Alibaba’s IPO: Approach Cautiously

International exposure is key to building a well-diversified portfolio, but foreign companies can raise issues you would not find in the United States. Take, for example, a common workaround for foreign ownership prohibitions in China-based companies: the variable interest entity (VIE).

Chinese e-commerce firm Alibaba is preparing for an initial public offering on the New York Stock Exchange. Alibaba’s sheer size (a total value estimated over $200 billion) has drawn a lot of attention from investors, but some of that attention comes in the form of concern. Alibaba uses the VIE structure, and a recent article from The Wall Street Journal reported that a U.S. government commission found that American investors face “major risks” if they purchase shares from companies structured this way.

VIEs are not new. Chinese Internet companies began using this structure in 2000 as a workaround for Chinese restrictions that ban foreigners from investing in certain sectors, including telecommunications. To avoid running afoul of the rules, non-Chinese investors own an offshore-listed business entity, which owns a subsidiary located in China. The Chinese subsidiary then owns one or more domestically licensed companies, which are the VIEs. In the case of Alibaba, U.S. investors will be purchasing shares in a Cayman Islands entity named Alibaba Group Holding Limited. This entity will have a contractual right to the profits of the Chinese company, but will not own the company’s assets.

While so far this structure has held up, the risks the commission identified are not insubstantial. Because the company ownership is indirect, foreign investors must rely on contractual agreements alone to ensure that they retain the economic benefits of ownership in the China-based company. These contracts would need to be enforced through the Chinese legal system in cases where shareholders believed their rights had been violated – a process that has been historically difficult for outsiders.

Even with these contracts in place, foreign investors have relatively little control. For example, in 2011 Alibaba’s Chinese entity disregarded the objections of Yahoo Inc., a large shareholder in the offshore entity, and split off the assets of a payments unit to put them under the control of company founder Jack Ma. Alibaba said the transaction was necessary to ensure that China’s central bank would allow the payment unit to continue operating, and it eventually reached an agreement with its shareholders, The Wall Street Journal reported. While some investors see the VIE structure as the cost of doing business in China, the lack of control it entails calls for caution.

Still, investors run a similar risk with the shares of U.S. companies that have a majority shareholder, whether or not that shareholder is the founder. Investors sometimes decide that being at the mercy of the majority shareholder is a price they are willing to pay to invest in a certain company. Some private equity firms, including The Carlyle Group (CG), KKR, and The Blackstone Group (BX), have also gone public using a limited partnership structure, where investors receive a share of the profits but remain at the mercy of the general partner where business decisions are concerned. That said, choosing to buy into a company with limited control in the United States comes with a host of rules and regulations designed to protect minority investors. While these are not bulletproof, they do offer some reassurance. Investing in Alibaba or another VIE-structured Chinese business involves giving up not only control, but transparency.

Perhaps more concerning, Chinese authorities have never formally confirmed that VIEs are legally valid. Should the Chinese government see fit to challenge the legitimacy of companies using VIEs, there might be little a foreign investor could do. While China has a vested economic interest in preserving firms as big as Alibaba, investors are banking on the Chinese government’s self-interest without a legal safety net. Some observers have warned that Chinese legal precedents suggest VIEs may fall if challenged.

This is not to say investors should always avoid companies structured as VIEs at all times and in all circumstances. Palisades Hudson clients currently have exposure to Baidu, another Chinese Internet company that uses the VIE structure, through the Asia-focused stock mutual funds we select. We also expect our clients to gain exposure to Alibaba through the same funds after the company goes public. Because our typical equity portfolios provide diversified exposure to thousands of different companies, we can live with minor exposure to these investments.

But we do keep an eye on our exposure to the stocks of Chinese companies, regardless of how they are structured. While we are comfortable with our current allocation to the region, we remain wary of the risks of investing in a place that does not always respect the rule of law or the principles of corporate governance that we take for granted in the United States. We have written before about the political and economic considerations that underlie our reluctance to wade too deeply into investment in mainland China. The investor-unfriendly structure of the VIE is one more reason to proceed with caution.

About Paul Jacobs 6 Articles

Affiliation: Palisades Hudson Financial Group

Paul Jacobs, CFP®, EA, joined Palisades Hudson as an associate in Scarsdale in 2002. In 2006 he became a client service manager and transferred to Fort Lauderdale. In 2008 Paul moved to Atlanta, where he is presently the client service manager in charge, to establish the firm’s office there.

As chief investment officer and chairman of the firm’s investment committee, Paul directs a team of portfolio managers and associates focused on finding the most efficient and cost-effective ways to implement client portfolio strategies. He oversees more than $1 billion in client assets, including all aspects of investment strategy, portfolio management, due diligence, and manager selection.

Paul formerly served as the firm’s Chief Compliance Officer, and he has had extensive experience in the firm’s investment management and tax compliance practices. His additional responsibilities include developing and monitoring client portfolios, reviewing tax strategies and returns for clients, and developing comprehensive personal financial plans. He also has worked on client projects involving charitable planning, bookkeeping, retirement planning, and estate planning and administration.

Paul graduated from New York University’s Stern School of Business with degrees in finance and accounting. He is a CERTIFIED FINANCIAL PLANNER® certificant, an Enrolled Agent and a member of the Financial Planning Association of Georgia.

Paul is the author or co-author of numerous Sentinel articles, including “Pay As You Go: Tax Rules Upon Expatriation” (June 2012), “Beware Mutual Funds Using Hedge Fund Strategies” (January 2012), “Is There A Bubble In The Bond Market?” (October 2010), “Should You Do A Roth IRA Conversion?” (February 2010), and “Private Equity In A Deleveraged World” (April 2009).

Visit: Palisades Hudson

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