Alibaba IPO: what investors will actually buy
Note of the translator : today, the question of what exactly investors will buy during the IPO of the Chinese ecommerce giant Alibaba does not lose its relevance, since the placement of shares, which the Alibaba concern had previously planned to hold in the first half of August, was postponed to September due to disruptions to the timing of preparation for the New York Stock Exchange.
Shareholders were willing to take a big risk in the thirst to make money on the initial public offering of shares (Initial Public Offering - IPO) of an Internet company, but the IPO of the Alibaba group could raise the risk to a new level. The risk is that in this placement investors will not have ownership of most of the financial assets of the Chinese company Alibaba due to the ban on foreign investment in China.
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You may be wondering what exactly investors are invited to buy. The provisional application for the placement of securities, filed on Thursday (the original text was published on May 6, 2014 - approx. Translator ), answers the question to Alibaba.
According to the application, the Chinese e-commerce giant will fully own its assets located outside of China, which provide the overwhelming majority of revenues. Alibaba will not own most of its Chinese assets, including the assets of the Taobao online store and the Alibaba.com marketplace. Thus, the companies that underlie all operations of the Alibaba group in China, and are the main cause of the expected and heated demand from investors, will not even belong to Alibaba itself.
As an alternative, the company uses the so-called Variable Interest Entity (VIE) structure of legal entities. This approach works for Jack Ma, co-founder and chairman of the board of directors of Alibaba, but if it works for investors, it remains to be seen. For investors of Alibaba, the VIE structure is extremely risky, but they may not pay attention to the risk in pursuit of potential profit.
What is the essence of the structure of legal entities with variable equity participation, you ask.
The VIE structure was established in 2000 to circumvent China’s investment restrictions in certain industries, such as technology and communications. Now it is a favorite way for companies to go public in the USA. For example, the sites Renren and Baidu are legal entities with variable equity participation.
Alibaba uses this structure directly for its Chinese assets. At a placement in the US, investors are invited to buy shares not from Alibaba China, but from a legal entity in the Cayman Islands called Alibaba Group Holding Limited.
Most of the Chinese assets of Alibaba will belong to Mr. Ma and another co-founder and board member Simone Xie. A company in the Cayman Islands has contractual rights to Alibaba China’s revenues, but has no economic interest.
Jack Ma
If all of this sounds too optimistic for you, then there are two significant risk factors in applying the VIE framework - risks that Alibaba honestly recognizes.
According to the laws of China, such a structure can be recognized as illegal, since it helps to easily circumvent bans on foreign investment.
There is a basis for such a conclusion - there is a precedent.
In a letter to Baidu, in which the effectiveness of such a structure was questioned, the Securities and Exchange Commission indicated that at the session of the Supreme People’s Court of China at the end of 2012, the VIE structure used by Minsheng Bank was recognized illegal.
In its response, Baidu noted that Minsheng Bank operated according to a different scheme and applied a non-standard VIE structure. Namely, the bank applied such a structure that provided the real owners of Minsheng with too high a level of control over voting.
Even if Minsheng used a nonstandard structure, this example emphasizes that the structure of legal entities with variable equity shares has dubious legality in China.
At least one locality recognized the use of this structure as illegal and, by court decision in 2011, the Chinese Department of Merger Control prohibited Walmart from using VIE to acquire a controlling stake in Yihaodian, a leading e-retailer in China.
In more detail, the structure of the VIE replaced another model of a joint stock company, which allows to circumvent the law, which was first applied by China Unicom in 1994. But four years later, this structure was declared illegal by the Chinese government, which made the company abandon it. What happened to China Unicom can happen to Alibaba.
Alibaba has attempted to take action against risk by requesting legal evidence that the use of the VIE structure is acceptable. However, Alibaba, in its application, also reports that the law firm, when giving an assessment, acknowledges that "there are significant uncertainties regarding the interpretation and application of current and future laws, norms and rules of the People’s Republic of China (PRC)". Thus, even the expert opinion that Alibaba requested to reassure its shareholders "encourages" them, saying that there may be trouble. In some ways soothing, yes.
Many argue that while risk is present, recognizing an illegal VIE structure would have a negative impact on China’s economy. But, in addition to the risk associated with legality, the use of such a structure means that if shareholders in the US want to protect their rights, they will have to be based on contracts between a legal entity in the Cayman Islands and a Chinese company on the mainland.
And these treaties will have to be executed according to the Chinese legal system. Historically, it is very difficult or impossible for Americans to ensure full compliance with treaty rights in China if they do not live there. This makes shareholders dependent on who owns the assets of a Chinese company.
The previous problems with the structure of V.I illustrate this. A number of Chinese companies that are listed on the US stock exchange, using such a structure, have lost control over their Chinese divisions. In 2008, a disgruntled executive director seized control of a subsidiary of Agria Corporation in China. The company was able to return its assets only when additional compensation was paid to the executive director.
Since Chinese assets are often in the hands of the CEO or the founder, disagreements with the CEO can be fatal for the company. In the case of the Chinese educational company ChinaCast, American shareholders rebelled and seized the board of a company listed on the US stock exchange. But investors were left with nothing when the previous leaders of ChinaCast simply transferred the company's assets to themselves.
If this is not enough, then I will give an example when the problem touched Alibaba as well. In 2011, there was a conflict between Yahoo and Alibaba over the fact that Mr. Ma, without the permission of Yahoo, transferred the assets of Alipay, an Alibaba-controlled electronic payments company, to a company he owned himself. The conflict was resolved by the fact that Mr. Ma retained possession of Alipay, and the company agreed to make payments for Alibaba.
In other words, US investors will depend on Mr. Ma and Mr. Xi, the holders of the Chinese assets of Alibaba. Ma was firmly convinced that the structure with which Alibaba will go public will retain his decisive influence on the outcome of the vote, but he went to extreme measures. The only people who have retained ownership of Alibaba’s assets are he and Mr Xi.
The Securities and Exchange Commission cannot prohibit a placement because it is “too risky” or even potentially illegal. The only thing that the supervisory authority can do is to demand to state these risks directly. This was done: Alibaba, in its share issue prospectus, states that if the structure of the VIE is recognized as illegal, the company's business may suffer substantially and may be subject to heavy fines.
In addition, the Internet company recognizes that the structure of legal entities with variable equity interests may turn out to be “not as effective in providing governance ... as direct ownership”. Just ask China Cast shareholders what this statement means.
The New York Stock Exchange or Nasdaq - whatever marketplace Alibaba chooses for its IPO - may refuse to accept a Chinese company due to the fact that it is too risky and placement guarantors can do the same.
But they seem willing to put up with risk, preferring to charge their fees and leave the American contributors deceived if something goes wrong.
And since investors expect to invest their billions in Alibaba, they probably would like to know exactly what they are buying.
PS If you notice a typo, mistake or inaccuracy of the translation - write a personal message, and everything will be promptly corrected.
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Source: https://habr.com/ru/post/234971/
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