China’s Steep Barriers for IPOs Come with Serious Economic Costs

Within days of its $4.4 billion IPO on the New York Stock Exchange last June, the Chinese ride-hailing giant Didi Global got sideswiped. Regulators in Beijing forced the firm to remove its apps from domestic stores and suspend new user registrations. Earlier this year, Didi’s investors voted to delist in New York, hoping to revive its fortunes by listing in Hong Kong. But those plans were upended by a data privacy investigation that led to a $1.2 billion fine.

The clampdown on the company once seen as China’s answer to Uber was widely viewed as retribution for its overseas initial public offering. In response to Didi and other big tech firms listing abroad, the Chinese government recently proposed tough rules for companies looking to go public outside the country, including several layers of official review before new share listings are approved.

These new restrictions come on top of China’s long-standing limits on domestic IPOs. The overall effect of these policies, says Charles Lee, has been a “brain drain” of capital, talent, and intellectual property out of the country.

That’s one of the striking findings in a recent paper coauthored by Lee, professor emeritus of accounting at Stanford Graduate School of Business. With Yuanyu Qu of the University of International Business and Economics and Tao Shen of Tsinghua University, Lee found that China’s steep barriers to market entry stifle innovation and competition, distort the value of private companies, and amplify the influence of incumbent companies and their owners.

Back Doors to Going Public

Chinese firms seeking to go public need to hit stringent revenue and profitability thresholds and must be individually approved by the state. The rules have substantially ratcheted up the economic value of a public listing in the country — so much so that some firms bypass IPOs altogether by executing a reverse merger. By combining with a public firm and taking control of the combined entity, a private firm can gain access to equity markets — a prized commodity in China.

Carefully analyzing each reverse merger, Lee and his collaborators find that between 2007 and 2020, unlisted Chinese firms paid more than $500 million on average for the value of a public company’s stock market listing. To put that figure into context, roughly one-third of the listed firms during this period were trading below the shell value they might fetch in a reverse merger.

“The gate fees for new entrants to the Chinese equity market are extraordinarily high,” Lee says. This is partly because Chinese public corporations are often controlled by a few “blockholders” who own most of the shares, in contrast to the diffuse ownership that’s the norm for U.S. firms.

Still, reverse mergers are relatively rare. Blockholders generally prefer to maintain the substantial benefits of ownership, even if a company is performing poorly. Instead of ceding control, they may choose to reinvent a company by changing its core business. For example, they may sell a minority stake to a private firm in exchange for its operating assets. Between 2000 and 2020, more than 2,300 firms engaged in this practice. Only 298 attempted a reverse merger.

The reason for this divergence is simple, if controversial. “If you control a company, you can channel its resources in directions that are beneficial to you,” Lee says. Controlling shareholders may use various strategies to transfer financial resources from the listed company to its blockholders. This practice, called “tunneling,” occurs because of China’s poor legal enforcement, weaker investor protections, and inefficient markets. The result is that controlling shareholders can “treat the company they control as an ATM,” Lee says, and “rip off minority shareholders” by taking out loans from the company.

These private benefits also help to explain the low mortality rates of Chinese stock markets, which have traditionally puzzled onlookers. Between 2007 and 2018, only 0.07% of Chinese public firms were delisted for performance reasons. In the U.S., the rate was 33 times higher during the same period.

“When you put too many rules at the gate and don’t allow good and new companies to come into the market, you create an uneven playing field,” says Lee. “The incumbents have a huge advantage: They can screw up over and over again but still don’t get eliminated. So it becomes a very inefficient market.”

The Cost of Staying Private

The stringent IPO rules also distort asset prices. Small firms tracked in Lee’s study earned an average monthly return 3% higher than larger companies’ (36% annualized). Lee says this “size effect” is 10 times higher than it is in the U.S. and reflects a form of compensation for investors with greater exposure to IPO regulatory risk.

“If China loosens the rules and makes it easier to go public, companies lose a lot of their value, as many are trading purely on their shell values,” he explains. When a firm’s corporate earnings are robust and growing, the value of its place on the stock market represents a smaller proportion of its total value. But when a firm’s core business falters, its listing status can become a major slice of its overall worth.

Another explanation for the size effect is that the market is mispricing smaller firms; investors do not fully appreciate the value of their listing status. Lee suggests that small companies are undervalued because they are more likely to execute a reverse merger or engineer a merger with a private company. Using these transactions, the small companies can monetize their listing status and deliver big payouts to existing shareholders.

His study ultimately shows that the impact of China’s IPO regulations is far-reaching and helps to explain many features of its equity markets — including the exodus of businesses seeking to go public abroad. This, in turn, has big implications for China’s global competitiveness, Lee says. “If your best companies, best ideas, and best people are going to go overseas, you cannot be a world economic power.”