Introduction
It has been a turbulent year for Chinese companies, as tech giants like Alibaba and Tencent have seen their share price fall by more than 50% from their respective highs, as can be seen in the chart below. BABA is now selling at barely 13X its 2021 earnings, while simultaneously exhibiting astonishing revenue growth (38% annualized growth over the past five years). Renowned value investors like Charlie Munger and Mohnish Pabrai have not missed out on the opportunity, as they have built significant stakes in BABA. However, the news of such prominent investors buying the company’s stock did not positively affect the share price. In fact, BABA’s share price has fallen by 52% since Munger first publicly disclosed his purchase. So, is Charlie Munger awfully wrong with his considerations? Or is the market committing a gross mispricing inefficiency?
Theoretically, the price of a company is the sum of all future cash flows discounted to present terms. However, the more uncertainty there is about said future cash flows, the less investors will be willing to buy the company at a non-discounted price. In simpler terms, if the perceived risk of a company increases, the price of the very company must decrease. Applying this very basic financial theory to current Chinese stock valuations, one could easily guess that the perceived risk associated to the Chinese markets has gone up dramatically over the past fourteen months, thus causing lower valuations. Among the many risks that may impact Chinese listed companies, one in particular stands out: the Variable Interest Entity structure (VIE). The present article examines the impact of the VIE on company valuations in the following way: First, the VIE is explained, including its theoretical foundations. Second, we take a closer look at the peculiarities of Chinese companies and their use of the VIE company structure. Finally, we conclude by presenting Chinese companies that take advantage of such structure, namely Tencent and Alibaba.
Variable Interest Entities
When US investors buy stock in Chinese companies on the NYSE and NASDAQ, they do not have ownership in the actual company. Instead, they purchase shares of Cayman-Islands-based shell companies. A shell corporation is a corporation without active business operations or significant assets, established to passively hold financial assets. Since the Chinese Communist Party does not allow foreign investment in some sectors such as education, e-commerce, Internet, and other technologies, it would be impossible for Chinese tech companies like Alibaba and Tencent to raise capital from non-Chinese investors. To escape the regulatory scrutiny, Chinese companies use a Variable Interest Entity. VIEs are incorporated as special purpose vehicles (SPVs) to hold financial assets and keep securitized assets off the balance sheet. Non-Chinese investors in such shell companies do not participate in the original entity's profits and losses, nor do they have voting rights. Under US law, companies must disclose their relationship to VIEs. By using a VIE, a company can control another company through contracts, rather than through ownership. For example, a private Internet company in China could set up a publicly listed shell company in the Cayman Islands, in which foreigners can invest. Then, the public company would have contractual control of the technology and Internet license in China. However, those real assets would still be owned by the private company in China.
Theoretically, this complex multi-layer structure of ownership should not affect valuations. However, as the VIE structure is illegal in China, the risk of VIE contracts being terminated cannot be neglected. Indeed, if this were to happen, VIE investors could end up with either nothing or only a small share of their investments. In the past months, while Beijing has cracked down on the for-profit education sector and the tech sector, it has also targeted the VIE market, destroying billions of dollars of the value of Chinese companies’ valuations. The termination of the VIE agreement could result in trillions of losses for US investors. Indeed, US regulators are now realizing the threat caused by Chinese VIEs: Gary Gensler, chairman of the US Securities and Exchange Commission (SEC), announced new transparency rules, which require Chinese companies to be more transparent with US investors about which assets they actually own and which they don't. Among others, the SEC will require Chinese companies to disclose "whether the operating company and issuer, where applicable, have received or been denied authorization by the Chinese authorities to go public on US exchanges."
Theoretically, this complex multi-layer structure of ownership should not affect valuations. However, as the VIE structure is illegal in China, the risk of VIE contracts being terminated cannot be neglected. Indeed, if this were to happen, VIE investors could end up with either nothing or only a small share of their investments. In the past months, while Beijing has cracked down on the for-profit education sector and the tech sector, it has also targeted the VIE market, destroying billions of dollars of the value of Chinese companies’ valuations. The termination of the VIE agreement could result in trillions of losses for US investors. Indeed, US regulators are now realizing the threat caused by Chinese VIEs: Gary Gensler, chairman of the US Securities and Exchange Commission (SEC), announced new transparency rules, which require Chinese companies to be more transparent with US investors about which assets they actually own and which they don't. Among others, the SEC will require Chinese companies to disclose "whether the operating company and issuer, where applicable, have received or been denied authorization by the Chinese authorities to go public on US exchanges."
