Gate Fees: The Pervasive Effect of IPO Restrictions on Chinese Equity Markets
Charles M C Lee, Yuanyu Qu, Tao Shen
Review of Finance, Volume 27, Issue 3, May 2023, Pages 809–849, https://doi.org/10.1093/rof/rfac044
Due to tight IPO regulations, unlisted firms seeking access to public equity markets in China face substantial costs. We use the shell value paid by private firms in reverse merger transactions as an empirical proxy for the economic impact of these regulations. We find that shell values are, on average $500 million, representing approximately 22% of the market value of the average listed firm. We argue that this large—and largely hidden—gate fee has far-reaching implications for the Chinese stock market.
Our analyses show that low mortality rates, the frequency of major-asset restructurings (MARs), and the size premium are all more pronounced during tight IPO regimes (2007–2018). In the cross-section, we find that firms with a high likelihood of becoming shells (high-ESP firms) are three times more likely to pursue MARs than firms with a low likelihood of becoming shells. The stock prices of high-ESP firms are less sensitive to corporate earnings but more sensitive to regulatory shocks that affect their shell value. Moreover, after we control for other pricing factors developed expressly for Chinese markets, high-ESP firms earn higher monthly returns. In fact, we find that adding ESP to a full-sample version of LSY’s CH4 model results in a “benchmark” pricing model that outperforms all Chinese asset pricing models discussed in the literature.
The overall effect of China’s regulations is to impose substantial risk and uncertainty on firms that seek to go public in domestic equity markets. Our paper highlights the pressing need for regulatory reform, particularly with respect to the rules and policies governing IPOs. Our message for other emerging countries is that it pays to proceed with caution when regulating new entries.
Figure 2B. Shell Value Deflated by the Average Market Value of Equity
