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Over the past few months, Chinese stocks have fallen over and over again. Many investors have taken advantage of these discounted prices for long-term gains. On the other side of the spectrum, many investors believe that there is too much risk surrounding China. Cathie Wood is in the middle of the spectrum, as she initially sold her Chinese stocks, but recently bought back in with a very unique strategy. This video will go in-depth on the future of Chinese stocks and explain both sides of the debate on China.
Chinese stocks have fallen by a substantial amount for a good reason. New regulations have been enforced on education, gaming, data privacy, monopolies, exclusive contracts, and US IPOs. The fact that all of this has happened over just several months is frightening for many investors. The Chinese Communist Party can easily ruin Chinese equities with the snap of a finger. Chamath Palihapitiya, a billionaire venture capitalist and SPAC sponsor, believes that the risk surrounding Chinese assets is far too high to be worth it. Chamath is particularly concerned with the variable interest entity, or VIE structure that Chinese companies use to go public on the US stock exchange. So what exactly is a VIE structure? I’ve seen many people talk about VIEs but never explain the risks of investing in them and how it works. It is currently illegal for foreign investors to invest in most Chinese industries. As a result, Chinese companies have used VIEs as a loophole for this restriction. In the following example, we will use Alibaba to demonstrate how a VIE works. Alibaba operates in an industry that is restricted from having foreign investors. In other words, foreign investors cannot directly own equity in Alibaba. As a result, Alibaba has to create a shell company in the Cayman Islands also called Alibaba.
For the purpose of this example, we will call this shell company fake baba. Note that in the real world, fake baba is actually named Alibaba.
After creating fake baba, Alibaba will now give fake baba contractual agreements over Alibaba’s profits and assets. This is done through a complicated legal process.The contractual agreements owned by Fake Baba give it control over Alibaba’s loans, exclusive call options, proxies, and equity pledges. Essentially, fake baba owns contracts for Alibaba’s profits and assets but doesn’t actually own the equity. Alibaba will now take Fake Baba public on the New York Stock Exchange so that US investors can invest in Fake Baba.
By using this process, Alibaba is able to bypass China’s law against foreign ownership. Alibaba isn’t actually going public on the US stock exchange, because Fake Baba is the one going public. On the other side of the transaction, US investors do not directly own equity in Alibaba. US investors only own equity in Fake Baba.
This type of structure is famously known as the variable interest entity structure, or VIE structure in short form.
The majority of Chinese companies use the VIE structure to go public on the US stock exchange. VIEs have worked well for many years, but there are some major concerns with the structure. First of all, the VIE structure is technically illegal, as it is just a loophole so that foreign investors can own equity in China. Because of that, China may declare that VIEs are illegal at any time. Chamath believes that investing in China is a risk not worth taking because of the VIE structure. On the other side of the spectrum, many investors believe that the potential returns in Chinese stocks outweigh the risks. What’s interesting to see is that many value and growth investors see potential in China. Cathie Wood, the CEO, and CIO of Ark Invest, recently re-entered her Chinese positions after selling them a few months ago. This was shocking for many investors who have been following Cathie, especially because Cathie previously said that China’s new regulations were destroying capitalistic incentives. Nevertheless, she is now approaching the situation in a very unique way. Instead of investing in all Chinese stocks that have disruptive potential, she is now investing in Chinese companies that have government support. More specifically, Cathie has been buying JD.com and Pinduoduo while selling Alibaba and Baidu.