Peculiarities of Chinese Companies.
With respect to the vibrant, liberal and free-moving western economic systems which we find ourselves living in today, the Chinese economic structure has for years rigorously scrutinized domestic commercial behavior. When China started to implement financial regulation in the 50’s to mimic the soviet’s communist regime, economic activity was greatly hindered. This was because the implementation of excruciatingly strict competition law meant that any glimpse of unfair competitive behavior would lead to irreversible sanctions. Over the last 20 years, the Chinese Communist Party has begun to loosen the shackles of Chinese businesses in order to match the West’s economic performance, and in particular, that of the American economy. In 2001, China joined the WTO (World Trade Organization). This historical move was followed by reports in 2005 that the Chinese private sector accounted for 70% of GDP. Chinese international deregulation allowed local private firms to access foreign markets, to attract foreign capital, and hence to perform financially at an enhanced level.
Nevertheless, in recent times, XI Jinping’s (China’s president) outlook on domestic policy as well as the country’s economic battle with the US have meant that regulators in most industries within the PRC have become increasingly sensitive to economic commerce. In 2021, during the depths of the coronavirus pandemic, the Chinese government laid out the foundations of the “10-point plan” - a list of changes to regulation aimed to crackdown on anti-competitive behavior particularly within the tech and education sector. The decree is said to strengthen “important fields” within Chinese society such as science, technological innovation, culture, and education. Specifically, the law strictly prohibits monopoly agreements, abuse of market power, anticompetitive mergers as well as “foreign-related rule of law”. The law also gives stronger powers to regulators allowing them to “conduct on-site inspections of business premises (so-called “dawn raids”), to hear witnesses (…),to seize relevant evidence, and to inquire about the undertakings’ bank accounts”. The ruthless nature of this regulation emphasizes the fact that China’s view of the free market is a stark one.
Another form of Chinese regulation which is more related to foreign investment is the country’s “Negative List”. This is a list of special administrative measures implemented to limit firms from accessing foreign investment. This ‘list’ strictly lays out the necessary requirements that businesses must meet to obtain any form of foreign investment such as equity requirements, senior management and personnel requirements.
What is clear is that the Chinese government’s keenness to limit foreign investor presence within local firms has had damaging impacts on the growth of many sectors within the Chinese economy. In particular, by making it ever more difficult to access foreign capital, the Chinese government has made it extremely hard for small enterprises to grow. This is quite simply because by having limited access to foreign cash, smaller firms have taken fewer financial risks as they fear future struggles to cover the full extent of their costs which they have accumulated in the short run. Hence, the uncertainty created by foreign regulation has damaged hunger for prosperity within certain Chinese markets.
Nevertheless, in response to the practice of anti-foreign investment laws, Chinese firms have begun to structure themselves in such a way that they can bypass the need for regulatory inspection. In particular, various company structures, particularly the VIE structure, as mentioned previously in the article, have been implemented so that foreign investors can inject their capital into Chinese companies without having to be examined by local watchdogs. These measures have been particularly effective and have helped many corporations to grow and to expand their international presence through the help of foreign funding.
Nevertheless, in recent times, XI Jinping’s (China’s president) outlook on domestic policy as well as the country’s economic battle with the US have meant that regulators in most industries within the PRC have become increasingly sensitive to economic commerce. In 2021, during the depths of the coronavirus pandemic, the Chinese government laid out the foundations of the “10-point plan” - a list of changes to regulation aimed to crackdown on anti-competitive behavior particularly within the tech and education sector. The decree is said to strengthen “important fields” within Chinese society such as science, technological innovation, culture, and education. Specifically, the law strictly prohibits monopoly agreements, abuse of market power, anticompetitive mergers as well as “foreign-related rule of law”. The law also gives stronger powers to regulators allowing them to “conduct on-site inspections of business premises (so-called “dawn raids”), to hear witnesses (…),to seize relevant evidence, and to inquire about the undertakings’ bank accounts”. The ruthless nature of this regulation emphasizes the fact that China’s view of the free market is a stark one.
Another form of Chinese regulation which is more related to foreign investment is the country’s “Negative List”. This is a list of special administrative measures implemented to limit firms from accessing foreign investment. This ‘list’ strictly lays out the necessary requirements that businesses must meet to obtain any form of foreign investment such as equity requirements, senior management and personnel requirements.
