SHANGHAI – China’s stock market collapse over the past week has been on everyone’s minds. Eyes have been glued to cell phone apps with greater concentration than ever before, checking minute to minute how fast and how far share prices will fall.

In China, the markets are dominated by retail investors, with institutional investors making up only 20 percent of the total – an inverse ratio to the U.S. where institutional investors make up the greater share. That means that in a city like Shanghai, everyone from office workers to nannies have seen their investments dwindle dramatically as the markets dropped 30 percent.

That is a major reason why the exchanges in China are heavily regulated, to ideally protect less savvy individual investors. Although in this case, the government took its eyes off the road.

It also helps to explain why start-up biotechs with unproven innovation are blocked from listing on the main boards in Shanghai (SHSE) and Shenzhen (SZSE). Only the less risky revenue-generating companies can list, and several of the larger biotechs have been holding their own on the main boards. (See BioWorld Today, July 10, 2015.)

But several months back, the government began encouraging the expansion of its pilot third over-the-counter (OTC) market, the National Equities Exchange and Quotations Co. (NEEQ), otherwise referred to as the “third board” or “xin san ban.”

As a part of the government’s push to move from a manufacturing-driven economy to a consumer-led one, greater emphasis has been placed on developing homegrown entrepreneurs. The NEEQ was initially set up to allow small and medium-sized enterprises located in high-tech parks access to financing.

“When governments create this kind of board where the regulations are a lot looser, they are trying to encourage companies. Companies, when they start up, need to see the light at the end of the tunnel,” said Judith Li, partner at Lilly Asia Ventures in Shanghai, a venture capital fund affiliated with Eli Lilly and Co.

As of July 10, there were 2,695 companies listed on the third board. It has grown swiftly in the last 18 months; at the end of 2013, there were only 356.

The NEEQ has been hit by the overall market meltdown as well, though, fortunately the government’s recent interventions to shore up markets seems to be working. It closed Friday up 5.41 percent at 1,480. Though that’s still far below its pre-crash high of 2,134 on April 7, and many say it is still too early to predict what the overall fallout will be.

In fact, the third board has seen a lot of volatility since its inception and, according to investor, David Chen, managing director of Beijing BFC Group, a China-based advisory firm, it is important to look at the bigger picture.

“I think we should not focus too much in the short term. We believe the [NEEQ] market is going to be quite dynamic,” said Chen. “I think the market is much less regulated and much more market-driven, and overall in the long term we are still quite optimistic.”

LIQUIDITY NOT THERE YET

There are two systems for transferring shares on the third board. The first one is by agreement, which Chen described as inefficient, with almost zero liquidity. The second is a market-making system, based on an electronic competitive pricing system to come online next year, holding greater promise in terms of liquidity.

“Right now for investors and founders, the liquidity is still not quite there yet in the NEEQ,” Chen said. “You are not going to list your company on the NEEQ and then exit tomorrow or in near term. You still have to build the company and make it more sizable. And certainly it will give the market more confidence and increase the liquidity eventually.”

Another concern is the lack of segmentation. Truly innovative companies might get lost in the fray of the thousands of start-ups that are listed.

“Our fund strategy,” Lilly Asia’s Li said, “is to invest in companies that have a really strong scientific core – a scientific or technical edge; that edge is at least good enough to be the best in China, if not competing on the world stage. A company like that has several options – it is not super clear they want to list on the xin san ban, it is not always the obvious choice.

“If the barrier to getting in is super low, that is both a good and a bad thing,” she added. “It might be easier for you to get in, but you are surrounded by other companies that are very young and relatively unproven.”

She has found companies in her portfolio, while interested in the local route, especially when the market was so vertiginous, that are still looking at listing overseas.

“Some of our companies have started to look at xin san ban, but our companies have looked more toward the main boards, Nasdaq, [and] some have considered the Hong Kong Stock Exchange. The xin san ban is actually quite new.”

A HIGHER THRESHOLD

While it is easier for a company to list on the third board, there is a higher threshold for investors who play the market. Investors must have ¥5 million (about US$800,000) in their bank accounts in order to invest.

“Not just the average joe investor can buy and sell NEEQ stock. There are more sophisticated investors and more large retail investors in the market,” BFC Group’s Chen explained.

The third board has generated avid interest from biotechs, but only a handful have taken the plunge and listed. BFC Group has identified three drug discovery biotechs on the third board, one under market making and two under transfer agreements.

Shanghai Benemae Pharmaceutical Corp. (Code: 830931) has four assets in its pipeline. Its most advanced is in phase III, a rhGLP-1 compound for type 2 diabetes. Chen said it is waiting for new drug application and GMP approval and could be the closest one to the market with a possible approval in 2016. There are three other preclinical assets, two for type 2 diabetes and one for liver cancer.

Its shares are traded under market making transfer, and its assets are valued at ¥230 million, with a negative net profit of shareholders of ¥19 million. Its market value is an impressive ¥7.33 billion, with a price earnings ratio of -1271.4.

Beijing-based Northland has eight assets in its pipeline, three at phase III, one at phase II and four at phase I. An ophthalmic antibiotic for dry eye is expected to be approved this year. Later-stage phase III candidates include a recombinant human interleukin 11 for thrombocytopenia and a human coagulation factor VIII for hemophilia A.

The company has total assets valued at ¥144 million and revenues of ¥650,000, with a negative net profit of ¥15 million. Its market value is ¥1.49 billion, which Chen said “is not a bad valuation for a discovery-stage biotech company.“ Those funds, however, are not readily accessible, but Chen said that “liquidity is not that critical to the moment; right now they are not in urgency to exit.”

Also as a transfer agreement, Shanghai Union Biopharm Co. Ltd. (Code:430598) has a monoclonal antibody asset in preclinical stage potentially for rheumatoid arthritis and ankylosing spondylitis. That firm also list three preclinical-stage programs.

It lists its assets at ¥203 million, with ¥5.6 million in revenue and ¥15.7 million in losses. Its market value is ¥210 million.

Editor’s note: Stock information is quoted from June 15, 2015.