Are We Witnessing a Giant Debt for Equity Swap?

A working theory by Chinese and foreign observers of the Chinese stock market run up has posited that listed companies are using this time to issue new equity buying out old debt and reducing leverage.  While this is an attractive theory, the data does not support the idea that this is taking place.

If we begin with broad market data on IPO and SEO offerings, we see that many firms are rushing to markets with IPOs.  In the past years, IPO’s have averaged about 25 per month in China but these have typically been relatively small IPOs with an average of 547 million RMB raised per IPO.  By Chinese standards, this is virtually irrelevant from a macro-financial perspective.

If we focus on SEO offerings, there has been an increase the number of firms with secondary offerings and an increase in the amount of total capital raised, but has been nothing like the flood being discussed.  For instance, the number of firms having SEO offerings appears structurally higher but only moderately higher, with lots of month to month fluctuations, and total capital raised reflecting similar patterns.  Total monthly capital raised in the first 5 months of this year averaged 69 billion rmb which a higher than the average 51 billion rmb raised during the same time frame in 2014, but not exactly what one would call a flood.  Furthermore, the average value of capital raised per firm declined from 1.65 billion rmb to 1.46 billion rmb.  While these are not completely insignificant sums of money, 69 billion rmb in equity raised monthly  in a capital market the size of China is virtually irrelevant and does not represent a flood of companies seeking to swap debt for equity.

If we break it down further to look at individual offerings and location, we see a similar pattern.  For instance, since the beginning of 2014, approximately 60% of new stock offerings have been offered by Shenzhen listed firms rather than Shanghai listed firms (180 to 115 to be precise).  Given the differences in types of firms, this results in significant differences in offering size.  The average secondary offering  size since the beginning of 2014 has been  364 million rmb in Shenzhen and 814 million rmb in Shanghai.  As noted in the previous post, given that most firms in Shenzhen are not what would be considered key firms and that most of them are many magnitudes smaller than their state owned competitors, this tells us that while smaller and private firms may be trying to raise new capital, there is scant evidence to support the idea that a macro-financial debt for equity swap is taking place.

There is one final points that makes the behavior of firms and regulators interesting in China.  While firms are typically motivated to obtain the highest price possible for the equity and investors typically see new share issuance as a negative sign, the complete opposite appears to happen in China, at least in the past 18 months.  For instance, the average stock price gain 5, 10, and 20 days after issuance on new stock was 117%, 184%, and 207%.  In one famous case, a post-IPO Shenzhen tech firm gained the maximum 10% every day after debuting for a number of months.  Three, six, and 12 month gains witnessed a flattening and then large declines based upon the original offer price with gains of 232%, 220%, and then 109% from original offer price respectively.  This implies that investors, initially caught up in the euphoria of a new stock offering bid it up rapidly until it peaks approximately 3-6 months after the original issuance, at which point reality sets in and a long term decline begins which still leave original investors better off than the original offer price but having lost a lot from the peak.  Given high average turnover rates however, it is unlikely that original investors remain invested in the stock.

Whereas firms and IBs in most developed markets are free to set equity offering prices pretty much at whatever they deem fair, Chinese regulators assume a much stronger role in initial price determination.  The average PE of newly issued stock is 22.6 with a standard deviation of 5.3.  In Shenzhen those numbers are 23.2 and 5.9 respectively while they are 21.7 and 4.1 in Shanghai.  On a broad market basis, regulators seem to be under pricing new share offerings in Shenzhen but overpricing them in Shanghai.  In fact of equity issued since the beginning of 2014, which is somewhat biased due to the recent stock increase, 6 months after issuance, Shanghai offerings are up 288% compared to 1,407% compared to Shenzhen.  There is no known clear reason why firms are essentially required to forgo lots of capital in order to under price their share offerings.  Furthermore, if the regulator was pushing firms to delever by swapping it for equity, this is a very expensive way to pursue this strategy by significantly under pricing the shares on offer.

It is incredibly tempting to try and read rational motives into the behavior of regulators, investors, and firms.  One theory on offer is that the stock market run up is allowing heavily indebted firms to delever by selling equity to buy out debt.  However, there is little evidence of this happening and definitely not in amounts necessary to reduce corporate debt levels or by the major companies in China.  While Chinese stocks may not be as overvalued as a whole as some believe, firms definitely are not using this time to delever by any significant degree.

Note:  Here is the data used in this analysis from WIND