Baidu and the VIE
Board: Rule Breakers Baidu
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BIDU and others are using a VIE structure that allows them to have foreign investors--- that means us I guess? The SEC is also saying that these VIE's might have bad accounting practices? Does this change anyone's thoughts about this being a good spot to add to our positions?
Hi ColdDay. The VIE (variable interest entity) structure has been an issue for quite a while. Because China bans foreigners from owning domestic companies in certain sectors, including the internet, and because China also made it very difficult for small companies to get listed on the Shanghai Stock Exchange, many Chinese companies got listed in the U.S. using the VIE structure. Essentially, it gives foreign stockholders what appear to be rights of ownership through a series of contractual agreements rather than actual ownership of the listed company. Here's a useful overview from last fall.
The problem is no one knows if the contractual agreements are enforceable in China. As the article notes, when Jack Ma removed a valuable entity (Alipay) from Alibaba, in which Yahoo had a major stake, it stoked Western fears that Chinese companies could appropriate invested Western capital at will, leaving Western investors without legal recourse. There is widespread doubt that Chinese courts would enforce the agreements behind the VIE structure on behalf of Western shareholders.
On the other hand, the P.R. blowback on Ma was considerable and he quickly moved to repair it by negotiating the repurchase of most of Yahoo's stake. The loss of credibility of Chinese investments in the West has already been considerable, owing to widespread perceptions of fraud in Chinese small caps.
China does want to be a player in world finance. Baidu is so widely-held in the West that any misappropriation of shareholder equity would have a massive ripple effect. Mutual fund companies and other institutional investors would probably have little choice but to swear off any Chinese investment with this structure, which would produce enormous outflows and a capital cold war that could last a long time.
As the FT piece notes, many officials within China seem to like the VIE structure as a way of promoting Western investment without fighting the political battle over foreign ownership of Chinese companies in key industries. But with a new generation of leadership scheduled to take over in China and an alphabet soup of often conflicting internal regulatory bodies, predicting the future course of policy is difficult.
I think the SEC's investigation with respect to EDU -- which prompted the general selloff in Chinese names on Tuesday -- is a shot across the Chinese bow. According to Bloomberg, this is what prompted the SEC inquiry:
The company changed the shareholding structure of Beijing New Oriental so that it’s held solely by a group controlled by Chief Executive Officer Minhong Yu, according to the company’s statement on July 11.
This is quite similar to what Ma did with Alipay and I suspect the SEC is trying to communicate that such maneuvers will result not only in investigations but also in the loss of market capitalization EDU has sustained. In short, I think it's trying to tell Chinese companies listed in the U.S. under the VIE structure that if China will not enforce the rights of Western shareholders, the U.S. will fire back when those rights are threatened.
The bottom line is Western investors in Chinese companies controlled through the VIE structure should probably expect to have few of the shareholder rights they are accustomed to in the West. But it also seems to me highly unlikely that a company as large and widely-held as Baidu would risk destroying its standing in the West by misappropriating shareholder equity. Baidu aspires to be the Eastern alternative to Google and it is very much in China's interest to have homegrown companies able to compete on the global stage.
So, to answer your question, yes, I think this is a good value point at which to begin or add to a Baidu position, so long as you're aware there is more political/regulatory risk than with most domestic investments. Of course, there's more growth, too, so we end where we began -- with a high risk/high reward investment case.
Hope that helps.