International exposure is critical to building a well-diversified portfolio, but foreign companies can present challenges you won't find in the United States. Take, for example, a popular alternative to banning foreign ownership of Chinese companies: the convertible interest entity (VIE). Chinese e-commerce company Alibaba is preparing for an initial public offering on the New York Stock Exchange. Alibaba's sheer size (with an estimated net worth of more than $200 billion) has attracted a lot of interest from investors, but some of that interest comes as concern. Alibaba uses a VIE structure, and a recent Wall Street Journal article reported that a US government commission found that American investors could face "significant risk" if they buy shares in companies structured this way. To understand the relation between alibaba vs aliexpress we need to make comparison than we will be in position to understand the relation.
VIE is nothing new. Chinese Internet companies began using the structure in 2000 as an alternative to Chinese sanctions that prevent foreigners from investing in certain industries, including telecommunications. To avoid violating the rules, non-Chinese investors own an offshore listed business entity that owns a Chinese subsidiary. Then the Chinese subsidiary owns one or more locally licensed VIEs. In Alibaba's case, US investors would buy shares in a Cayman Islands company called Alibaba Group Holding Ltd. This entity will have contractual rights to the profits of the Chinese company, but will not own the company's assets.
Although this structure remains in place, the risks identified by the Commission are not significant. Since the ownership of the company is indirect, foreign investors should only rely on contracts to ensure that they retain the economic benefits of owning a Chinese company. These agreements must be enforced through China's legal system in cases where shareholders believe their rights have been violated, a process that has historically been difficult for foreigners. Even with these agreements, foreign investors have relatively little control. For example, in 2011, Alibaba's Chinese subsidiary overtook Yahoo Inc. objections. , which is the offshore firm's largest shareholder, and the asset arm of the payment structure to keep it under the control of the firm's founder, Jack Ma. The Wall Street Journal reported that Alibaba said the deal was necessary to ensure China's central bank would allow the payments body to continue operating and eventually reached a deal with its shareholders. (2) Although some investors view the VIE structure as a cost of doing business in China, the lack of control calls for caution.
Investors still face the same risk as US stocks. Companies with a majority shareholding, whether or not the shareholder is a founder. Investors sometimes decide they are willing to pay to invest in a particular company while at the mercy of the majority shareholders. Some private equity firms, including The Carlyle Group, KKR and Blackstone Group, have also gone public through a limited partnership structure in which investors receive a share of the profits but remain at the mercy of the general partner for business decisions. However, being able to buy a US LLC comes with a set of rules and regulations designed to protect minority investors. While not bulletproof, they do provide some reassurance. Investing in Alibaba or any other VIE-structured Chinese company involves not only relinquishing control, but also transparency.
Perhaps most worryingly, Chinese authorities have never officially confirmed that VIEs are legal. If the Chinese government sees fit to challenge the legality of companies using VIEs, foreign investors cannot do so. Although China has an economic interest in sustaining large companies like Alibaba, investors rely on the interests of the Chinese government without a legal safety net. Some observers have warned that Chinese legal precedent points to the potential demise of VIEs if challenged. This is not to say that investors should avoid structured entities such as VIEs at all times and under all circumstances. Asia-focused mutual funds, as part of a well-diversified equity portfolio, can provide diversified exposure to thousands of different companies, and we can live with a minimal investment in VIE-regulated companies like Alibaba.
But keep an eye on Chinese stocks regardless of their structure. There is reason to be wary of the risks of investing in a space that does not always follow the rule of law or the principles of corporate governance that we take for granted in the United States. The investor-friendly structure of VIEs is another reason to proceed with caution.
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