The Role of Private Equity When Portfolio Firms Go Public: Evidence from ChiNext Board

ABSTRACT

We probe into the question of why entrepreneurial firms choose to obtain private equity finance (PE) shortly before going public on the ChiNext Board (the Chinese alternative stock market for smaller firms, part of the Shenzhen Stock Exchange, SZSE). Using unique hand-collected data we find that, compared with non–PE-backed firms, firms with PE equity stakes introduced shortly before the IPO did not reduce IPO underpricing or decrease the offering cost. However PE investors increased the probability of approval when the firms applied to the China Securities Regulatory Commission (CSRC) for listing. We suggest the stock issuance rules for the ChiNext should be reformed to lower entrepreneurial firms’ financing cost and to encourage PE firms to undertake more value-adding activities.

KEY WORDS:

• ChiNext
• IPO Underpricing
• private equity
• reputation

Acknowledgments

We appreciate helpful comments from Jun Qian (Boston College), Zhishu Yang (Tinghua university), and Wei Li (East Chin0a Normal University), and conference participants at the 2011 China International Conference in Finance (CICF, Wuhan, China), 2013China Conference of Finance at Peking University(Beijing, China), the Capital Market and Financial Innovation International Convention at SUFE 2013, and 5th Chinese Capital Markets Conference (2015,in Manitoba, Canada).

Notes

1. In 2013, China’s IPO was suspended. In the period 2014–2017, the number of IPO per year in ChiNext was between 50 and 150 enterprises, accounting for 1/3–1/2 of the total number of IPO enterprises in China. And in 2017 ChiNext IPO numbers were 141 enterprises.

2. Usually investments held for less than 2 years are referred as quick flips in the private equity industry. See Blenman and Reddy (2014).

3. In June 1993, the CSRC decided to establish SIEVC as one of the most core and essence system designs of Chinese securities market. Since then the SIEVC has lasted for 24 years until 2017. During the period ChiNext was set up in 2009. So the SIEVC has two affiliates, one is for main board (including 25 committee members, for 16 sessions), the other is for ChiNext (including 35 committee members, for 6 sessions). In July 2017 CSRC announced the revised SIEVC policy：1. To combine the two affiliates into one. The total committed members are increased from 60 to 66. A committee member’s continual tenure should not surpass two sessions instead of three sessions, and the committee should at least replace one half members every year. 2. To establish two new subcommittees, the selection committee and the supervision committee, in SIEVC. In this way, the principle of the separation of selection, operation, and supervision by committee members can be achieved. The SIEVC reform is necessary. Some scandals about SIEVC emerged recently. For example, one former committee member of SIEVC, Feng Xiao Shu, made a stir in the market in 2017. When Mr.Feng was an officer of the Shenzhen Stock Exchange and a part-time member of SIEVC, he illegally earned 248 million Yuan from only 3 million Yuan investment by inside trading in just three years service in SIEVC. The CSRC confiscated the illegal income and imposed a fine of 251 million Yuan along with a lifetime ban on his involvement in the securities market.

4. Fan, Wong, and Zhang (2007) define a firm as politically connected if either the Chairman or CEO currently serves or formerly served in the government or military. Liu, Tang, and Tian (2014)use a definition that includes firms whose chairman or CEO serves/served as a deputy of National People’s Congress(NPC) or the Chinese People’s Political Consultative Conference(CPPCC) because both of them are important authorities in the Chinese central and local governments. Bao et al.（2016） also use the CEO and other board directors’ political connections as: (1) a current or former member of the National People’s Congress (NPC); (2) a current or former member of the Local People’s Congress (LPC); and (3) a current or former member of the Chinese People’s Political Consultative Conference (CPPCC).

5. We tried to collect the PE partner’s information from the public disclosure of their personal profiles. Most of them are not NPC or CPPCC member (see Fan et al., 2007; Bao et al., 2016). Many of the profiles of PE general partners are undisclosed, and you can’t read between the lines from those disclosed personal profiles. But the surface doesn’t reveal the essence. Here are three famous anecdotes in China PE industry. 1. One of the former general partners of New Horizon Capital, a famous Chinese PE firm, is the son of Mr. Wen Jiabao, the former Premier of China. 2. The incumbent CEO of CITIC industry investment fund (called CITICPE, listed as No. 78 in World PE 300 by PEI in 2017), Liu Lefei, is the son of Liu Yunshan, current member of Politburo Standing Committee of Communist Party of China. These PE partners very likely have powerful networks. 3. Huijin Cube, a secretive PE firm, specializes in investment of Pre-IPO projects and then getting them listed on the ChiNext. Its chairman, Wang Cheng, is a pseudonym. His real background is that he is Ling Jihua’s younger brother. Ling Jihua, is the former vice chairman of the CPPCC National Committee, former director of General Office of the CPC Central Committee, found guilty of accepting bribes, illegally obtaining state secrets, breach of privilege crimes, who was sentenced to life imprisonment in 2016.

