By Dan Su, CFA
NYSE-listed Chinese firm New Oriental Education (EDU) recently acknowledged a Securities and Exchange Commission investigation that the firm believes is related to its variable interest entity structure. New Oriental and other Chinese ADRs we cover use a VIE structure to effectively be in control of Chinese operations while bypassing restrictions on foreign direct investments in regulated sectors, including Internet, media and private education. New Oriental's share price has fallen 36% since the unexpected announcement in mid-July. While there may be other factors at play (such as reduced investor appetite for emerging-market exposure and the Muddy Waters Research report accusing New Oriental of improper disclosure and accounting of its franchise business), we think investor panic over the opaque VIE structure was the key driver of the sell-off.
It is not yet clear whether the SEC probe was triggered by the recently disclosed change that consolidated control of the VIE with New Oriental founder, chairman, and CEO Michael Yu. (He has a 17.1% stake and is the largest shareholder.) It is also unknown whether the probe will spread to other Chinese ADRs that use a similar structure. In any case, we believe it's helpful for investors to better understand how the VIE structure is set up and what provisions can offer protection to holders of American depositary receipts, should conflicts of interest with the VIE controlling party arise.
VIE Structure Frequently Used to Tap China Opportunities in Regulated Industries
U.S. GAAP-compliant VIE structures have been used by publicly listed companies over the past 12 years to tap growth opportunities in China while complying with restrictions of foreign investments in regulated sectors such as Internet services, media, travel, and private education. Major Chinese ADRs, including Baidu (BIDU) and Sina (SINA), have VIE agreements in place and consolidate VIEs in their financial reporting.
The structure has served a practical purpose of helping numerous fledgling Chinese firms in the regulated industries to access funding from venture capital firms or multinationals, which then exit via initial public offering on an overseas exchange or a merger or acquisition. Chinese regulators have acknowledged the existence of the VIE structure for quite some time, but remained tolerant and passive for the most part.
This is a gray area through which firms have trod lightly over the years; associated risks and uncertainties are regularly disclosed in SEC filings. And the use of VIE structure is not unique to China-based entrepreneurs. A number of U.S.-domiciled companies under our consumer sector coverage, including TripAdvisor (TRIP), Expedia (EXPE), and Amazon (AMZN), have also disclosed in 10-K filings the use of VIEs for their China operations and associated risks and uncertainties.
Notable exceptions are Google (GOOG) and eBay (EBAY), both of which are known to operate in China, but do not use a VIE structure there, based on information provided in their annual reports. Several years ago, China relaxed the restriction on foreign investments and allowed joint ventures between foreign and local firms to obtain licenses in regulated sectors as well, although the policy insisted that only "strategic" investors, not "financial" investors, were eligible for such ventures. For example, Google's license in China is held by a 50-50 joint venture between Google's Irish subsidiary and an Internet firm in Beijing, whereas eBay's license is held by a joint venture with a local partner in Shanghai.
VIE Structure Can Pose Risks to Investors
Contractual agreements and the absence of direct equity stakes are two key elements of the VIE structure. In the regulated Internet services sector, for example, business licenses are issued only to local companies owned by Chinese nationals. To comply with the restrictions while accepting overseas funding, a company usually creates a shell in the British Virgin Islands or Cayman Islands, sets up wholly owned subsidiaries in China, and establishes contractual relations with VIEs that hold the business licenses, run the operations on the ground, and are in most cases registered under the Chinese founder of the Internet venture (or close business associates). While in theory the VIEs are not owned by the shell company domiciled in BVI or Cayman, contractual agreements are in place to ensure that the latter can direct the major business activities of the VIEs and are entitled to most (if not all) economic profits or losses generated by the VIEs, thus satisfying requirements set by the Financial Accounting Standards Board for consolidating the VIEs in the reported financials of listed firms.
