Q: Has the growing number of cornerstone investors impacted the IPO process?
Gilbert Li, partner, Linklaters
Cornerstones, which began in Hong Kong as a mechanism to attach prestigious names to new listings to generate interest and momentum, appear to have evolved into becoming security blankets to minimise the risk of failure, especially for deals launched in choppy waters.
Cornerstone investments have continued their prominent role in Hong Kong IPO transactions, with the market witnessing a rising participation of cornerstone investments in IPOs, both in terms of the size of investments and the number of investors. Cornerstone investments have become a staple feature in Hong Kong IPOs and some even took up as much as 75% of the offering in mega deals launched in 2016. Has the role of cornerstone investors shifted from boosting confidence in the quality of IPO issuers and helping to refine the price range at which the IPO would be launched, to distorting the price discovery process, hurting liquidity post-listing due to the regulatory post-listing six-month lock-up requirement and putting pressure on the stock when the expiry of the lock-up period approaches?
Not so long ago, before the global financial crisis, cornerstone investors were mainly major international institutional and financial investors, sovereign wealth funds and high net worth tycoons. These investors are often return- and value-focused. They would scrutinise the fundamentals of an issuer, and the questions and answers that typically followed would offer reassurance to retail investors about the credibility of the issuer and the IPO price. This kind of activity may improve the quality of prospectus disclosure and so indirectly help public investors to understand the issuer.
With the sharp increase in cornerstone investments in recent years, the cornerstone club has a wider class of participants, featuring mainland corporates buying up large proportions of Chinese state-owned enterprises in their IPOs. Critics have said that these new club members, the so-called friends and family investors, are not so profit- and value-driven but rather are invited to participate in an IPO to support the completion of the new listing at a price which may not otherwise be supported by natural market demand.
The perceived negative effects of cornerstones on IPOs have been on the Hong Kong Stock Exchange’s radar for a while
Cornerstones don't only affect the price of stock at listing. There was a time when well-known institutional investors would compete in the cornerstone selection process to try to get in on a hot deal early and get their guaranteed amount of stock. In return for this privilege, the cornerstone investor's shares were subject to a compulsory six-month non-disposal lock-up post-listing. This resulted in a large chunk of the public float being locked up post-listing, which affected the liquidity of the stock and increased the risk for mispricing, and a large overhang which might hit the market when the lock-up expired.
Data support a trend that issuers with significant Chinese cornerstone backing have not performed as well as those with support from international institutions or without cornerstone support. Some say this is due to a combination of factors, such as the lack of a real price discovery process, which may mean the IPO price does not reflect the genuine market value of the issuer, and the quality of the issuers which may not otherwise be listed without Chinese cornerstone backing.
The perceived negative effects of cornerstones on IPOs have been on the radar of the Hong Kong Stock Exchange (HKEX) for a while. Its Listing Committee first reported it was considering the impact of cornerstones on free float, shareholder base, price discovery and the share overhang in 2014, and it has asked the HKEX to continue to monitor the situation. In 2016, it asked the HKEX to conduct discussions with stakeholders to gain a better understanding of how cornerstones form part of an offering, and impact the price discovery process, in order to conclude whether any changes are necessary.
Linklaters counsel Terri Poon also participated in the drafting of this article
John Baptist Chan, partner, King & Wood Mallesons
In recent years, the Hong Kong market has seen strong cornerstone investment becoming the trademark of IPOs of PRC state-owned companies, especially in mega deals where up to 20 such investors have participated at one time. This high level of cornerstone investment stands in sharp contrast to those in other international markets where cornerstone investment typically accounts for less than 25% of the offering. Another distinguishing feature of the current Hong Kong IPO market is the demographic of the cornerstone investors. In the past, these were typically funds and investment companies from the international market. As of late, most of those that participated in mega size H-shares deals were mainland companies and often also state-owned. When did mainland companies take such a dominant role in Hong Kong IPOs?
In 2011, a leading securities firm launched its much anticipated public offering for the first time, indicating in its prospectus that its shares would tentatively be listed by the end of 2011. Only a few international cornerstone investors were secured, subscribing approximately 14% of the total offered shares for the first launch. However, the market was volatile and hit a low point at that time. The marketing efforts during the international roadshows were unable to attract sufficient interest from foreign private equity funds to cover the international tranche offering and pricing was delayed indefinitely. After this unavailing attempt to market its shares in roadshows, the stated-owned, embarrassed applicant took matters in its own hands and turned to its fellow compatriots in the PRC to bridge the gap in its second attempt by inviting domestic investors to subscribe. As a result, only a fraction of the offered shares were offered to retail investors as one third of the shares had already been sold to Chinese state-run companies. More than 10 cornerstone investors subscribed for approximately one-third of the offered shares in the second launch in 2012 and the IPO went on to achieve a higher agreed price for its shares. This event demonstrated the benefit of having cornerstones to ensure the successful launch of an IPO and achieve a higher price.
With guaranteed subscription from cornerstone investors in high volume, strong and genuine demand from the public is no longer a key consideration for deal launches. However, the problem with having a high concentration of cornerstone investment is the lack of liquidity of the shares post-listing as the cornerstone shares are subject to a lock-up of six months. What makes matters worse is that some state-owned cornerstone investors are not as investment centric as private equity funds and do not actively manage their investment. Their shares become parked in the account of the cornerstone investors, meaning, even after the lock-up period, such shares are not traded.
This event demonstrated the benefit of having cornerstone investment in ensuring a successful launch of an IPO and achieving a higher price
The nature and role of cornerstone investment has always caught the attention of the regulators. Dating back to 2008, the Hong Kong Stock Exchange (HKEX) published a consultation paper on whether a holistic approach should be taken to consider the nature of cornerstone investment. To ensure sufficient market for shares after listing, it consulted on whether cornerstone investors should be considered as members of the public by taking into account all facts and circumstances of each application on a case-by-case basis. However, the HKEX admitted that taking such a holistic approach would contradict the principle of regulatory clarity. But no concrete action or reform was taken addressing the issue of large chunks of offered shares being subscribed by cornerstone investors before being marketed to retail investors. Relevant waivers on public floats have also been granted, effectively reducing the shares held by retail investors who are not subject to lock-up periods. For instance, in the case of CDB Leasing, one single cornerstone investor subscribed for approximately 42% of the offered shares, 10% of the total issued share capital - the HKEX granted a waiver which effectively reduced the public float to 15%. The approach of reducing the shares being held by a wider base of public hands to secure a better offer price and size is passively endorsed by the regulator.
Some questions need to be asked: substantial cornerstone investment leads us to wonder whether there is a real market for the securities. The Hong Kong stock market has recently topped the global charts in terms of amount of funds raised by IPOs. Fundraising activity is supposed to reflect the quality of the stock market. and the listing status of a company is supposed to suggest public confidence in the company's future performance.
However, is it a healthy development for the market if strong public demand in both the retail and international market is effectively not a pre-requisite for an IPO? If cornerstone investment continues to grow and secures a substantial portion of the offered shares in Hong Kong IPOs, is the rationale behind the public offering still being followed when retail investors are not even able to invest in the listed shares due to the cornerstone investors' commitment? Assurance might be given to retail investors, but the offering structure might also put the cart before the horse as the available shares offered are predominantly secured by these commitment prior to roadshows.
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