Hong Kong IPOs - Increase in profit requirement for the Main Board
The Hong Kong Stock Exchange (the Exchange) released its consultation conclusions in May 2021, increasing the profit requirement for IPOs on the Main Board – the first increase in the last 26 years. The profit requirement was increased despite the current economic uncertainty, as the main reason for the change is to combat market misconduct that have arisen since the market capitalisation requirement was last increased in 2018. The new rules will take effect on 1 January 2022.
Changes to profit requirement
The profit requirement will be increased as follows:
| Requirement | Current rules | New rules |
| Aggregate profit requirement for the three-year track record period | HK$50 million | HK$80 million (i.e. 60% increase) |
| Profit requirement for the third year of the track record period | HK$20 million | HK$35 million |
| Profit requirement for the first two years of the track record period | HK$30 million | HK$45 million |
| Profit spread (last year vs. first two years of track record period) | 60% : 40% | 56% : 44% |
The new rules will take effect from 1 January 2022. In addition, the Exchange may waive the profit spread requirement on a case by case basis.
The 60% increase in the profit requirement is much lower than what the Exchange had originally proposed1. The Exchange had originally proposed either a 150% or a 200% increase, which led to strong resistance from the market, as this would make many small to medium sized issuers (SMEs) ineligible to list on the Main Board and weaken the Exchange's competitiveness against other stock exchanges.
The Exchange settled on a 60% increase in the end, as it is in line with inflation since the profit requirement was first introduced in 1994, and similar in range to the average of some of the alternative proposals put forward by market participants. The Exchange was also of the view that SMEs may choose to list on GEM instead of the Main Board. It was also of the view that the Exchange's competitiveness would not be affected as the profit requirement alone cannot be assessed in isolation without taking into account the overall listing regime.
Under the current rules for the Main Board, listing applicants that marginally meet the profit requirement would need a historical P/E ratio of about 25 times (based on the profit for the most recent financial year) at the time of listing to meet the minimum market capitalisation requirement of HK$500 million. The new rules translates to an implied P/E ratio of approximately 14 times, which is similar to the average P/E ratio of the Hang Seng Index between 1994 and 2020.
Waiver from the profit spread requirement
The Exchange may grant a waiver from the profit spread requirement on a case by case basis, provided that the listing applicant meets the new aggregate profit threshold of HK$80 million.
The Exchange will:
- assess the listing applicant's business nature and reasons for being unable to meet the profit spread (e.g. due to COVID-19);
- assess the need to include a profit forecast in the listing document so that investors can make an informed decision regarding the prospects of the applicant;
- enquire how the applicant's IPO price was determined based on the book-building process; and
- impose appropriate conditions (e.g. include a profit forecast in the listing document).
Combat against market misconduct
Applicants relying on the profit requirement for listing must meet the minimum market capitalisation requirement. The market capitalisation requirement was last increased in 2018 (from HK$200 million to HK$500 million), however, there was no corresponding increase to the profit requirement.
The regulatory concerns below also caused the Exchange to evaluate and increase the profit requirement.
Barely meeting the market capitalisation requirement or very high P/E ratios
Since 2018, there has been a huge surge in companies that marginally met the profit requirement, and which only managed to meet the market capitalisation requirement with a very high historical P/E ratio compared to their listed peers. These companies normally justified their higher valuations with optimistic profit forecasts, but they either failed to meet the forecasts and/or their share prices dropped considerably post listing.
Companies seeking to list under the profit test normally demonstrate compliance with the market capitalisation requirement based on its offer price. The Exchange is concerned that these companies reverse engineered their valuations in order to meet the market capitalisation requirement when there was insufficient interest in their shares at the offer price, which meant these companies may not have been suitable for listing in the first place.
"Ramp and dump" schemes
In these stock market manipulation schemes, scammers artificially ramp up the stock price using different means (e.g. nominee accounts), induce unwary investors to purchase shares before dumping the shares at a high price, causing the share price to collapse below the IPO price with negligible turnover afterwards.
These schemes often involve companies with small market capitalisation. Over the past few years, these problematic IPOs involved unusually high underwriting commission (some exceeding 20%) and other listing expenses that were disproportionate to the amount of IPO funds raised. The Exchange has reasons to suspect that some of the underwriting commission or listing expenses were used to finance arrangements to artificially satisfy certain initial listing requirements (such as market capitalisation and adequate spread of shareholders) or to carry out "ramp and dump" schemes.
Going forward
The change in the profit requirement represents a balance against competing interests. Although the amount and timing of the increase of the profit requirement may be questioned by some in the market, it is also important for the Exchange to address misconduct that has been identified to ensure that the Hong Kong stock market attracts quality companies.
In this connection, the Securities and Futures Commission (SFC) and the Exchange issued a joint statement in May 2021 on IPO-related misconduct, highlighting a number of factors that would lead to more enquiries, and reminding the market that they may object to new listings, suspend dealings or take other regulatory action if they suspect misconduct has taken place. Factors that would attract heightened scrutiny from the regulators include:
- the applicant's market capitalisation barely passes the minimum requirement under the Listing Rules;
- a very high P/E ratio, taking into account the applicant's fundamentals, its profit forecast, and valuation of its peers;
- an unusually high underwriting or placing commission or other listing expenses ; and
- a high concentration of shareholding in a small number of shareholders, especially if the public float is small and the spread of shareholders barely meets the minimum set out in the Listing Rules.
In addition, the SFC will also enhance its supervision of intermediaries involved in book building and placing activities in IPOs, and the Exchange will make appropriate use of its revised disciplinary regime (including holding individuals accountable for wrongdoing).
The Exchange will monitor the situation after the new rules come into effect, and may review the profit requirement again in future. The Exchange also plans to launch a review of GEM, including its positioning and market perception of GEM.
1. See the Exchange's consultation paper dated November 2020.
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