Matthews Asia Insight
"Chinese companies have generally benefited from the use of VIEs, growing their businesses at home with the use of funding from overseas investors... Foreign investors have also benefited."
Complex Structures for Investing in China
In recent years, certain Chinese companies that trade on the New York Stock Exchange (NYSE) and NASDAQ have come under increased scrutiny by the Securities and Exchange Commission (SEC). Known as variable interest entities (VIEs), these entities have complex corporate structures that non-China investors have used to own Chinese companies listed overseas. Although many Chinese firms have used VIEs for more than a decade to list in overseas markets, some doubt has been cast over their legality, and investors have begun to worry that Beijing may take action against them.
VIE structures were first employed in 2000 by Chinese Internet companies. The structure was used to avoid restrictions that ban foreigners from investing in certain sectors such as banking, insurance and telecommunications services. While the VIE structure is most prevalent among Internet-related Chinese companies, listed both in the U.S. and in Hong Kong, this same practice has also been used by Chinese overseas-listed firms in education and financial services. Today there are more than 100 publicly traded Chinese firms in the U.S. with VIE structures, according to one Asia-focused broker. About 42% of U.S.-listed Chinese companies in a variety of industries employ this structure, according to research by a professor at Peking University’s Guanghua School of Management.
Chinese companies have generally been benefiting from the use of VIEs, growing their businesses at home with the use of funding from overseas investors. Meanwhile foreign investors have also benefited from being able to invest in some fast-growing companies. Considering the size and range of companies involved, both China and the U.S. need to proceed cautiously.
Given the widespread use of VIEs, let us take a closer look at this format and examine some of its implications.
Under a VIE structure, there is first an offshore-listed entity that foreign investors own. In turn, this entity establishes, as a direct subsidiary, a wholly foreign-owned enterprise in China. This China subsidiary then sets up one or more domestically licensed companies as its operating companies. It is these domestically licensed companies that are referred to as VIEs. They hold the necessary licenses in their respective sectors. The China subsidiary acts as a go-between agent to the overseas-listed firm since foreign investors are not permitted to invest directly in these VIEs. The VIEs use a series of contractual agreements with the China subsidiary to enable the overseas-listed company to effectively run a business inside China. This gives the overseas-listed entity de facto control over its Chinese operations, despite Beijing’s limits on foreign ownership. As a result, even though the overseas-listed company does not directly own the VIEs, it can consolidate the assets and profits generated by them into its financial statements as permitted by current accounting rules. Thus, the lack of direct ownership places enormous importance on the effectiveness of the contractual agreements used to establish the overseas-listed company’s economic ownership of underlying assets.
In order to achieve this effectiveness, most overseas-listed firms have carefully designed their contracts with clauses, allowing themselves to have as much control over the operations and management of VIEs as possible. Besides operations, these contracts typically cover areas such as management appointment, voting rights and intellectual property licensing.
In theory, if such contracts were carried out as stipulated, shareholders of these overseas-listed companies could feel some degree of reassurance that their interests were being protected. But in reality, this is a grey area. Chinese authorities have never formally confirmed the validity of the VIE structure. While most firms using this structure claim the format is compliant with Chinese law (and thus believe those contracts are enforceable in China), they have also acknowledged that direct ownership ensures more actual control.
Indeed, last year, a Chinese company pulled its application to list on a major U.S. stock exchange, saying that provincial government officials in China told them the VIE structure arrangement was “against public policy.” While the incident did not cause much concern among investors, it does highlight the potential risk of government intervention in this area. Some believe that a motive of various local Chinese governments may be that they would prefer the domestic consolidation of smaller players rather than see them attract foreign investors abroad.
But the fact that China has not openly challenged the legitimacy of VIEs may reflect the government’s cautious approach to this issue. The recent SEC scrutiny and subsequent market volatility highlighted investor concerns regarding the risks in these structures.
When it comes to investing in VIEs, investors should focus on firms with well-constructed contracts. Ideally, overseas-listed companies should try to avoid using this format if they operate in industries that are open to foreign investment. Also, these companies should allow VIEs to hold only minimal assets while the majority of assets go to the China subsidiaries. The VIEs should have a diversified shareholder base and maintain the same board of directors and management as their overseas-listed company in order to align the shareholder interest.
