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The show covered the Chinese government crackdown against large sectors of China’s economy, namely the tech sector.
Many U.S. investors probably never give China a second thought. It’s just another overseas emerging market. And they may have little or no investment dollars tied to the country.
But what authorities in Beijing are in the process of doing right now could have huge implications on stock markets, not just in China but around the world, and especially in the U.S.
That’s because many of China’s leading technology companies have listings on U.S. stock markets. This includes huge, successful companies like Alibaba (BABA), JD.com (JD), Didi (DIDI), and Baidu Inc. (BIDU), among many others.
These “listings,” however, aren’t exactly what they appear to be. Many U.S. investors may not even realize what they actually “own” by holding these stocks.
At the same time, China is now in the process of tightening regulations on these companies and their stock listings on U.S. markets. The result could be that these stocks disappear entirely from U.S. markets, perhaps taking American investors’ money with them.
And this is a very big potential threat. Out of the 180+ Chinese companies listed on the NYSE and Nasdaq, the vast majority (about 70% of them) use the VIE structure.
What is a Variable Interest Entity?Almost every Chinese company listed in the U.S., and in other international markets outside China, is listed through what’s known as a variable interest entity structure (VIE for short). As a result, investors do NOT actually have clear ownership stakes in these giant China-based businesses.
Instead, U.S.-listed Chinese companies are mostly set up as proxy corporations for China’s mainland businesses to attract Western investors. These proxies are typically established in the Caribbean Islands and other locations outside China and the U.S.
Take Alibaba, which is listed on the NYSE. The company is known as the “Amazon of Asia” thanks to its huge online presence. Alibaba operates one of the world’s biggest and most popular online shopping websites.
But what U.S. investors think they own with the ticker BABA on the NYSE isn’t the real thing.
Variable interest entities have been widely used for more than two decades, especially by Chinese technology companies, to sidestep Beijing’s restrictions on foreign investment and to give them access to overseas capital. That’s because China restricts which mainland businesses foreign investors can invest in.
And Beijing is especially wary about foreign ownership of China’s tech-sector giants like Alibaba. So, back in 2000, a Chinese tech firm named Sina.com listed shares on the U.S. Nasdaq exchange using the VIE structure for the very first time.
The way it works is that principals in the Chinese parent company form a new company, usually incorporated in the Cayman Islands or the British Virgin Islands. Then, through a series of contracts, they agree to share the profits or economic benefits of their main business in China.
It’s the only way that foreign investors can participate in the growth of these stocks. And VIEs have been a lucrative way for investors to participate in China’s fast-paced growth over the years.
Due to Beijing’s recent scrutiny of VIEs, U.S.-listed shares of Alibaba and Baidu have fallen 60% over the past year. But before that, Baidu shares soared more than 5,000% from the time it debuted on Nasdaq in 2005!
Since its inception, the VIE structure has become the go-to method for listing companies in industries relating to the internet, e-commerce, education, and other sectors considered to be the new economy in China.
The question is, why did the authorities in Beijing even allow VIEs to exist and flourish in the first place? The answer: Money, and lots of it. As recently as 2006, 98% of Chinese companies could not access bank loans in order to finance and expand their businesses. Starved of capital within China, private sector companies looked to well-developed overseas markets for investors, mainly the U.S. and Hong Kong.
And overseas investors were only too happy to oblige. After all, they wanted to cash in on China’s economic miracle as the country’s growth boomed in the 2000s.
At first, Chinese regulators ignored the growing use of VIEs, even as most of China’s tech/internet sector expanded by taking advantage of the model. Essentially, Beijing decided to look the other way because growth of these key sectors required more money than Chinese state-owned banks could deliver.
The fact remains that no regulatory body in China has ever officially approved of the VIE structure. But many investors in the companies believe that VIEs have tacit approval.
In fact, China’s regulators recently gave them an air of legitimacy, proposing a new exchange that will allow VIE structures to list on China’s new technology-focused exchange using Chinese Depositary Receipts (CDRs) for the first time.
Still, there have been plenty of challenges to the legality of VIEs from China’s regulators in the past, and more recently Beijing has openly attacked one high-profile VIE structure, sending its U.S.-listed stock tumbling in the process.
Didi is a HarbingerDidi Global (DIDI) is considered the Uber of China. In fact, the leading ride-sharing and delivery company in China is part owned by San Francisco-based Uber Technologies. Didi filed for a stock offering on the NYSE in June, but it was against the wishes of Chinese regulators, who preferred that the company list its shares in Hong Kong instead.
And the company got into hot water with Beijing almost immediately after its $4.4 billion IPO. First, Chinese regulators launched a data-security review of the company and went so far as to ban the Didi app in China, effectively bringing its ride-sharing and delivery business to a halt.
Then regulators from the Cyberspace Administration of China signaled that Didi should plan to delist from the NYSE entirely by the first half of 2022. Instead, Didi is now pursuing a new stock offering in Hong Kong sometime in the first quarter of next year.
Not surprisingly, all this sudden uncertainty triggered a big decline in Didi shares, which have plunged more than 60% in value from their first day of trading less than six months ago.
The big unanswered question is, how will U.S. investors in Didi get some, if not all, of their money back?
The money raised from the Hong Kong IPO could be used to buy back the NYSE-listed shares. But at what price? It’s suddenly a mess for U.S. investors. And potentially, it’s not just Didi that may go be compelled to drop its U.S. listing.
The worry now is that Beijing may no longer be willing to look the other way on VIEs. And if the authorities suddenly decide to outlaw the structures altogether, it could instantly destroy these companies and with them, almost all of China’s internet and tech sectors.
I think such a drastic move by China’s regulators is unlikely for several practical reasons, but it’s still a non-zero risk that has been on the rise recently.
What Does This Mean for Your Investments?First, if you’re a fan of investing in technology stocks individually, you should think long and hard about any Chinese tech stock holdings in your portfolio. They’re almost certainly VIEs. These are some of the largest and most profitable companies in the world. They represent great businesses. But right now, their ability to keep trading on U.S. exchanges is unclear.
Second, if you prefer going the ETF or mutual fund route by investing in tech-focused funds, then be sure to carefully review the fund’s list of stock holdings. That’s the only way to know for certain how much exposure you really have to China’s U.S.-listed tech stocks.
A good investment opportunity may arise from this chaos at some point. Personally, I’m not ready to put my money into Chinese stocks. But in part two on this topic, I’ll explain how the situation could lead to big potential profits for other Chinese stocks. Stay tuned.