Will China’s GEB Empty the PIPEs?

Chinese regulators are hopeful that the impending Growth Enterprise Board will prove to be a field of dreams for Chinese SMEs, and a serious competitor to foreign PIPEs.

Just when I thought the paucity of investor interest in Chinese OTC-listed companies couldn’t sink any lower, a friend of mine in New York asked me how China's Growth Enterprise Board will affect the PIPEs (Private Investments in Public Entities) market in China. After all, the Nasdaq-like GEB, slated to open on May 1, is intended to serve the very same small- and medium-size enterprises (SMEs) that readily flowed through PIPEs in 2006 and 2007 onto the OTC markets. Will GEB cork the PIPEs market once and for all by drawing China’s best SMEs away from a US listing? My short answer: in the short-term, “no.”

Before the world went topsy-turvy, the US capital markets were the ultimate goal for many of China's best companies; a promised land of abundant capital, global prestige and deep liquidity. For those that weren't large enough to pull a Nasdaq IPO, a backdoor listing onto the OTC markets, financed with a PIPE, was the next best thing. Cash-hungry Chinese companies going west kept bankers and investors like me busy through much of 2006 and 2007. But the flow became increasingly anemic in 2008, before shutting down completely last September, largely due to lack of investor interest. Nonetheless many in the industry are waiting for the PIPEs market to re-open, hoping to resume the party where they left off. But as China’s own capital markets become more robust there’s good reason to believe that the flow of companies westward may never be what it once was.

Having met with close to 200 Chinese management teams in the last few years I’ve come to appreciate that not every Chinese entrepreneur dreams of listing his company overseas. Rather than brave a back-door listing onto the fickle OTC market and commit to quarterly treks across the globe for investor presentations in a foreign language, many Chinese entrepreneurs are just fine to list on the A-Shares, thank you very much. But with a domestic listing out of reach for most Chinese SME's (for a number of reasons that I've discussed in previous writings), a foreign listing was their only option.

The forthcoming GEB, which boasts relaxed listing requirements, promises to change that by offering SMEs a viable domestic option for raising public capital. And with Chinese OTC-listed companies down as much as 60% or more since the market's collapse, and China's A-Shares up nearly 30% on the year, a domestic listing on the GEB looks all the more appealing. If it performs as advertised, the GEB will indeed be a competitive draw against OTC listings in the long term.

But while the "build it and they will come" philosophy worked for Kevin Costner in Field of Dreams, it often fails in business. Simply opening the GEB doesn’t guarantee there will be enough investors to provide sufficient liquidity to support a rush of SME listings. In fact, China's big boards, the A-Shares in Shenzhen and Shanghai, already suffer from a lack of liquidity, largely due to the fact that they are primarily retail markets with little participation from institutions. This, combined with regulatory hurdles, makes secondary financings and PIPEs particularly difficult in China. Given that liquidity is already a problem, opening more exchanges is likely to exacerbate the problem in the short term, spreading China's retail investor base even thinner. Only when market reforms pull in more institutional participation will the problem be resolved. And this will take time.

So when the world rights itself—hopefully sometime later this year—I expect that China’s best cash-hungry SMEs will still find the deepest pools of liquidity in New York, London, and Hong Kong. And while the GEB market may indeed draw potential listings away from the OTC market, a lack of liquidity and investor participation will soon belie the market's weaknesses. For the best Chinese SMEs, many of whom will require several rounds of financing, a backdoor OTC listing, financed with a PIPE, may yet be their best option.