GIULIETTA TALEVI: Living in interesting times

Is China about to pull the big red chair from under foreign investors?

According to Bloomberg sources, the country is readying itself to ban companies from listing on foreign stock markets through variable interest entities (VIEs), “closing a loophole long used by the country’s technology industry to raise capital from overseas investors”.

The article goes on to say that companies using the so-called VIE structure “would still be allowed to pursue IPOs in Hong Kong, subject to regulatory approval”.

Denials that such a move is in the works were swift, however, with the China Securities Regulatory Commission saying on its website on Tuesday that the media report wasn’t true. 

A few months ago, the FT’s Jamie Powell tried to describe what a VIE is, comparing it to American depositary receipts.

He wrote: “Normally when a foreign company lists its shares in the US, it deposits the stock in a US bank, and then receipts for those shares are listed in the States. These are known as American depositary receipts, or ADRs. It’s a neat way for a dollar-denominated investor to buy exposure to say, VW, without any of the faff of German taxes, euro-exposure or other pesky regulations. Some dude called JP Morgan came up with the idea.” 

Whereas, in China, he continued, “there is no share neatly sitting in an American bank somewhere. In fact, you don’t buy an ownership stake in anything when you invest in say, Alibaba, DiDi or NIO. Instead, what you buy is a simulacrum of a share; a spider-web of contractual obligations that almost perfectly mimics owning the real thing to the point you don’t notice the difference. Unless you like voting at AGMs.”

It is all rather academic until you consider that locally Naspers and Prosus hold their interest in Tencent – the investment regarded as the most successful in the world, ever – through a VIE structure.

And Naspers and Prosus – thanks to that staggeringly acute investment made by former CEO Koos Bekker in 2001 – owe their colossal standing on the JSE and position in almost every South African’s pension fund, to that same Tencent stake. 

As Counterpoint Asset Management’s Piet Viljoen wrote in a paper this August, does this vulnerable VIE structure mean that Naspers’s share in Tencent could actually be worth nothing at all?

“Yes,” wrote Viljoen, “the Naspers/Prosus investment in Tencent faces existential risks. This is very different from normal market volatility, where the prices of good-quality businesses like Tencent can decline sharply, but then recover again over time. When governments appropriate your assets for policy purposes, you generally get nothing in return.”

At this stage, and given Chinese denials that a ban on VIEs is likely, it’s probably unwise to panic. And, in fact, Naspers shares rallied 0.45% on Tuesday, while Prosus gained 1.2%. Year to date, however, thanks to increasing Chinese government intervention into sectors it regards as strategic – like technology –means that both stocks have performed uncharacteristically badly, losing 18% of their value.

For those of you who would like to pursue a little more investigation into the arcana of the VIE, then this report from GMT Research is a must-read. 

It’s easy to forget that China was completely shut off from the rest of the world economy until not too long ago, and that its stock markets only reopened to the world in 1990, thanks to the capitalist-minded Deng Xiaoping, who succeeded Mao Zedong.  

As the researchers write, “by 2002, the share of GDP produced by the nonstate sector exceeded two-thirds. Private companies, however, had great difficulty accessing capital. As late as 2006, a study found that 98% of Chinese companies could not access bank loans. In 2000, only 1% of companies listed on China’s stock exchanges were privately owned. That began to change in 2001 when Jiang Zemin invited businessmen to join the Communist Party, signalling the beginning of reforms that would lead to the establishment of Chinese venture capital and private equity firms, the SME board on the Shenzhen Stock Exchange, and ChiNext, China’s answer to Nasdaq.”

The article goes on to discuss how VIEs were created in 2000, their structures, risks and governance peculiarities.

The questions everyone in the capital markets now grappling with are what structure companies will be able to use to raise capital from overseas markets, and what happens to existing VIEs – and shareholder rights in companies that have VIE structures. “May you live in interesting times,” goes the Chinese proverb.

I suspect that asset managers and pensioners would opt for something less interesting, and a little more certain.

Talevi is the editor of the FM’s Money & Investing section