG.