Because of China’s strict capital controls, foreigners interested in investing in many Chinese companies must do so through a variable interest entity. In the simplest terms, a variable interest entity (or, VIE) is an offshore holding company that has a contractual right to the income of a Chinese company. The linked Wall Street Journal article provides a useful diagram explaining how VIEs work:
Until recently, the Chinese government mainly turned a blind eye to VIEs – a very blind eye, when considering the size of some of them, like Alibaba and Baidu. Investing in VIEs has thus always carried some – though of debatable seriousness – risk of some rash action by the Chinese government.
Recent draft proposals suggest the Chinese government plans to take a more active role in overseeing this channel of foreign investment. This new policy might carry some drawbacks for foreign investors, like requiring Chinese control over Chinese companies. However, the central government’s recognition should prove a net boon for those previously burdened worried about the legality of VIEs.
The new rules still might not address one of the largest risks carried by Chinese VIEs: the constant threat that the actual Chinese company will not honor its contractual obligations to the holding company / VIE. Take for example, Alibaba’s 2011 transfer of Alipay to Jack Ma without the VIEs immediate knowledge or consent.
China’s new stance potentially could mitigate these risks if firm contractual enforcement accompanies legal recognition. Indeed, ensuring VIE’s contractual rights could spur greater foreign investment, even under stringent requirements for Chinese majority control. However, at this point, BABA and BIDU shareholders still face the harsh reality that they really do not own Alibaba or Baidu.
http://http://www.wsj.com/articles/how-chinas-draft-rules-may-affect-foreign-investors-1422412416
Investing in a developing countries often entails these sorts of risks. Can a company buy foreign exchange to pay dividends? Can shareholders actually help chose management? Are the accounts credible? How about related party transactions, particularly when only a portion of shares are sold in an IPO?
All this is apparent in Alibaba. Unlike Amazon, Alibaba is very profitable and still growing rapidly. But to whom do those profits accrue? I don’t like Apple Computer for that reason: it sits on cash, and if Microsoft is an example, a lot will be frittered away on pointless acquisitions while coming up with a successor to the iPhone — well, as smart phones become ubiquitous and fall dramatically in price, the value proposition for Apple’s products is less and less compelling. What’s to keep Alibaba from being more of the same?
It is interesting to note how some of the VIE’s you mentioned are allocating their capital in China. To give context, China’s transport ministry just recently banned car-hailing apps such as Kuaidi Dache and Uber from using cars and drivers that do not possess state-controlled taxi licenses (which are regulated in a manner similar to the NYC taxi medallions), and the use of car-hailing apps has been banned altogether in the city of Beijing.
Despite the intense legal scrutiny faced by the car-hailing industry, Alibaba, in conjunction with Japan’s SoftBank, just completed a $600 million investment round in Travice Inc., the company behind China’s widely popular taxi-hailing app, Kuaidi Dache. Similarly, Baidu recently purchased an undisclosed stake in Uber Technologies Inc. and expressed commitment to expanding the company’s operations in China.
Both of these investments represent significant capital commitments to a volatile industry that is largely subject to the policies set forth by the Chinese government.