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Solid As A Rock - Academic Tests The Value Of Hong Kong's "Cornerstone Investors" For IPOs

Tom Burroughes, Group Editor , 13 November 2015


IPOs are important liquidity events - as wealth managers know - and Hong Kong's practice of embracing "cornerstone" investors has drawn some controversy. An academic crunches some numbers.

Floating shares on a stock market brings a number of risks and one jurisdiction that tries to inject stability into the process is Hong Kong through the practice of involving what are called “cornerstone” investors – typically wealthy persons or organisations. The practice has become controversial in some quarters, prompting a Hong Kong academic to analyse it.

In October, for example, the Wall Street Journal, citing unnamed sources, reported that China International Capital Corp raised nearly 60 per cent of its planned $800 million initial public offering in Hong Kong from cornerstone investors. CICC is China’s largest foreign-backed investment bank and the earliest to gain foreign backing. It is partly owned by KKR & Co. An article on www.breakingviews.com claimed that the practice in Hong Kong is “spinning out of control”, saying that large firms planning share sales “now routinely pledge half or more of them to friendly investors”, giving examples such as China Huarong Asset Management, the state-owned financial firm seeking to raise up to $2.5 billion; it also gave cases such as that of China Reinsurance. 

Cornerstone investors commit funds to an IPO and agree to buy at the float price; however, they must hold the stocks for a period of time once the shares start trading. This removes the risk, advocates say, of such IPO participants dumping the stock immediately after a float to make a short-term killing.

In an analysis of the practice, Professor Paul McGuinness of the Chinese University of Hong Kong Business School examines the role cornerstones play.

The report states that cornerstone investors are typically high net worth parties, and include among their number local tycoons, Chinese state-invested entities, privately controlled public companies, sovereign investors and institutional investors like asset managers. 

Professor McGuinness says that unlike private equity investment, cornerstone investment comes in during the IPO period itself (although the contractual obligations surrounding such agreed allocations are finalised just prior to the prospectus release).
Cornerstone parties thus pay the same offer price as all other IPO subscribers. By contrast, he notes that any private equity investment occurs well ahead of IPO, sometimes months or even several years prior to listing. Private equity stakes typically occur at sizeable discounts to eventual IPO offer prices, at least in those cases where listing of the invested entity arises.

The fact that the particulars of cornerstone allocations are disclosed in the IPO issue document (prospectus) means such parties' identities are revealed before the formal application period starts. "Cornerstone investors are lending visible and high-profile support to the IPOs," he said. At the same time, Professor McGuinness said the larger such allocations and the more extensive the lock-ups (typically set at a minimum of six months), the greater the potential "certification (i.e. endorsement) effect."

Why has this practice become so prevalent in Hong Kong? The report said it is based on several forces. "On one hand, Hong Kong's regulatory environment is quite flexible, which allows for significant cornerstone investor presence. On the other, the emergence of cornerstone investment is closely tied to the growth and expansion of mainland Chinese enterprises as well as Hong Kong's strategic and political relationship with the mainland. International institutions, corporate parties and Asian tycoons have shown a keen interest in investing in Chinese companies listed in Hong Kong, so the demand is strong. Other markets may also have regulatory flexibility but not necessarily the demand for such allocations,” Professor McGuinness said.

“Many market watchers see cornerstone parties as value investors. The typical nature of such parties, sovereign funds, institutional investors, tycoons and high net worth individuals, as well as the post-IPO lock-ups that they have to adhere to, suggest certain certification effects. Cornerstone presence therefore serves as a potential signalling device,” he added.

In a research paper titled IPO firm value and its connection with cornerstone and wider signaling effects, Professor McGuinness examines cornerstone investors' role in signalling or certifying IPO value. He says certification effects have been widely examined in connection with venture capital investment, dating back to Megginson and Weiss' (1991, Journal of Finance, 46/3: 879-903) study on the subject. However, there is very little information about cornerstone investment in the academic literature.

The study focuses on IPOs launched on HKEx's Main Board between January 2005 and December 2009, a period characterised by a proliferation in cornerstone investor agreements. Among the findings is that cornerstone presence displays strong association with initial value multiples, market-to-book (M/B) ratio and Tobin's Q ratio. (When the Tobin Q ratio is between 0 and 1, it costs more to replace a firm's assets than the firm is worth. A ratio above 1 means the firm is worth more than the cost of its assets.) Strong associations are also apparent, the report says, when looking at other cornerstone dimensions: size of allocation, lock-up period and number of investing parties. Thus, greater cornerstone involvement correlates with higher M/B and Tobin's Q levels. The study also examines possible causal effects between equity value and cornerstone participation.

The study's second major finding, which reinforces the signalling angle, is that cornerstone investment tends to go with post-IPO earnings growth. Thirdly cornerstone invested-entities have more resilient and more stable trading volumes during an IPO firm's first 30 days' listing. 

Recent data from KPMG, meanwhile, showed that the total IPO funds raised on the Hong Kong Stock Exchange for the first six months of 2015 was HK$129.4 billion with 45 newly listed companies. The IPO funds raised in Hong Kong in the first six months of 2015 were dominated by the listings of two Chinese securities companies, with funds raised of HK$70.8 billion in aggregate. Huatai Securities (carrying on business in Hong Kong as “HTSC”) debuted on the exchange in June 2015; Hong Kong secured the world’s largest IPO market position in terms of funds raised in the first six months of 2015. The market was dominated by Huatai Securities, the world’s third largest and Hong Kong’s largest IPO year-to-date, and GF Securities.


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