Chinese VIE Investments Warrant A Change

Includes: GIGM, SINA
by: Donald Rudow

In a previous article, I described two basic problems that negatively affect the valuations of Chinese variable interest entities (CVIEs) through conventional discount cash flow valuation methods. This is important to US investors involved with the China hybrid space because many corporations within this space generate at least a portion of their cash flows and income through CVIEs. In fact, some derive all of their operating cash flows through CVIEs (SINA is an example).

The first problem is caused by moral hazard. The management of the CVIE lacks a profit motive as they manage the operations for the wholly owned foreign entity (WOFE) that is entitled to its residual profits. Because of this the CVIE management team will manage its operations differently than the WOFE would like it to be run, implying lower profits for the WOFE, and consequently lower operating cash flows in the long run. This is something akin to the principal-agent problem shareholders have to be concerned with and economists have studied in the past.

The second problem is due to what I referred to as enforcement uncertainty. This arises for two reasons. The first is due to the increased scope of the legal red tape involved with designing contractual agreements that succeed in any and all jurisdictions involved. More complexity creates greater opportunity for error on behalf of the legal team involved, and I cite the odd case of Gigamedia (NASDAQ:GIGM), wherein the CVIE equity owner succeeded in cutting off the WOFE from its residual profits due to what appears to be minor legal red tape issues mentioned in my previous article, as one example.

The second cause for enforcement uncertainty involves the PRC’s inconsistent treatment of CVIEs. After years of not forbidding CVIEs as a means of providing financing for various industries facing PRC restrictions on foreign investment, Buddha Steel (AGVO) has been treated differently and forbidden from continuing the contractual relationship with the CVIE. Obviously, precedent is not sacrosanct in China because China does not subscribe to Common Law. However, reading between the lines of the news pieces coming out of China, individual CVIE relationships may have been largely unknown to PRC regulators.

What I address in this article is the need and the ability of addressing the moral hazard issues that lead to lower valuations of CVIE investments, through a change in how CVIE investments are paid for. I will get to this after a brief review of the recent changes affecting enforcement uncertainty.

There are two pieces of news now that suggest the enforcement uncertainty surrounding CVIEs will be reduced. First, as of September 1, 2011 foreign mergers and acquisitions of Chinese business entities operating within industries China deems sensitive to national security must be reviewed by China’s Ministry of Commerce (MOFCOM). Foreign financing restrictions have been in existence for these industries, which had originally given rise to the contractual innovation that created these CVIE structures. Either MOFCOM will approve or reject such investments, removing to some degree the uncertainty of whether these contracts are in accordance with China’s foreign investment policies.

Perhaps the legal teams involved with designing these contractual agreements will have an opportunity to make contracts associated with approved investments more robust through interactions with MOFCOM. I see this as a good thing for both the private equity investors involved with the first round of financing and those getting involved once the company is registered on one of the exchanges. Any reduction in the risk premiums via a reduction in enforcement risk is going to make the CVIE cash flows more valuable.

Secondly, Reuters has reported that four legal sources have informed them that China’s State Council (CSC) has been asked by the China Securities Regulatory Commission (CSRC) to “take action against the structures known as Variable Interest Entities”. Any future promulgations on these specific structures by the CSC is good news for investors. Greater clarity on the enforcement of existing and future CVIEs could very well be realized, either in favor or out of favor for owners of the contractual agreements. Specific regulations concerning CVIEs have been lacking and anything that clarifies the validity of these sets of agreements should reduce at least one and possibly both causes of enforcement uncertainty leading to higher risk premiums associated with CVIE valuations.

There continues to remain, however, the moral hazard problem. Whether it is private equity with the intention of eventually cashing out on a foreign exchange or a WOFE within a China hybrid company already trading on a foreign exchange, investing in a CVIE should include explicit performance incentives. Some form of incentive based off of share price appreciation is an effective tool to align the objectives of the CVIE equity owners with those of shareholders.

Specific types of warrants, options, have been a historically effective means of addressing principal agent problems with managers for most US companies trading on the exchanges. Incentives within that spirit, tied closely with share price appreciation of the China hybrid company, may allow the CVIE equity owners to profit when their efforts are consistent with the desires of shareholders. It is far better for the CVIE equity owners to realize the benefits of selling their residual profits through long term share price appreciation of the WOFE’s holding company, than it is for them to seek to maximize their own well being via CVIE management practices that ignore maximizing profits for the China hybrid company through the WOFE.

Decisions are made by individuals so as to maximize their own well being. While character of the management team is important, it is of paramount importance in my opinion to always be mindful of mankind’s decision making process being centered around benefitting ‘self’ and rely on incentives that exploit this quality.

I have not examined all firms that attempt to generate positive cash flows through investments involving CVIEs, but the few I have examined cause me to conclude moral hazard is a problem at the point of investment. These investments are typically viewed as business acquisitions, and nothing could be farther from the truth. There is a controlling interest created by the contractual agreements, rather than ownership entitling the investors enforcement of property rights, and the appearance of assets and liabilities on the balance sheet is post-Enron accounting.

The CVIE assets and liabilities are not properly owned by the China hybrid company. These can only be thought of as transactions involving cash flows of one type for cash flows of another. For example, if an equity owner of an internet services firm in China expects to earn a cash flow return on their assets of 16% per annum in perpetuity, and they are willing to sell these flows of cash at a discount rate of 11%, then this may present an opportunity for US investors owning a China hybrid. Backing out the opportunity cost of capital, let’s say 4%, this should yield US investors 7% more than the next best use of capital yields.