What is clear is that the Chinese government’s keenness to limit foreign investor presence within local firms has had damaging impacts on the growth of many sectors within the Chinese economy. In particular, by making it ever more difficult to access foreign capital, the Chinese government has made it extremely hard for small enterprises to grow. This is quite simply because by having limited access to foreign cash, smaller firms have taken fewer financial risks as they fear future struggles to cover the full extent of their costs which they have accumulated in the short run. Hence, the uncertainty created by foreign regulation has damaged hunger for prosperity within certain Chinese markets.
Nevertheless, in response to the practice of anti-foreign investment laws, Chinese firms have begun to structure themselves in such a way that they can bypass the need for regulatory inspection. In particular, various company structures, particularly the VIE structure, as mentioned previously in the article, have been implemented so that foreign investors can inject their capital into Chinese companies without having to be examined by local watchdogs. These measures have been particularly effective and have helped many corporations to grow and to expand their international presence through the help of foreign funding.
Examplatory Evidence: The case of Alibaba
As already presented, the VIE structure serves the objective of both providing Chinese enterprises with access to Western capital and Western investors with access to Chinese equities. However, in China, the structure itself is illegal and, although for years the China Securities Regulatory Commission (CSRC) has had a blind eye, new regulations and restrictions started to be discussed in July 2021. These new rules may potentially have major consequences for both new listings on Chinese companies and already listed Chinese companies. The upcoming section takes a closer look at the latter category.
As of July 2021, Tencent, JD.com and Alibaba as well as 237 other Chinese firms have VIEs listed on US exchanges, with a total market capitalization of over $2 trillions. To limit the scope of the present article, we will only focus on Alibaba as an example of a company currently profiting from the use of a VIE.
Founded by Jack Ma in 1999, Alibaba is a multinational technology corporation specialized in several sectors comprising e-commerce, retail, internet and technology. It provides different kinds of sales services (B2B, B2C and C2C) through web portals, as well as shopping search services, cloud computing services and electronic payments services. The Alibaba group, thus, runs a wide portfolio of companies (e.g Alibaba, Taobao, Aliexpress) in numerous business sectors throughout the world.
Its IPO on the NYSE, in September 2014, was the largest recorded in the world’s history, by raising $25 billion and a market value of $231 billion. However, 2021 has been a nerve-racking ride for investors. Several obstacles had to be faced by Alibaba compared to its rallying American tech counterparts: the worrying Jack Ma’s absence from the public eye for several months, the COVID-19 pandemic, the Chinese Communist Party tech crackdown, as it resulted in a $2.8 billion fine for the firm, and, lastly, the lukewarm earnings results did not help. Above all, foreign investors’ confidence in the company has increasingly been affected by the perennial “headwind” of the company’s status as a Variable Interest Entity. When purchasing BABA stock, an investor technically is not purchasing shares in the Alibaba Group, but rather in an offshore shell corporation (typically based in the Cayman Islands) that has a claim to its earnings. More specifically, buying BABA stocks on the New York Stock Exchange means purchasing American Depositary Receipts (ADRs), which have a claim on the Alibaba VIE. If, instead, an investor purchases Alibaba as “9988” on the Hong Kong Stock Exchange, the investor will become a direct shareholder in the VIE. BABA shares are convertible into 8 “9988” shares. Please note that either share reflects only ownership in a VIE, not ownership in the corporation.
VIE holders suffer a lot of risks since they have no input in how the underlying firm is operated. The greatest threat is having the VIE structure itself declared illegal in court and ending up with essentially nothing. In the case of Alibaba, other main risks may emerge in two further ways:
Firstly, China could enforce its bans on VIEs. In China, VIEs are already banned, but the legislation is not enforced. Chinese corporations circumvent this by establishing VIEs in the Cayman Islands. Because they operate in a foreign country, China cannot technically prohibit them. However, it might retaliate against corporations who employ the VIE structure, for example, by slamming them with large fines and other penalties. We already witnessed this kind of sanctions in 2021, as demonstrated by the fines imposed on Alibaba and, for instance, how DiDi, a Chinese business operating in the taxi industry, had its application removed from the app stores in reprisal for going public in the United States under a VIE structure.
Secondly, the nationalization of Alibaba could be threatful. There have been rumors that China aims to completely avoid the VIE issue by nationalizing Alibaba. Even if this option seems to be far-fetched, it isn’t, as proven by the fact that the Chinese government has taken an equity stake in a subsidiary of ByteDance, one of the main companies involved in the tech crackdown. If Jack Ma’s company happened to be nationalized, it would be far from obvious that foreign shareholders would be paid off, in particular after the continuous relationship deterioration between the Western countries and China.
