Didi’s U.S. IPO is one of several key moments of the recent regulatory shift inside China regarding its leading technology companies. The other is Ant’s IPO that never happened, pulled in the wake of criticisms of the Chinese government’s handling of newer technologies by the previously prominent Alibaba founder Jack Ma.
It’s been a busy year for changes to how the autocratic Chinese government handles its economy. From a larger crackdown on technology firms to new rules regarding youth video game playing, a shellacking of the for-profit edtech sector, and changes to how fintech can operate, watching China from a tech perspective this year has proved hectic.
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Even though it’s the first of December, we may not be done yet with this year’s changes.
Bloomberg reports that China is considering removing the VIE loophole that allowed Chinese companies to list in the United States, closing a method by which local companies could access foreign capital.
VIEs, or variable-interest entities, are complex. But legal group Winston & Strawn has a good summary of why they matter, which will do for our purposes. Per the law firm, VIEs are “commonly used in China to allow foreign investors to participate in industries that are explicitly or practically restricted from foreign investment.”
VIEs don’t grant ownership of the underlying asset as we might normally understand it. Instead, they can help get around Chinese laws concerning foreign ownership of companies in select industries. How do they do that? By using an offshore company setup to collect “a claim on the profits and control of the assets that belong” to the actual company in China, GCI Investors explains. That’s where the interest part of VIE comes into play.
VIEs are how Tencent, Didi and others went public in the United States. Not by listing their main corporate bulk, but instead by dodging domestic rules, creating a puppet entity, and selling Americans stock in that corporate bridge. Not what you expected? Did you think that your Alibaba holding was in the actual company? Well, bad news.
The model was always risky as heck, but tolerated because folks wanted to buy shares of Alibaba, as well as the general risk-on climate of the last few years. But now the Chinese Communist Party is considering doing away with the side-step of its own rules.
Bad news or not, none of this is surprising. Didi’s smothering by China’s government — after delisting Didi’s app, among other penalties, domestic rivals are raising money from state-owned capital pools — came after the company warned investors that the VIE structure it used to list in the United States was a risk.
As TechCrunch noted after Didi went public in the U.S., only to run into a buzzsaw of government pique back at home, “Chinese cybersecurity probe validates Didi’s pre-IPO warning to investors.”
Recall that Didi’s F-1 listing included notes on the VIE structure and its risky status. Per that filing (emphasis added):
Part of the Group’s business is conducted through the VIEs of the Group, of which the Company is the ultimate primary beneficiary. The Company has concluded that (i) the ownership structure of the VIEs is not in violation of any existing PRC law or regulation in any material respect; and (ii) each of the VIE Contractual Agreements is valid, legally binding and enforceable to each party of such agreements and will not result in any violation of PRC laws or regulations currently in effect. However, uncertainties in the PRC legal system could cause the relevant regulatory authorities to find the current VIE Contractual Agreements and business to be in violation of any existing or future PRC laws or regulations.
Yep.
More broadly, China’s decoupling with the world is deepening. China is doubling down on domestic propaganda film production over allowing Hollywood creations to enter its market, to pick an example. Another is the smothering of free expression in Hong Kong. If that’s the level of control at play, why the gray-area-at-best VIE model would be allowed to persist is hard to argue. Thus, its anticipated demise is an utter non-shock.
For Chinese companies, it’s not great news. Closing markets limits capital access and lowers competition among exchanges for business. Less competition leads to worse pricing, and so forth. If the VIE ban passes, all technology investments in China will have to list domestically, or perhaps in Hong Kong, where there may be a VIE exception; that’s a far smaller pool of places to sell stock than they previously had access to.
I’ve been surprised that the Chinese venture capital market has stayed as strong as it has given the crackdown, but perhaps the elimination of a key liquidity channel will have the impact that we’ve long anticipated. After all, not being able to list on the Nasdaq means that a huge investor base is no longer on supply. That means, we presume, lower prices for Chinese tech shares, and more state control of ownership and investment. Hardly a recipe for strong multiples and unfettered innovation.