Posts Tagged ‘China Investment’

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.

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In a move that is likely to have many investors in China concept stock scratching their heads the Chinese government has further restricted access to SAIC filings, often used as the start of any due diligence on a Chinese investment. The new rules make it virtually impossible to get detailed financials, as filed to the Chinese government, without the expressed consent of the company involved.

While there are limits to what you can tell by comparing SAIC filings to those made by the company overseas it is nonetheless the preferred starting point of most DD professionals and can act as a good road map for where to look in more detail. So restricting, or in effect banning, access to these files will cause some very real problems for investors looking to confirm the validity of a company’s financial statements.

Some are speculating that the reason behind the new restrictions is the use of SAIC filings in short reports written by muddy waters et al. While this may well be true, the effects of the policy will likely be much more widespread as the filings are also used to confirm financial information by investors looking to take long positions in Chinese companies. Perhaps most interestingly, checking SAIC filings was always a relatively cheap way to get some level of confirmation about a company’s financials. The alternatives that we are left with are likely considerably more time consuming and expensive, so these restrictions are potentially putting a higher value on reliable China DD.

The timing of the change in policy could also have been better, coming on the back of delistings,  companies unable to file financials on time, and changes in ownership of the big 4 in China this adds more uncertainty that foreign listed Chinese companies certainly don’t need right now. Something that may prompt companies to act on their own to provide some level of transparency for their investors.

In such an uncertain climate, one way to assuage investor concerns might be to grant any holder of a company’s ADS the right to review its SAIC filings. Whether this will happen or not investors are unlikely to act in a positive manner to restrictions in their ability to double check companies in a sector historically prone to misstatements and frauds.

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The title of this post was taken from an article in the Economist, worth a look if for nothing else than its wonderful cartoon illustration. The title caught my attention because we have dealt a lot with VIE contracts and challenges to its structure, yet there continues to be a gaping hole in the discussion – specifically, around the ownership of a VIE.

Who owns what in a VIE structured company is critical as the incentives of the VIE owners can be completely misaligned from the interest of investors, as often indicated by companies in the risk sections of their annual filings. Yet for all the acknowledgement of risks, we seldom see companies taking actions to mitigate them.

Generally, VIEs fall into at least one of three different categories of ownership: CEO/Founder-owned, Family-owned, and Employee-owned.

CEO/Founder owned VIEs are common if for no other reason than for its relative simplicity.  The founders tend to be PRC nationals who have started a company and then set up a foreign SPV; they can then simply retain ownership of their original company in China and sign the normal VIE contracts with their SPV’s WFOE. This ownership structure is often perceived as the least risky for foreign investors, but certain situations have given foreign investors reason to reflect.

One such situation is exemplified by the divorce proceedings of Tudou’s CEO Gary Wang, where his wife settled to drop the claim of 76% of the equity interest in the company’s operating VIE for cash payments. This led to the now prevalent Tudou clause, which aims to remedy the situation; however, it will be interesting to see if companies that have already listed will also add this to their existing arsenal of VIE agreements.

Another interesting issue that surfaces is the increase of Chinese companies taking a collective beating on the foreign exchanges, causing a misalignment between the incentives for the owner of the VIE with those of shareholders in the public company, as the value of shares in the US is now sometimes even below reported cash balances. The rationale is that there is no reason a company should be listed in the US with a P/E of four, when it could just as easily trade in China at a P/E of 12.

There has been talk about the dangers and difficulties of PE firms delisting a company from a foreign exchange in order to take it public domestically in China instead, but simply cutting the VIE contracts before listing domestically simplifies this process significantly.

Family-owned VIEs work on another level than CEO-held VIEs; there is an overhanging monetary incentive for any member of the family to simply cut the contracts and walk away, as they normally don’t hold equity in the public company. We must then infer that the reason they do not jump ship is because of their bond to the relative who runs the company.