6. In this article’s research period, the majority of PE in the Chinese market is engaged in what is called the pre-IPO PE investment (defined as less than two years before IPO, that is, quick flipper.), in order to obtain the return, also to establish the prestige as soon as possible. The article omits the PE whose investment holding period surpasses 2 years before IPO.

7. According to the 2007 China’s Ministry of Finance and the State Administration of Taxation “ Notice on tax policy on promoting the development of venture capital investment enterprises,” if the equity investment of venture capital in China has been invested in unlisted small- and medium-sized high-tech enterprises for more than two years (including two years), the taxable income of the venture capital can be deducted by 70% of the investment.

8. ChiNext started on 17 September 2009. The IPOs of Chinese stock exchanges (including ChiNext and the main boards of Shanghai and Shenzhen) were all suspended by CSRC from 3 November 2012 until 17 January 2014. That means CSRC ceased new stock release examination and approval during the period. The main reason is the reform of the IPO system by CSRC.

9. The CSMAR (China Stock Market Accounting Research) database was developed by GTA IT Co. in 1999 in order to meet the demands of the Chinese financial market information from financial institutions, researchers, and academic scholars.

10. WIND is the first China financial electronic database which was established in 1994, and now a leading financial information provider aimed at being a Chinese Bloomberg.

11. The reasons are as: (1) Our hand-collected data includes 494 sample companies, among whose shareholders there are 975 PE institutions. From the prospectus we know all shareholders of the firms before IPO. Many of these PE institutions’ shareholding ratio is not high enough to be in the list of the “top ten shareholders.” (2) We find there are at least 196 shareholders’ names containing key words such as “investment,” “venture capital,” “private equity,” “venture,” etc. But by checking the biography of the shareholders we find these institutions should not be classified as PE investors as they have close relationship with the de facto controlling holders or the founders, managers of the enterprises, and many of the institutions are established with the aim to execute manager/employee stock incentive schemes. These institutions should be excluded from the PE investors. (3) Additionally, we find that some shareholders should be counted as PE investors although their names do not contain words of PE or VC. This can be verified by checking the main business of these institutions in the shareholder profiles.

12. China Venture Capital Annual Ranking was initiated by Zero2IPO Group in 2001 based on overall surveys on aspects as investment, management, fundraising, exit, and so on. Ranking indicators are modified on a yearly basis according to the actual development. Since 2006, Zero2IPO has also introduced the ranking list of private equity investment institutions in the annual ranking. China Venture Capital & Private Equity Annual Ranking by Zero2IPO Group has won high recognition by domestic and overseas venture capital and private equity institutions, and it has been widely cited by well-known financial media at home and abroad. In 2007–2010, the ranking annually gives Top 10 private equity firms and Top 20 venture capital firms in China.

13. The CSRC requests the application materials for IPO/and also the later prospectus should include such a part of “risk disclosure.” The applicant firm and underwriter should disclose the risk factors as price fluctuation, financial risk, management risks, and so on in red-herring materials/prospectus, so that CSRC will understand the impact of the risk factors may affect the company’s profits. If there are more factors, the company may be believed with more risks. So it may influence the CSRC judgment of approval. So we include the “risk factors” in Approval regression.

14. In China’s new stock offering, the lead underwriter and the issuing firm determine the primary offering price through book building process. The IPO market is divided into the online and offline markets, in which individual and institutional investors subscribe the new shares online and offline separately. When investors ’effective subscription is bigger than the new shares quantity, the stock exchange will allocate sequent numbers automatically by system computer according to every 1000 shares subscription. Then the exchange computer will determine the lucky numbers by lottery. Each luck number will be entitled to buy 1000 shares. The lottery rate is: Lottery rate = new offering shares/all effective subscription shares *100%. And that forms the online and offline lottery rates. The online lottery rate is usually an indicator to represent investors’ emotions.

15. The ChiNext listing requirements issued by CSRC are mainly on profitability. The applicant should have continuous profits and accumulated net profits no less than 10 million Yuan in the last two years before application. Or the applicant has profit and the most recent annual revenue of no less than 50 million Yuan in the last year.

Additional information

Funding

Yao Li acknowledges the financial support of National Social Science Fund of China (13BJL038).