As the accounting issues between the US and China escalates investors in China concept stocks aren’t the only ones scratching their heads. Equally troubled are the country’s VC and PE firms who were just starting to see a light at the end of the tunnel with YY’s recent IPO.

People may be underestimating the potential losses for China if the US markets were to be closed off, in particular when it comes to the technology sector. There are currently many young promising Chinese tech companies, but most of them have at some point taken in foreign capital to grow, which means they will have a VIE structure in place.

A VIE structure and foreign shareholders will automatically rule out a domestic listing, so the only possibility is to go abroad for an IPO exit or try to find M&A options in China, something that has been very slow moving so far. A foreign exit has traditionally meant one of two places for up and coming Chinese tech companies: US or HK.

The problem we could face now is that the US exchanges will close completely for Chinese companies, and HK’s new VIE regulations means it should be all but impossible to list the company their either. At that point we’re left with the “secondary exchanges” for Chinese companies, most likely London or Singapore.

However, these exchanges don’t have the same history of taking in Chinese companies, much less the soon-to-be-big tech companies and their disclosure rules for VIEs are relatively lacking. These factors combined mean that the ambiguity and risk both for investors and the company that wants to IPO increases, and if there’s one thing Chinese companies and investors in them don’t need right now it’s more ambiguity and risk.

This development poses very real problems for the country’s VC and PE firms, and in turn for innovation and new company creation in some vital Chinese industries.

A lot of the debate seems centred around the issues this will raise for investors and the US role as central capital market, but China does not walk away scot-free from this either. And decreased private investment in key innovation industries is not what China needs right now.


The big talking point last week was undoubtedly the New York Times article that laid out the personal wealth of Wen Jiabao’s family in great detail. It was a piece of reporting very reminiscent of the earlier Bloomberg piece regarding the wealth of Xi Jinping’s immediate family, and the result of both articles has been the same: immediate blocking of the entire site inside China. But there are other potential repercussions because of this as well, and they have the potential to harm investors and Chinese stocks listed overseas.

Both stories used Chinese records to build and confirm the bulk of the data they presented, this is also commonly done when conducting due diligence on Chinese companies. These are the SAIC filings where you can find a lot of data about a company to help guide your due diligence process. It used to be that you could get all manner of economic data from the SAIC files, but access rights were severely restricted earlier this year, which forced due diligence professionals to adapt their processes.

It was widely speculated that the restricting of access to the SAIC files was a response to them often being used as a first stop when the now infamous short sellers were putting together reports on Chinese companies. The theory then went that because these reports were having a negative effect on Chinese stocks overall, as the perceived fraud risk increased, the political class stepped in to try to limit the short reports and decrease the downward pressure on Chinese stocks. It may even have been the case that the reason for the political class to move on the issue was that they were themselves losing too much money because of the stock decline.

The risk we face, now that these reports have been put together, at least to some extent, based on the SAIC filings is that access will be restricted even further. This would cause a multitude of problems for conducting due diligence in China, and it would add uncertainty to the market for China concept stocks as it would become even harder to confirm holdings, or even simple things like ownership.

This is especially problematic for people who trade Chinese stocks on the IFRS exchanges, as disclosures from companies on these exchanges tend to be much less detailed. The classic example for me in this is the fact that you can still report a VIE as a subsidiary under IFRS. The classic check on this would be to pull the SAIC filings to find out who were the actual registered equity owners of the entity in question, if you remove this option then investors truly are flying blind.

What’s more, this will probably also increase the costs of performing due diligence in China, which would harm smaller investors more that institutional players who have enough money involved to warrant the outlay. With the easy option of checking SAIC filings for suspicious discrepancies gone investors will need to find other ways of red flagging potential investments, it will also increase the value of having a good network set up for conducting due diligence.

Further, In my opinion it’s quite the opposite of what the overseas listed Chinese companies, especially the small- and mid-cap companies, need right now. many of them appear to be legitimately undervalued and would benefit greatly from increased transparency to help soothe investors concerns regarding them.

So there’s been an awful lot of speculation and rumours around VIEs of late. Starting with the continued EDU issues that I discussed at some length in my Tradingfloor column earlier, to some new rumours about issues for MNCs. It’s this latest rumour I find most interesting, and I think it’s a very interesting development if we put it in its proper context.

First of all we have to say that we currently have very few details about this crackdown, for instance we don’t know which AICs or MNCs are involved. We could indeed be looking at a situation similar to what we had with Buddha Steel where enforcement appeared to differ depending on where in the country you conducted your business. As we’re talking about local AICs here it’s entirely possible that we’re currently seeing different enforcements in different areas of the country.

But this is not the whole story, of course. What’s really interesting about this is that it seems to follow something of a pattern. It started off with the article discussing the issue of foreign influence in the restricted industries in China, then all was quiet for a good while before we saw some real movement when MOFCOM approved the Walmart takeover of Yihaodian with some reservations, creating what I called the restricted VIE.

This is now the next step in what appears to be a gradual campaign to limit the use of the structure. As Professor Gillis pointed out in his post they’re apparently staying away from the foreign listed companies as they are too high profile. What they do appear to be doing is targeting MNCs in particular. I think this is likely to be an attempt to rein in the most obvious foreign elements in the restricted industries, as they are very obvious examples of the foreign influence the article warned against.

While there are arguments that can be made about the supposed foreign influence many of the foreign listed VIEs are actually subject to (you’ll find most still have a heavy voting majority of Chinese nationals), it’s much harder to argue the same for an actual foreign company.

This is yet another issue with VIEs that will relate particularly to foreign companies. The structures used by the foreign companies are already less stable, in general, than a Chinese VIE due to the difficulties in aligning incentives when the VIE is held by an employee. You create a lot of potential issues with an employee held VIE, as the employee suddenly has an unreasonably strong negotiating position, and with very limited ownership in the foreign parent there are often strong incentives to take the VIE and run.

