Live and Let VIE

Sunday 09/28/14

        Last week the markets moved modestly lower after a series of large swings in both directions. In fact, the Dow moved over 100 points everyday last week except Monday. There were quite a few news items that moved the market, but pundits had a hard time identifying a clear narrative. Apple, being the largest component in the S&P 500 and NASDAQ indices, contributed a lot of the downward pressure, because of speculation around product defects and a botched software update that briefly cut phone service. Another big news event was the surprise resignation of Bill Gross from Pimco. Bill Gross founded Pimco in 1971 and grew it into the largest fixed income manager in the world with nearly $2 trillion in assets under management. He left suddenly on Friday morning for Janus Capital which has roughly $150 billion in assets under management. Investors moved their money to Pimco over the years because of Bill Gross' success as a manager, now that he is gone this will likely lead to numerous outflows from Pimco either to his new fund at Janus or elsewhere. Money will likely not begin moving until next week, but expect some disruptions in the fixed income market. This week I want to write about the increasing issuance of Chinese ADS (American Depository Shares) and some of the risks that investors are ignoring.

Alibaba

        Earlier this month investors piled into the long anticipated Alibaba IPO. Alibaba is an e-commerce business in China, similar to Amazon in the United States, but also heavily focused on connecting overseas buyers with Chinese manufacturers. Alibaba has been an incredible success since it was founded by Jack Ma back in 1999. Jack Ma grew the company to where it now earns $248 Billion per year in gross merchandise volume in over 190 countries. After its recent IPO, Alibaba now has a market capitalization of over $220 billion, which makes it much larger than Amazon and almost as large as Walmart. Nearly all of Yahoo's $40 billion valuation can be attributed to its early investment in Alibaba. In short, Jack Ma has created a behemoth of a company in a relatively short period of time and is an inspirational rags to riches story.

VIE

       So maybe you like the Alibaba story and think this stock has great potential, apparently a lot of people thought so when they piled into the IPO. However, despite what many thought, they did not buy Alibaba stock, they bought shares in in a variable interest entity or VIE in the Cayman Islands. A VIE is a holding company that has the right to profit of a mainland Chinese company through a series of contracts and agreements. The VIE structure does not own Alibaba's Chinese businesses, but instead owns its wholly owned foreign subsidiaries. If this all sounds complicated and shady, that's because it is. The Chinese government restricts foreign investment in Chinese companies, and the VIE structure is used as a way to circumvent this. The VIE structure may seem like a great way to get around the law in China, but the only problem with the VIE structure is that it may be totally illegal under Chinese law.

        The Supreme People’s Court of China has invalidated a VIE structure in the past for Minsheng Bank and has blocked Walmart from using a VIE to acquire a Chinese company. In Alibaba's F-1 filing with the SEC it states:

“If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC (People's Republic of China) governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations.”

        Well that is a pretty big deal considering that VIE structure is of ambiguous legality in China and certainly does not follow the spirit of the law. The VIE structure also creates a conflict of interest for Jack Ma as stated in their F-1, “...conflicts of interests may arise due to dual roles both as directors and executive officers of the variable interest entities and as directors of our company, and may also arise due to dual roles both as variable interest entity equity holders and as directors of our company.” This means that if there is a conflict of interest, Jack Ma is probably going to favor the actual company, not the VIE. The American investor will be forced to take their case to a Chinese court which will almost certainly rule in favor of Jack Ma. A dispute happened in the past when Jack Ma spunoff Alipay, an extremely lucrative payment system used by Alibaba. This angered Yahoo quite a bit because they were not informed until after the fact, despite being a major shareholder. Eventually the dispute was resolved with Alipay agreeing to make payments to Yahoo.

        The VIE has become a common way for Chinese internet companies to raise money from U.S. investors. Alibaba is just the most high profile example. The smaller less profitable companies could create many problems for U.S. investors in the coming years. However, proponents of this structure claim that if the Chinese government would never deem it illegal, because it would create a negative economic shock in China.

        I personally do not trust the Chinese government and would be very cautious investing in Chinese stocks, especially social media stocks. China is an oppressive government that may just decide to pull the plug on social media because they are unhappy with the content. In fact, just today the Chinese government pulled the plug on Instagram because of protests in Hong Kong. Not only does China have legal and corporate governance risks, but they have a deteriorating macroeconomic picture, hidden debts, and slowing growth. There are so many better opportunities globally that I think investors should avoid China and Chinese companies.