Alipay Fiasco Underscores the Expropriation Risk of China Investments

Includes: AABA, FXI
by: Northwest Investor

Once upon a time, so the story goes, a great treasure was hidden away in a cave, to keep it safe. Enterprising young Ali Baba discovered its secret, and with the magic words "Open Sesame" he gained entrance to the cave, and made off with its riches.

In our world, there are also riches, many of them owned by corporations for the benefit of their shareholders, and it does happen that every so often a clever fellow discovers the secret of appropriating those riches for himself. In the case of Alibaba, a company 43% owned by Yahoo (YHOO), it turns out that the magic words which open the door to shareholder assets are not "Open Sesame" but rather "Chinese Regulations."

One day in March, Yahoo management and directors, not to mention Yahoo shareholders, were alerted to an unpleasant surprise: Jack Ma, their Chinese "partner" and the CEO of Alibaba in which Yahoo holds a stake, had transferred the valuable Alipay service from Alibaba to a new company, owned by him.

According to Yahoo this occurred without the approval, or indeed the notification of Yahoo's Board of Directors. Yahoo's statement is that the transfer occurred last August, and that the Yahoo board was informed only this March, a bit more than six months after the fact.

Ma claimed that this asset sale was necessary because the Chinese government had prohibited a company such as Alibaba, with substantial foreign ownership, from owning something as important as a domestic payment service. He's also been trying to buy back Yahoo's stake in Alibaba, but hasn't been willing to pay what Yahoo thinks its worth.

Mr. Ma, nothing if not creative, apparently decided that if Yahoo wouldn't sell him their stake at the price he wanted - well, he'd do the next best thing, and sell Alibaba's valuable asset, Alipay, to a company wholy owned by himself. Bloomberg quotes Alibaba CFO Joseph Tsai as stating: "It's 'inappropriate' for Internet companies in China to have high foreign ownership given the increasing regulations on overseas investment rules in the industry". Its also "inappropriate" to sell assets without getting a sign off from the Board of Directors, but that point seems to have slipped by Mr. Tsai.

Investors sold on the China story need to take heed: If what you buy in China only stays "bought" as long as convenient for Beijing and their local friends, you might consider that you're just leasing the asset. Like Hong Kong and Macau, if they want it, sooner or later its going back.

What's particularly troubling about this story is the suggestion of collusion between Chinese authorities and Mr. Ma, and this story begs the question as to whether any foreign investor in China can expect fair play.

When the Chinese state uses its regulatory policies to the disadvantage of foreign investors, and does so unpredictably and at the behest of local businessmen, then one's "investment" becomes a speculation. What will China think of your company tomorrow? Will some Chinese entrepreneur take an interest in your enterprise, and prevail upon friendly (to him) state authorities to make life hard for you? A large number of foreign firms have indicated that this is the direction China is going. The concerns have been raised recently by the European Union Chamber of Commerce in China, which recently released a poll of their members, 43% of whom indicated that China's regulatory policies had become less fair, a significant increase over the 33% who reported similar concerns a year earlier.

We've seen this story before, most particularly in Putin's Russia. Those with long memories will recall British Petroleum (NYSE:BP) when they did extensive and expensive exploration in the Russian East, Sakhalin island, and found large oil deposits, which inspired continuous harrasment and finally expropriation by Russian authorities on the most trivial of pretexts.

What does this mean for investors? It means that China investments, like those in Russia, must take account not just of business risk, but of expropriation risk. What is noteworthy is that the direction of change in risk seems to be in the wrong direction. While Russia at least is paying lip service to the notion that their dealings with companies must become fairer and more transparent, China is moving in the opposite direction, at precisely the same time that many companies count on the Chinese market for more and more of their business.

Modellng expropriation risk is tricky - no one lifts underperforming assets from you, why would they? Its a kind of "success tax" - a penalty which will only accrue when your enterprise goes as well as or better than expected. As such, it should lead investors to mark down possible returns in China.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.