While the risk of the owners absconding with the VIE can be mitigated by properly structuring the assets etc. it’ll be very hard to deal with this new issue. It’ll be interesting to see how far authorities take these actions, but MNCs will certainly need to keep on top of the situation. Authorities are unlikely to relax the new restrictions against foreign elements anytime soon.

Part of the reason I haven’t been posting as much on my blog lately is that I’m currently writing about China equities for Saxo Bank on their platform Tradingfloor.com

So for a regular healthy dose of China equities analysis you can go to my trading floor blog.

I already have three posts up, discussing China’s rebalancing, Auditor track records, and trading the short seller bounce.

As a result I will be talking more about VC and PE matters on this blog, as I have a feeling running two blogs about equity investing will quickly get tedious enough to drive me insane. I do expect some of the important topics to be relevant for both blogs, but as the viewpoint on trading floor is very much that of an equity investor I’ll attempt to stick to a more early stage view here.

As regular readers of this blog will be aware, I am currently doing some research on Chinese companies going private from the US exchanges with my colleague Jens Ørding Hansen. During this process we have collected some data that, while not fitting into the overall narrative of our paper, is nonetheless very interesting.

One of these interesting sets of data regards what happens in the trading of these companies leading up to the going private proposal. We looked at the data in a few different ways, and found what appears to be indications of “information leakage”.

Jens then took the time to actually compile this data into some very useful and informative graphs that we believe will interest some readers.

Firstly, we looked at the difference between prices leading up to the proposal and the price development on the proposal date.

As we can see here there are some interesting developments in the price of some of these equities before the actual proposal to go private, to the extent that we sometimes even see large increases pre-proposal followed by negative reactions to the actual proposal.

Looking more closely at the developments leading up to the proposal we decided to split the data into the 7 days leading up to the proposal and the day prior to the proposal. As we have already seen some evidence of abnormal price increases, and there is already some documented evidence of options trading spikes leading up to going private proposals, we decided to look at trading volumes.

Starting with the average trading volume for the 7 days leading up to the proposal, we see some abnormal trading patterns emerging.

These patterns get more extreme if we look at what happens on the day prior to the going private proposal, this is also where we see some of the most interesting gains in stock price.

Some of the price increases and increases in trading volume we see in these companies would suggest that there may indeed have been information about the impending proposal leaking through to investors prior to the announcement. However, it must be said that caution should be used when interpreting these numbers as we did not have enough data available on the companies to compare all the relevant data points. However, there is still enough data here to show that something quite interesting has been happening leading up to some of these going private deals.

While there are some fairly varying opinions regarding exactly what happened when walmart got conditioned approval for their acquisition of Niu Hai Holdings, one thing at least seems clear: MOFCOM is not overly fond of VIEs.

This certainly won’t be welcomed by foreign investors using VIEs, but its hardly news either. MOFCOM have been the most vocal department when it comes to issues relating to VIEs, for instance in their recent M&A regulations, so a continues negative stance is hardly shocking. What is interesting is how they express their negative views.

They haven’t banned the VIE structure as such, if anything they are acknowledging its existence, but they are limiting the scope under which they will allow it to operate. So far I don’t think this will cause any major issues for Walmart, so from their point of view this is probably a pretty good result.

Other VIEs might want to take notice of the restrictions, however. just in case this turns out to be the start of a trend. While MOFCOM can’t really declare VIEs illegal, they may find a simpler solution in simply restricting their business scope until they are basically useless.

Seasoned watchers of the VIE space will know to take any such hints of future regulatory enforcement with caution though, as we have seen similar things before, with Buddha Steele for instance. What we can say is that MOFCOM certainly doesn’t seem to like VIEs, and if you cannot ban them limiting them is probably your next best option.

This post was written in collaboration with Jens Ørding Hansen from University of Agder with whom I’m writing an academic paper on Chinese companies going private from the US exchanges.

Last week saw the announcement of the largest ever going private (GP) proposal for a Chinese company on the US exchanges. Focus Media had a market cap over 3 billion USD, pushing the record for largest market cap for a Chinese GP from a previous high of 1.8 billion.

This deal can be seen either as a continuation or a new beginning, depending on your perspective. On the one hand the deal fits the trend of Chinese companies going private from the US that many people expect to continue; on the other hand the deal sticks out from the recent trend in some respects.

The sheer size of the deal is the first, and most eye-catching, way that it sticks out. 75% of GP proposals for Chinese firms fall within a range of USD 50-390 million for market cap, with an average of 288 million. So with a deal over 10 times the average historical value we really are talking about an anomaly.

It could be argued that what we’re seeing here is the start of an exodus trend for the larger Chinese companies that are listed in the US. However, the other big GPs we have seen have not resulted in a discernible trend of large companies heading back to China. What we have seen is that one or two larger deals seem to come before more GP proposals among the smaller firms.

Another interesting aspect of this deal is that it does not include China Development Bank (CDB) funding, something that many thought was going to be the driving force behind the next wave of GP transactions. This was especially true after the CDB agreed to provide funding to help close the Fushi Copperweld deal.

This is not entirely out of character for the CDB as a policy bank, however, as they may be allowing market forces to play out before they decide on stepping in to help close deals. Because there was enough financial backing for the Focus Media deal the bank didn’t actually need to step in, at least not yet.

It might be that the bank is more likely to step in and help conclude some of the old GP deals that have been languishing, seemingly unable to close. There are still 6-8 older GP proposals that are seemingly stuck and not going anywhere. If these proposals are genuine then this might be the best use of the bank’s funds, rather than stepping in and helping deals that would likely close anyway.