Hong Kong Stock Exchange's Path to Modernization

Hong Kong has established itself as one of the top IPO venues in the world. According to the World Federation of Exchanges, the Hong Kong Stock Exchange ranked no.1 five times in the last 8 years (2009, 2010, 2011, 2015 and 2016). This is due to its simple tax system, established professional services industries, common law system and proximity to the mainland.

In the last five years, improving market integration with and giving foreign investors access to mainland companies have been Hong Kong’s core strategy. In 2012 and 2014, equity trading links to the mainland were set up through the stock connect programs to Shanghai and Shenzhen respectively. On July 3 this year, the China-Hong Kong Bond Connect program began, giving offshore investors another way to access the mainland’s $10trn market.

Not All Rosy

However, Hong Kong has every right to be worried about its future importance to the Asian financial markets. The Hong Kong stock exchange has seen some wild erroneous moves this year. Huishan Dairy Holdings declined 85% on March 24 after becoming a target of activist short seller Carson Block from Muddy Waters.

More recently on June 27, more than $6.1bn was wiped out from the Small-Cap stocks after the “Enigma Network” report from former HKEX board member and activist investor David Webb riled the Hong Kong market; 17 companies had lost more than 40% of their value, among them was China Jicheng and Greater China Professional Services both of whom sank more than 90%.

These recent market routs have investors and policymakers questioning the integrity of the market, whether there are more problematic companies waiting to be uncovered by the next short seller, and whether this may discourage prospective companies from listing in Hong Kong.
Shrinking Significance?

The growing influence and competency of the mainland has everyone contemplating whether they should eventually stop relying on Hong Kong’s platform to connect with international investors. In 1997, Hong Kong accounted for 16% of China’s total GDP, this number is only 3% today.

Another problem with Hong Kong’s market is its industry composition. The HKEX Main Boardis rooted in the ‘old’ economy that although has served the economy well, is extremely susceptible to external shocks and cyclical movements in the economy. Financial, and Property and Construction companies make up 44% of the Hong Kong stock exchanges’ total market capitalization, whereas only 10.2% is from IT companies as of the end of 2016.

While IT’s share of the market has increased from 3.76% in 2012 to its current level (14.3% YOY increase), it is still underrepresented compared to other major financial centres. For example, the market capitalization weighting and composition for the New York Stock Exchange (NYSE) is more balanced. Financial and Real Estate account for 35.9%, while Information Technology accounts for 33% of the S&P 500’s total market capitalization.

To address these problems, the Hong Kong Exchanges and Clearing (HKEX) issued two new concept papers last month. The first paper outlines plans to overhaul the current Growth Enterprise Market board (GEM) listing requirements, and second paper details a proposal of the “New Board” to attract “New Economy” companies.

Rough GEMs

GEM, first established in November 1999, originally addresses an issue that HK attracts too few SMEs, or ‘growth’ enterprises to list. It would allow companies ineligible to list on the Main Board to use the GEM as a “stepping stone” to the Main Board (streamline transfer process took effect on 1 July 2008). The higher listing requirements of the Main Board would originally have prevented these companies with potential from access to equity capital market financing.

However, the current rules which allow these small, loosely regulated companies to list on GEM have created an environment where such problematic companies flourish. The NYSE, for example, says that companies trading at less than $1 per share (penny stocks) will face delisting after 30 consecutive days. HKEX has no such rules in place.

When 40% of the roughly 2000 common stocks traded is less than HK$1 per share, accounting for 4% of the total market capitalization of the exchange, it highlights the structural flaws created by GEM. New listings on GEM are only required to offer a minimum 25% of total shares to a minimum of 100 shareholders.

Since senior management is likely to keep the lion’s share for themselves, this creates a low liquidity, high volatility environment resulting from a high concentration of public shares in few shareholders. The potential big moves have attracted the attention of short sellers to descend on GEM-listed companies. In the recent stock rout, 7 of the 20 biggest decliners were listed on the GEM. The top three decliners were GEM companies: Luen Wong Group (-89%), Greater China Professional (-94%) and China Jicheng Holdings Ltd. (-95%).

