Around the Great Wall
Using non-equity financial vehicles to invest in Sino-tech
Just 24 hours after it hit the NASDAQ, Baidu’s initial public offering (IPO) had set a record with a first-day gain of 354%. This level of IPO activity for a foreign company had never been seen before, and cast a spotlight on China’s emerging technology sector. However, despite the demand from foreign investors, Chinese technology companies found themselves unable to offer investors a traditional equity stake. Firms looking to ride the rise of China’s technology sector faced one major hurdle: the government of China.
The Chinese government limits foreign equity ownership of Chinese technology companies to a minority position. This limitation makes it particularly difficult for a Chinese technology startup (CTS) to access capital, as there are lengthy domestic listing requirements and tight restrictions on debt, on top of the international listing cap of 49%. Fortunately, there are alternative means to access offshore capital. The most financially innovative technology firms have adopted another method to cater to foreign investors: a structure called the Variable Interest Entity (VIE).
Using the VIE Structure
The VIE structure provides foreign shareholders of a CTS company with a contractual agreement that offers many of the primary benefits of an equity ownership stake, such as a return on investment if the underlying firm’s market value increases. The key difference is that the VIE is a contract lacking the level of legal support typically associated with owning a company through buying equity. Chinese companies using a VIE structure will use a separate offshore entity to list on a foreign exchange. This listed company is financed with North American capital, which it sends to the Chinese parent company using a Wholly Owned Foreign Enterprise (WFOE) as an intermediary. The WFOE is also used to direct the domestic company’s cash flow offshore as dividends. Chinese shareholders have the option to invest in the offshore entity, as well as the domestic company, while foreign investors are limited to the offshore listing only.
The VIE structure is used by CTS firms to work around restrictions set by the Chinese government. The People’s Republic of China (PRC) uses censorship laws to limit access to external information in order to protect national ideologies and intellectual property. This mindset was exemplified when China entered into the World Trade Organization (WTO) as a “socialist market economy.” It applies the WTO platform to welcome foreign investment, but meanwhile restricts the technology sector through stringent legislation.
Foreign capital is crucial for a CTS firm to grow, as the economic environment in China makes domestic capital difficult to obtain. By broadening the potential investor base, the risk of CTS firms will be offered to investors best able to understand and price that risk, which would lower the cost of capital. The nation continues to be dominated by state-owned enterprises, making funding for private ventures hard to come by. Much of the country’s economic wealth is within the hands of the governing body, with 160 of the richest 1,024 citizens in China holding seats in the Communist Party Congress. Clearly, wealth and politics are seated at the same table. Without direct connections in the Chinese government, funding options for independent startups are limited. This issue is augmented for CTS firms because they compete in the information technology sector, which the government regulates tightly.
The VIE structure allows access to external capital that would otherwise be unavailable due to ownership restrictions. As globalization continues to increase competition, international technology players will view China’s fast-growing online market as the next frontier. CTS firms need to utilize the VIE structure now in order to access capital and solidify their market positions prior to the entrance of foreign competitors. Furthermore, if CTS firms hope to compete in foreign markets they will need to level the playing field in terms of access to and cost of capital. The landscape for technology firms in China is still evolving, leaving an opportunity for CTS companies that are able to execute a listing on a foreign exchange using a tactful and well thought out VIE structure.
VIEs enable firms to work around the Chinese laws that limit foreign majority ownership. Since its first use in 2000 by Sina Corp., a social media company, the VIE structure has received mixed reviews in the Western world. Some firms have successfully applied the VIE to raise capital in international markets, though skepticism about the structure sprouts from instances where other firms have manipulated the instrument to unduly favor domestic shareholders. This violates the contractual rights and spirit of the ownership stake of offshore funders. In 2011, a slew of scandals regarding Chinese companies exploiting foreign investors’ lack of legal rights put the structure’s reliability into question. Concerns about the VIE structure come off the back of issues related to Chinese companies – Sino-Forest, China MediaExpress, and Longtop Financial Technologies Ltd. to name a few – who produced falsified statements for North American shareholders. Shortly thereafter, these so called “fraudcaps” were delisted from the NASDAQ and NYSE respectively, damaging investor confidence for Chinese companies. In response, and in order to regain foreign credibility, CTS firms must market and utilize a version of the VIE structure that addresses investor concerns by ensuring investor interests are protected to the same extent as with traditional equity holdings.
