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An Unpopular IPO Rule Hands Chinese Banks Big Windfalls

When China rolled out its own Nasdaq-style listings venue last year, the country’s regulators forced investment banks to buy stocks in the companies they took public.

That unusual requirement for banks to eat their own cooking is now paying off big time.

In a measure meant to ensure underwriters brought good deals to market at fair prices, authorities required the most senior institutions on any deal on Shanghai’s Science and Technology Innovation Board, also known as the STAR market, to take part themselves. These banks, known as sponsors, must buy between 2% and 5% of the shares sold, up to a maximum of about $147 million, and then hold the stock for at least two years.

Chinese and foreign banks were wary of the risks this posed, not least because the country’s markets have experienced a series of booms and busts over the last decade and a half.

Amid a broader rally, however, things have worked out well so far. Banks have made hundreds of millions of dollars in gains on STAR stocks since the market launched in July 2019.

To date, sponsors have invested nearly 3.5 billion yuan, the equivalent of about $519 million, in the STAR market’s 20 biggest initial public offerings and secondary listings, Wall Street Journal calculations show. As of Tuesday’s close, those holdings had doubled in value to more than $1 billion.  

The overall totals will be much higher, since more than 180 companies are now listed on the STAR market, according to Shanghai Stock Exchange data.

Another major outlay will be necessary when Ant Group Co., the financial-technology group backed by

Alibaba Group Holding Ltd.

, goes public. It is preparing for a dual listing on the STAR market and in Hong Kong, in a deal that could rank as the world’s biggest-ever IPO.

The banks largely opposed the requirement in consultations last year with the securities regulator, according to several officials at investment banks in Shanghai.

Bi Mingjian, then the chief executive of investment bank

China International Capital Corp.

, told a public forum in November the rule was unique to China and “goes against market principles,” according to a recording of the event.

CICC has sponsored five of the 20 top deals. Its $207 million investment has turned into $440 million, according to Journal calculations. In its financial results, CICC reported an equity-investment gain of 1.5 billion yuan, equivalent to about $222 million, for the first half of this year and said much of this came from STAR stocks.

In its half-year earnings report for 2020,

Haitong Securities,

a major sponsor, said it had co-invested in five STAR companies. Its investments surged more than five times in value to 1.39 billion yuan, the equivalent of $206 million, it said.

To be sure, these are paper gains and the brokerage firms could be required to write down these holdings in the next year or so if there was a major downturn.

Shen Meng, director of boutique investment bank Chanson & Co., said banks had benefited from official moves to encourage more rational IPO pricing, which in practice meant lower valuations for some deals.

For example, he said one pricing mechanism sometimes used for STAR IPOs discarded orders from investors who placed the highest-priced bids. In some cases, he said, companies were pricing deals at lower multiples of earnings than their listed competitors.

Last month,

Swancor Advanced Materials Co.

sold shares on the STAR board that were priced at 12.8 times 2019 earnings, according to its prospectus. It said that compared with an average industry valuation multiple of 30 times earnings.

The rules are particularly challenging for Western banks, which are expanding in China. Beijing in recent years began allowing them to take control of securities businesses; previously, they were largely restricted to holding minority stakes in joint ventures.

Lijun Sun, the co-head of global banking for

UBS Securities,

UBS Group AG’s Chinese securities subsidiary, said the rules were a challenge for most Western banks, because they lock up capital and create conflicts of interest by making a bank act as both seller and buyer. Mr. Sun said Chinese and Western banks were still urging regulators to loosen the co-investment rules.

Western-backed brokerages in China also have relatively small amounts of registered capital, and are reluctant to deplete this by investing in deals. UBS Securities is the only foreign player to act as a sponsor for a STAR listing to date. In that case, the securities regulator let the parent company, UBS Group, make the investment so the deal didn’t reduce the mainland unit’s capital, Mr. Sun said.

The STAR board has shaken up China’s capital markets in other ways, dispensing with practices used elsewhere such as unwritten caps on valuation, limits on first-day market moves and rationing of IPOs by regulators.

Write to Xie Yu at [email protected]

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