by kimjungoon
Been seeing a lot of users posting DD on Alibaba and making a bullish case for it. Seems like the massive drop in share price now should be a fantastic opportunity to pick up the Amazon of China at only a forward P/E of 18 right? Not exactly.
This has been posted before in less detail, but I think it’s important to remind investors of the current circumstances arising during the anti-trust probe with China.
The reason why BABA is nose-diving on any extra news of government involvement is that BABA represents ownership of a shell company in the cayman islands, not actually Alibaba itself. The shell company doesn’t even have ownership of Alibaba’s equity. If you want proof of this, simply open up any of their financial statements filed with the SEC.
Chinese law forbids foreigners from owning strategic assets in the country, and Alibaba wouldn’t be able to keep its licenses if, say, a U.S. hedge fund directly bought into the company. Basically, the Alibaba stock will buy you a stake in a Cayman Islands-registered entity that is under contract to receive the profit from Alibaba’s Chinese assets but will not actually own them. This structure is called a VIE.
So think about this, if Chinese laws prohibit foreigners from owning/investing in these kinds of assets in China, what would protect the shell company in the Caymans from enforcing their contract to receive profits from Alibaba if shit hit the fan with the CCP? If Alibaba gets broken up during anti-trust probes, how do we know which subsidiaries BABA ( the shell company in the caymans) will be contractually obligated to receive profits from? Heck, is this contract to receive profits even enforceable in China, where the law clearly states foreigners can’t own strategic investments?
Is this VIE structure even legal in China? Beijing has never acknowledged the legality. According to Harris Bricken, an international law firm:
” VIEs are illegal. We disagree with those who are saying that what is proposed is a two tier, foreign/Chinese system. ”
We don’t know the true answers to the above questions. BABA could easily be worth 0$ if investors one day decide that the “contract” to receive profits from Alibaba is basically BS.
Alibaba and Chinese executives come out a winner either way. Alibaba was able to raise billions from foreign investors without giving up a single bit of ownership.
Oh, by the way, all Chinese listed companies on US exchanges are listed as Cayman shell companies, this isn’t specific to Alibaba. Baidu and JD are set up the same way.
EDITS:
- Since many of you are asking, yes NIO is also set up this way. When I said all Chinese companies are listed this way, I literally mean 100%.
- I don’t know why so many high-profile investors still buy these ADR’s. My favourite value investor, Bill Miller, also holds a huge position in BABA. I guess you’re either in the camp that believes China won’t enforce their own laws on foreign ownership so BABA’s VIE is undervalued, or that one day they will and so the intrinsic value of BABA’s VIE is 0$ because profits can never legally flow to foreign investors.
- The SEC just last month in a report published in November expressed serious concerns: “These China-based Issuer VIE structures pose risks to U.S. investors that are not present in other organizational structures. For example, exerting control through contractual arrangements may be less effective than direct equity ownership, and a company may incur substantial costs to enforce the terms of the arrangements, including those relating to the distribution of funds among the entities. Further, the Chinese government could determine that the agreements establishing the VIE structure do not comply with Chinese law and regulations, including those related to restrictions on foreign ownership, which could subject a China-based Issuer to penalties, revocation of business and operating licenses, or forfeiture of ownership interests. ” Source: www.sec.gov/corpfin/disclosure-considerations-china-based-issuers
- After some further research, Mainland Chinese companies listed on the HKE are also VIE’s and considered “offshore”. Here is what the org structure looks like: cdn.i-scmp.com/sites/default/files/d8/images/methode/2020/12/21/7b58a856-4294-11eb-be63-b2d34bb06b66_972x_163317.jpg
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.