DEALTALK-Hong Kong's cornerstone investors dominate but drain IPOs of vitality

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HONG KONG, June 24 (Reuters) - Hong Kong has a deepening love affair with a system that allows major institutions or rich individuals to buy stakes in IPOs before the companies’ sell shares to the public but it may be undermining the vibrancy of the city’s stock market.

The Chinese territory, the world’s biggest initial public offering venue, has been unique in the way it has used so-called cornerstone investors, who agree not to sell the stakes they acquire in the IPO within a specified “lock-up” period, to a much greater extent than any other major market.

The Hong Kong system has often been held up as one that bolsters confidence. It signals that big investors and the smart money are committed to the company doing the IPO, and they aren’t going to bail out as soon as the shares start trading.

But now, the cornerstone investors are taking up such a large percentage of the IPOs that there is little left for other investors, hurting liquidity once the shares start trading. The cornerstone money also becomes an overhang over the stock as the expiration of the lock-up period nears, and there are wider fears that the system is one of many signs that the market is losing its mojo.

Average daily turnover in the first five months of the year totalled HK$68.8 billion ($8.87 billion), down nearly 44 percent from the same period in 2015, while the benchmark Hang Seng index has tumbled about 27 percent in the past 14 months.

“Large cornerstone tranches ... create issues in terms of after market liquidity and share overhang, nearer the time of expiry of the lock-up,” said Philippe Espinasse, a former banker at UBS and Nomura.


China Development Bank Financial Leasing Co IPO-CDBL.HK is the biggest poster child yet for the trend. The leasing unit of China's state-owned development bank has already pre-sold between 68 percent and 78 percent of its IPO, which could raise as much as $1.13 billion. That means it is set to take the questionable honour of having the Hong Kong listing with the biggest-ever percentage level of cornerstone investment.

The IPO itself is pricing on June 30 and the shares are due to start trading July 11. CDB Leasing declined to comment on its cornerstone strategy.

It has attracted six cornerstone investors, including Three Gorges Capital, China Reinsurance and Hengjian International, the overseas investment arm of China’s southern Guangdong Province.

CDB Leasing is not alone. Nine out of the top 10 IPOs in the territory over the past year counted on cornerstones for about 50 percent or more of their deal proceeds, underscoring the growing influence of these share sales in Hong Kong IPOs. Just two years back, cornerstone investors would typically account for only about one-quarter to one-third of an IPO.

When the cornerstone system first came to prominence about 10 years ago at a time when there were a lot of large Chinese company stock listings in Hong Kong, it was widely regarded as being complementary to the sale of shares to other investors in the IPO. The presence of big names on the share register gave investors increasing confidence and the lock-up period helped to put a floor under the share price when trading began.

In those days many IPOs were heavily oversubscribed, sometimes by more than 500 times, and the cornerstone holdings were more modest, usually well below 50 percent of the overall allotment of shares.

Now, many companies have allocated more than 50 percent to the cornerstone investors. Bad debt manager China Huarong Asset Management Co had 63 percent of its $2.5 billion IPO, the largest in the past year in Hong Kong, bought by cornerstones, while for China Reinsurance (Group) Corp’s $2.12 billion deal the figure was 52 percent. Aircraft lessor BOC Aviation, which went public last month and has a similar business to CDB Leasing, also had a 52 percent cornerstone tranche for its $1.13 billion deal.

Such a high percentage of cornerstone investors sharply reduces trading volumes on the stocks, because shares are locked up for at least six months. It also creates the overhang as investors fret about a sudden supply of shares hitting the market once the lock-up period expires.

China Huarong has traded only $3.2 million a day on average since going public, a fraction of its $15.4 billion market capitalization, while ChinaRE has traded an average $9.2 million and BOC Aviation $35.6 million on average a day.

The move underscores the strategy that some companies, particularly Chinese state-owned enterprises (SOEs), and their underwriters go through to get their deals completed despite market jitters, including the make-or-break European Union referendum in Britain this week.

“We’ve got the Brexit vote this week and the IPO market volumes have been down this year. It’s still a large amount of stock and you can’t really rely on retail investors to participate these days,” said a Hong Kong-based equity capital markets (ECM) banker in reference to the CDB offering.

The trend has become more prevalent the past year as global markets have been on edge over a slowdown in China’s economy and on concerns that U.S. interest rates were heading higher.

Chinese state-owned companies tend to rely more heavily on cornerstone investors even during market downturns and they can often count on other state firms when global pension funds and asset managers stay on the sidelines, bankers said.

“SOEs make a plan to list and they stick to the plan. They’re not going to pay attention to the realities and vagaries of the market,” said an equity capital markets banker. “Unlike most issuers elsewhere, they also have the ability to call in some favours and make things happen if they need to.” ($1 = 7.7570 Hong Kong dollars) (Reporting by Elzio Barreto; Editing by Denny Thomas and Martin Howell)