China’s internet sector is a curious paradox – it enjoys the most foreign equity investment of any part of the Chinese economy, while at the same time, foreigners do not own a single share.
A curious regulatory loophole known as a VIE, or variable interest entity, has allowed foreigners to get around Beijing’s prohibitions against foreign ownership of internet assets. They have amassed huge holdings in companies such as Tencent, Baidu and Alibaba, the ecommerce group that on Tuesday filed for a US IPO that could value it at up to $200bn.
Prospective investors in Alibaba’s listing – likely to raise about $20bn and to be the biggest stock flotation in the world since Facebook – will know that in any dispute with Alibaba’s Chinese investors, their shares could be invalidated and rendered worthless in a Chinese court.
Alibaba’s blockbuster IPO caps a revival for US listings of Chinese companies after a two-year drought brought on by a series of financial scandals at Chinese groups. Ironically, one of the biggest involved none other than Alibaba, which was accused of abusing its VIE to strip assets out of the company in 2011.
But memories are short, and this year “Alibaba is the tide which is lifting all boats after two years of scepticism towards most US listed Chinese companies”, according to Nicholas Manganaro of Ogilvy Financial in Beijing.
Investors will have to have strong nerves. “Every so often someone will read a [IPO] prospectus and say ‘hold on a minute, what do I really own here?’” says Mr Manganaro, adding that the ownership issue has been “hiding in plain sight” for years.
“Chinese regulators have always turned a blind eye, but the fear is what if they don’t? What if it is challenged in court?”
A convenient loophole
Since the first Chinese internet IPO in 2000, Chinese start-ups wanting to list abroad have skirted ownership restrictions by setting up offshore companies known as VIEs. They are domiciled mainly in the Cayman Islands and have a series of contracts that “simulate” ownership in the Chinese company. In the event of a lawsuit, analysts doubt the contractual powers would be enforceable.
“It appears that the VIE structure works – until you need it to work, and then it won’t work. That is a concern that has many investors scared to jump back into Chinese stock,” said Paul Gillis, a professor of accounting at Peking University.
Of the more than 200 Chinese companies to list in the US since 1999, roughly half have used VIEs, according to Fredrik Oqvist, a Beijing-based accountant. These are mainly internet and education companies which are restricted from having foreign shareholders.
Gene Buttrill, of the Jones Day law firm, says the main risks of a VIE are that the individuals holding the shares of the operating company will abscond with the assets and good name of the company. The other is that the Chinese government will deem the structures illegal and “collapse them”.
The Alipay scandal
Everything could go horribly wrong, and has on a number of occasions. In Alibaba’s case, chairman Jack Ma in 2011 transferred ownership of Alipay, the company’s payments arm, out from a VIE and into a structure that he controlled personally. At the time Alibaba Group, the VIE, was 40 per cent owned by Yahoo, and 34 per cent owned by Japan’s SoftBank.
Executives at Yahoo complained that they were not informed of the transfer, though Mr Ma says he consulted Alibaba’s board, on which Yahoo and SoftBank have a seat. Yahoo and SoftBank deny this. The three companies came to a settlement in which if Alipay ever went public, it would pay Alibaba between $2bn and $6bn.
Mr Gillis says Mr Ma’s history of taking advantage of a VIE structure should set off alarm bells. But Alibaba’s prospectus outlined bold plans to mitigate investor fears by holding most of its assets, aside from licences, in the foreign-owned part of its business, and to ensure that most revenue is generated directly by the foreign-owned business.
“Mr Ma seems to have gotten some religion from his past VIE experience,” says Mr Gillis. “The present VIEs are structured better than most, putting most operations in wholly owned subsidiaries and leaving only the licences and permits in the VIEs.”
The VIE structure has always been a grey area in the Chinese legal system, and the Chinese government prefers to look the other way. In 2012, according to a number of lawyers, China’s ministry of commerce drafted a memo suggesting the VIE structure be abolished. But the suggestion “never made it out of committee”, said one.
Mr Buttrill said that the VIE structure has actually been strengthened by the scrutiny. US and Chinese regulators “have each re-examined the structure over the past couple of years, with the result that it is here to stay”, he said.
Auditors under scrutiny
VIEs are just one of the risks that prospective Alibaba investors will have to consider. Another relates to the auditing of Alibaba’s financial statements.
After several US-listed Chinese companies, such as Longtop Financial and Sino Forest, were accused of financial fraud last year, there has been a diplomatic stand-off between the US Securities and Exchange Commission and China’s financial regulators over access to the audit papers of Chinese companies.
This means, as Alibaba writes in its prospectus, that the audit of its accounts by PwC is not fully inspected by the Public Company Accounting Oversight Board, the US’s top audit watchdog, and could, as with all other US-listed Chinese companies, be barred from being listed on a US stock exchange.
“The path we’re on now is that all US-listed Chinese companies could eventually get kicked off US exchanges,” said Mr Gillis.
“What we’re hoping for is a diplomatic agreement, because at the end of the day this is not between the SEC and Chinese regulators. It is between the US and China trying to figure out their respective places in the world.”
Yet if the risks can be daunting, investors have in many cases been compensated richly as well. Shares in 58.com, a Chinese version of Craigslist that listed in November, has nearly doubled since its debut.
South Africa’s Naspers, the publishing company, bought a 46 per cent stake in then-lossmaking Tencent in May 2001 for $32m. Thirteen years later, Hong Kong-listed Tencent is one of Asia’s biggest technology companies, with a market capitalisation of $114bn.
According to its internal estimates disclosed in the prospectus, Alibaba in April valued itself at up to $121bn, though the final valuations at its IPO could be swayed by internal performance, the market and investor reaction to a roadshow spanning three continents.
Nevertheless, the message is clear – the risk-reward calculation is heavily skewed in favour of the reward.
“The scenario is so binary,” says one lawyer. “You can’t afford not to invest in these things. But if something goes wrong, you are left with nothing.”
北京奥美金融(Ogilvy Financial)的尼古拉斯?曼加纳罗(Nicholas Manganaro)表示，人的记忆是短暂的，“在大多数在美上市中国企业普遍遭到怀疑两年后，（今年）阿里巴巴IPO就相当于涨潮，能把所有船只都抬高”。
众达律师事务所(Jones Day)的卜嘉男(Gene Buttrill)表示，VIE的主要风险是，持有运营公司股份的个人可能卷走公司资产，并损害公司的良好声誉。另一点担忧是，中国政府可能认为VIE架构非法，并“摧毁该结构”。
一切事情都可能变得非常糟糕，而且在很多情况下这确实发生了。以阿里巴巴为例，该公司董事长马云(Jack Ma) 2011年将支付业务子公司支付宝转移出VIE，转入他本人控股的一家公司。在当时的VIE阿里巴巴集团(Alibaba Group)中，雅虎(Yahoo)持股40%，日本软银(SoftBank)持股34%。
去年，东南融通(Longtop Financial)和嘉汉林业(Sino Forest)等多家在美上市中国企业被控实施了财务欺诈。随后，美国证交会(SEC)与中国金融监管机构，在获取上市中国企业审计工作底稿的问题上陷入了一场外交对峙。
正如阿里巴巴在其招股说明书中所写，这意味着，普华永道(PwC)对阿里巴巴账目的审计结果，没有经过美国最高审计监管机构——上市公司会计监管委员会(Public Company Accounting Oversight Board，PCAOB)的完全审查，因此，可能像所有其他在美上市中国企业一样，被禁止在美国的股票交易所挂牌上市。