Wednesday, January 19, 2022
Can the Beijing Stock Exchange become China’s NASDAQ?
By Huang Sheng and Sun Xi
After a plan for the Beijing Stock Exchange (BSE) was revealed at the China International Fair for Trade in Services on September 2, 2021, the BSE opened for business on November 15, 2021.
With a focus on serving Chinese SMEs, the BSE will play a significant role in building China into an innovation-oriented country and boosting the reform and development of its multi-level capital market. Indeed, it has already received a warm response from the market. However, there is still a long way to go for the new-born exchange to achieve long-term healthy development and many problems will need to be addressed.
Current market opportunities brought by the BSE
The BSE’s existence is well-grounded in facts. Although already the second-largest capital market in the world, China has many shortcomings that it needs to shore up in providing services to SMEs and the private economy.
Today, most Chinese SMEs rely on indirect loans from banks for funding. However, due to increasing downward pressures on China’s economy and concerns about risks and returns on the part of credit providers, large amounts of financing have flocked to real estate and large state-owned enterprises (SOEs). This has to a certain extent limited SMEs’ access to credit and created more pressing demands on the capital market to increase the share of direct financing for SMEs.
Since its launch in 2013, China’s National Equities Exchange and Quotations (NEEQ) has been dedicated to exploring the benefits of open market services for SMEs. In 2016, it initiated a tiered market management mechanism consisting of a Base Tier and an Innovation Tier, and added a Select Tier (the highest tier of the NEEQ system) in 2020. Select Tier enterprises are permitted to issue shares to non-specified qualified investors when they go listing (as a result, Select Tier listings are also nicknamed mini-IPOs).
BSE rules for stock listings and board transfers
The BSE will retain the basic framework of the NEEQ Select Tier. What is more, Select Tier-listed companies will be converted into BSE-listed companies, with their identities transformed from non-listed public companies to listed companies. In the future, eligible companies from the Innovation Tier will also be listed on the BSE. This will help promote the status of Select Tier and Innovation Tier companies and will facilitate changes in investors’ expectations in the future.
Compared with the Shanghai and Shenzhen exchanges, the BSE is envisioned to serve companies that are earlier in their development stage, smaller in size and more innovative. Its goal is to cultivate SMEs that feature “specialization, refinement, uniqueness, and innovation”. More than 90% of eligible SMEs are manufacturing companies – and are therefore in line with China’s strategy to develop as a manufacturing powerhouse.
However, amongst these companies, only a small number have been listed, while the rest still face difficulties in raising capital. Statistics show that since 2019 China has incubated 4,922 national-level ‘little giant’ companies (i.e., innovative SMEs with high growth potential and advanced technologies) recognised by China’s Ministry of Industry and Information Technology, yet only 328 (roughly 6.7%), have been listed. That said, the number of eligible NEEQ-listed companies has reached 370, including 12 in the Select Tier. In addition, there are more than 20,000 specialised and innovative SMEs at the provincial level, many of which have a strong need for direct financing.
In recent years, enthusiasm for IPOs amongst NEEQ-listed companies has remained high. In 2020, for example, more than 400 companies initiated pre-listing preparations and 105 successfully listed on the A-shares market. Amongst those companies listed on NEEQ, around 30% have initiated or going through this process.
A large part of the financing needs of these companies still remains to be met, as the sub-billion RMB market value of nearly 80% of these companies makes them ineligible to list on the STAR Market and ChiNext. In light of this situation, the BSE has lowered the market valuation threshold to 200 million RMB, making it attainable for 60% of the above-mentioned companies.
In addition, the BSE has put more emphasis on R&D input and growth in operating income, and the time for review and approval has been shortened from three months to two months. The BSE will also follow NEEQ’s board-transfer relisting rules instituted in mid-2020. Upon meeting relevant conditions, BSE-listed companies will be able to choose to relist on the ChiNext Board or STAR Board without having to delist and queue for a new IPO (thereby saving a lot of time). This represents a huge benefit to the direct financing of innovative SMEs.
The establishment of the BSE will also generate spill-over and conduction effects:
Listed companies will enjoy greater market visibility and convenience in information disclosure, and gain a competitive edge in terms of talent recruitment, business development, bank loan applications and debt issuance.
The establishment of the BSE also creates a wider range of exit channels for PE/VC investment, eliminating investors’ worries and making their funding more available.
How to build a healthy market ecosystem in the long run?
The launch of the BSE has ignited great market enthusiasm for new issuances from Select Tier-converted companies. One superstar company has even seen its market cap skyrocket to over 80 billion RMB. However, if the BSE is to prosper in the long run, it will require continuous efforts to improve its capital market infrastructure and cultivate a sound market ecosystem with active participation from investors and market intermediaries.
First, there is a need to cultivate a multi-tier investor system in order to improve market liquidity.
In the past, a prohibitive NEEQ threshold for individual investors narrowed the scope of eligible participants, leading to a shortage in market liquidity. Since the beginning of 2021, the average daily turnover rate (trading volume as a percentage of the total number of shares outstanding) at the ChiNext Board and STAR Market have stood at around 5.9% and 5.6%, respectively, while the NEEQ has stagnated at 1.2%.
Institutional investors are an important source of long-term stable funding, but both the number of NEEQ investors and the size of their investments have been out of proportion with its market scale. According to statistics from the Asset Management Association of China (AMAC), a total of 665 NEEQ-themed PE funds are in operation, but their total value is less than 100 billion RMB (using an average fund size of 150 million RMB). This number is negligible in comparison with both the 2 trillion RMB NEEQ market and the 19 trillion RMB size of total PE funding.