Some observers have pointed out that there are severe unreported risks in the potential deterioration of ties between the VIE owner and their relative within the listed company. For instance, the Tudou situation could have ended worse if the VIE was been owned by the CEO’s ex-wife.

Should family disputes and squabbles be reported in the 20-F annual reports?

It may sound ridiculous, but with some companies, there is the risk that a divorce or a falling out amongst kin could lose the company its entire China operation.

Employee-owned VIEs are another option, and perhaps most interestingly the only viable one for foreign players in the market. Many point to GigaMedia as a prime example of what could happen if there is a falling out between the VIE owner and the company.

The obvious drawback is the amount of power given to a single employee. The employee, as the GigaMedia case showed, becomes impossible to fire. In fact, the employee can hold the company hostage, with the implied threat that the company’s entire operations are under his/her control and could disappear at any point.

Additionally, I question the wisdom of this method of ownership due to historically high employee turnover rates in China.  What would happen if the employee joined a rival company? You could in effect “recruit” an entire business, or business segment, from your competitor.

Now, the above cases discuss the purer forms of VIE structures, as in ones where basically the entire company, or at least an independent part of a company, is in a VIE.

One way to minimise adverse incentives created by this form of ownership is to set up your organisation so that no VIE can operate as a separate entity.

The goal should be to hold as much of the business as possible in WFOEs, preferably limiting the VIE to holding nothing but the necessary licenses. This way, a VIE on its own has no real value; its only value is as part of the whole organisation, the listed company. Then, the value of the VIE bargaining chip is lessened substantially because no one stands to gain from picking the company apart.

We do see that companies set up this way better aligned between shareholders and the owners of the VIE; Baidu is one example of this.  Not all companies have taken these steps however, and in some cases, it’s difficult to tell to what extent these steps have been implemented at all.

The question of adverse incentives in VIE structures, and how to mitigate them by aligning the interests of investors and VIE owners, deserves attention. PE and VC firms that come into these companies likely have a better chance at instigating real change than shareholders of publicly traded companies, but the issue is a pressing one for any investor who is not the owner of the VIE.

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As we have seen in articles and blog posts all over the Internet, the VIE structure comes with very real risks. As such, investors should take care, and when possible apply pressure, for how and when these structures are used to make sure they are not subject to unnecessary risks.

The VIE structure is sometimes seen as a temporary solution while waiting for the Chinese government to further liberalize the market. Once it is possible to legally own the business through a WFOE, the VIEs should be abandoned for its securer counterpart.  Unfortunately, there are still cases in which VIEs are used when there are no legal necessities to do so.

One example of this is Cogo Group [COGO], a reverse listed Chinese company in the Diversified Electronics Industry. The company uses a VIE structure for two of their subsidiaries, Shenzhen Comtech and Shanghai E&T, both are in commodities trading where there is no legal necessity for a VIE structure.

Here’s how the situation was presented in the company’s latest 10-K:

At the time of its incorporation, foreign shareholding in a trading business such as Shenzhen Comtech could not exceed 65%. With subsequent PRC deregulation, foreign ownership of such a trading business can now reach 100%, and approval of foreign ownership of companies in the PRC engaged in commodity trading businesses—which includes agency trade, wholesale, retail and franchise operations – is now delegated to local government agencies of the PRC Ministry of Commerce. In order to exercise control over Shenzhen Comtech (a PRC operating company legally permitted to engage in a commodity trading business), without direct shareholding by us (a U.S.-listed company and therefore a foreign-invested entity), Honghui Li, our vice president, and Huimo Chen, the mother of our principal shareholder and chief executive officer, Jeffrey Kang, hold 99% and 1%, respectively, of the equity interests of Shenzhen Comtech, and through contractual agreements with us hold such equity interests exclusively for the benefit of our 100% directly owned subsidiary, Comtech China.

As you can see from this excerpt, the reasoning for the VIE structure does not hold up. Moreover, they could have held up to 65% of the operations even with the tougher legislation at the time of incorporation, but chose not to do so.

