Alibaba IPO: approach with caution
International exposure is key to building a well-diversified portfolio, but foreign companies can pose problems that you wouldn’t find in the United States. Take, for example, a common solution to foreign ownership bans in China-based companies: the variable interest entity (VIE).
Chinese e-commerce firm Alibaba is preparing for an initial public offering on the New York Stock Exchange. Alibaba’s sheer size – a total value estimated at more than $ 200 billion – has drawn a lot of attention from investors, but some of that attention comes in the form of concern. Alibaba uses the VIE structure, and a recent article in The Wall Street Journal reported that a US government commission found that US investors face “great risks” if they buy shares in companies structured in this way. (1)
VIEs are not new. Chinese Internet companies began using this structure in 2000 as a solution to Chinese restrictions that prohibit foreigners from investing in certain sectors, including telecommunications. To avoid breaking the rules, non-Chinese investors own a foreign-listed business entity, which owns a subsidiary located in China. The Chinese subsidiary then owns one or more nationally licensed companies, which are VIEs. In the case of Alibaba, US investors will buy shares in a Cayman Islands entity called Alibaba Group Holding Limited. This entity will have a contractual right over the profits of the Chinese company, but will not own the assets of the company.
While this structure has been maintained so far, the risks identified by the commission are not insignificant. Since ownership of the company is indirect, foreign investors should rely solely on contractual agreements to ensure that they retain the economic benefits of ownership of the China-based company. These contracts should be enforced through the Chinese legal system in cases where shareholders believe their rights have been violated, a process that has historically been difficult for outsiders.
Even with these contracts in place, foreign investors have relatively little control. For example, in 2011, Alibaba’s Chinese entity ignored the objections of Yahoo Inc., a large shareholder in the offshore entity, and divided the assets of a payments unit to bring them under the control of the company’s founder, Jack Ma. Alibaba He said the transaction was necessary to ensure that China’s central bank would allow the payment unit to continue operating, eventually reaching an agreement with its shareholders, The Wall Street Journal reported. (2) While some investors view the VIE structure as the cost of doing business in China, the lack of control that comes with it requires caution.
Still, investors run a similar risk with stocks in US companies that have a majority shareholder, whether that shareholder is the founder or not. Investors sometimes decide that being at the mercy of the majority shareholder is a price they are willing to pay to invest in a certain company. Some private equity firms, including The Carlyle Group, KKR, and The Blackstone Group, have also gone public using a limited partnership structure, where investors receive a portion of the proceeds but remain at the mercy of the general partner in regards to business decisions. That said, choosing to buy a company with limited control in the United States comes with a number of rules and regulations designed to protect minority investors. While these are not bulletproof, they do offer some peace of mind. Investing in Alibaba or another Chinese company structured by VIE means giving up not just control, but transparency.
Perhaps most worryingly, the Chinese authorities have never formally confirmed that VIEs are legally valid. If the Chinese government sees fit to challenge the legitimacy of companies using VIEs, a foreign investor may be able to do little. While China has a strong economic interest in preserving companies as large as Alibaba, investors rely on the Chinese government’s self-interest without a legal safety net. Some observers have warned that Chinese legal precedents suggest that VIEs may fail if challenged.
This is not to say that investors should always avoid structured companies like VIEs at all times and in all circumstances. Asia-focused equity mutual funds, as part of a well-diversified equity portfolio, can provide diversified exposure to thousands of different companies, we can live with less exposure to investments in VIE-structured companies like Alibaba.
But keep an eye on your exposure to Chinese company stocks, regardless of how they’re structured. There are reasons to be wary of the risks of investing in a place that does not always respect the rule of law or the principles of corporate governance that we take for granted in the United States. The VIE’s investor-hostile structure is all the more reason to proceed with caution.
Sources:
1) The Wall Street Journal, “US report casts doubt on legal structure of Alibaba and other Chinese companies”
2) The Wall Street Journal, “Alibaba Founder’s Recent Deals Raise Flags”