Dumb Investment of the Week: Chinese Companies with Weak VIEs

After a wave of accounting and fraud scandals in 2011 (billions of investor dollars were lost), Chinese companies, particularly small and mid cap, are beginning to come back to US markets. Investors are beginning to warm up to these companies again and the share prices of many have risen as the memories of the multitude of fraudulent Chinese companies fade away.

How can investors protect themselves from a repeat of 2011? One thing investors need to do is thoroughly educate themselves on the WFOE (Wholly Foreign Owned Enterprise)/VIE (Variable Interest Entity) system many US listed Chinese companies use. Because of prohibitions on foreign ownership in certain sectors many Chinese companies use a complex legal structure to get around this.

At its most basic the WFOE/VIE structure looks like the diagram below. There is a US listed entity that is registered in Delaware or another corporate haven like the British Virgin Islands or the Cayman Islands. This entity then owns the WFOE which is a PRC registered entity. The WFOE then has a contractual arrangement with one or more VIE entities. The owners of the US listed entity do not own any of the assets in the VIE.

Some companies also include a Hong Kong based entity between the US listed entity and the WFOE. Additionally, most companies have multiple VIEs and various Chinese nationals (typically founders and management) with varying equity stakes in the assortment of entities.

One need to look no further then the scandals involving ChinaCast Education and GigaMedia in 2012 to see how effective the VIE structure is. In both cases the company’s Chinese owners simply made off with the assets of the VIE leaving US based shareholders with nothing but an empty shell. It is next to impossible for Western investors to enforce any of the VIE contracts in a Chinese court.

Investors should stick to only those Chinese companies that have a strong VIE structure and minimize the assets and revenue contained in the VIE. The more assets the WFOE contains the more difficult it is for management to steal the company.

What does a bad VIE structure look like?

Examples of Weak VIEs

New Oriental Education (EDU) probably wins the prize as the worst VIE. Most of the company’s assets and revenue are contained in the VIE as shown below.

New Oriental Education (EDU)

Percentage held by VIE FY2013 FY2012 Revenue 99.1% 97.2% Assets 65.5% 60.4%

(Source: FY2013 20-F)

What should trouble investors even more is that this is completely unnecessary. Unlike some companies such as Sina and Baidu that operate in restricted sectors, New Oriental does not operate in a restricted sector. There is no legal reason that a majority of the assets cannot be held by the WFOE rather than the VIE.

Don’t believe me or any of the legal experts? Simply look up the number of western owned language and test prep schools in China. Western owned English schools are frequently up for sale and I encourage you to do as I did and to contact the sellers and ask them about any legal restrictions they had regarding their ownership.

Another company with a weak VIE is Sky-Mobi Limited (MOBI).

Sky-Mobi Limited (MOBI)

Percentage held by VIE FY2013 FY2012 Revenue 99.5% 98.5% Assets 58% 64.9%

(Source: FY2013 20-F)

Again we see most of the assets and revenue in the VIE rather than the WFOE.

NQ Mobile (NQ) takes the cake when it comes to assets held in the VIE with a whopping 80.2% of company assets held in the VIE for the latest fiscal year, 2012 (the company was unable to file its 2013 financial statements on time).

NQ Mobile Inc. (NQ)

Percentage held by VIE FY2012 FY2011 Revenue 59% 57% Assets 80.2% 52.9%

(Source: FY2012 20-F)

So what does a strong VIE look like?

Examples of Strong VIEs

The best examples of a strong VIE that is designed to protect shareholder interests are the “gold VIE standard” triumvirate of Sina Corp (SINA), Baidu (BIDU), and the soon to IPO Alibaba.

With Sina you can see below how the assets held by the VIE are minimized.

Sina Corp (SINA)

Percentage held by VIE FY2013 FY2012 Revenue 68.4% 59.4% Assets 7.4% 9.0%

(Source: FY2013 20-F)

The Sina VIE is basically limited to the necessary government licenses and some cash. If management absconded with the VIE it would still leave shareholders with the bulk of the assets and the company could likely resume operations. This is in contrast to weak VIE companies that have seen their operations essentially cease to exist once management stole the VIE since the VIE contained a majority of the company assets.

Baidu has the same structure as well with limited assets and revenue in the VIE.

Baidu (BIDU)

Percentage held by VIE FY2013 FY2012 Revenue 28.3% 28.8% Assets 10.1% 9.3%

(Source: FY2013 20-F)

Alibaba, which is set to IPO soon, also has a shareholder friendly structure.

Alibaba Group Holding Ltd.

Percentage held by VIE FY2013 Revenue 11.9% Assets 7.5%

(Source: F-1)

Sina, Baidu, and Alibaba operate in heavily regulated and restricted sectors. There is simply no reason why all Chinese companies should not follow their template and restrict the use of the VIEs as much as possible. The fact that companies continue to hold significant assets and revenue in VIE entities should be a huge red flag for investors. What reason is management continuing to keep assets in the VIE if not for holding open the option of perhaps making off with them one day?

Final Words of Caution

The article would not be complete without mentioning that fact that even a Chinese company that minimizes the use of VIEs is not always a great investment. One needs look no further then the history of Jack Ma and Yahoo! regarding Ma’s attempt at absconding with Alipay (part of Alibaba).

My recommendation would be to avoid VIEs altogether, and if one must invest in a company with a VIE insure its structure is similar to that of Sina, Baidu, and Alibaba which protects US shareholders to the greatest extent possible.

Investing in companies with weak VIEs such as New Oriental, NQ Mobile, and Sky-Mobi is a fool’s errand and with investors forking over money for shares in an entity that really owns next to nothing. The only thing the shares represent is hope and hope is never a good foundation for building an investment portfolio.