Last week, I outlined real challenges for a very popular IPO. Ride-hailing company DiDi Chuxing (NYSE:DIDI) went public in late June. It had the largest IPO for a Chinese firm since Alibaba Group (NYSE:BABA) a few years ago. But just days after going public, shares fell from the sky. The reason: The China Administration of Cyberspace (CAC), an extended arm of the Chinese government. The CAC banned all smartphone app stores in the country from continuing to offer the DiDi app. Home to 377 million DiDi customers, China will prohibit any new members until a cybersecurity assessment is complete.
Variable Interest Entity
The problem for DiDi – or its investors – is a fundamental one. It is a problem that all Chinese companies listed in the U.S. face. The problem also has a name: Variable Interest Entity or VIE for short. If you haven’t heard of it, you’re in good company.
When a foreign company takes its shares public in the U.S., those shares are first typically deposited with a U.S. bank. Then, they’re traded during U.S. trading hours as American Depositary Receipts, or ADRs, through U.S. broker-dealers. ADRs simplify investing in foreign securities because the depositary bank manages all custody, currency, and local tax matters.
This approach is not the case for Chinese companies listed in the United States. There are no shares that have been deposited as a pledge with a U.S. bank. Investors in Chinese stocks do not buy a stake in a company.
When you buy a share of Alibaba, Tencent, or DiDi, for that matter, you are instead buying a promise of contractual obligations that almost perfectly mimics owning a real share. With just one exception: as the owner of such a promise – you can’t call yourself a shareholder – you have no voting rights. But most private investors – judging by the hustle and bustle at the buffet table – overlook that anyway.
This promise is Variable Interest Entity. So VIEs allow Chinese companies to access foreign capital that would not be available because of government regulations on foreign ownership of specific industries and assets.
What if it’s All Gone?
Now we have seen in the past week that the Chinese government can come up with crazy things. Now, what if it occurred to it, given the legal gray area in which VIEs operate, to just ban them completely? Not just a few billion, but several trillion U.S. dollars of market capitalization in the USA and Europe (where Chinese shares can also in the form of VIEs) would wipe out without further ado.
Is this a foolish thought-experiment? Looking at the escalating Sino-American tensions, I seriously wonder if it will be exactly that in the long run. The recently deceased U.S. Secretary of Defense, Donald Rumsfeld, spoke of the “unknown unknowns” in this context. You should seriously consider whether you want such a risk in your portfolio.