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The Evolution of IPO Pricing Mechanisms in China: A Regulatory Perspective

China's capital market has undergone significant transformations in its IPO pricing mechanisms over the years, with fixed prices, price control, and market pricing being implemented at different stages. Prior to 2004, the stock market predominantly employed a fixed PE ratio to estimate the price of the stock, based on the P/E ratio and EPS. However, the introduction of the stock inquiry system by the China Securities Regulatory Commission (CSRC) in 2005 marked the beginning of the market pricing mechanism for IPOs in China.

The inquiry system has been instrumental in improving the stock issuance mechanism, with institutional investors having the right to set the pricing of stock issuance. This has reduced the subjectivity and arbitrariness of the pricing of stock issuance, allowing the price of stock issuance to better reflect the market's supply and demand situation. As a result, the resource allocation function of the capital market has been enhanced.

The IPO inquiry system involves a two-step procedure, with pricing and allotment being determined by underwriters based on information obtained from investors. For a long time, both pricing and allotment procedures were heavily regulated by the CSRC. However, occasional loosening of regulations occurred during multiple waves of reform. This paper focuses on pricing mechanisms and how regulatory policies have influenced firm behavior.

The CSRC has traditionally regulated the issue price by setting the price earnings ratio or issuing a ceiling. In 2009, the Guiding Opinions on Further Reforming and Improving the Issuance System of New Shares removed the price-cap regulation on the P/E ratio, handing over the right of pricing to the market. However, firms listed during this period were associated with high offer prices, P/E ratios, and excessive raising problems. Book builders incurred commission fees based on the total IPO funding, collaborating with analysts and firms to sell overvalued stock to investors. This resulted in negative price adjustments post-IPO, with stock prices dropping below the offer price and resulting in IPO failure.

To address this issue, supplementary regulations were issued in 2012, linking issuance pricing to the P/E ratio of the same industry. Newly listed enterprises with a P/E ratio exceeding 25% of the median P/E ratio of the same industry were required to explain the reasons and indicate the risks to investors. However, this policy did not prevent new listed stock prices from dropping below their offer price, leading the CSRC to suspend IPO listings from October 2012 to December 31, 2013. Firm approval for listing was then paused until June 9, 2014.

After 2014, although no compulsory regulation or guiding opinion was enacted, a tacit agreement was reached for book builders to set the offer price. This forced firms to have an IPO P/E ratio less than 23, with firms violating this agreement being unlikely to be approved for listing. From 2014 to 2021, only 11 firms exceeded this limit, most issuing stock at the PE ratio close to the pricing cap. With the exception of three firms, Shenwang Hongyuan, China Three Gorges International Corporation (CTGI), and China Satellite Communications Corp (CSNET), which have a powerful state-owned background, the P/E ratios of listed firms have remained below 23.

Before 2006, the main forms of equity refinancing for listed companies in China were public issuance and stock allotment, with restricted regulations on return on equity (ROE) and dividend payout. After 2006, the introduction of private placements allowed firms to issue stocks to a limited number of investors with a certain lock-up period to raise funds or acquire assets. Private placements replaced public issuance and stock allotment as the primary source of equity refinancing channels. Although they required approval from the CSRC, the process was simpler and had a higher rate of approval than IPOs, taking about one year to prepare for SEOs.

In conclusion, China's IPO pricing mechanisms have evolved over the years, with regulatory policies playing a significant role in influencing firm behavior. The current tacit agreement for book builders to set the offer price has led to a relatively stable P/E ratio for listed firms, with private placements replacing public issuance and stock allotment as the primary source of equity refinancing channels. These regulatory changes have contributed to the development of a more mature and efficient capital market in China.