The VIE structure can pose risks to investors, chief among which is inadequate control of the VIE assets, given the lack of direct ownership. This concern is often compounded by worries of an opaque legal system and currently weak law enforcement in China. A case in point was the 2011 "stealth" ownership transfer of popular online payment system Alipay (similar to PayPal) by Jack Ma from the VIE of privately held Alibaba Group to an entity under his own control, without a formal agreement with Alibaba Group's other major owners, SoftBank of Japan and Yahoo. The parties involved subsequently reached an agreement to compensate SoftBank and Yahoo on their losses stemming from the Alipay asset transfer, but the incident nevertheless left a bad taste in the mouths of international investors, whose enthusiasm for Chinese names has been increasingly tempered by concerns of lack effective internal control and shareholder protection. These doubts, coupled with rumors of Chinese regulators mulling a ban on VIEs, set off an indiscriminate sell-off of major Chinese ADRs in fall 2011, though the lost ground was almost entirely recovered within a month.
The most recent VIE controversy erupted in mid-July and involved New Oriental Education, which acknowledged an SEC investigation that it believes is related to its VIE structure. The investigation was probably triggered by the firm's announcement that it had changed the shareholder structure of New Oriental's VIE in China, which essentially has consolidated control of the VIE into the hands of its founder, CEO, and chairman from its 11 original shareholders. In our view, regulators and investors were rightfully cautious after being kept in the dark about the very important restructuring of the VIE ownership, which went on for about six months. The lack of transparency during the process probably prompted the question of how much New Oriental shareholders are really allowed to know about the firm's underlying operations, or if the shareholders actually have any control of the VIE assets. In addition, with Yu now having exclusive control over the VIE that holds the license and the critical school assets of New Oriental, it's not unreasonable for shareholders to feel a bit insecure should there be conflicts of interest with Yu.
Regulatory uncertainties are another major risk for the VIE structure, as the structure essentially enables firms to bypass official restrictions on foreign investments. In 2006, the Ministry of Information Industry announced its plans to closely monitor the use of VIEs in the value-added telecom industry, signaling a toughening of stance, although it did not follow up with concrete measures to police the sector or with detailed guidelines as to what is allowed and what is not. The absence of crackdown on the practice has been construed as tacit approval from regulators, and we think the large number of companies using this structure may force government agencies to carefully weigh the outcomes of different policy options, which may take quite some time. That said, we'd consider it prudent for investors interested in Chinese ADRs to carefully read through the regulatory risk factors involving the VIE structure as disclosed in the SEC filings.
Chinese ADRs employing a VIE structure might also face capital control, which can make it a more cumbersome process for these firms to deploy capital overseas to buy back shares, pay dividends, or pursue strategic acquisitions. As cash is held within China, the listed firm may need to jump through various regulatory hoops before obtaining the quota to convert cash into desired foreign currencies to be sent overseas. There are various ways to address this hurdle, though. For instance, to expedite the payment of a one-time $201 million cash dividend payment, Chinese online gaming operator Changyou (CYOU) recently announced that it will use offshore bridging bank loans, which would be secured by an equivalent amount of yuan-denominated onshore bank deposits of its Chinese subsidiaries.
Some Clauses in VIE Structures Can Offer Protection
For investors who would like exposure to the fast-growing but regulated sectors in China and have some risk tolerance, we'd suggest a close study of the SEC filings to identify firms with well-designed clauses in the VIE agreements that offer shareholder protection. In our view, a good example would be the VIE structure of Baidu, which is established based on a series of agreements that give the listed firm effective control of the VIEs. These agreements are between wholly owned Chinese subsidiary Baidu Online and four VIEs that carry out search advertising and other Internet-related businesses in the country.
In our opinion, through these contractual agreements, Baidu Online has effectively gained the power to direct board decisions (including executive appointments) and main business activities that affect the economic performance of the VIEs; obligated itself to unlimited financial support of the VIEs and entitled itself to the bulk of residual economic returns through the license and technology consulting/service contracts with the VIEs; and obtained exclusive rights to repurchase the VIE equity stakes when permitted by Chinese law. While Baidu's VIE structure may not be fault-proof, we think the underlying contractual agreements put in place should allow effective control of the VIE assets and avoid conflict of interests with registered owners of the VIEs.
Likely Response From Regulators and Entrepreneurs Following VIE Controversies
We think Chinese regulators are more likely to grandfather the VIE structure into the regulated sectors than issue an outright ban. Given the flexibility that Chinese regulators have exhibited in recent years in resolving policy issues, we think they are probably leaning toward grandfathering in the VIE structure over a number of years, mindful of the policy impact on the listed firms as well as thousands of venture capital/private equity funded startups using the VIE structure. At the same time, we would not be surprised to see a flurry of additional clauses to the existing VIE agreements as companies strive to allay investor concerns about ineffective control. These changes will probably show up in the 20-Fs that the Chinese ADRs file in the first half of 2013.
