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Archive for March, 2012

There are reports coming out now that the VIPshop.com IPO is going to be pulled, due to lack of interest from investors. This move will hardly be surprising for people who have followed the reception of the F-1 filing and the roadshow.

A more important question is what this means for Chinese IPOs as a whole. Has the window just been slammed shut on Chinese IPOs, or is this more of an isolated incident? To me at least it looks a lot more like the latter.

The company did not look like a tempting proposition in almost any respect, and there were a few red flags to go along with it, so I don’t think we can use this as a good temperature gauge for better-looking Chinese IPOs. I suspect AdChina, and possibly Cloudary, might be the IPOs used to judge the market appetite for more Chinese listings in the near future.

A couple of quick comments on why I don’t think VIPshop.com was an attractive offering to begin with might be in order, in case you haven’t read the filings.

The company was losing money at an increasing pace, and it was hard to see how the company was going to turn it around. The business model was also very “heavy”, by which I mean the company had a very long supply chain (warehousing, sales, after sales services, distribution etc.) and was probably taking on too much.

To top this off they had a VIE contract that must be an absolute nightmare for anyone working with transfer pricing issues, leaving the company open to very large tax liabilities indeed.

All in all, I’d wait for the AdChina IPO reception before I start declaring the IPO window for Chinese companies is definitely closed.

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A report in the Chinese press has outlined yet another instance of the government criticising VIEs and foreign influence in sensitive sectors.

While this might not sound as news it has two features that sets it apart from the average criticism. It is supposedly the opinions of some fairly senior people in the central government, and it outlines a potential course of action to bring current business practices more in line with official law and policy.

Although generally vague there are two features relating to the scrutiny of VIEs that offer some interesting insights into how enforcement around the issue could look. Something that should be of interest to investors seeking to understand risk exposure in the area.

  1. Talks about scrutinising all contracts between domestic and foreign companies in these restricted industries.
  2. Examining the suitability of the foreign partner in these contracts

The reason this is interesting is that it sets out a potential focus of enforcement that is different from what some thought it would be. For instance there’s no direct attack on the VIE concept, but rather a slower approach that starts with scrutinising the contracts involved and the companies that have signed them.

This is important as it shifts the focus from the structure as a whole into its individual parts, and as such opens up for treating different VIEs differently. This type of action looks a lot like trying to pick off some low hanging fruit in the industry, which in this case would likely mean some of the poorer constructed VIEs.

As I have mentioned before there are big differences between one VIE structure and another, ranging from how much of the assets are kept in the VIE to how they have formulated the contracts used to extract the money into the WFOE. These factors will take on a new importance if this type of action is implemented.

For instance, if the government was to start scrutinising the contracts used in VIE structures they will find that some of the technical services agreements have terms that can by no means be referred to as “at arms length”. Some of these agreements stipulate that the VIE is to pay all of its revenues as fees for services rendered by the WFOE, as well as any residual profit at the end of the year. While this contract might be good from a consolidation standpoint it is an absolute nightmare from a transfer pricing point of view, and leaves the company open to some very serious tax liabilities.

Increased scrutiny of the WFOE used in the deal offers another set of potential problems. With some of these companies holding virtually their entire operations in the VIE it could be hard to argue how the WFOE is providing services of enough value to receive all the profits from the VIE. Another potential issue that could arise is questions of whether the WFOE is acting outside its business scope, for instance when it provides loans to capitalise the VIE.

This type of enforcement, if enacted, is not so much an attack on VIEs as a tightening of the screws surrounding the structure. While well-constructed VIEs may walk away unscathed some lower quality arrangements could get in very real and costly trouble. Investing on this information will be all about being able to tell a good VIE from a bad one, which will require looking over the details of your investment structure before the Chinese government does.

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With last years going private boom among the US-listed Chinese companies in a lull we have some time to reflect on the potential aftermath.

There was quite a bit written about the going private opportunity at the time, mostly implying that the current valuations were far too low and that a de-list re-list deal taking the company from the US to Asia could yield quick returns. A promise that appears to have intrigued any number of PE firms to take a closer look at this type of deal.

The problem with this type of investment, which was also pointed out at the time, is that it usually requires another IPO exit, which at the moment is a lot easier said than done. This is creating issues for foreign PE firms currently finding out just how hard-accomplished exits are in China these days.

As was pointed out in an excellent piece on the China Private Equity blog, the domestic IPO market is tightly controlled, backed up and dominated by a few domestic firms who appear to hold the keys to the door. Also, Hong Kong is getting stricter on who they allow in, especially on VIE listings that need to provide a lot more these days, and the M&A market is still so small that it cannot be counted on to pick up much of the slack.

There are of course measures the companies can still take to increase the value of their investment, rebuilding the investment structure is one such example, but in such a stale market it will still be hard to find viable exit options.

In fact, it appears the industry has now taken some measures to try to remedy the situation itself. One such instance is the new occurrence of PE firms exiting deals to other PE firms, which begs the question of where these new owners are expecting to find an exit that their colleagues missed. We also have an interesting addition of buy-back clauses in the investment contracts that would potentially require the company to buy back the shares the PE firm took for a set yearly ROI rate.

This last measure appears particularly strange, as it does not detail where the money to buy back the shares should come from, or what enforcement mechanisms the company has at its disposal. It would seem ill advised for the PE firm to try to enforce its’ claim and make the company sell off assets etc. to pay back the investment potentially crippling a well-functioning company. The PE industry isn’t popular to begin with and such a move would certainly hurt the industry as a whole.

Overall the industry seems to be in some state of collective hibernation, with a reported $50 billion invested, and another $50 billion waiting in the wings there needs to be viable exit options available. At present you’d be hard pressed to find even one reliable exit for the industry, and even when the market starts moving in the right direction PE firms are likely to find tougher demands on what will be let through this time around.

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