The VIE Model – understanding what you are buying when you are investing in Chinese stocks

Key Points

  • Understand the key structure that facilitates Chinese companies to raise funds from overseas investors while complying with government regulations
  • Has the storm for Chinese stocks past or is there more to come?

Are your investments in China at risk? Why was there such a sell off of Chinese stocks? Will foreign investors be cut off from their investments and the Chinese market due to regulations? To answer these questions, we need to understand the method Chinese companies raise funds from investors abroad – the VIE model.

1. Introduction

Source: [1]

A variable interest entity (VIE) refers to a business structure in which an investor has a controlling interest despite not having the majority of voting rights. VIEs are set up such that investors do not have a direct ownership stake in the company but rather have contracts, which specifies rules and a percentage of profits. Hence, investors do not participate in profits or losses that usually come with ownership. The contracts don’t provide for voting rights either.

Variable interest entities are usually established as special purpose vehicles (SPVs) for a multitude of purposes – which could include conducting R&D or just passively holding financial assets.

2. VIEs in China

China's ICBC bank sells products online to consumers and companies
ICBC (Industrial and Commercial Bank of China) has its A shares listed on the Shanghai Stock Exchange (601398.SS) [2]

For companies within Mainland China, there are two routes to raise capital via IPO: onshore listing (also known as A-share listing) and offshore listing (also known as red-chip listing).  A-share listing requires companies to meet higher qualifications and can be quite a lengthy procedure. Hence, many companies look to be listed abroad.

Under the PRC laws, any companies that wish to directly list abroad requires approval from the PRC authorities – which is extremely difficult, especially for companies within the TMT sectors. This is because listing domestic companies on overseas exchanges (e.g., in the US) would result in being under the direct jurisdiction of countries abroad, posing potential national security threats due to the sensitivity of the data these companies store.

Here we show the most common VIE structure used by Chinese companies.

Notes: [a] Starting January 2020, per new Foreign Investment Law, WFOE has been abolished and superseded by a new type of business referred to as “foreign-funded enterprise”; Existing businesses are expected to transition to the new designation within five years. [b] PRC Individuals that are in contractual agreements with the WFOE are usually the company’s founders.

Below the cashflows between all parties have been shown:

The VIE structure seems to kill two birds with one stone; it allows foreign capital to invest in the Chinese market while still maintaining within PRC regulations.

Operationally, the offshore company which investors invest in has no control over the domestic company. As it is not a PRC entity, it does not require approval. This also means that, when purchasing stock, investors are investing into the offshore company which the domestic company is obligated to share profits with, resulting in the lack of voting rights while owning a controlling interest.

3. Why is it in the news now?

Weibo-owner Sina to go private in $2.6 bln deal with CEO-led firm - CGTN
Sina Corporation was the first to be listed abroad using the VIE model in 2000. [3]

The present-day most used VIE model was first deployed by in 2000 to help it list on the NASDAQ – the model is commonly referred to as the β€œSina-model”. Since then, hundreds of Chines companies have been able to list on foreign exchanges, most notably in the US. While β€œloopholes” are generally frowned upon, the previous general inaction by regulators showed a silent consent for the VIE structure, as it has attracted plenty of foreign investment – especially in the TMT sector.

Shares in Hong Kong bourse operator plunge as city increases trading tax |  Financial Times
Chinese companies moving away from Wall Street to relist in Hong Kong [4]

However, recent events have made investors nervous. Regulators had already become much stricter, as ultimately control of domestic companies comes at their discretion. As a response to the SEC’s HFCAA (Holding Foreign Companies Accountable Act), which requires foreign companies to open their books to American accountants, Chinese companies began to delist as China continues to uncouple from US exchanges. Examples included Didi, China’s vehicle for hire company that delisted from NYSE just 6 months after its IPO, and more could follow amid national security concerns and rising geopolitical tensions. This has also pushed many companies to relist on the Hong Kong Exchange instead.

Due to the lack of formal regulation on VIEs, this uncertainty led to worries of the structure being banned entirely and resulted in a large sell off in many Chinese equities.

However, the CRSR’s recent announcements gave foreign investors something to cheer about as the regulatory organisation announced its support for VIEs. The new rules state that deals will require effective regulatory approval and can take up to 20 working days to process. In addition, the new rules will not be retroactively applied.

Overall, the outlook looks to trend upwards as China seems content to allow foreign investment in domestic companies, albeit on the HKEX instead of the NYSE.

Disclaimer: Our content is intended to be used solely for informational and educational purposes, and not as investment advice. Always do your research and consider your personal circumstances before making investment decisions. ChineseAlpha is not liable for any losses that may arise from relying on information provided.

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