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Investing in China? It can be complicated

What you need to know about Chinese companies structured as variable-interest entities.

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The successes of recent Chinese Internet offerings, like Baidu [BIDU] (the “Google” [GOOG] of China) and Weibo [WB] (the “Twitter” [TWTR] of China), have sparked a lot of interest in what might be coming down the pipeline next from the world’s most populous nation.

However, amid the euphoria for new opportunities emerging out of China, investors should understand what they are really getting into. Some, but not all, publicly traded Chinese investments are structured as variable-interest entities, or VIEs. This structure carries with it more complexity than your traditional stock or even American depository receipt (ADR).

What is a VIE?

Chinese law places restrictions on foreign ownership of certain businesses that the Asian nation deems “sensitive industries,” a group that includes Chinese Internet companies. In order to offer foreign investors securities linked to one of these sensitive Chinese companies, a VIE can be created. This is accomplished by the subject company, such as Baidu, transferring revenues from key assets to other Chinese entities (the VIEs).

The subject company—which is owned and controlled by principals of the subject company who established it—reaches an agreement with a third party, a wholly foreign owned enterprise (WFOE) in China which is typically a subsidiary of a foreign-based holding company (see the graphic below). The VIE is essentially the combination of the subject company and the WFOE. By virtue of owning the shares of the WFOE and/or through other contractual arrangements with the WFOE, the holding company has a claim on the revenues of the WFOE, which in turn has a claim on the revenues of the subject company. Sounds a little complicated, right?

The risks

In addition to all the characteristics that accompany investing, including the risk of loss, the structure of VIEs presents some unique risks that should be considered.

First and foremost, VIE structures do not give investors ownership in the operating company, as stock does. The holding company through the WFOE, and ultimately the holding company shareholder, has contractual rights to the revenues of the VIE operating company. However, none of the WFOE, the holding company, or the investor has any direct claim on the core, restricted business assets of the VIE operating company.

As a result, investors may not exert as much influence over the subject company as they could if they were owners of common stock. Often, the voting rights in the VIE operating company, especially in matters of corporate governance, are controlled by the principals who established the VIE operating company.

Moreover, given that the VIE is controlled by the principals who established it, the VIE could possibly void the agreement with the WFOE and the holding company, as was the case with the principal of one of the subsidiaries of Chinese online entertainment company GigaMedia. It is unclear if investors will be able to effectively enforce their contractual rights in either the jurisdiction of the VIE or the holding company.

Another important risk factor is that the enforceability of the VIE structure has been called into question, as it has never received explicit approval from the Chinese government and is recognized as a structure put in place principally to work around Chinese restrictions on foreign investment. The risk here is uncertain; it is not known whether, or how, the Chinese government would take action against VIEs, given the potential impact on the financial system.

Decide for yourself

Only you can determine whether these risks are worth the potential reward. Despite the complex structure and lingo associated with VIEs, a number of these investment opportunities that have been trading in the secondary market for some time now have performed relatively well. 

Learn more

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Stock markets, especially non-U.S. markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. Risks are particularly significant for investments that focus on a single country or region.

Past performance is no guarantee of future results.

There are risks associated with investing in a public offering, including unproven management, and established companies that may have substantial debt. As such, they may not be appropriate for every investor. Customers should read the offering prospectus carefully, and make their own determination of whether an investment in the offering is consistent with their investment objectives, financial situation, and risk tolerance.

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