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That’s all well and good on paper. But, that 16% was the return earned while the equity owners were enjoying the full benefits of the return, the primary motivation for the effort of managing operations. Now that they have sold this return to someone else there is no incentive for the equity owners to strive to continue to earn that same type of return on the assets they originally invested in. The CVIE equity owners are ‘cashed out’ in a sense, and non-optimal quantity/price combinations, a slowdown in the turnover of receivables, less aggressive negotiating with suppliers, and related parties transactions are all more likely and will all lead to lower cash flow returns.

If the investment cost is not a function of the return on assets, i.e. if the investment cost is not affected by whether the CVIE continues to earn a 16% return on its assets, then this return is vulnerable to decline. This requires some investment costs to be tied to performance over time, such as warrants of some nature that are awarded to the CVIE equity owners whenever certain performance targets are reached that assure the recipient of the residuals that assure the CVIE equity owners also desire optimal decision making within the operations, and they are doing their part to enable this outcome.

Even a decline of ½ percent return annually in the aforementioned example will dramatically alter the market value of the investment unless there exists an incentive to neutralize such behavior. This is illustrated in the tables below.

For simplicity, the moral hazard market losses in the table above represent losses in market valuations of the China hybrid if the CVIE were its only source of cash flows. In this example, a ½ % loss due to sloppy operations and related parties transactions causes the market to deduct nearly 5% off the at risk cash flows from what it would have been valued if the operations were being run optimally. If the losses are expected to be 1%, a nearly 10% loss in market valuation is borne by the shareholders.

For situations involving CVIEs contributing a portion of the cash flows, the market loss due to moral hazard specific to the CVIE in question should be in like portion, obviously. This is an addressable problem, I think. Given these moral hazard losses are reductions in future cash inflows, we can calculate the present value compensation to offset moral hazard losses as part of the CVIE investment based off the discount rate for the cash flows.

This compensation should be awarded as warrants of some nature such that annually, a portion is exercisable that just offsets the estimated moral hazard costs and is tied with the share price of the China hybrid company. For example, if the investors expect that the moral hazard problem represents ½% in cash flow losses as a percent of CVIE assets then $144.995 in cash and $4.55 in expected warrants are given in exchange for the cash flows. These warrants are given in allotments of $0.50 annually and subject to redemption based on the market price of the China hybrid company. This is obviously an oversimplified case, but effective for illustration purposes. And it illustrates there is a potential solution at the point of investment.

Given that many of the CVIEs are owned by executives of the China hybrid companies that are engaged in these contractual agreements, it is reasonable to question whether the incentives in place as shareholders of the China hybrid mitigate moral hazard losses. The answer is yes, but it does not eliminate them. Any gains through related parties transactions, for example, benefitting the CVIE equity owner incurs a cost on these executives that is proportional to their share of ownership in the China hybrid.

Basically, moral hazard gains for CVIE equity owners have their losses diluted as China hybrid equity owners, yielding net gains for them. So the basic problem of moral hazard losses for the China hybrid company remains the same as before regardless of ownership. From the same hypothetical example, the CVIE equity owner gains can be seen in the following table.

Thus, executives within the China hybrid that also own the CVIE equity do not remove the problems of moral hazard for the shareholders at large. A similar compensation structure needs to be created, as described before. Asymmetric information, namely the action of the CVIE equity owner influence being hidden from the China hybrid equity owners at large, still exists independent of who the players are. It is a problem that can only be dealt with through incentives created on behalf of all shareholders.

What also becomes clear through the previous table is why that there is actually an incentive for fraud by executives within China hybrid companies that are also CVIE equity owners if the investment is not structured properly. Embezzling a portion of the returns through related parties transactions nets out positive gains for these individuals. The best negotiation for existing China hybrid shareholders is to make no cash payment up front and finance the entire purchase of new CVIE cash flows through warrants that are exercisable annually, forcing the CVIE equity owners to maximize all their own gains through their contributions within the CVIE, adding to market price appreciation of the China hybrid. This is no more extreme than expecting the China hybrid to use shareholder funds to purchase the cash flows up front without any incentives to deliver satisfactory returns.

Despite the promising news that China may soon provide greater clarity on how they view VIE relationships, leading to less enforcement uncertainty and thus lower risk premiums, these structures continue to be plagued by moral hazard. The moral hazard problem is an addressable problem through incentives that are incorporated into the initial investment in a CVIE, openly acknowledging that this is a continuous problem rooted in imperfect information, at the point of investment.

For cases where the beneficial owners of the China hybrid are the CVIE equity owners, the problem does not go away. The China hybrid’s investment is vulnerable to downside risk due to the ongoing asymmetric information and the ability of the CVIE equity owners to gain through related parties transactions and other management practices that lead to lower profits. The loss these executives experience as beneficial owners of the China hybrid are less in magnitude than the gains acquired through the CVIE.

This problem is not complicated and it requires no different treatment, as far as I can tell. Incorporating China hybrid warrants of some nature as a part of the transaction yields the potential for payment flows contingent upon performance that align the CVIE equity owners’ interests with those of shareholders. Shareholders need to voice their dissatisfaction with these inferior investments. These investments warrant a change and I hope this starts or adds to any existing discussion on this problem.

As I finished writing this, some more news came across concerning CVIEs through an unconfirmed CSRC research paper here and commentary here.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SINA, GIGM over the next 72 hours.