Five Key Changes

The aforementioned first paper proposes to increase the listing requirements for GEM to tackle issues of low liquidity/high volatility and quality of listings. Some of the proposed changes include:

• Increasing the minimum cash flow requirement from at least HK$20m to at least HK$30m: Greater cash flows indicate more operational stability to pay off short-term obligations
• Increasing the minimum market capitalization requirement from HK$100m to HK$150m: Higher market cap requirement reduces the number of potentially “bad” companies looking to obtain equity financing, increasing protection for public shareholders. Also, the higher market cap possibly represents greater confidence in the company
• Changing the post-IPO lock-up requirement on controlling shareholders from one year to two years: Longer lock-up period requirement would prevent controlling shareholders from trading on insider information, therefore increasing market confidence in the company
• Increasing the minimum public float value of issuing company securities from HK$30m to HK$45m: Greater public float value can increase market efficiency. However, it is necessary to increase the percentage share of public float (currently at 25%) to reduce share concentration

Re-positioning the GEM as a stand-alone board. Done by removing streamlined process from GEM to Main Board, and requires the company not to have been subjected to disciplinary investigations by the HKEX for 24 months to be considered for board transfer: More stringent regulations to ‘upgrade’ to Main Board should improve corporate governance

Addressing the New Economy

Another initiative proposed by HKEX is a new exchange platform for underrepresented “New Economy” sectors. The “New Economy” encompasses generally high-tech venture industries such as Biotech, Health Care Technology, Internet & Direct Marketing retail, Internet Software, IT Services, Software, Technology Hardware, Storage & Peripherals.

Both the Main Board and GEM require that the company must be profitable to be considered for listing. Many of the “New Economy” sectors are unable to reach profitability due to factors including aggressive growth strategy and upfront research and development (R&D) costs. For example, biotech and healthcare tech companies have extremely high R&D costs, and would likely not be profitable until the product becomes commercially viable. HKEX seeks to address this missing market with the New board.

New board PRO companies need to have HK$200m minimum market capitalization and are only open to professional investors but do not require prior financial track record. Meanwhile, New Board PREMIUM companies need to have equivalent listing requirements as Main Board companies (minimum HK$500m market cap and public float of HK$125m) but are open to both retail and professional investors.

Furthermore, the New Boards would for the first time allow a weighted voting rights (WVR) structure which could make a listing in Hong Kong more attractive because it gives greater voting rights to founders, thus protect their vision for the company.

HKEX have explored the inclusion of WVR structures for SMEs in the GEM exchange back in 2014, after losing out on Alibaba’s IPO to NYSE because the HKEX refused to allow senior executives to nominate its board. However, the proposal was ultimately put on hold after mixed responses from over 200 respondents which consisted of large corporations, government and independent organisations. On the one hand, the ones who voted against WVR state that the structure violates the ‘one share, one vote’ principle of the HKEX.

On the other hand, the ones who voted for WVRs believed that it is applicable in certain circumstances, and the simplistic ‘one share, one vote’ principle can lead to short-termism in the absence of a controlling shareholder. No matter which side of the argument is correct, it is undeniable that Hong Kong’s loss is New York’s win. Alibaba went on to record the biggest ever IPO, raising over $25bn. Other developed markets have a similar, more flexible system in place for high tech, intangible asset-heavy companies.

For example, Snap Inc. has never made positive operating cash flow or profit, but still,manages to list on NYSE and was valued at US$25bn in this year’s hottest tech IPO. Co-Founders Evan Spiegel and Bobby Murphy hold a combined 88.5% of the voting power as a result of the triple-class WVR structure, giving them uncontested decision-making authority.

Keep up With the Competition

Major exchanges are developing innovative solutions to attract IPOs from foreign companies. Singapore stock exchange is actively considering the listing of companies with WVR structures, while the London Stock Exchange is considering an “international segment” on which large international companies with WVR structures can list.

If HKEX does not take steps to keep up or go beyond the competition, they could get left behind in the modern financial system. The revisions to GEM could mitigate the issues resulting from the small public float, while the New Board can attract local “New Economy” sectors to consider Hong Kong over New York. Whether these changes will be effective or not, it is a step in the right direction.