As of July 2021, Tencent, JD.com and Alibaba as well as 237 other Chinese firms have VIEs listed on US exchanges, with a total market capitalization of over $2 trillions. To limit the scope of the present article, we will only focus on Alibaba as an example of a company currently profiting from the use of a VIE.
Founded by Jack Ma in 1999, Alibaba is a multinational technology corporation specialized in several sectors comprising e-commerce, retail, internet and technology. It provides different kinds of sales services (B2B, B2C and C2C) through web portals, as well as shopping search services, cloud computing services and electronic payments services. The Alibaba group, thus, runs a wide portfolio of companies (e.g Alibaba, Taobao, Aliexpress) in numerous business sectors throughout the world.
Its IPO on the NYSE, in September 2014, was the largest recorded in the world’s history, by raising $25 billion and a market value of $231 billion. However, 2021 has been a nerve-racking ride for investors. Several obstacles had to be faced by Alibaba compared to its rallying American tech counterparts: the worrying Jack Ma’s absence from the public eye for several months, the COVID-19 pandemic, the Chinese Communist Party tech crackdown, as it resulted in a $2.8 billion fine for the firm, and, lastly, the lukewarm earnings results did not help. Above all, foreign investors’ confidence in the company has increasingly been affected by the perennial “headwind” of the company’s status as a Variable Interest Entity. When purchasing BABA stock, an investor technically is not purchasing shares in the Alibaba Group, but rather in an offshore shell corporation (typically based in the Cayman Islands) that has a claim to its earnings. More specifically, buying BABA stocks on the New York Stock Exchange means purchasing American Depositary Receipts (ADRs), which have a claim on the Alibaba VIE. If, instead, an investor purchases Alibaba as “9988” on the Hong Kong Stock Exchange, the investor will become a direct shareholder in the VIE. BABA shares are convertible into 8 “9988” shares. Please note that either share reflects only ownership in a VIE, not ownership in the corporation.
VIE holders suffer a lot of risks since they have no input in how the underlying firm is operated. The greatest threat is having the VIE structure itself declared illegal in court and ending up with essentially nothing. In the case of Alibaba, other main risks may emerge in two further ways:
Firstly, China could enforce its bans on VIEs. In China, VIEs are already banned, but the legislation is not enforced. Chinese corporations circumvent this by establishing VIEs in the Cayman Islands. Because they operate in a foreign country, China cannot technically prohibit them. However, it might retaliate against corporations who employ the VIE structure, for example, by slamming them with large fines and other penalties. We already witnessed this kind of sanctions in 2021, as demonstrated by the fines imposed on Alibaba and, for instance, how DiDi, a Chinese business operating in the taxi industry, had its application removed from the app stores in reprisal for going public in the United States under a VIE structure.
Secondly, the nationalization of Alibaba could be threatful. There have been rumors that China aims to completely avoid the VIE issue by nationalizing Alibaba. Even if this option seems to be far-fetched, it isn’t, as proven by the fact that the Chinese government has taken an equity stake in a subsidiary of ByteDance, one of the main companies involved in the tech crackdown. If Jack Ma’s company happened to be nationalized, it would be far from obvious that foreign shareholders would be paid off, in particular after the continuous relationship deterioration between the Western countries and China.
Conclusions
In the most likely case, the VIE structure will keep characterizing listed Chinese companies and the future IPOs coming from the country. As a matter of fact, it is hard to believe that China would be so self-destructive as to enforce its laws and consequently wipe trillions of dollars off the US stock market.
Frequently Western investors ignore what they are purchasing or do not inform themselves about the existence of shell-companies to escape the Chinese regulatory scrutiny. It is thus essential for them to understand in what they’re investing in, as the investments are essentially characterized by numerous illegitimate and unenforceable contracts held by some Cayman Islands-registered shell businesses that share the same name as the real Chinese corporation. Following that, risks concerning the VIE structure and geopolitical factors shall be evaluated in deep, since they will undermine the evaluation of Chinese stocks for years to come.
Frequently Western investors ignore what they are purchasing or do not inform themselves about the existence of shell-companies to escape the Chinese regulatory scrutiny. It is thus essential for them to understand in what they’re investing in, as the investments are essentially characterized by numerous illegitimate and unenforceable contracts held by some Cayman Islands-registered shell businesses that share the same name as the real Chinese corporation. Following that, risks concerning the VIE structure and geopolitical factors shall be evaluated in deep, since they will undermine the evaluation of Chinese stocks for years to come.
Matteo Panizza
Boaz Lister
Lorenzo Morosini
Boaz Lister
Lorenzo Morosini