STAR Launched

China has been transforming the business landscape for the last forty years. Starting from the 1980s, China has become an industrial powerhouse from an agrarian society in 40 years. Many international businesses shifted their manufacturing facilities to China and the manufacturing output spiked. Then, the Chinese economy moved forward, being one of the fastest-growing economies despite its size. Along the way, Chinese tech companies started to blossom. Most notably, Alibaba and Tencent made their breakthroughs in the last decade. However, including these two, other big Chinese tech companies such as Baidu (BIDU), JD.com (JD), Xiaomi and Pinduoduo (PDD) chose either New York or Hong Kong to go public instead of Shanghai.

Chinese industrial revolution, which started 40 years ago, transformed the country

 The Shanghai Stock Exchange has never been a major player, although China hosts the largest banks in the world. Liquidity was always problematic, and many Chinese tech companies found the solution elsewhere. For instance, Alibaba went public in New York Stock Exchange (NYSE) and Tencent stocks were circulating on the Hong Kong Stock Exchange (HKEX). Now, this about to change. Star Market (STAR) presents a new exchange platform for Chinese tech companies amid the infamous trade war. Tensions between the world’s two giants spread to the technology sector and peaked when Donald Trump signed an order banning the use of equipment made by China’s Huawei. It is uncertain that Nasdaq-like stock exchange initiative is related to trade wars, but that initiative turned into a reality this week.

Before moving further, we need to investigate US counterparts to understand what China targets. NYSE was founded in 1817 and has been hosting the greatest firms in the world since then. The Nasdaq, founded in 1971, is relatively younger. Nasdaq and NYSE have certain operational differences in terms of auction-dealer type and market-making. The yearly listing fee in Nasdaq is much lower than the NYSE listing fee. However, the greatest difference between the two is the companies listed. The stocks on the NASDAQ are more volatile and growth-oriented. Many tech giants are listed on Nasdaq reinforcing the perception of its technology orientation. NYSE stocks are less volatile and more stable. Therefore, it should not come as a surprise that Amazon and Google are listed on NASDAQ and other giants like Coca Cola, AT&T, and Chevron, etc. on the NYSE.

This week, China launched the STAR market. The top 25 stocks listed on STAR gained over 100% on average on the first day of trading. Shares in Anji, which makes materials for semiconductors, ballooned as much as 500% (before trimming those gains to 400%) that trading of those stocks was suspended for the stabilisation purposes. The market imposed a set of rules including halting trading for 10 minutes if a company’s stock rises or falls 30% from its opening price during the first five days of trade or 10-minute suspension if the jump or fall hits 60% during the day. Those rises and falls are uncommon in US stock exchanges. We can conclude that STAR made a huge breakthrough and Chinese tech companies got massive investment. Now the question is what’s next? Will international companies also be listed on the STAR market? Is the throne of Nasdaq at stake?

Shanghai, the commercial capital of China, hosts the STAR market

 STAR has several initiatives to take down Nasdaq, starting from attracting Chinese companies floating elsewhere. The new tech board has fallen into line with the NYSE, Nasdaq and HKEX by allowing listings of companies with dual-class shares. That change is mainly for attracting Chinese tech companies trading overseas. At the end of 2018, 156 Chinese companies were listed on major U.S. exchanges with a total market capitalisation of 1.2 trillion USD and 1,146 mainland companies were listed in Hong Kong, with a market capitalisation of 2.6 trillion USD. Still, considering the size of Nasdaq and STAR (10 trillion USD / 80 billion USD in market cap vs 90 billion USD / 7 billion USD in daily trading — first-day trading data — volume respectively) NASDAQ will still be the likely route for going public for both Chinese and international companies.

Nasdaq is the second-largest stock exchange in the world by market capitalization, behind only the NYSE

However, it is not unrealistic that if the trade war intensifies (last month, U.S. introduced legislation that would subject Chinese companies listed in the U.S. to stricter financial reporting requirements), Chinese companies in the US will have more reasoning to go back to China. The critical question will be the financial success of the STAR market.

Conspiracy theorists claim that Star is the new Nasdaq. However, pundits have doubts about the long-standing success of the market. Previous attempts of China to create a rival to Nasdaq in 2009 and 2013 failed because of a lack of quality listings and limited turnover in shares. Shanghai’s Star Market might be different. Supporters claim that Chinese retail investors were relatively inexperienced in trading and they easily fell for speculation. There are also reform efforts ongoing to improve the application process and increase transparency. Chinese stock markets became more mature and foreign investors have more confidence in taking their firms public in China than in the past. Still, those doubts revolve around the virtuous cycle of the stock exchange. Liquidity attracts companies and investors that can create further liquidity. Only the financial gains of the STAR market can attract more liquidity to the market.

Until so far, the market has made three tech executives billionaires. On average, the stock prices went up nicely. Star-listed companies were worth 120 times earnings on average by the end of the first day, according to Wind, a Chinese market data provider. Nasdaq stocks are typically worth 24 times earnings. Although it seems spectacular and flashy, sustainability puts a huge question mark. The government efforts played a huge role in those valuations, Chinese president taking part from the announcement to launch. Besides, funds did not miss the opening day because of the fear of missing out. So, it was a great start. However, these valuations are merely aberrations and will come to more reasonable levels. When the dust settles, I think STAR will take its place in the landscape, not a direct competitor to Nasdaq but an alternative way for the tech entrepreneurs. For long-term success, the market should not solely depend on Chinese entrepreneurs and could attract international companies. As a starting point, it should be an attraction point for entrepreneurs in Asia. Thus, STAR should prove its competence against Hong Kong and Taiwan before challenging Nasdaq. For now, we can safely say that Nasdaq is not relinquishing its throne.

