China’s astonishing economic growth over the past four decades is well-documented, but perhaps less appreciated is the central importance of financial market reform in facilitating a continuation of that growth going forward.  How and when these reforms take shape will go a long way in determining the country’s economic trajectory.

Of particular interest is the economic impact of China’s IPO policies. Unlike the registration-based systems in most countries, China’s IPO process is subject to strict regulatory rationing and control. The China Securities Regulatory Commission (CSRC), a functional ministry of the central government, decides which, and how many, companies can obtain public funding through an IPO.  The process can be arduous and the outcome may not be determined solely on the basis of economic merit.

Our study ‘Reverse Mergers, Shell Value, and Regulation Risk in Chinese Equity Markets’, uses the price paid for shell companies in reverse merger (RM) transactions to examine the effect of China’s IPO regulations. As an alternative to an IPO, a firm can secure a public listing through a ‘reverse merger’, whereby it essentially takes over a dormant ‘shell company’. The typical shell company is publicly listed, but has little or no value as an on-going operational entity. Because the prices paid for shell firms reflect the marginal benefit/cost to the firms engaged in each RM transaction, they provide a ‘shadow price’ for the economic cost of gaining access to China’s public equity market.

Using a comprehensive sample of RM transactions, we show that shell values in China are remarkably large. During our sample period, unlisted firms paid an average of between 2.9 to 4.4 Billion RMB (or more than $400 Million USD) for each listed shell.  Even the most conservative estimation method yields an average shell value that represents close to two-third (65.6%) of the median market capitalization of a listed firm.  In other words, at any given moment in time, many Chinese listed firms are trading below their shell value.

The existence of such a large shell value has direct implications for the returns and prices of China’s publicly listed companies. To document these effects, we construct a measure of expected shell value to market (ESVM) for each firm, defined as its expected shell value divided by its total market capitalization. We show that high-ESVM firms earn a substantial return premium over low-ESVM firms. A long-short strategy based on extreme ESVM deciles generates a raw return of 29% per annum and an abnormal return of 5.4% per annum after controlling for all five Fama-French factors. High-EVSM firms earn higher returns, either because they are more exposed to regulatory risk or because their latent value as target shells is underappreciated by market participants.

The existence of such a large shell premium helps to explain the infamous ‘size’ effect in China – the empirical finding that small listed firms earn much higher monthly returns than large listed firms. We show that adding an ESVM-based factor to five Fama-French factors significantly improves return attribution, and effectively eliminates the Size premium. Our findings establish the shell effect as one of the most consistent predictive variables for equity returns in the Chinse stock market. 

We also document a direct empirical link between the shell premium and regulatory shocks. Using an event-study approach, we examine returns to an ESVM-hedge portfolio in the days immediately surrounding the release of policy announcements that impact IPOs and RMs. Because a tightened RM (IPO) policy will decrease (increase) the RM probability of listed firms, we expect high-ESVM stocks to earn relatively more negative (positive) returns to around these announcement dates. We find strong support for this prediction around all six policy events over our sample period.

One puzzle is why, despite the large shell value, so few RM transactions are actually consummated: over our sample period the number of IPOs is approximately 10X larger than the number of RMs. Our results suggest that the owners of high-ESVM firms would rather hold onto control than sell their firms at their shell value, even when the underlying business is performing poorly. This evidence comes in the form of ‘major asset restructuring’ (MAR) reports. The CSRC requires listed firms to file a MAR report whenever the firm’s operating asset base changes by 50% or more. We show that a shockingly large percentage (around 19%) of the firms in the top-ESVM decile will undertake a MAR in the next 12 months.  In fact, the frequency of MARs is 5 times larger for high-ESVM firms than for low-ESVM firms.

This behavior points to another hidden cost of China’s IPO policies: floundering public companies do not face a natural ‘sunset’ mechanism. Rather than facing the prospects of delisting and bankruptcy, because of the high shell value, owners and managers of floundering public companies can continue to acquire and operate new businesses.  Therefore, China’s restrictive IPO regulations not only impede successful businesses ability to secure public funding; they also prevent unsuccessful businesses from facing the natural consequences of poor stewardship.

Collectively, our results show that shell value is the key to understanding many asset pricing puzzles, and even business investment decisions and M&A activities in China. They highlight the importance of regulatory reform of Chinese capital markets, particularly with respect to the rules and policies governing IPOs. These findings also have implications for other emerging markets where governments play a dominant role in the operations of financial markets.

Charles M. C. Lee is the Moghadam Family Professor and Professor of Accounting at the Graduate School of Business, Stanford University.

Yuanyu Qu is a Ph.D. candidate at the School of Economics and Management, Tsinghua University.

Tao Shen is an Assistant Professor at the School of Economics and Management, Tsinghua University.