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China’s Fraught IPOs

The Magical VIE

By | Updated Sept. 15, 2014

China’s Internet companies are exploding in value, so foreign investors naturally want a piece of the action. A little problem: Chinese law restricts foreign investment in Internet businesses (along with those in banking, mining and private education). Not to worry — where there’s a will, there’s a way, in this case an exotic corporate structure that magically turns a Chinese company into a foreign one with shares that overseas investors can buy. And they have. Since 2000, foreigners have poured money into initial public offerings of China’s Internet companies. The total value of Chinese Internet companies on U.S. exchanges reached $8.4 billion in July. It’s a risky business, though, because nobody knows yet whether the Chinese government considers these companies legal.

The Situation

The gargantuan online retailer Alibaba is scheduled to become the 12th Chinese Internet company since 2000 to put its shares up for sale on a U.S. exchange. To do this, it plans to use what has become a standard legal shuffle to deploy a variable interest entity, meaning it will transfer profits to an offshore corporation with shares that foreign investors can own. Pioneered by the Chinese-language media company Sina in its April 2000 IPO, the VIE structure is already in use by all 11 major Chinese Internet companies. Investors won’t own shares in Alibaba’s profitable e-commerce business. Instead, they’ll be buying a piece of a shell company in the Cayman Islands. The earlier Chinese companies went public with as much as 99 percent of their revenue tied to the VIE, but only 12 percent of Alibaba’s revenue and 8 percent of its assets are fixed to the structure. Shareholders will be betting on faster growth of China’s Internet use, which climbed almost 700 percent in the last decade. They’ll also be crossing their fingers in hopes that the Chinese government doesn’t object. If it does, both sophisticated and less experienced investors could be hurt. The hedge fund Lone Pine Capital LLC, led by billionaire investor Stephen Mandel Jr., is one of the largest shareholders in the Chinese Web services company Baidu Inc. The California Public Employees’ Retirement System, the largest U.S. pension fund, owns almost 500,000 shares of the Chinese social network RenRen.

The Background

The Chinese government divides its major industries into categories. Some are encouraged or permitted to offer ownership interests to foreigners. Others face restrictions or prohibition. Many foreign industry leaders say these rules violate the market reform agreements the Chinese government signed when it joined the World Trade Organization in 2001. Executives in industries like steel and mining have long called for China to be more open to foreign direct investment. No Chinese regulatory body has officially approved a VIE structure and the Chinese government has largely ignored the companies operating as VIEs. In 2012, China’s Supreme Court broke up one form of a VIE when it invalidated contracts made between Minsheng Bank of Hong Kong and its mainland proxy, cutting off foreign investors from future profits. Chinese Internet companies say the ruling doesn’t apply to them because the bank didn’t use the typical VIE structure, leaving itself exposed to lawsuits.

The Argument

Senator Robert Casey of Pennsylvania asked the SEC to press Chinese companies to disclose the risks of participating in their initial public offerings. The U.S.-China Economic and Security Review Commission called for China to eliminate Internet restrictions, open its markets, and spell out the legal status of variable interest entities. China says that its restrictions safeguard its economy, which grew almost 150 percent in the last decade, according to Bloomberg data. Chinese companies insist they have minimized the risks associated with the VIE structure and investors seem to believe them. They’re betting that the purchasing power of China’s burgeoning middle class, which is expected to triple in the next decade, is reason enough to tolerate the risks.

The Reference Shelf

  • The law firm O’Melveny & Myers published a 2011 report, “VIE Structures in China: What You Need to Know.”
  • PricewaterhouseCoopers offered 245 pages of guidance in 2013 on accounting for VIE structures.
  • A 2012 explainer on VIEs by the Hong Kong research firm Forensic Asia explores why China doesn’t let its companies list shares overseas.
  • Bloomberg News reported in July that lawmakers and regulators in Washington weren’t objecting to the way Alibaba’s IPO proposal disclosed its risks.
  • Bloomberg QuickTake on Alibaba.

(First published Aug. 4, 2014)

To contact the writer of this QuickTake:

Leslie Picker in New York at lpicker2@bloomberg.net

 

To contact the editor responsible for this QuickTake:

Mohammed Hadi at mhadi1@bloomberg.net