Chinese Variable Interest Entities: Basic Thoughts on Valuations

by: Donald Rudow

Variable interest entities (VIEs) realized through contractual agreements are commonly found within the financial statements of Chinese based firms that have acquired equity financing from US markets. These types of VIEs have become increasingly popular in China, where the VIEs’ contractual relationships are with wholly owned foreign enterprises (WOFEs) within its national borders that are subsidiaries of larger holding companies trading on the US exchanges.

Market valuations for companies that earn any portion of their income through VIEs are affected by the economic incentives these contracts create. The Chinese VIE model is a contractual innovation designed to connect investors looking for an enlarged set of investing opportunities with firms that operate in markets facing foreign investment financing restrictions in place by the PRC. Under the set of contractual agreements that establish the Chinese VIE relationship, the only assets the holding company owns are the contracts containing the agreements that permit the transfer of benefits earned by the VIE.

According to Fredrik Öqvist, 42% of Chinese publics listed on US exchanges derive at least a portion of their income from VIEs. Some of these firms derive substanitially all of their income through contractual agreements (THE9 Limited (NASDAQ:NCTY), chart), while others derive a portion of their income through such arrangements (Baidu, Inc. (NASDAQ:BIDU), Qiao Xing Universal Telephone, Inc. (XING), chart).

The only reason why the contracts have any value is because of the expected benefits the contractual agreements transfer from the VIE to the firm, realized through profits and cash flows. Without this contractual innovation, profits from certain industries within China are inaccessible to US investors. The consolidation of the VIE on the company’s financial statements does not imply any claims to ownership of the VIE equity, so it is important for investors of any type to consider what affects the expected benefits, i.e. cash flows, derived from said equity.

This article will demonstrate that expected cash flows of any of these contracts is going to be affected by the scope of the contract, its ability to align VIE managers’ interests with those of the WOFE, and the enforceability of the contracts in court. All of these expectation issues are independent of the benefit generating potential the entity under contract with the firm possesses. Furthermore, it can be concluded that whenever possible, it is always preferable for investors to choose an equity ownership position through a WOFE rather than a Chinese VIE model, due to the existence of moral hazard and increased uncertainty.

The economic benefits to be transferred under the contractual agreements specifies the portion of the net income that the company is entitled to receive from the VIE over a period of time. The VIE transfers these earnings to an established WOFE which is a subsidiary of a holding company, often located in some other country like the British Virgin Islands, Hong Kong, or the USA. A common set of contracts typically include the following.

  • Service agreements, provided by the WOFE to the VIE.
  • Financing term agreements for the VIE’s capital expenditures.
  • Operating practice agreements.
  • Purchase options agreements.
  • Liquidation agreements.
  • Proxy voting rights agreements for the WOFE.

Paul Gillis provides a nice summary of the basic agreements that are very much in line with those I outlined above. This set may be the minimum necessary that allows the transfer of income to occur, but that does not imply this set is ideal for the holding company. In fact, this set falls short in that the VIE is left with little to no incentive to manage the operations in a profit maximizing manner. It’s not a matter of bad management at the VIE level, it is a lack proper incentives in a setting of asymmetric information between the WOFE and the VIE.

Given that the VIE does not enjoy higher profits achieved through greater efficiencies, the VIE owners have no incentive to produce competitively, and because of this they are prone to purchase labor, materials, and all other inputs at prices higher than they would if they were keeping the profits for themselves. There is also no incentive for the VIE managers to control shirking, which will only drive up production costs. These purchase and operational issues, along with the sale of goods at prices and quantities not optimal for profit maximization are of tremendous concern, precisely because the profit incentive is absent for the VIE.

There also exists a concern over the transfer of economic benefits to parties related to the VIE through both the supply and the sales channels. These are all problems arising from the existence of moral hazard, realized because the actions of the VIE are hidden behind the contracts, so to speak, and not directly under the control of the company. So, it is important to both incorporate incentives within the contracts to reduce this wastefulness and minimize the scope of the VIE’s activities in purchasing, operations, and sales.

Any reduction in problems that occur due to moral hazard through both of these focus points will inevitably increase profits and make the contractual agreements more valuable for shareholders. BIDU incorporates a Pay-for-Performance incentive contract for one of its VIEs that mitigates the problem of moral hazard to a degree, but never assume these incentives completely neutralize the losses under the basic set of contracts. The best outcome, the elimination of moral hazard, is nearly impossible because the actions under management of the VIE are hidden from the company. This is a problem that is going to exist independent of the industry and any qualities unique to the entity that allows it to enjoy any protection from competition.

