In an effort to combat shell-creation and related activities so as to safeguard the interest of the investing public, the Stock Exchange updated guidance letter HKEX-GL68-13A in April 2018, setting forth additional guidance on how it will assess new listing applicants’ suitability for listing on the Stock Exchange.
The Stock Exchange’s annual listing decisions indicate a marked increase in the number of new listing applications being rejected. Listing decision 121-2019, published in March 2019 detailed 24 listing applications rejected in 2018, while listing decision LD119-2018, published in March 2018, detailed only three new listing applications rejected in 2017. This increase comes as the Stock Exchange ratcheted up its scrutiny and assessment of suitability for listing of new listing applicants.
On the passing of the anniversary of the updating of guidance letter HKEX-GL68-13A, we take this opportunity to share some of our observations on what this enhanced scrutiny entailed by focusing on three of the most critical factors which the Stock Exchange have cited in recent rejections of new listing applications (see Listing Decision LD121-2019 issued by the Stock Exchange). These include a listing applicant’s commercial rationale for listing, including funding needs; valuation and methodology used; and the make-up of the group to be listed. This note concludes with a brief discussion on the assessment of suitability.
Lack of commercial rationale for listing and lack of genuine funding needs
In principle, a company would seek a listing to raise funds on equity markets in order to fund further expansion in circumstances where its proposed expansion should be commensurate with past strategy, as public equity funds represent the best funding option.
A listing applicant and its sponsor should be able to explain, with basis, the rationale for taking the chosen development path and how applying the listing proceeds in the way described in the listing application and listing document will allow the applicant to achieve those future plans. Fundamentally, the listing applicant’s plans should be commercially sound and reasonable, and assumptions and bases used in forecasts should be reasonable.
Examples (non-exhaustive) of circumstances which had led to greater scrutiny from the Stock Exchange include:
- plans for expansion not supported by increased demand;
- deteriorating financial performance of existing business;
- expansion that is not commensurate with past strategy (for example, the business had not expanded materially for a significant amount of time or the expansion plans described in the listing application might appear to be significant compared to the existing scale)
- the application of proceeds would not make substantial difference to its business (for example, where funds are sought to acquire premises that an applicant already leases)
If a listing applicant is not able to demonstrate a commercial rationale for listing, this may call into question whether there is genuine need for the funds proposed to be raised. In addition to demonstrating a sound commercial rationale for its development plans, a listing applicant will be expected to demonstrate a genuine need to raise funding for such plans. Factors that may lead to greater scrutiny on this front include:
- the listing applicant has substantial amounts of cash and/or banking facilities to fund its expansion plans
- the projected cashflow of the expanded business is such that external funding might not be necessary for those expansion plans
- the listing applicant has historically been able to expand without relying on external funding
Valuation is an art as well as a science and there are many possible methodologies for determining the value of a company’s shares. That said, a valuation should be supported by a reasonable basis. Regardless of the methodology adopted, a listing applicant should give careful thought as to the inputs into the valuation.
- Factors to be taken into account: Only recurring revenue/income from the principal business of the listing group should be taken into account.If a listing applicant proposes to take into account one-off, new or other non-principal business revenue/income, it should be able to demonstrate a good reason for doing so.For example, the Stock Exchange is unlikely to accept the inclusion of income/revenue from a business that has only started and which the listing applicant is unable to demonstrate the same becoming a long-term principal and/or viable business.
- Comparisons: This issue feeds both into the selection of comparable companies, as well as determination of commercial justification for any premium attributed to the listing applicant in relation to the financial metric(es) being compared.
As for selection of comparable companies, the companies selected should be truly comparable to the listing applicant, in terms of product offering, market, scale, size, and other factors. In particular, if a comparable company that has been selected is an outlier in terms of a particular financial metric, the Stock Exchange might be more likely to place greater scrutiny on the selection of that comparable company.
Any premium in terms of a financial metric that is to be attributed to the listing applicant over the comparable companies would need to be justified by reference to forecast growth in revenue and profit, and other factors (for example, valid distinguishing strengths that has been robustly tested).
The reasonableness of a valuation will more likely be called into focus if a listing applicant only marginally meets the quantitative eligibility criteria for listing. Conversely, if a listing applicant comfortably exceeds the quantitative eligibility criteria and would do so even taking a conservative approach, valuation would less likely be scrutinised, although it should still be reasonable.
Composition of the listing group
It is common for a controlling shareholder of a listing applicant to run several businesses, and to seek a listing for only a portion of those businesses. This is generally permitted and, often, a pre-IPO reorganisation would be effected in order to achieve the desired listing group structure.
Care should be taken to ensure that the delineation between the listing group and the excluded group is not artificial or superficial. The make-up of a listing group should reflect the historical operation of the business(es) to be listed. The listing group should not be artificially assembled together for the purposes of meeting listing eligibility criteria.
If two distinct businesses/groups of companies which had historically not been operated as one integrated group and which on their own would not meet the quantitative eligibility criteria are brought together into a listing group (by way of a reorganisation), this would be considered artificial packaging of the listing group.
Additionally, there being similar businesses in both the listing and excluded group may give rise to suggestions of artificial delineation to exclude certain negative matters (for example, loss making subsidiaries that may impact on satisfaction of quantitative eligibility criteria or on valuation generally, or companies with instances of non-compliance). Such artificial delineations would also give rise to other concerns, such as competing interests of the controlling shareholder and conflicts of interests.
Assessment of suitability
While we have shared some observations on three particular factors in the assessment of suitability, these are not exhaustive and should not be used as a checklist. In particular, there are other factors which have not been specifically discussed in this note but which the Stock Exchange has indicated will be considered (for example, whether a listing is consistent with the applicant’s strategy). The Stock Exchange has emphasised that its focus is a qualitative review of a listing applicant’s suitability and that it has broad discretion in determining suitability.
One particular area in which the Stock Exchange is increasingly exercising its discretion is determining whether there are facts and circumstances for it to believe that the applicant is likely to invite speculative trading or to be acquired for its listing status. Such applicants are likely to be associated with shell-creation and related activities, which the Stock Exchange and SFC are trying to combat. Some of the facts and circumstances which may lead to such a belief include small market capitalisation; only marginally meeting the quantitative listing eligibility requirements; and superficial delineation of business from parent. Some of these circumstances may also overlap or be related to other factors and may call for a more focused review of suitability.
In the shadow of the authorities’ increasingly rigorous scrutiny of an applicant’s suitability for listing, demonstrating suitability and the related disclosures required becomes increasingly burdensome for listing applicants and their sponsors. It is therefore incumbent upon sponsors, with the assistance of all other professionals engaged in listing exercises, to work with listing applicants to likewise tailor adequate due diligence processes to identify, assess, test and address factors and matters deemed critical by the authorities. Professional scepticism must be exercised. Due diligence and disclosures will need to be geared towards demonstrating suitability and addressing circumstances which may lead to a negative assessment of suitability.