The reason the VIE was not converted into a WFOE seems to be because it requires approval from MOFCOM, as indicated in an earlier 10-K:

However, foreign ownership of companies in the PRC engaged in commodity trading businesses—which includes agency trade, wholesale, retail and franchise operations—is subject to restrictions under PRC laws and regulations, and requires special approval from the PRC Ministry of Commerce, which is time consuming to obtain.

There is no indication, however, that the company has even tried to change its current makeup in this direction, and the question needs to be asked whether something being “time consuming to obtain” is a valid reason for keeping a VIE structure.

The description of the ownership of Shanghai E&T is a rather complicated affair in itself. As far as we know, there is no reason why the company cannot simply own this subsidiary outright: yet not only is the majority ownership held by Shenzhen Comtech, but the same company also holds 35% more equity “through trust agreements” for the benefit of Comtech China (the WFOE).

Shenzhen Comtech, in turn owns a 60% equity interest in another of our PRC operating companies, Shanghai E&T, with the other 40% being held by Comtech China through trust agreements. Under the trust agreements, Shenzhen Comtech owns a 35% equity interest in Shanghai E&T for the benefit of Comtech China and Honghui Li owns a 5% equity interest in Shanghai E&T for the benefit of Comtech China.

This trust agreement arrangement was accomplished by the company’s WFOE paying 16 million RMB for the 40% minority stake. To then give this stake away under a trust agreement, for which there appears to be no good justification, seems a strange move.

There is no further information available about the nature of the VIE contracts.

These issues might not seem very important at first glance, but recent events have taught us just what the risks in a VIE structure are, and as such this is something that warrants investors concerns.

There seems to be no legal for why these entities cannot be converted to WFOEs, other than potential issues with MOFCOM approval. It appears that no effort has been made to gain such approval, and it seems as if the company simply wants to keep its business in a VIE structure.

Investors need to assert pressure on companies to move away from VIEs and towards securer forms of ownership, where possible. While it may not be of much difference for the founder of the company, it is of the utmost importance for foreign investors to make sure that their money is as safe as possible.

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After a couple more days, with some added information on this topic we can now start to guess at an outline of what actually happened when Yahoo lost its’ Alipay investment.

There’s been some mud-slinging between the companies involved and the crux seems to be whether or not Alibaba’s board, and thereby Yahoo, was informed of the transfer of Alipay or not. The Chinese side are claiming the duly informed the board, while Yahoo are claiming they got no word about this.

I think they’re both telling the truth, although they’re missing each others points.

Due to restrictions of foreign investment in certain relevant areas of its’ business areas, Alibaba has to conduct parts of its business through VIEs. A VIE is in reality a series of contracts that aim to create ownership of a company without actually holding any equity interest in it. As Chinese laws strictly speaking only ban equity ownership, this type of structure “allows” foreign investment in restricted areas. However, there are quite substantial doubts as to the legitimacy and enforceability of these contracts.

As I mentioned in a previous post the transfer of Alipay was actually made in two stages, the first one transferred 70% of the company, the second one transferred the remaining 30%. Hence we can safely say it was transferred into a VIE, or it would have de-consolidated at the first stage.

Here’s the sequence of events that I think brought about the de-consolidation of Alipay, and the subsequent misunderstanding regarding the information. It should be noted that this is my best guess, I’ve had no way of truly confirming this.

  1. Alibaba wants to transfers 70% of the Alipay into Zhejiang Alibaba E-commerce Company (Zhejiang Alibaba) its’ VIE, in order to facilitate approval from banking authorities.
  2. The board are duly notified that Alipay is being transferred to Zhejiang Alibaba, which looks and acts like just another subsidiary unless you know what you’re looking for.
  3. The regulators still will not approve the company for a banking license, most likely because they still consider it a foreign investment, so Alibaba want to transfer the remaining Alipay equity to Zhejiang Alibaba, which would then be a wholly-domestic company on paper.
  4. The board are notified that the rest of Alipay should be transferred into this subsidiary-looking VIE thing. As it will still be consolidated this does not appear to be a big deal.

