China’s Overseas IPOs
The Magical VIE
The world’s biggest population is getting online, and foreign investors naturally want a piece of the action. A little problem: Chinese law restricts foreign investment in Internet companies (along with 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. They had shares valued at about $40 billion trading on U.S. exchanges at the end of 2015. It’s a risky business, though, because nobody knows yet whether the Chinese government considers these companies legal.
China’s gargantuan online retailer Alibaba sold shares to U.S. investors in 2014, raising $25 billion in the largest initial public offering in history. To do this, it used 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 IPO in 2000, the VIE structure is used by many of China’s Internet companies. Investors don’t own shares in Alibaba’s profitable e-commerce business. Instead, they hold 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 were fixed to the structure. Shareholders are betting on rapid growth in China’s Internet use: More than half of the population — 688 million users — was online by the end of 2015. 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 California Public Employees’ Retirement System, the largest U.S. pension fund, owned almost 2.5 million shares of the Internet retailer at the end of 2015.
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. 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.
No Chinese regulatory body has officially approved a VIE structure and the Chinese government has largely ignored the companies operating as VIEs. In January 2015, the Ministry of Commerce proposed a draft law that would unify regulations on foreign investments and begin regulating the structures, though it was never brought into force. In 2014, U.S. Senator Robert Casey asked the Securities and Exchange Commission to press Chinese companies to disclose the risks of participating in their IPOs. The U.S.-China Economic and Security Review Commission has called for China to eliminate Internet restrictions, open its markets, and spell out the legal status of VIEs. China says that its restrictions safeguard its economy. 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. 3, 2014
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