China VIE trouble for BABA?

That didn’t take long.

Over the past few months I have been writing (also here and here) about Alibaba (Ticker: BABA). I mentioned one of the key risks with buying BABA stock is that when you do you are not really buying a share in Alibaba the company. Instead, you are buying a share in a Cayman Islands-registered Variable Interest Entity (VIE) which is tied to Alibaba through a ream of contracts. But there has always been the risk that this relationship is vulnerable.

One of those risks has now perked up. Last week the Chinese government issued draft legislation overhauling the law covering VIEs. For a good break down on this, check out the China Law Blog (CLB) which has a great overview of the changes and a list of other experts writing on the subject. (Side note: If you are currently or are about to do business in China, save yourself a fortune in legal fees and future headaches and go read the entire China Law Blog now.)

I will leave the details of the changes to those posts, but put simply the announcement last week calls into question the whole basis for the relationship between VIEs and the actual underlying companies to which they are tied. Now some people will say this is just another example of bad faith in Chinese business law, which many see as being increasingly tilted against foreigners. I disagree that sentiment. In particular, the problem is that everyone working around VIEs has always known they were a grey area, at best. It says so in BABA’s S-1 Risk Factors.

The whole VIE structure grew up as something of a hack. Foreigners are not allowed to have equity in Chinese media companies (as well as several other ‘strategic’ industries). Going back to the 1990’s ‘.com’ era, as Chinese Internet companies went public, some clever lawyers (or bankers) stumbled on this VIE structure as a way to separate ‘ownership’ of the companies from ‘economic participation’ in those companies. From a philosophical perspective it is unclear if that is even possible. But from a technical legal standpoint, it has always been a bit shaky. So now the government of China is going to clarify the law. Seemed like this latest news was inevitable, and I have to wonder if the high profile of the BABA IPO did not play a role in catalyzing the matter.

So what happens now? The answer is unclear. It seems possible that BABA and some of the other China Internet names may get some sort of one-time exception, or be ‘grandfather-ed in’. However, as CLB points out, that penalizes any private BABA competitor. Alibaba has raised a lot of money from foreign investors, and can use that to build its business (not least through strengthening its loan book), but anyone coming after them will be prevented from doing so. Leaving them at a permanent disadvantage. At the other extreme, there is a non-zero possibility that Alibaba’s VIE structure is ruled entirely invalid, leaving investors in the lurch. This would be some pretty bad publicity for the Chinese marketplace, but that may not matter to the lawmakers. If I had to guess (and that’s all I can do), I imagine we will end up with some highly pragmatic compromise that further erodes the control that the BABA VIE has over Alibaba the company, but nothing disastrous.

The odd thing is that there has been no affect on BABA’s share price. The stock is down about 5% over the last five days, exactly in line with the broader market. I have not read all the research out there, but as far as I can tell, no one seems terribly worried about this change, or even mildly interested.

From all of this, I imagine that most investors had some earlier warning that a legal change may take place. This may have come up in the IPO roadshow. Or investors may just assume that Alibaba can find some way to a reasonable settlement with the new law. In fact, if they do get an exception, penalizing all the smaller competitors may help the company. Nonetheless, a part of me suspects that many investors outside China are just treating this as a non-event because it falls in the bucket of China Politics, and thus unknowable.

For me, this latest news is just one more example of the uncertainty underlying BABA that keeps me from buying the stock. After my earlier posts, I had a few investors mention to me that they felt the same way (although they put it a little more cynically). The logical interpretation of this is that BABA should trade at a discount to its peers, but little about current Internet stock multiples are ‘logical’.

As much as I like Alibaba’s underlying business, I am staying on the sidelines for now.

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