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Trade war raises risks for BABA ownership structure

Alibaba (BABA) may be listed in New York, but it is a Chinese company at heart. And a fantastic firm as well, with large, profitable and sustainable businesses. My focus here is not on the quality of Alibaba’s businesses – which is excellent – but on the risks of owning their US-listed shares.

This risk I am focused on is that owners of these shares do not own the underlying assets of the businesses, which is no small matter. Shareholders do not have direct ownership. Instead they own shares in a Cayman Island entity that owns a Chinese entity that has contractual rights to the economic benefits of the underlying businesses. It’s not clear if those contracts are enforceable under Chinese (PRC) law, but they probably are not enforceable in the courts, as to date no similar VIE-style arrangement has been enforced by the courts in China.

This arrangement currently works as it is in the interests of all parties concerned (Alibaba and the other US-listed VIEs, the PRC government, the SEC, the US exchanges, and the shareholders) to not question it too stringently, for reasons that I explain below. But this is a fragile peace. While it has been in the interests of the Chinese government to allow this arrangement to exist up until now, their interests are evolving. And a trade war, or other geopolitical fracas, could metastasize into a situation where the PRC government decide that it is their best interest to question the enforceability of the shareholder’s economic interests.

That event would be very painful for shareholders, and so investors in these companies should consider cutting risk if the trade war escalates.

To explain this further we need to jump into more detail.

The Variable Interest Entity (VIE) structure is an economic arrangement that has been used by some Chinese firms to list on foreign stock exchanges since the year 2000. The structure allows these firms to appear to comply with Chinese laws that restrict foreign ownership of companies in certain sectors (such as Internet businesses) and still allow their foreign shareholders to share in the economic benefits of ownership. The mental gymnastics required here – shareholders are seeking the economic benefit of owning shares while not being legally allowed to own them – provides a clue that the structure is risky. There is an excellent overview of the VIE structure and its use in China written by Professor Paul Gillis from Peking University here.

The potential risks of using the VIE structure are well-known to many investors, and the companies even include them in the risk factors of their financial filings. For example, in Alibaba’s recent 20-F filing, on page 36 they note the following risk: “If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations.”.

But many investors still own these firms, and I have owned them in the past. What gives?

The counter point to the VIE risk is that it is in the interests of all parties involved to maintain the status quo, and not call this arrangement into question. On the Chinese side, the government is happy for these firms to access foreign funding (at least for now) because the government still has plenty of influence over how the firms operate within the PRC. The PRC government also does not want to do anything that would unnecessarily diminish China’s growing standing on the global stage or provide supporting evidence for any arguments that “the Chinese are untrustworthy”. The Chinese companies themselves want continued access to US capital markets, and most of the wealth of the founders and senior management teams is tied up in these listed assets.

On the US side, the SEC and the exchanges do not want to cry foul as that would then raise the question of why they allowed the listings in the first place, and the current shareholders obviously do not want to focus on this issue as the value of their holdings would surely drop.

But this is a fragile peace, especially on the Chinese side. Alibaba is extremely profitable, and many Chinese would question why that value should accrue to US investors (as most Chinese cannot own shares in the company due to restrictions on their capital leaving China). Such nationality-focused arguments are likely to gain credence if this trade war escalates or US-Sino relations deteriorate for other reasons (such as, for example, any US threats to Chinese interests in the South China Sea). If relations between the nations were to deteriorate, and the PRC government wanted to retaliate by hitting the wallets of US investors (and especially US pension funds), then it has several mechanisms for doing so.

One option would be a multi-stage “repatriation” of the shares by first creating a Chinese listing for the shares (maybe in Hong Kong, or in the mainland itself), then creating a different share class for the Chinese-listed shares, and finally giving preferential treatment to the Chinese-listed share class. Such a series of moves could likely be done legally under Chinese law (but note I’m not a lawyer, much less a Chinese lawyer), potentially using the laws prohibiting foreign ownership of internet firms as cover. There has been much talk recently about the prospects of Alibaba seeking a listing in Hong Kong or a secondary listing on a mainland Chinese exchange, and potentially as early as the middle of this year, according to reports. While such moves could be positive for the current shareholders in the short term as it raises demand for the shares (as then Chinese could buy in), it could also be the first step in the series of moves that I outlined above.

Another option for the PRC government, if they want to gain more for the Chinese people at the expense of US investors, could be to ask the firm to do national service by using their cash reserves to prop up other Chinese businesses. This type of approach has been used in the past, such as when cash-rich China Mobile bought a large stake in struggling Shanghai Pudong Bank in 2010. We haven’t seen any evidence of similar activity yet within the internet sector, but we also haven’t seen Alibaba distribute any of their cashflow to shareholders. Alibaba does not pay a dividend, and their share buybacks are more than offset by share creation for employee incentive schemes.

For the record, I am not saying that any of this will happen. It remains unlikely. But it is a tail risk that investors in any US-listed Chinese internet firm must consider, and especially because the chances of that tail risk occurring do appear to be increasing – and will increase even more if relations between the US and Chinese government deteriorate further.

From an investment strategy perspective, if I owned the shares I would consider cutting my exposure due to the tail risks involved. But to be clear I don’t see Alibaba as a viable short candidate, as their businesses are too strong to seriously consider shorting them. I have sold my own investment in Alibaba: after recommending it in my 20 firms for 2020 list I scaled back my China exposure late last year (see my follow up article here). I have no plans to buy back in while the risks of an escalating trade war remain as elevated as they are currently.

Note: This article was originally posted to the Seeking Alpha website on April 9th, 2018.

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