This is the bit the Chinese side are talking about, because they informed the board of all of these transfers, Yahoo clearly knew what was going on. Alipay had been transferred to Zhejiang Alibaba, a VIE entity technically separate from the company but consolidated in the financial statements. Thus, Alibaba’s management had fulfilled its duty.

However, from Yahoo’s point of view this was simply an internal transfer to comply with some pesky regulations, they didn’t see the entity as separate until it de-consolidated. The last two steps are what they weren’t informed of, and this was the important bit from their perspective:

  1. The banking authorities take the VIE hardline, saying that this type of legal construction circumvents the law and is therefore not allowed. If Alipay is to get its’ license it needs to desist from this activity.
  2. In order to finally obtain the license and not hurt its’ business too much Alipay cuts the contracts, and disappears from the Alibaba financial statements. The board is not notified.

Thus, Alibaba’s management failed to fulfill its duty.

My guess is that Yahoo’s board representation simply didn’t realise the risks involved in a VIE-structure, or the current legal pressure being asserted on them, and took the decision to allow the transfer of the equity under the view that this was a very solid system of control.

Now Yahoo is pushing to be compensated for what is being called a spin-off, and in reality this might be the only road still open for them. Consolidating Alipay again seems like an impossible task, given what appears to be a hardline approach by the authorities on the matter.

The trend for legal landscape for VIEs is one of increased enforcement of the laws against them, however, this enforcement is not coming from Beijing. Instead we’ve seen regional enforcement, as in the Buddha Steel case, and now also industry specific enforcement with Alipay. Navigating the VIE field is becoming more and more like a maze, and Beijing seem likely to allow local and industry regulators to continue to police the VIE question as they see fit.

Investors should duly take note of this situation and see if their own companies have any system in place to compensate for potentially forced termination of the VIE contracts. Further, is this high-profile case perhaps the final proof needed of just how substantial the uncertainty of enforcing VIE contracts truly is?

Update: Good article which seems to confirm at least some of the guesses I made earlier

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The big news in Chinese-American finance this week has undoubtedly been the Yahoo vs. Alibaba spat.

If you haven’t read about it, you should!

The basics are that Alibaba transferred its profitable Alipay business (Chinese paypal) to a company controlled by Jack Ma, and Simon Xie founders of Alibaba. And now this transfer has resulted in de-consolidation of the company from Yahoos investment in Alibaba. This all came to light this year and Yahoo claim to have had no prior knowledge of this, even though they had board representation in Alibaba.

Now what’s interesting is that it appears as if 70% of the company was transferred in 2009, meaning that there would have had to be a VIE agreement in place for it to stay consolidated even at that point. Which means that the transfer of all the remaining ownership to this new structure should not have had any impact at all, it would merely be 100% VIE.

So the question really is, why did it suddenly de-consolidate?

As we have very little info to go on here it’s very hard to have any type of certainty in the predictions or warnings we get from this example. However, the current debate seems to be talking about the wrong thing.

The fact that the company transferred its ownership to a Chinese entity is not the issue, they avoided a lot of regulation by using a VIE structure, nothing strange about that.

The question investors need to be asking themselves is why, and how, the VIE structure disappeared. This could be the definitive proof of just how risky the VIE structure actually is, but as we have no information of how it was structured it’s hard to say anything for certain.

If we assume that the VIE was set up in the normal fashion then something must have happened with the contractual agreements between Alibaba’s subsidiaries and Alipay. What exactly happened is impossible to say at present, but regardless of what it was it raises some very poignant questions about the issues of VIE contracts. All we know currently is that a VIE has simply walked off the consolidated financial statements without an explanation, this in itself should be enough for anyone investing in VIE companies to start asking some serious questions.

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