Are there any near-term solutions to this issue? Some smaller U.S.-listed Chinese firms have been privatized and delisted from stock exchanges with the intention of relisting on Chinese stock exchanges. For firms with larger market sizes, one possible alternative would be to merge all offshore and onshore entities into one firm, and list them both domestically and overseas with two classes of shares. To satisfy the rule of foreign investment restrictions, domestic shareholders would hold voting power while foreign shareholders would not. Which resolutions appear to be most feasible is still unclear, and the alternatives to accessing some of China’s rapidly growing sectors, for most investors, remains limited.
Despite the concerns over VIE structures—indeed, they do require scrutiny—these formats were devised to enable access and encourage foreign investment in China, and have allowed investors to participate in some of the more enticing parts of China’s new economy.
Matthews International Capital Management, LLC
This month’s Asia Insight focuses on the topic of Variable Interest Entities used by Chinese firms in a conversation with the following Matthews Investment Team members:
- Richard Gao, Portfolio Manager
- Henry Zhang, CFA, Portfolio Manager
- Hardy Zhu, Research Analyst
Q: As investors, how do you weigh the pros and cons of investing in such structures as Variable Interest Entities, or VIEs?
Richard Gao: There’s the legal aspect to the variable interest entity (VIE) issue and there’s the practical aspect of the issue. From a legal perspective, I’m sure there are many areas that need clarification because I could see how, from the lawyer’s point of view, the structures or frameworks touch upon many grey areas that have not been well-defined. VIEs have been used for years to obtain foreign investment in many broad categories in which China has officially restricted foreign ownership.
I think investors worry that scrutiny of VIEs may mean that they will be eliminated but people need to understand that both the U.S. and China have a vested interest in these structures, which have existed for over a decade. I doubt it would be in anyone’s interest to destroy these existing firms. I believe that both parties will proceed cautiously and ultimately find a way to fill in the legal loopholes and solve the issues.
Q: What are the chief concerns that investors may have over this issue?
Richard Gao: One of the biggest concerns is the potential for owners of VIEs to do something strictly in their own interest that may destroy shareholder value. And, sure, this potential can exist. But it’s important to emphasize that if the management of a company is dishonest and motivated purely by self-interest, there are many, many ways that they can go about destroying shareholder value. A VIE structure itself does not mean that a firm cannot be successful or ethical.
So, for us, as investors, the bottom line has always been a solid evaluation of a management’s ethics, credibility and practices. These criteria are critical for us.
Henry Zhang, CFA: I agree. Management integrity is definitely a chief factor for us. If a firm’s management is not solid and dedicated, it does not matter what the legal structure of the company is. In vetting VIE businesses, we are careful to check that their contractual agreements ensure that the overseas-listed company has strong control in terms of operations, management and the economic interest of the VIEs.
One interesting thing to note is that foreign private equity and venture capital firms helped create this structure long ago, when there were few domestic private equity firms to help support technology firms. So these foreign partners introduced this framework in order to have an exit strategy in their own currency. Chinese firms went along with this to be able to raise foreign capital for their start-up businesses. Based on my meetings with some of those founders, in many cases, these frameworks were established not by the founders’ choice, but rather by the requirements of their venture capital partners.
Q: Does your evaluation of VIEs involve more efforts or a different process?
Hardy Zhu: Besides taking the time to assess the contractual agreements that tie the Chinese subsidiary to the overseas listed holding company, we employ the same process of evaluating management. Our face-to-face and on-the-ground meetings with management are always important in our screening and selection process and this is even more so in the case of VIEs. Power of attorney, or the express authorization to represent the VIEs, is also an important factor for us in considering investments in such firms. Often, intellectual property, such as branding, trademarks and domain names, are owned by the overseas-listed company so there are some built-in protections, which may also minimize any incentive for VIEs to go against the best interest of its minority shareholders.
The views and information discussed in this report are as of the date of publication, are subject to change and may not reflect current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. Investment involves risk. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. Past performance is no guarantee of future results. The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Matthews Asia and its affiliates do not accept any liability for losses either direct or consequential caused by the use of this information.