‘For years, big Internet companies in China, like Alibaba and Baidu, have raised billions of dollars by effectively skirting Chinese regulations that ban foreign investors from acquiring stakes in companies operating in restricted industries, like energy, telecommunications and the Internet.’
But, now foreign investors are worried that their lawyers’ weren’t all that competent, their analysts a tad optimistic (or myopic, or just clueless about China), and their Chinese chickens may be coming home to roost. Here’s our first look at the risks they so blithely accepted.More from the quote above:
Using a complex investment vehicle known as the variable interest entity — or V.I.E. — Chinese companies have been able to accept money from foreign investors through offshore entities they set up.
So reports the New York Times DealBook in its article, ’A Loophole Poses Risks to Investors in Chinese Companies.’
In recent months, foreign VIE investors have been increasingly concerned because of rumblings within the Chinese bureaucracy that it might modify or dismantle this loophole all together. Then, what happens to their investments?
But, as the DealBook further reports, there are also risks inherent in the invested companies themselves:
Jack Ma, the chairman of the Chinese Internet giant Alibaba, surprised investors last May when he acknowledged that he had transferred the assets of the company’s online payment platform to a private company that he controlled.
Executives at Yahoo, which owns around 40 percent of the privately held Alibaba Group, complained that they had not been properly informed of the move, and that the Alibaba board did not approve the transfer.
Welcome to China, Yahoo. This was not only a shock to Yahoo but another wakeup call for all investors in VIEs.
Here are details from China Law Insight on the VIEs purpose :
The VIE structure is also commonly referred to as the Sina-model structure, since it was first used by Sina in 2000. In China, the foreign direct investment market is not totally open to foreign investors.
According to the Provisions on Guiding the Orientation of Foreign Investment, promulgated in 2002, and the Foreign Investment Industrial Guidance Catalogue revised in 2007, we understand that the industries are classified into four categories, namely, the encouraged, permitted, restricted and prohibited.
With respect to the encouraged and permitted industries, there are few restrictions on foreign investment, which means that foreign investors may usually make investments freely in those industries. As to those restricted industries, higher conditions or qualifications or stricter requirements are provided for foreign investors.
Foreign investors are not permitted to invest in prohibited industries at all. Those companies which adopted the VIE structure, in a sense, usually face restrictions on foreign investors, and for the purpose of attracting foreign venture capital or private equity financing in the early stages and completing offshore listings, the VIE structure was finally created by certain imaginative individuals in an effort to circumvent certain legal restrictions which they encountered in China.
In recent years, more than one hundred Chinese companies have adopted the VIE structure for their offshore listings, including internet companies such as Alibaba, Tencent, Baidu, Sina, Tudou, etc.; private education companies such as New Oriental, Global Education & Technology Group and AMBOW Education, etc.; media companies such as Focus Media, Vision China Meida and Bona, etc.; retail companies and companies in other industries.
And, some details about how a VIE works:
The typical VIE structure is set up as illustrated in the following diagram:
As indicated in the diagram above, foreign investors and PRC individuals establish SPV1 in Cayman; then SPV1 sets up a wholly-owned SPV2 in Hong Kong; and then SPV2 establishes the wholly foreign-owned enterprise (“WFOE“) in the PRC.
The domestic company usually is the one which owns licenses or approvals for the business. However, due to restrictions on foreign investment, the WFOE cannot obtain licenses or approvals from the PRC authorities to operate in the desired industry.
Through a set of contractual arrangements among the WFOE, PRC individuals (usually PRC individuals are the companies’ founders) and the domestic company, the WFOE may be able to actually control the domestic company as if it directly owned the equity interests in such domestic company.
Thus SPV1 may consolidate the financials of the domestic company into the group’s overall financial statements, which is permitted and accepted by the US General Accepted Accounting Principles. [paragraphs by me]
Now, I have long marveled at how the Chinese find ways around what their government wants or tells them to do. They are masterful.
So, you can imagine that I am pleased that my people, that is, foreigners, found a loophole to get around a well-founded (not always the case) policy and explicit (also not always the case) laws prohibiting foreign ownership of specified Chinese industries such as telecommunications companies and in turn Internet companies.
Now, unsurprisingly really, unanticipated risks are surfacing.
My first thought is these risks actually could have been anticipated and maybe mitigated.
My second thought is what were they thinking?
And, my third thought is there may be an array of vested interests in and out of the Chinese government that will effectively keep the foreigners’ investments safe–just as heaven protects children and drunks. Except in this case heaven is protecting itself first.
More later on the risks of VIEs, the complexities of analyzing these risks, and perhaps some strategies for protecting against those risks.
But, in the meantime, I would really like to know how the foreign investors analyzed (or didn’t analyze) these risks and whether or not the analysts are still working for them.