Under the China Securities Regulatory Commission (CSRC), public equity funds were not permitted to invest in NEEQ market until April 2020, and since has been restricted to Select Tier companies only. Currently, there are only 12 NEEQ-concept public equity funds. These funds have invested only limited amounts in Select Tier companies due to insufficient underlying assets and difficulties in portfolio liquidity management. According to the mid-term report of 2021, only two funds have maintained significant holdings in NEEQ shares, with their market value at less than 10% of the underlying companies’ market caps.
The lack of market liquidity has not only led to higher transaction costs for investors, but has also limited the financing abilities of listed companies, which in turn has dented the exchange’s attractiveness for companies seeking IPOs.
Since the BSE was established, it has lowered the securities asset threshold for individual investors qualified for BSE trading from 1 million RMB to 500,000 RMB (the same as the STAR Market). At the same time, there is no minimum fund requirement for institutional investors. This move, which has received a positive response from the market, may allow the BSE to break through the liquidity conundrum that has hampered the NEEQ Board. Eight fund management companies (including China Southern Asset Management and GF Fund Management) have applied to set up BSE-themed funds.
Nevertheless, investors may bear greater risks in BSE trading, as Beijing-listed companies are innovative SMEs in their early development stage with highly volatile business operations. This necessitates the introduction of professional institutional investors with corresponding risk-bearing capacities. Therefore, a key task facing the new exchange is to foster a multi-tiered investor system to promote market pricing efficiency and facilitate the entry of institutional investors.
Second, there is a need to enrich exit channels for investors.
Apart from the highly liquid secondary market, the NEEQ Board’s Base and Innovation Tiers and the private placement market (which functions as a transitional market between them) have important roles to play. Thus, it is crucial to expand the number of exit channels available to investors to attract more investment for the initial development of start-ups. Feasible approaches include developing regional centres for equity transactions and nurturing more secondary fund managers.
S-funds (or secondary funds) refer to fund products that acquire fund shares and investment portfolios from investors. As China was a late-starter in secondary funds, the country’s quantity and scale still remain at low levels. Based on available statistics from China-FOF.com, there are around 10 foreign S-funds and around 30 domestic S-funds in China, with a total value of around 47.6 billion RMB. In April 2021, the Beijing Equity Trading Center launched a pilot programme under which investment shares of PE and VC firms could be transferred, representing the first step in the establishment of an open trading platform for such transfers. This will set a beneficial trend in the long run.
It is also necessary to improve the mergers and acquisitions market. Since the late-1990s in the United States, for example, 90% of innovative startups funded with PE/VC investment have ended up being acquired, while just around 10% have exited through IPO listings. In the future, the development of China’s M&A market will play a bigger role in facilitating the exit of investors.
Third, market intermediaries need to perform their due diligence responsibilities.
Though the BSE could benefit from market connections accumulated during the NEEQ phase, many intermediary institutions do not have an active presence in NEEQ-related businesses, which means more time will be needed for the new exchange to expand market intermediary participation.
Taking investment banking business as an example, the demand for listings on NEEQ has experienced a massive decline due to policies tightened in 2017, with new listed companies dropping from more than 2000 in 2017 to around 100 in 2020. Consequently, many security companies have quit NEEQ, with only around 30 still providing investment banking services on the board at present. Moreover, with the establishment of the BSE, intermediary institutions lacking business experience on NEEQ may have to start from scratch with staff recruitment and project operations if they want to tap into new opportunities – a reality which could lead to greater time and financial costs.
Despite the favourable policies, IPOs at the BSE are typically small and limit the profits generated by investment banking services, since their profit margins are interconnected with the amount of securities issued by the trading companies. Therefore, from the perspective of profitability, securities firms that have already exited NEEQ may remain wary about rebooting their businesses at the preliminary phase when market demand is not yet clear.
Therefore, safeguarding stable market operations and consolidating market confidence will be critical to motivating more intermediary institutions to build and expand their BSE-related business lines. Orderly progress at the BSE will also deliver a boost to business at the Innovation and Base Tiers, thus vitalizing the whole BSE-related business system.
Fourth, information-related intermediary services should be encouraged to eliminate information asymmetry on the market.
Information is a major driver of trading and reducing information asymmetry is significant both for business valuation and the market. Many NEEQ-listed companies have seen a dramatic rise in their valuation after they were transferred to the BSE, though their fundamentals have largely remained the same. In addition to the difference in liquidity between these two markets, this reflects the poor investor awareness and high level of information asymmetry on the NEEQ Board. Given that many Beijing-listed companies specialize in niche sectors, investors need information intermediaries (such as financial analysts) to help them better understand the business models and strengths of these companies.
In the A-shares market, the prevailing model of commission revenues has led to more focus on listed companies with larger market caps amongst analysts. In 2020, listed companies whose market caps ranked amongst the top 25 percentile on the A-shares market were followed by an average of 37 analysts while over two-thirds of low-market cap companies (companies whose market caps were below the median for all A-shares companies, or about 5.5 billion RMB) were not followed by any analysts.
The market values of BSE-listed companies are even smaller than those of A-shares listed companies. As per the current situation, securities trading companies may have less interest in carrying out investment and research. How to better communicate with the market and provide adequate information for investors will be a challenge for BSE-listed companies.
The establishment of the BSE has stirred huge market interest, but a key task facing the BSE is how to explore a sustainable business model to attract continuous interest from investors and analysts and build a virtuous circle featuring lower information asymmetry, higher stock valuations, a larger investor pool and greater analyst coverage.
Huang Sheng is an Associate Professor of Finance at CEIBS. For more on his teaching and research interests, please visit his faculty profile here. Sun Xi is a Research Associate at CEIBS. The authors would also like to thank Bian Xiaoxuan for her contribution to this article.