International exposure is key to building a well-diversified portfolio, but foreign companies can address issues you wouldn’t find in the United States. Take, for example, a common workaround for bans on foreign ownership of China-based companies: the Variable Interest Entity (VIE).
The Chinese e-commerce company Alibaba is preparing for an IPO on the New York Stock Exchange. Alibaba’s sheer size (an estimated total value of over $200 billion) has drawn a lot of attention from investors, but some of that attention comes in the form of concerns. Alibaba uses the VIE structure, and a recent Wall Street Journal article reported that a US government commission found that American investors face “major risks” when buying stocks in companies structured in this way are. (1)
VIEs are not new. Chinese Internet companies began using this structure in 2000 as a workaround for Chinese restrictions prohibiting foreigners from investing in certain sectors, including telecommunications. In order not to break the rules, non-Chinese investors own an offshore listed business entity that owns a China-based subsidiary. The Chinese subsidiary then owns one or more domestically licensed companies, the VIEs. In the case of Alibaba, US investors will buy shares in a Cayman Islands company called Alibaba Group Holding Limited. This company has a contractual right to the Chinese company’s profits, but does not own the company’s assets.
Although this structure has proven itself so far, the risks identified by the Commission are not insignificant. Because company ownership is indirect, foreign investors must rely solely on contractual arrangements to ensure they retain the economic benefits of ownership of the China-based company. Those contracts would have to 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, foreign investors have relatively little control. In 2011, Alibaba’s Chinese company ignored objections from Yahoo Inc., a major shareholder in the offshore company, and spun off the assets of a payment entity to put it under the control of company founder Jack Ma. Alibaba said the transaction was necessary to ensure the People’s Bank of China could continue operating the payment entity and eventually reached an agreement with its shareholders, The Wall Street Journal reported. (2) While some investors see the VIE structure as a cost of doing business in China, the lack of oversight involved calls for caution.
Still, investors take a similar risk with the stocks of US companies that have a controlling shareholder, whether or not that shareholder is the founder. Investors sometimes decide that dependence on the controlling shareholder is a price they are willing to pay to invest in a particular company. Some private equity firms, including The Carlyle Group, KKR and The Blackstone Group, have also gone public with a limited partnership structure, in which investors receive a share of profits but remain at the mercy of the general partner in making business decisions. However, the decision to buy into a company with limited control in the United States comes with a host of rules and regulations designed to protect minority investors. While these aren’t bulletproof, they do offer some security. Investing in Alibaba or any other VIE-structured Chinese company means giving up not only control but also transparency.
Perhaps more worryingly, the Chinese authorities have never officially confirmed that VIEs are legal. Should the Chinese government see fit to question the legitimacy of companies deploying VIEs, there was little a foreign investor could do. While China has a vested economic interest in preserving companies as large as Alibaba, investors without a legal safety net are banking on the Chinese government’s self-interest. Some observers have warned that Chinese precedents suggest VIEs could fall if challenged.
This is not to say that investors should always avoid companies structured as VIEs at all costs. Asia focused equity funds can offer diversified exposure to thousands of different companies as part of a well diversified equity portfolio, we can live with a small exposure to VIE structured companies like Alibaba.
But keep an eye on your exposure to Chinese company stocks, regardless of how they are structured. There is reason to be cautious about 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-unfriendly structure is all the more reason to proceed with caution.
1) The Wall Street Journal, “US report casts doubt on legal structure of Alibaba and other Chinese firms”
2) The Wall Street Journal, “Alibaba Founders’s Recent Deals His Flags”