China’s Overseas IPOs

The world’s biggest population is more active online than ever, and foreign investors naturally want a piece of the action. A little problem: Chinese law restricts foreign investment in internet companies (along with banking, mining and private education). Not to worry — where there’s a will, there’s a way, in this case an exotic corporate structure that magically turns a Chinese company into a foreign one with shares that overseas investors can buy. And they have. Chinese firms have raised about $76 billion through first-time share sales in the U.S. over the past decade, including $4.4 billion in June by ride-hailing giant Didi Global Inc. It’s a risky business, though, because nobody knows whether the Chinese government considers these structures legal. They may soon find out, however, as China looks to tighten overseas listing rules.

The Situation

China’s gargantuan online retailer Alibaba sold shares to U.S. investors in 2014, raising $25 billion in the largest initial public offering in history. To do this, it used a standard legal shuffle to deploy a variable interest entity, meaning it transfers profits to an offshore corporation with shares that foreign investors can own. Pioneered by the Chinese-language media company Sina in its IPO in 2000, the VIE structure is used by many of China’s internet companies, including Didi. Investors don’t own shares in Alibaba’s profitable e-commerce business. Instead, they hold a piece of a shell company in the Cayman Islands. The earlier Chinese companies went public with as much as 99% of their revenue tied to the VIE, but only 12% of Alibaba’s revenue and 8% of its assets were fixed to the structure. Shareholders are betting on rapid growth in China’s internet use: 70% of the population was online in 2020 — 989 million internet users. A lot is at stake for both China's national champions and U.S. investors including teachers and firefighters whose public pension funds have poured billions into China's tech firms. Among them: the California Public Employees’ Retirement System, the Washington State Investment Board and the Teacher Retirement System of Texas.

China’s Overseas IPOs

The Background

The Chinese government divides its major industries into categories. Some are encouraged or permitted to offer ownership interests to foreigners. Others face restrictions or prohibition. Many foreign industry leaders say these rules violate the market reform agreements the Chinese government signed when it joined the World Trade Organization in 2001. Executives in industries like steel and mining have long called for China to be more open to foreign direct investment.  In 2012, China’s Supreme Court broke up one form of a VIE when it invalidated contracts made between Minsheng Bank of Hong Kong and its mainland proxy, cutting off foreign investors from future profits. Chinese internet companies say that ruling doesn’t apply to them because the bank didn’t use the typical VIE structure, leaving itself exposed to lawsuits.

The Argument

Chinese companies insist they have minimized the risks associated with the VIE structure, although no Chinese regulatory body has officially approved one. The U.S.-China Economic and Security Review Commission has called for China to eliminate internet restrictions, open its markets and spell out the legal status of VIEs. China has said that those restrictions safeguard its economy, but it has largely ignored the companies operating as VIEs — until recently. In introducing new anti-monopoly rules in February — part of a broader effort underway to curb the power of increasingly pervasive Big Tech companies — the government referenced the need for official approval for mergers and acquisitions involving VIEs. Three months later regulators were said to be  planning to ask companies using VIE structures to also seek permission for going public overseas. A week after Didi’s IPO, the State Council, China’s cabinet, said rules for overseas listings will be revised and China will step up its regulatory oversight of companies trading in offshore markets, sending Didi’s and other Chinese tech company shares plummeting. Regulators in Beijing were soon said to be planning rule changes that would close the loophole. All this is playing out as U.S. exchanges become more hostile to Chinese companies, which may face delisting if they refuse to hand over financial information to American regulators, and Beijing encourages them to list back home.  

The Reference Shelf

  • The law firm O’Melveny & Myers published a 2011 report, “VIE Structures in China: What You Need to Know.”
  • PricewaterhouseCoopers offered 245 pages of guidance in 2013 on accounting for VIE structures.
  • An explainer on VIEs by the Hong Kong research firm Forensic Asia explores why China doesn’t let its companies list shares overseas.
  • More QuickTakes on Alibaba, on Didi and China’s broad crackdown on the tech sector, and U.S.-China flashpoints.

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