IPOs are not dead

It is a year now by the time Spotify went public on the New York Stock Exchange on April 2018. Spotify was always disruptive for the music industry, but its public offering also sparked a well-known dispute again. The pinnacle of discussion reached when Spotify’s chief financial officer Barry McCarthy said “It’s moronic”, implying IPOs. Spotify exercised a Direct Public Offering (DPO), also known as a direct listing instead of an investment bank-backed Initial Public Offering (IPO). Slack followed the suit in June 2019. Considering the huge fees that investment banks charge for the IPO, now DPO is in everybody’s lips nowadays. Is DPO the new version of IPO or applies for only a handful of companies?

Before jumping the discussion, let’s analyse the stock performance of them. The Spotify stock (SPOT: NYSE) started with 166 USD in April 2018 and dipped with 103 USD in December 2018 and now trading around 144 USD. Although the first period until December seems complex even grim for the retail investors, the combination of slow growth and decreasing ARPU caused that. Then the company applied a huge buyback (stock repurchase) worth 1bn USD in December 2018. It worked and the stock price went up again. Slack Stock (WORK: NYSE) started with 36 USD now trading at 31 USD, but still, we are in early days.

It is no surprise that after reaching a certain threshold, companies go public for several reasons. Investment banks play a crucial role in the process, form a syndicate in case a large IPO. They provide advisory and underwriting services. They look at the data, exercise due diligence and come up with a valuation in line with the management and the business plan. It is not different from the acquisition of a private company. Then, (equity) underwriting process begins. Banks buy shares at a determined price and sell to their network. Generally, they charge fees 1.5% to 7% dependent on the size. Considering a 20 billion USD IPO, investment banks collect 300 million USD for the services they provide. Because some say it is moronic to pay those fees, we can dig up further and compare two alternatives.

DPOs are far cheaper as a company does not pay underwriting fees. However, please remember that IBs still take part in the advisory part. For example, Spotify hired Morgan Stanley for advisory. However, they got rid of the huge underwriting fees. For example, Uber paid 106 million USD to its underwriters, while Spotify gave about 32 million USD to its financial advisers. Surely, bankers use the money to reach investors and understand their willingness to pay — roadshows — before listing. Since Spotify is well-known all around the world, the management probably did not need to present the company disclosing its full financials during those roadshows.
Bankers usually define the price of the stock at a discount to attract investors and keep the liquidity high in a conventional IPO. As a rule of thumb, stock prices go up on the first day. However, sometimes it goes up to 50% higher than the starting price. It means that shareholders miss a great chance and leave too much on the table. Therefore, the valuation, which investment banks define and the management approves has the utmost importance. Because that’s the price bankers market the securities. Conversely, in DPOs market forces define the price.

IPO is a tool for raising capital. The company with the help of the investment bank issues new shares and sells it to the public. DPOs do not enable companies to raise capital. Previous shareholders sell their stock to the public. Although it seems counterintuitive for companies going public, it was the case for Spotify. Spotify closed a funding three months before the IPO. Therefore, it has all the money they needed. Therefore, investors should believe the growth trajectory if they invest in DPO. Although it seems DPO is the favourable option, please keep in mind that DPOs can have the first day crashes.

Companies usually distribute the employee stock option plans to attract the top talent. Considering the size of the company, even thousands can have those plans. After years of employment, IPOs are a good way to turn those years into cash. Yes, and no. Yes, you can sell your stock in the public market. But you cannot do it right after the IPO. The employees must keep those stocks for a decided period — 1 year, mostly. It helps to stabilise the first day and later pricing. However, in DPOs, employees may sell their stocks when they want, despite the possibility of creating volatility. Spotify should have trusted that employees still see growth potential in the company and they do not sell all their stocks right away.

Traditional IPOs provide stability and liquidity that are both important but they charge for that service. They do. On the other hand, DPOs are more adventurous method betting higher. Does DPO make sense? Yes. Is it the future of going public? Not likely. I assume that other companies continue to try DPOs but I think DPOs are suitable for a few. Spotify was a B2C business and had a huge brand name. Millions of people used it every day, and it did not need to market its name. Besides, it did not have to raise money closing a funding round a few months prior. Therefore, it had a somewhat unique path to going public. The management trusted investors to value the company higher and higher without marketing the company — providing financial documents, management plans, etc. Consider an American B2B food company produces crackers and sells to grocery retailers (supermarkets, etc.). It would have a different trajectory and possibly need the help of investment bankers for underwriting and roadshows. European and Asian investors would know little and see all the financial data, growth story, business plans, etc. A DPO would be a disaster for that hypothetical company. To sum up, DPOs will still be a less likely option for companies going public. Companies that have certain treats like Spotify could exercise but need to be ready for 40% valuation losses.