By Alvin Lee
Credit: Singapore Management University
By Alvin Lee
SMU Office of Research & Tech Transfer – When Chinese consumer electronics giant Xiaomi (小米) listed on the Hong Kong Stock Exchange (SEHK) in June 2018, it followed the well-beaten path travelled by earlier mainland companies, ranging from high-tech predecessors Tencent (腾讯, 0700.HK) to non-tech companies such as Tsingtao Brewery (0168.HK) and China Eastern Airlines (0670.HK).
While the IPO raised US$4.72 billion in the tech world’s biggest float in four years, it garnered extra attention for being the first SEHK listing with dual-class shares (DCS). Co-founders Lei Jun (89.27 percent) and Lin Bin (10.73 percent) controlled the Class A shares, with each of such shares carrying 10 votes instead of a single vote for Class B shares. The move to allow DCS structures, also known as weighted voting rights (WVR), prompted SEHK’s regional rivals Singapore Stock Exchange (SGX) to follow suit, breaking its heretofore adherence to the one-share-one-vote (OSOV) principle.
The justification for changing a long-held cornerstone of corporate governance was a business one. Charles Li, then Chief Executive of SEHK’s operator, Hong Kong Exchanges and Clearing (HKEX), had said six months before the Xiaomi listing, “The market has made it clear they want the Exchange to take action to broaden Hong Kong’s capital markets access and enhance its competitiveness.”
“Hong Kong wanted this reform [because] so-called high-tech unicorns like Alibaba and its spinoff Ant Group wanted to list [on the SEHK], and their founders have this strong preference of holding dual-class shares,” explains Liang Hao, Associate Professor of Finance at the SMU Lee Kong Chian School of Business. “They couldn’t be listed in Hong Kong nor Singapore because it was simply not allowed. And all of them went to the New York Stock Exchange, which allowed it.
“Hong Kong said, ‘Okay, we are losing all these deals. Let’s make the change to attract more big unicorns from the mainland.’ Given the fierce competition between Singapore and Hong Kong, Singapore immediately followed suit.”
He adds: “It’s not clear whether this reactive reform was actually good or bad. If you think about dual-class shares giving more power to the company’s founder, should the founder turn out to be a dishonest person or want to exploit other shareholders, then dual-class shares are bad corporate governance. This is the common belief within the corporate governance literature.”
To D(CS) or not to D(CS), that is the question
To fully understand the costs and benefits of DCS listings, Professor Liang embarked on the MOE Academic Research Fund (AcRF) Tier 2 project titled “Dual-Class Shares in a Time of Unicorns Going Public” in July 2019, and which concluded in September 2022. He explains the title’s reference to “A Time of Unicorns” as a counterpoint to the pre-Google IPO days when DCS listings were associated with family businesses looking to raise money without relinquishing control, an arrangement that raises red flags.
Within the context of tech unicorns, there were two arguments for a DCS structure: ‘founder’s vision’ and ‘long-term orientation’. Google’s 2004 IPO, which bestowed upon co-founders Sergey Brin and Larry Page a combined majority of voting rights despite owning little more than 10 percent of total shares, is often cited as Exhibit A for handing control to visionary leaders to move fast and capitalise on growth opportunities. Since then, Facebook, Lyft, and Pinterest have gone the DCS route. Professor Liang points to long-term orientation as a stronger justification for a DCS structure.
“Whenever you see stock prices fluctuate, you might panic, and institutional investors begin to question the company, ‘What are you doing?’” Professor Liang explains to the Office of Research & Tech Transfer. “In order to please the investor, the company does something to boost short-term returns, but that probably means giving up on some long-term projects [that might benefit the company later on].”
But the central question remains: Do listed firms with DCS outperform or underperform their single-class peers? Given the relative lack of data in Asia-Pacific where SGX has only one DCS listing (financial and investment firm AMTD, stock counter HKB) and SEHK just approaching its fifth year with such companies, Professor Liang examined U.S. data and existing literature in a collaboration with Zhang Wei, Associate Professor of Law at the SMU Yong Pung How School of Law, and former SMU postdoctoral fellow Junho Park, now Assistant Professor of Finance at Myongji University. The answer was ‘Yes’ on condition that DCS listings come with a ‘sunset clause: “Firms with perpetual dual-class stock trade at a significant discount to those with sunset provisions,” the U.S. Securities and Exchange Commission (SEC) wrote in 2018.
Sunset clauses turn preferential shares into ordinary ones after a period of time – usually seven years – or when the owner of such shares dies or becomes incapacitated. Should such shares be sold, the preferential voting rights cannot be transferred. As such, founders who are considering listing their companies with DCS should expect to outperform non-DCS companies post-IPO, but they should be mindful that perpetual DCS are unlikely to be beneficial long-term.
Together with Associate Professor Zhang Wei and SMU postdoctoral fellow Phuong Nguyen, Professor Liang also examined the following question: How will a change in listing rules worldwide, especially in Hong Kong and Singapore, affect investor expectation and the competitive landscape in the technological industries in Asia? He answers that question by looking at two dimensions: the competition channel and the capital channel.
“If investors, on average, favour DCS, we expect the prospect of allowing DCS listings in a market to lower the shareholder value of existing listed firms, as they cannot convert to DCS,” he wrote, articulating the competition channel. “In contrast, if investors see DCS as harmful to firm value, due to governance concerns, we expect investors in listed peer firms to react positively to the potential regulatory changes, as they are better protected.”
As it turned out, share prices of existing high-tech listed firms on SEHK lost ground between 2015 and 2017 when the stock exchange discussed permitting DCS listings, suggesting favourable investor expectations of companies with dual-class shares. But by the time Xiaomi listed in 2018, it became clear that “the regulatory change would enable all tech firms to attract more institutional capital”, and returns of incumbent high-tech firms listed in Hong Kong rose significantly, wrote Professor Liang of the capital channel. A rising tide of institutional capital lifts all boats, but technology firms, both with and without DCS, will benefit disproportionately.
Investors and regulators must decide
Despite these findings, concerns over corporate governance remain front and centre. With Southeast Asia generating its fair share of unicorns in recent years (Carsome, Grab, Bukalapak etc.), the topic of dual-class shares is unlikely to go away. Professor Liang cites former Google CEO Eric Schmidt telling critics of Google’s DCS structure – he owns over eight percent of preferred shares – to not buy its stocks if they do not approve of it; they will simply miss out on the exponential growth that has driven it to become one of the biggest companies in the world less than 30 years from its founding.
“If investors are concerned about governance, they will stop buying a stock, the company will become less and less popular, and over time the company will die out. We call this equilibrium,” observes Professor Liang. “That was what happened before Google’s [explosive post-IPO growth]. But if investors don’t care about that, they care more about the benefits, or they think the benefits outweigh the cost, then they’ll just keep on buying Google and other dual-class share companies.”