The vague value of Chinese VIEs

Just as Gary Wang, the founder of China’s online video giant Tudou, was about to launch an IPO on  NASDAQ in early 2011, his wife sued him for divorce. What started as a private matter suddenly became high-profile – because she claimed half his ownership stake in the company as part of the settlement.

Wang owned 95 percent of Tudou through a variable interest entity (VIE), a Chinese investment structure designed to accommodate capital from foreign investors, which was set up in the founder’s name.

Since all of Tudou’s assets (valued at $822 million in 2011) were contained in the VIE, Wang’s ex-wife was set to own half of Tudou without any accompanying shareholder restrictions.

In the end, Tudou delayed its IPO offering for six months until the Wangs reached an out-of-court settlement. She accepted an undisclosed cash payout, and Tudou went on to raise $174 million in its August 2011 IPO.

Tudou’s problem was not the company itself, but the nature of the VIE – and as such, it serves as an excellent illustration of both the value and the risk inherent in these structures.

THE ONLY WAY IN

The purpose of the VIE is to allow foreign investors to control Chinese companies and share their profits without actually owning them.

For instance, given China’s regulatory restrictions on foreign ownership, the VIE is effectively the only way for private equity firms to invest in China’s lucrative but sensitive TMT sector. Internet companies like Baidu and Sina.com typically make use of the VIE structure to give offshore investors contractual rights to their licenses and earnings. And Silver Lake and Temasek Holdings have a VIE investment in Alibaba Group that is now worth about $1.6 billion, according to law firm Ropes & Gray.

But its legal protection is only theoretical. The few international court cases related to VIEs – such as those filed against Gigimedia when it lost control of its VIE in 2010 after a falling-out with the founder – have been inconclusive in terms of the actual structure. No Chinese court has ever made a final ruling on it either.

The Chinese government consented to the structure because it wanted to promote investment in the country’s TMT sector, and realized it needed foreign investment to do that. The Communist Party couldn’t consent to direct foreign ownership, so the VIE became the solution.

“If you really think about it, the VIE is just the government closing [its] eyes,” says one China-focused GP.

One major drawback, however, is that the VIE structure has to be owned by an individual – usually the founder of the target company (PRC law does not allow for holding companies onshore, meaning that investment vehicles need personal ownership). Thus, if anything threatens the individual’s ownership – such as a divorce or death – the VIE structure could get caught in the crossfire.

“All individuals have flaws, and these VIEs are all tightly connected to the companies’ leaders,” says Ropes & Gray partner Marcia Ellis.

REGULATORY SCRUTINY

Scrutiny of the VIE structure has intensified over the past year, since the various accounting scandals prompted the US Securities and Exchange Commission to investigate Chinese companies more thoroughly. Since VIEs tend to be one of the more opaque and private aspects of these companies’ structures, the SEC worked with Chinese regulators to examine how they were used, and began demanding additional disclosure, according to Paul Boltz, a partner at Ropes & Gray.

The China Securities and Regulatory Commission cranked up the pressure once it uncovered misuse of the VIE. The structure was originally intended only for sensitive sectors in China such as media, but some companies had begun to use it in other sectors, such as mining.

According to Ellis, this was to get around the Chinese government’s restrictions on what is known as “red-chip restructuring” – the creation of an on offshore holding company that controls and receives the profits of a Chinese company through either direct ownership or contractual agreement, and then lists that company’s assets on overseas markets (there are very few other ways to get Chinese investments offshore).

So far, Beijing has never approved a proposal for red-chip restructuring, Ellis says – which became frustrating for investors that didn’t want to list on China’s stock exchanges. That’s when the VIE began to look like an attractive exit route.

When some Chinese companies in non-sensitive sectors (like mining) used the VIE to list overseas, that was “the straw that broke the camel’s back”, Ellis says. Regulators have since been scrutinizing all VIEs to make sure they remain in approved sectors.

This extra scrutiny has also made government ministries and even lawyers much more tight-lipped on VIEs in the past year, Ellis adds. It has been some time since lawyers published substantive opinions on the subject, because they are concerned about the reaction of PRC government officials who may not agree with them.

“Indeed, lawyers might even have their licenses for issuing opinions for the purpose of IPOs pulled if the Ministry of Justice doesn’t like their opinions on VIEs. [Legal] opinions on VIEs have come with many more caveats to them,” Ellis says.

Another factor, according to Steven Xiang, head of the China practice at Weil, Gotshal & Manges, may have been China’s political transition, with President Hu Jintao handing over power to Vice President Xi Jinping; officials and regulators want to avoid big decisions until the new leadership is firmly ensconced.

Even now that the leadership transition in China has been completed, another Hong Kong-based lawyer believes it will be at least a few months before investors can be sure what the new authorities plan to do with the VIE.

However, there was no legislative activity related to VIEs in 2012, and Xiang believes the government is unlikely to take any extreme measures.

“They’ve acquiesced [to] the structure for so many years without saying anything; it would be draconian if they overturned it,” Xiang said.

TOO MUCH RIDING ON IT

O’Melveny & Myers partner David Roberts, who says he has closed a few VIE private equity deals in the past few months, estimates that hundreds of billions of foreign dollars are tied up in VIE structures. No officials want to negatively impact China’s (well-connected) internet and media moguls, he believes.

“It’s hard to undo something like this without creating turmoil for entire industries,” he points out. At the moment, there are simply no other viable options for investing in Chinese media.

Moreover, Roberts believes the Chinese government has little motivation to take a clear stance on the VIE. In fact, it’s in the government’s interest to leave the situation vague, he explains. “If you want to encourage the development of a certain sector, like the internet, but still maintain some kind of control over it – sort of a hammer hanging over the industry – you keep things vague.”

However, as long as investors remain unsure where the line is, they may choose to err on the side of caution. As another China-based lawyer puts it: “[Investors] won’t get carried away, because they know [the regulators] can always come in and make life miserable for them.”