Investor uncertainty lies in the two major risks presented by the VIE structure:
- Lack of Legal Support in China
The VIE bypasses restrictions on foreign majority ownership, therefore Chinese law does not provide sufficient legal support in the event of VIE misconduct. Furthermore, VIEs operate in China without having been formally recognized by the PRC; there is concern, albeit remote, that the structure could be outlawed. Such a scenario appears unlikely given the use of VIE structures historically, but uncertainty lies in the fact that there is no precedent, as no structure has ever been formally combated in court.
- No Asset Ownership
The lack of formal asset ownership for shareholders in the listed company can result in a false sense of domestic company control if Chinese shareholders do not respect the VIE ownership rights.
In order for the VIE to operate effectively, the onshore Chinese shareholders must effectively treat the listed participants as true, equal equity owners. Structuring the relationship to align the interests of domestic and foreign investors can mitigate the risks associated with poorly structured VIEs that were previously listed.
When Chinese shareholders opt out of investing in the listed company, their stake in the VIE structure is completely separate from that of foreign shareholders. A united VIE structure would require that the Chinese investors hold half of their equity stake in the domestic company, with the remainder deposited into the listed company. This modification to the original VIE structure would ensure that both sets of participants hold a significant interest in the VIE entity, combatting concerns that Chinese management will not treat the contractual equity rights of the VIE as true ownership.
Baidu Leading the Way
The alignment of both onshore and offshore shareholder interests has proven to be an effective strategy. Chinese internet giant Baidu has raised over $25B in foreign capital while mitigating investor risk by having both the foreign and Chinese owners invest in the listed company. The company’s chairman and CEO Robin Li holds a large stake in both the onshore and offshore operations. By adding this additional link between investors, Baidu offers a more dependable VIE structure to foreign participants. The actions of domestic company managers are more likely to benefit the listed as well as the domestic company when their money is invested in both entities.
By marketing a required equity alignment between the onshore Chinese shareholders and the listed company, a CTS firm can more effectively raise capital on a foreign exchange by reducing the probability of manager manipulation. Addressing the historical misuse of the VIE structure will add value to a CTS listing, providing a more reputable entry onto a foreign exchange.
More Transparency, Less Uncertainty
The transparency of the VIE instrument and how it is reported on a company’s financial statements is a concern to foreign investors. In July 2012, the Securities and Exchange Commission (SEC) probed into the accounting used by the VIE structure for listed company New Oriental Education & Technology Group (New Oriental). It was questioned whether Beijing New Oriental Education & Technology (Group) Co., a VIE of New Oriental, as well as its wholly owned subsidiaries, should be consolidated on New Oriental’s financial statements. The VIE structure was not clearly defined. This created investor uncertainty, leading the NASDAQ-listed stock price to drop by 50%, and Western regulators to step in. The unique nature of the VIE structure can result in foreign investors failing to see the reality of what they are investing in. Clearly defining the logistics of the VIE will help international investors feel confident that they understand their investment.
The best way to mitigate this risk is for a CTS firm to market itself properly as being fully transparent and in compliance with the SEC standards regarding the use of the VIE structure. Specific actions CTS companies can take include clarification of the onshore company financials and the full breakdown of the VIE structure including ownership stakes for all parties.
There is a clear opportunity for CTS firms to find the necessary growth capital to better establish their market positions by listing offshore. Combating the uncertainty surrounding the VIE structure by aligning the interests of the Chinese shareholders and foreign shareholders will mitigate the risks for foreign investors. Having the Chinese players dedicate 50% of their investment to the listed company will ensure benefits for both sets of shareholders. Making this modification to the VIE structure will provide reliable access to a new and hopefully profitable investment for international investors while providing capital to allow CTS firms to establish a competitive sustainable position in the industry.