The market for initial public offerings has picked up significantly this year, with an estimated €8bn (£6.6bn) of issues being prepared in Europe in the first quarter. Alibaba, the Chinese e-commerce group, is riding the IPO wave, but prefers the US to the more local Hong Kong exchange. This decision appears to have more to do with corporate governance issues and exchange rules, but it shows that the IPO renaissance is global.
In the UK, Pets at Home and Poundland launched successfully in early March. These two retailers received institutional investor backing despite the market’s long memory of other retailers such as Debenhams, which went backwards after its flotation in 2006. Pets at Home and Poundland, however, offer investors defensive qualities with upward potential and they are less vulnerable to competition from online retailers.
Royal Mail’s soaring share price following its issue last autumn was an early sign of the rapid improvement in investor sentiment. The issue was priced at 330p but rose quickly beyond 550p to leave all involved looking rather foolish. The Business select committee examined the increase and demanded to know how such an underpricing could have been allowed to occur.
Only feeble excuses were brought forth. To be fair, there was talk of a strike – not exactly the right backdrop for an IPO when market conditions have been so sensitive for so long. In the event, the IPO was a roaring success, being launched at a watershed moment, with the before-and-after market conditions looking quite different. Interestingly, one analyst (at UBS) published a sell recommendation when the shares were 550p with a price target (that is, the price the analyst considers the stock should fall to) of 450p.
Stock exchanges see IPOs as an important source of new income and compete for IPO business. Newly launched companies contribute directly to exchange fee income and create trading activity, which generates transaction fees for the exchange. In 2013, the London Stock Exchange launched a new listing opportunity called the High Growth Segment with the precise intention of attracting high-tech companies that otherwise might have been tempted by Nasdaq or a competing exchange.
The idea behind this new listing class is to provide many of the benefits of a full London listing – and therefore be superior to the Alternative Investment Market – but with fewer of the demanding rules of a full listing, such as the requirement to list at least 25 per cent (the new High Growth Segment sets the minimum at 10 per cent). There is also a minimum size requirement of £30m – a clear signal that the new segment is not intended for the very small companies that should be accommodated on Aim. Just Eat, the online takeaway-ordering service, is expected to be the first company to apply to the High Growth Segment for a listing.
When Alibaba decided against listing in Hong Kong it could be because the rules set by the listing authority in Hong Kong did not permit the unusual board arrangements sought by the company’s management. It appears that Alibaba founder Jack Ma and other senior executives were keen to exert control over the board. Ma in particular has a fairly small shareholding of just 7.4 per cent, which does not afford him the degree of control he desires – that is, to avoid the board disagreeing with him.
Ma’s tactic has been to seek arrangements that allow a majority of the board to be selected by himself and other key managers. The Hong Kong listing authority rejected this request, so Alibaba switched its focus to the US. This led to calls by the head of the Hong Kong exchange for a consultation and review of its rules on such issues.
The most common technique employed by minority shareholders to control the majority of a company is by means of different classes of voting shares. Typically, a family that has owned a company might wish to retain control after an IPO, in particular to have the power to resist a takeover. If the family does not have a majority shareholding, it is vulnerable unless it can increase its voting power at the expense of the other shareholders. This can be done by issuing the family with voting shares and issuing external investors with non-voting shares. Control would then remain firmly with the family.
This type of capital structure is commonly used by venture capital investors, who usually seek a degree of control even if they only rarely exercise it. The venture capitalist would have A or B shares but would have the power to appoint a majority of the board even though their shares did not represents a majority of all shares. But anything is possible for private companies.
In London, split voting structures for public companies were outlawed many years ago and today democracy prevails: one share equals one vote. In the US, however, much greater flexibility is possible. When internet company Google listed, the two founders (Larry Page and Sergey Brin) kept control by converting their shares to a special class of ordinary share with 10 times the voting power of the shares issued to the new investors. The move attracted criticism at the time but is not uncommon in the US. Mark Zuckerberg, the founder of social networking site Facebook, did something similar and it has been used in the flotation of Manchester United football club in the US.
Chinese IPOs in the US in the past have raised questions. Between 2009 and 2011, a number of Chinese reverse IPOs in the US bombed. A reverse IPO is a special type of transaction. An IPO candidate is seeking to list. In this case, The Chinese companies could not list in China as the market there was effectively closed, so the IPO candidates looked elsewhere. One route that became popular was the reverse takeover.
Reverse IPOs – which are also outlawed in the UK – are a special type of transaction. First, you find an existing US company that is in a zombie state. In other words, its original reason for being has passed and it has no meaningful future – it is a shell waiting for a new occupier. An IPO candidate company can sell itself to this shell company in exchange for new shares, perhaps ending up with a large proportion of the enlarged company. The shareholders in the IPO candidate could end up with, say, 80 per cent of the enlarged company, while the shareholders in the shell company find their stake diluted to 20 per cent, but then they become shareholders in a real business.
There is an obvious disadvantage to the shareholders in the IPO candidate as their holding is also diluted, but they gain a listing for their shares. Because it is a reverse takeover, there is no conventional IPO, hence the disclosure requirements are lower and much less expensive.
A marketing of shares can then be arranged. This is often called a backdoor listing and has attracted a number of Chinese companies that have abused the mechanism. One was Sino-Forest, which turned out be a scam and led to Ernst & Young being fined $117m (£70m) for audit failures.
Alibaba looks like it is taking advantage of split voting but, combined with good valuations for new-generation technology stocks, the IPO should be a great success, with US internet group Yahoo, a shareholder, one of the beneficiaries.
The reverse takeover mechanism has not yet been outlawed in the US, even though it has in the UK. Alibaba is not using this mechanism but looks like it is taking advantage of split voting that is still permitted in the US but not the UK or Hong Kong.
Andrew Hampton is a former investment banker
Key points
An estimated €8bn (£6.6bn) of issues are being prepared in Europe in the first quarter.
Alibaba is a leading internet company in China, yet it decided against listing in Hong Kong.
The most common technique employed by minority shareholders to control the majority of a company is by means of different classes of voting shares.