In the aftermath of the VIE structure controversies, we expect the growth rate of Chinese listings in the United States to slow in the coming years, driven by a changing mix in venture capital funding source and Chinese entrepreneurs' shifting preference to list closer to home. Assuming the ban on foreign investments in regulated sectors will not be lifted, the prospects of VIEs being grandfathered in the near future may prompt China-based business owners and international venture capital firms to scramble to find a way out, by either expediting an overseas IPO (which can be risky timing-wise) or trying to secure funding from domestic venture funds. In our view, a Chinese firm backed by yuan-denominated venture capital will probably have less incentive to list its stock on the U.S. exchanges, especially if it can fetch a higher valuation on the home market.
Additionally, the high legal expenses that New Oriental is likely to incur in defending itself in the SEC investigation and in a slew of securities fraud class-action lawsuits may prompt other Chinese firms to reconsider their listing options. We think the trends of listing businesses in Hong Kong/Shanghai instead of in the U.S. and of taking U.S.-listed companies private for future asset sales or relisting in Shanghai will probably gain momentum among Chinese entrepreneurs. Significant privatization deals in recent years involved online gaming operator Shanda Interactive, which after delisting from the Nasdaq sold some assets to Chinese buyers at a significantly higher valuation than what the firm was trading at before the delisting, and CRIC, which was taken private by parent company E-House in a merger less than three years after it was spun off for a separate listing in 2009. Leading digital media advertising firm Focus Media was the latest to receive a $3.5 billion buyout offer backed by a consortium of private equity firms and the founder/chairman. According to research firm ChinaVenture, 12 U.S.-listed Chinese firms have announced (but have not completed) plans to go private, most through buyouts led by the founders/management and private equity firms. We would not be surprised to see more Chinese ADRs following suit in the coming years.
Our Favorite Chinese Firms With a VIE Structure
Many people consider Baidu to be the Google of China, and its rise to dominance over the past decade is no less impressive. We think the firm's strength is not in a particularly compelling search technology, but in deep local knowledge of generally young and entertainment-seeking Internet user crowd in China. Many of the seemingly irrelevant free services offered over the years have been hugely popular and are essential to the firm's success in garnering leading market share in site traffic and search queries. This in turn has made Baidu particularly attractive to paid search advertisers and enabled it to branch into other areas, including video and travel. We see a long-term trend of Chinese advertisers shifting their ad budgets to paid searches, attracted by better targeting and measurability. The tailwinds should propel Baidu to thrive further, although competition is on the horizon.
As one of the few services that Chinese Internet users are willing to pay for, online gaming grew rapidly during the past decade into a $6.5 billion business by 2011, generating solid cash flows for top operators such as NetEase (NTES) that consistently deliver the excitement that gamers demand. As the number two in online gaming (after Tencent), NetEase generates 88% of its revenue from gaming and is known for strong in-house games, including some of the longest-running ones in the market. Adding to its arsenal are the hit World of Warcraft games under exclusive licensing from Activision Blizzard. We believe the game developer is attracted by the well-run platform, skillful marketing, and financial strength of NetEase. We think NetEase is poised to continue posting strong growth in the coming years, but it remains vulnerable to intense competition in the no-moat online gaming industry.
Hong Kong-listed Tencent  may be less known to U.S. investors than Baidu, but it is among the most influential and profitable Internet firms in China, with dominant positions in instant messaging, online gaming, and social networking. Thanks to a massive and loyal user base of several hundred million subscribers, the firm benefits from strong network effects that give it a narrow economic moat. By successfully converting users into paying customers for gaming and other premium services, Tencent has increased revenue and free cash flow by 73% and 113% annually in recent years. And we see plenty of upside ahead, as paying accounts make up only 10% of the user base. New strategies of opening up its platform for third-party applications should provide further growth for Tencent, but we expect intensifying competition in China's Internet market to weigh on investment returns in the coming years.
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