Any contract must be of sufficient quality to satisfy any and all requirements of the PRC for enforceability. Any degree of uncertainty concerning this creates risk that the economic benefits of the VIE will not be transferred to the WOFE. Keeping this in mind, at all times I am assuming that investors are risk averse. What this implies is that there exists a risk premium compensating an individual for exposing himself to risk. For anyone invested in a company with uncertain income and cash flows, the risk premium is the difference between the maximum he would pay for the company with certain income, less the maximum he is willing to pay for that same investment with uncertain income.[1] This difference is the compensation the investor receives for accepting the exposure to risk. Recent events in China demonstrate that the economic benefits from a VIE are more uncertain than a WOFE, for more than one reason.

Chinese VIEs typically involve holding companies owning subsidiaries owning a WOFE receiving income under a set of contractual agreements with a VIE. The holding company is often in the USA, the British Virgin Islands, or some other country with subsidiaries in Hong Kong that own a WOFE in one of the provinces of China. Often the WOFE is owned by a subsidiary holding company within China, generating several layers of business entity ownership.

The legal contracts are of benefit to the holding company only after passing through the ownership chain that crosses provincial borders and national borders. Existing loopholes that reduce the ability of any of the agreements to be enforced in any of the relevant courts of law reduce the quality of the contracts, and make them less valuable.

The case of Gigamedia (NASDAQ:GIGM) is one example. After the owners of the GIGM VIE decided to break the contracts under their own terms, GIGM decided to pursue legal action under the conditions of the contract. This involved lawsuits in Singapore, China, the USA, the British Virgin Islands, and Hong Kong with no success thus far in collecting the expected benefits under the contractual agreements with the VIE. Without a legal team researching the various sets of laws, the investor can only assume a distribution of loopholes and gaps exist throughout the VIE space that make collection of the flow of benefits from the VIE to the WOFE less than certain.

GIGM leaves us with no other conclusion for now. Thus, any expected cash flow stream by way of a VIE is necessarily going to be worth less than a cash flow stream by way of equity ownership, ceteris paribus, due to the increased uncertainty surrounding the enforcement of the entire set of contracts. Perhaps we will see certain lawyers in the future that have established a reputation for high quality contracts in this area through enforcement of contractual agreements by the courts of China, but this will take some time if it happens. The good news, I suppose, is that it seems possible to eliminate the risk of poor quality contracts, but it does seem difficult to expect perfection which leaves us with uncertainty.

Contracts of perfect quality are for naught, though, if contracts are not enforceable through the courts due to PRC policy changes or attitudes, as was the case with Buddha Steel (OTCBB:AGVO) earlier this year. Officials in Hebei province declared the contracts to not be conforming with PRC policy, despite the fact AGVO followed the common Chinese VIE model and roughly 100 companies on US exchanges involve Chinese VIEs without any such declarations from provincial officials in China up till that point.

As a country firmly rooted in central planning with a judicial system unfamiliar to US investors, arbitrary regulatory changes are to be expected as are inconsistent judicial outcomes, all resulting in enforcement uncertainty. As I see it, time is the vehicle for this risk in that what is enforceable in time t, may not be enforceable in time t+n, for some n ε {1,2,…}. Given that some WOFEs refrain from having the benefits transferred from the VIE due to tax consequences on a local level, there exists a risk that when it is time to make this transfer, the regulatory or judicial landscape may have altered its enforcement of these types of contracts, yielding nothing but losses for WOFEs that follow this tax avoidance strategy.

At a minimum, this makes any contract questionable over the long term, adding another layer of uncertainty concerning cash flows from the VIE contract. It seems prudent for the WOFE to demand that the VIE transfer those benefits under contractual obligation sooner rather than later for this reason. What is needed to eliminate this problem does not exist, a crystal ball that predicts the future. Thus, if investors are going to choose a cash flow that involves a Chinese VIE, they are going to demand a risk premium. The value of those cash flows will be less than the value of those same cash flows if they were generated by a WOFE because of the risk premium required for investors to hold that risk.

So, we can see that the Chinese VIE model is worth less than a Chinese WOFE for two reasons. It is worth less due to the moral hazard problem created by a lack of a profit motive present for the VIE managers, which removes the incentive to produce more efficiently and sell at prices and quantities that are optimal. Profit sharing incentives with the VIE equity owners would go a long way in reducing this problem and make the Chinese VIE more valuable.

Another option is to minimize the scope of operations handled by the VIE. It is also worth less because of the need for a risk premium due to uncertainty surrounding contract enforcement, with some of it addressable through competent legal teams, but a portion of it appears permanent unless China eliminates all regulatory meddling in the near future, which seems like an unrealistic hope. Whenever possible, investors interests are better served with the WOFE structure than the Chinese VIE structure because the WOFE will realize a higher valuation due to fewer principal agent issues and the elimination of enforcement risk.

[1] For a nice treatment on risk and uncertainty, see The Economics of Risk and Time by Christian Gollier.

Disclosure: I am long XING.

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