New securities lending rules designed to reduce the volatility of newly listed shares in China are undercutting the appetite of hedge funds for private placements by making it more difficult to manage their risk exposure.
The rules were introduced in October after a series of incidents in which IPO shares allocated to insiders or strategic investors were lent to short-sellers, drawing criticism from other investors.
In one such incident, the shares of Shandong Golden Empire Precision Machinery Technology first soared 180% on their debut on the Shanghai bourse on September 1 after a Rmb1.19bn (US$166m) IPO. The stock, issued at Rmb21.77, then retreated from a Rmb61 peak to end the day at Rmb48.27 on volume of 4.6m shares, or 9.35% of the free-float.
Investors immediately suspected that company insiders, who had bought IPO shares through a strategic tranche with a two-year lock-up, had lent the shares to facilitate short selling. An investigation by the China Regulatory Securities Commission later confirmed that Golden Empire’s senior executives and key employees had lent shares to 124 investors.
The arrangement did not breach any regulations at the time, which allowed stock lending for short selling as a way to curb excessive share price rises for newly listed companies. However, investors said the system unfairly allowed insiders to profit at the expense of other shareholders.
A month later, HHLR Management, an investment arm of Chinese investment giant Hillhouse, was probed by the regulator for violating share transfer rules when lending shares of Shanghai-listed LONGi Green Energy Technology.
Securities rules require shareholders who own a stake of 5% or more to make a disclosure before selling shares. In March, LONGi had reported that HHLR’s holdings had been temporarily reduced to 5% from 5.85% after stock lending and would be further lowered to 4.85% after more stock lending in the next 90 days.
But investors were shocked to find out in LONGi’s third-quarter report that HHLR had quietly reduced its stake in the solar energy firm to 4.98%, even though all the lent shares had been returned. Since its stake had been temporarily lowered to below 5% through stock lending, it had not needed to make a disclosure ahead of the share disposal.
Increased margin ratio
To address concerns, the CSRC revised securities lending rules in October, mainly increasing the margin ratio of borrowers and imposing restrictions on share lenders.
The margin ratio for share lending was increased to 80% from 50%. If the borrowers are private securities investment funds, the new margin ratio is 100%.
"The previous margin ratio for securities lending was 50%, which means that you could use 2x leverage for short selling. When the ratio goes up to 80%/100%, there is no room for leverage," said an investor.
Under the new rules, senior management and key employees who obtain IPO shares via strategic allotment cannot lend their shares during the lock-up period. Shareholders who own a stake of 5% or more still need to make disclosures ahead of any share disposal even if their stakes temporarily fall below 5% due to stock lending.
"This new rule restricts arbitrage through private placements. As the follow-on prices always offers a discount, the subscribers can make profits by immediately selling shares through securities lending after the subscription,” said a Beijing-based analyst.
“However, the new rules lower the supply of stock lending while increasing the margin ratio, which will greatly reduce the profit for those investors," he said.
“Because of the revised rules, we are seeing fewer and fewer hedge funds participate in private share placements,” said a Beijing-based banker.
However, the changes are expected to help support IPO performance.
A report from brokerage Shenwan Hongyuan said that under the old stock lending rules, about 28% of newly listed companies subject to securities lending traded below water, while only 16% did when there was no securities lending.