China Dot-Coms Rush to U.S. as Buyers Shrug Off Murky Structures

Sky-high valuations mixed with murky corporate structures often scare off investors. That’s less so if the companies are from China.

From microblogging site Weibo Corp. to real-estate website Leju Holdings Ltd., China-based companies have announced more than $2.5 billion of U.S. initial public offerings in 2014, data compiled by Bloomberg show. That’s the most since the fourth quarter of 2007, when Chinese stocks in the U.S. peaked before losing almost two-thirds of their value. The rush isn’t slowing soon. Alibaba Group Holding Ltd. is preparing to file this month for the biggest IPO since at least 2012.

Investors, who have been rewarded with an average 88 percent gain for buying Chinese IPOs last year, are taking risks that would make many stock buyers wary: The companies are approaching the U.S. market with valuations that are as much as 10 times higher than their American counterparts. Many use a legal structure that’s raised concerns among regulators, and have accounting practices that don’t always line up with those in the U.S. By poking holes in both areas, short sellers have been able to trigger losses.

“People get starry-eyed about the billion-plus consumers in China,” said Carter Mack, president of JMP Group Inc., a San Francisco-based investment bank. “But these companies still have a long way to go with corporate governance and legal structures. Investors have to do the extra work to understand the businesses.”

Valuation Concern

Top among the concerns is the valuation that companies are being awarded relative to their U.S.-based peers, said Josef Schuster, the founder of Chicago-based IPOX Schuster LLC.

While Alibaba hasn’t said at what price it will sell shares, China’s largest e-commerce company is valued by analysts at $153 billion, on average. That’s 23 times its sales in the year through September, the latest for which revenue figures are available. The ratio is five times higher than EBay Inc.’s and over 10 times more than Amazon Inc.

“There are a lot of risks, but the biggest one is that all these Chinese IPOs now come to the market at extreme valuations,” said Schuster, whose firm tracks IPOs.

The largest Chinese IPO in New York last year -- classifieds website operator Inc. -- has more than doubled since its October debut and now trades at 16 times estimated 2014 sales. That’s the highest of any Internet-based services company listed in the U.S., including TripAdvisor Inc. and Zillow Inc., data compiled by Bloomberg show.

The best performer among newly-listed Chinese companies is Ltd., an online sports-lottery operator, that has almost tripled since its October debut. trades at 61 times estimated 2014 profits, compared with a median of 22 times for seventeen U.S. listed casino and gaming stocks.

Both and recently filed to sell more shares.

Prices Justified

Some investors say demographics justify the valuation discrepancy between Chinese and U.S. companies. China’s middle class, earning between $10 and $100 per day, is expected to triple to 500 million people within the next decade. China is the largest smartphone market in the world, according to researcher International Data Corp. Internet companies are priced on the potential to profit from these mobile users, according to David Chao, co-founder of DCM.

“The market for Chinese companies listing in the U.S. is absolutely fairly valued,” said Chao, whose venture-capital firm has invested in more than 200 technology businesses across the U.S. and Asia. “The impetus that sustains these valuations is the phenomenal smartphone growth in China.”

Through yesterday, the median gain of eight Chinese companies to debut last year was 102 percent, data compiled by Bloomberg show. By comparison, 179 U.S.-based companies rose by a median of 34 percent since their 2013 IPOs.

VIE Risk

One factor that bullish investors may be overlooking is that companies use a legal structure known as “variable interest entity,” or VIE, that is intended to circumvent the Chinese government’s restriction on foreign ownership of key industries. Alibaba, e-commerce site Inc. and Weibo are expected to sell shares using this structure, which gives overseas investors the gains and losses of the business through contracts rather than direct ownership.

U.S. and Hong Kong stock market regulators have raised concerns these contracts may not hold up in court.

“The risk associated with VIE is that if the operation contract defaults, what investors have invested in would be just a piece of paper,” said Echo He, a New York-based analyst with Maxim Group LLC, who covers U.S.-listed Chinese companies.

Managers of Chinese companies are also taking uncommon steps to retain control over their businesses: At, Chairman and Chief Executive Officer Richard Qiangdong Liu must be present before any voting can take place over such matters as electing directors and approving transactions. By skipping such sessions, Liu could effectively veto any proposal.

Alibaba Partnership

Alibaba, meanwhile, wants a partnership to be able to nominate a majority of board members, with other investors able to vote on those nominees. Hong Kong’s exchange, which bans different classes of shareholders, refused to allow such an arrangement and helped push Alibaba to list in the U.S.

“An emerging market like China is more like the Wild West when it comes to corporate governance,” said Eric Jackson, president of hedge-fund Ironfire Capital LLC, which invests in technology companies in China. “But America is way too lax with its listing requirements for companies. As an investor, you need to decide who you feel comfortable with.”

Spokesmen for Alibaba and declined to comment. Spokesmen in Beijing and San Francisco for Sina Corp., owner of Weibo, didn’t reply to calls seeking comment.

Accounting Practices

Chinese accounting practices have created problems in the past. Chinese companies refrained from tapping the U.S. markets in the second half of 2011 after short sellers such as Muddy Waters Research LLC, founded by Carson Block, accused companies including Sino-Forest Corp. of misstating assets. Last October, Muddy Waters called Chinese mobile-security service provider NQ Mobile Inc. a “massive fraud,” sending the stock plummeting 47 percent in one day.

NQ denied the allegations and said in November that its independent special committee retained the law firm Shearman & Sterling LLP to review Muddy Waters’s report. NQ’s shares have more than doubled since their low in late October.

U.S. regulators in January asked Chinese affiliates of the four biggest accounting firms for documents related to fraud probes. When the firms didn’t comply, the U.S. Securities and Exchange Commission in January banned them for six months from conducting audits of U.S.-listed Chinese companies.

“When you look at the U.S.-listed names and the China Internet stocks and the valuations that they are trading, people putting money into that -- yes, I scratch my head there,” Block said in an interview on Bloomberg TV in February.

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