SEC investigation raises concerns over VIEs

Private equity firms are wondering how their investments might suffer as another Chinese company listed in the US under the variable interest entity (VIE) structure has come under investigation by the US Securities and Exchange Commission, according to Hong Kong-based partner at law firm Ropes & Gray, Paul Boltz.

This week, the SEC launched a formal investigation into China-based education provider New Oriental Education, according to a statement released by the company.

The news caused New Oriental’s share price to drop 57.7 percent in the week, along with a number of other VIE-structured businesses listed on the New York Stock Exchange, according to media reports.

Boltz explained to PE Manage, “[New Oriental] is one of the leading listed companies out of China in the sense that it has been listed for a long time, it is considered royalty among the listed companies and they’ve had a market capitalisation that has been well over $3 billion for a while.”

VIEs allow foreign investors to circumvent restricted sectors in China such as the internet and telecommunications. Using this structure, foreign investors can control companies operating in China without actually owning them.

Private equity firms are now anxious that regulators will question the validity of VIEs, which could compromise their interests in the business. Boltz explained that if the VIE structure was deemed invalid, a Chinese owner could effectively walk away with the business.

“We’ve gotten calls from basically all our private equity investors asking specifically about what is going on,” says Boltz.

However, a publically available report from Muddy Waters, a research firm run by a short seller of stocks, showed that New Oriental is being called into question over how many schools and learning centres the business owns, not its VIE structure. The company alleges it has 664 locations, however, Muddy Waters believes many to be franchises.

Industry sources believe this will affect private equity investments in the education sector as their share prices have plummeted this week. Marcia Ellis, partner at Ropes & Gray, said that many private equity firms have such investments on the NYSE, leaving them in danger of a prolonged period of low valuations.

For example, China-based education service provider Ambow Education, backed by private equity firms Avenue Capital, Actis and Baring Private Equity Asia, and Tiger Global Management and Prime Capital Management-backed TAL Education Group, were identified in the Muddy Waters' report as having an “oddly symbiotic relationship” with New Oriental and a “number of red flags as well.”