The risks and rewards of investing in the Chinese tech sector

[/vc_column_text][vc_column_text]The once timid Chinese tech companies have gone global, with major names such as Alibaba, Baidu and Lenovo already having made a number of high profile overseas acquisitions. Due to a lack of domestic capital and political restriction on foreign investment into companies listed in China, the country’s three tech giants Alibaba, Sina Weibo and Baidu all listed on US stock exchanges in 2014.
This prompted a number of Chinese smaller tech companies to go global in search of investors for a booming domestic market. While Hong Kong is generally the go-to market for Chinese entities looking to list abroad, tech companies benefit from the higher levels of trust given to tech stocks on Western markets, despite their volatility.

More recently, a number of Chinese companies have considered an exit from their overseas listings to take advantage of the new domestic liquidity. However, such plans were halted by the crash in the Chinese stock markets, beginning in June 2015. The Chinese government implemented a series of severe measures to halt the falling indices, including a ban on new IPOs. The turmoil in China has since spread to overseas markets, with foreign listed Chinese companies seeing their share values tumble.

This erratic behaviour has caused American investors in particular to lose confidence in Chinese tech stocks.1 The ban on new IPOs in China has also made a listing on overseas markets the most likely course of action for Chinese tech firms looking to expand when – and if – markets rebound. As a result, Chinese companies are increasingly looking to list on European stock markets.2 The London Stock Exchange (LSE) is developing a growing reputation as a yuan trading centre. In June 2015, the LSE struck a deal with China’s second biggest underwriter, Haitong Securities, for the promotion of Chinese flotations on the LSE.3 Judging by the record of Chinese firms listing abroad,4 it is likely that a significant proportion of potential overseas listings will be tech firms.[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column width=”1/1″][ultimate_spacer height=”20″][vc_column_text]Since Chinese law restricts or even prohibits direct foreign investment in internet and financial services companies, the Chinese government has tried to restrict the ability of these companies to list on overseas stock exchanges. In turn, the tech firms have managed to circumvent these restrictions by using Variable Interest Entities (VIE). VIEs are a high risk type of holding company, which are often incorporated in locations such as the Cayman Islands, linking foreign investors to Chinese entities via a complex web of legal contracts. Investors face a number of risks when engaging with Chinese tech companies that employ VIE structures to gather foreign investment.

Firstly, the VIE structure provides little oversight on the part of investors. While entitled to a share of profits, foreign investors generally do not have any measures of control through their shares. This was shown in 2010 when Alibaba CEO Jack Ma unilaterally and secretly decided to spin off Alipay, originally part of Alibaba Group, as an entity solely owned by himself, despite angry protests from investors.5 Mr Ma’s actions were made possible by the obscure VIE corporate structure that connected Alibaba to its investors on the NASDAQ stock exchange.

More importantly, however, is the questionable legality of VIEs in China. In essence, VIEs are set up to appear to be Chinese entities to Chinese regulators, and foreign entities to foreign regulators. Legal contracts are established between a Chinese company’s wholly foreign owned subsidiary and the VIE. However, since both of these entities are incorporated in China, the contracts are only binding and enforceable if Chinese courts are willing to uphold them. Since VIEs are specifically designed to circumvent Chinese regulations, there is a real risk that Chinese courts will choose not to uphold these contracts. Additionally, even if a Chinese court would choose to uphold a contract involving a VIE, rule of law in China is generally rudimentary, and rulings are often subject to political bias.

The Chinese government has yet to take action on VIEs, perhaps due to the fact that its major tech firms are all heavily reliant on this form of ownership structure to raise capital. The government has, however, taken note of the dubious nature of VIEs, stating that they conceal “illegal intentions with a lawful form.”6 For this reason, it is not unlikely that the Chinese government may implement measures to restrict the use of VIEs in the future.

Investors also face political risks when engaging with the Chinese tech sector. In a campaign to consolidate ideological control, Chinese President Xi Jinping has warned against “foreign influence” on Chinese culture, and the People’s Liberation Army has identified the internet as an important battleground against the influence of foreign states.7 The tech sector has been specifically targeted in this campaign. Earlier this year, the Chinese government made political training sessions for tech elites mandatory,8 while state media announced that tech firms will soon be required to embed a unit of “internet police,” ostensibly to “combat fraud and the spreading of rumours”.

Furthermore, several of China’s tech giants are indirectly owned by the political elite – often nicknamed “princelings” or “red nobility” by Western media commentators – through private equity funds. One example of this is princeling ownership of Alibaba Group, one of China’s most profitable tech companies. Winston Wen, son of the former Premier Wen Jiabao, owns a stake in Alibaba through New Horizon Capital. A group of red nobility headed by former President Jiang Zeming’s grandson, Alvin Jiang, has also invested in Alibaba through private equity firm Boyu Capital.

There are also risks of a more mundane nature. Tech firms have been at the centre of corruption and bribery, mainly related to illegal private censorship businesses. These firms are mainly set up by employees of large internet service and social media companies, providing privatised censorship services for companies and public officials in exchange for bribes. The government has moved to crack down on these “black” internet PR agencies. One notable example is the fraud conviction involving former Baidu employees in 2013.9

While China’s tech companies are an attractive investment, the highly risky political environment they operate in remains an important factor to take into account for any investor. Developments related to VIEs and the tech industry could have huge ramifications for tech firms and other investors seeking to expand in China.

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