The fiasco surrounding the IPO of the Chinese ride-hailing service Didi is a warning signal: Beijing is taking increasingly tough action against capital outflows from the People's Republic. This is a red flag for investors in Chinese internet giants such as Alibaba, Tencent and Baidu.
Bright-orange splotches appear on Gila monsters when they want to show that they can spew poison if predators mess with them. Male dogs hump females. And when Chinese companies make billions in portable, hard currency by listing overseas, as Didi Global Inc. (DIDI) did in its IPO on June 30, Chinese regulators flex their muscles.
The wishful among the investment community see this as a one-off. It is a tectonic shift.
China’s July 4 order to halt new downloads of the Didi app on the excuse that user data security was being compromised tanked the new listing and led to comments by Chinese officials about how companies really need to get their approval before an IPO.
The «Wall Street Journal» explained the move as a way of fixing a lack of inter-agency coordination, claiming that China’s data watchdog is miffed that it could not stop an IPO. That does not add up: the IPO in no way made the data vulnerable to American snooping. The issue here is not data but power.
One need only to look back to 2017, as the wrath of the central government came down on private conglomerates like the Dalian Wanda Group, Anbang Insurance, and HNA Group, all of which had committed the cardinal sin of buying offshore assets with their cash. China had grown preoccupied with regulatory capture of privately controlled assets that are held in hard currency rather than in the Monopoly money that is the Chinese Renminbi. Beijing promptly dismantled the vast empires held by these companies - including Wanda’s controlling share of AMC, HNA’s stake in Hilton, Anbang’s 15 U.S. hotels - and engineered the sale of many of the assets to military-controlled companies
While the key motivation is control, there is also an element of tit-for-tat. After many years of acceding to Chinese belligerence on issues like Taiwan, Falun Gong, and the jailing of Liu Xiaobo, Western nations have begun to voice objections. There have been successive U.S. bans on purchasing from Chinese companies suspected of being connected with the military. There was the Holding Foreign Companies Accountable Act, enacted last December, which implicitly targets Chinese companies listed in the United States for delisting. In March, there were sanctions on Chinese officials for human rights abuses in Xinjiang - measures against which Beijing immediately retaliated. In June, President Biden issued an executive order banning investments in 59 entities. China has struck back with a number of measures, the most recent being the «Anti-Foreign Sanctions Law,» which tries to keep companies from following the laws of their own countries.
The next step in the muscle-flexing exercise will be to curtail the use of Variable Interest Entities (VIEs).
The most valuable portions of China’s Internet, such as search algorithms, news reporting, and video rights, are by law owned by Chinese nationals. Public-market investors participate in the companies’ profit by proxy: they own offshore holding companies - VIEs - that have contractual rights to profit streams from the onshore businesses. But the contracts are legally iffy.
Directionally, it is clear that the VIE goose is cooked. In 2015, a new Foreign Investment Law made ownership synonymous with control. This was the equivalent of putting a lobster in a pot of cold water and starting the flame. Now authorities say they need to approve Chinese companies for IPOs even when the companies are VIEs established in tax havens.
Because of the go-go years in public markets, many have conveniently forgotten about 1998. That was the year when the telecom company Unicom decided to list in Hong Kong. Because foreign ownership was not permitted in telecoms, Unicom developed a work-around called «Chinese-Chinese-Foreign» or «CCF,» which mirrored the current VIE structure of the Internet. Companies like Siemens and Bell South would nominate employees to be the titular owners of fully domestic companies, which would joint venture with China Unicom. The domestic nominee companies, via contract, conveyed some of the economic benefit of the joint venture to the foreign telco.
In summer of 1998, all this changed. Premier Zhu - who had previously publicly praised the arrangement - signed a decree requiring that all the foreign partners exit the trilateral arrangements and the joint ventures be unwound.
International companies had firmly believed in China’s intention to «reform and open» its telecom sector and believed that the CCF arrangements were the start of a process. It turned out that the ventures in the end were mechanisms through which to capture needed capital and technology. Once that goal had been accomplished, the foreign ownership by proxy was ruled illegal.
This is likely to be ultimately the fate of Chinese VIEs in general and the Internet companies in particular.
There is still a way to make money from the rich valuations that are still being awarded to Chinese companies: let them buy you. In that regard, the Didi case is instructive: the real winner is Uber.
Squeezed out of China by dozens of discriminatory rules, Uber threw in the towel and sold its business to Didi in 2016 for $7 bln and a 12.8% stake. Even with the share decline, that should be worth around $7.4 bln. That is more than two-thirds of Uber’s total 2020 revenue. That’s an easier way to make a living than humping rides.
Selling to over-valued Chinese companies turns out to be the smart move. Whether Yahoo and Alibaba, Walmart and JD.com, or Tesla and Tencent, the easier path than building a Chinese business is to sell to a Chinese company for shares. Who even remembers Yahoo? Here’s a bet: Tesla will sell its troubled Chinese operations to a Chinese grandee for shares.
But as for investing in listed Chinese companies, after the continuing house arrest of China’s most visible and successful billionaire, Jack Ma, founder of the company with the biggest IPO in history, one wonders what it will take for the U.S. market to understand that Chinese companies are simply not investable.
Deng Xiaoping cautioned that flies would come in through China’s «open door,» so the door has been carefully watched, cracked open when it suits and shut more tightly when undesirables pass through. Currently, China’s door is closing to inbound traffic - Internet content and other forms of media, other channels of cultural influence, many kinds of inbound travelers, and many imports. In this regard, Covid-19 was a boon to regulators looking for an excuse to limit who comes into China. For capital, the inbound door remains wide open, but the way out is increasingly shut. Policies around IPO approval, VIEs, Internet control, anti-monopoly regulation, and investment policy have everything to do with capturing and holding onto hard currency.
Thus, in the waning days of the Chinese growth story, the deepest motivation behind China’s reform agenda is revealed as very simple: capturing dollars and then leveraging up foreign reserves by printing up a massive money supply in RMB. And directing a portion of the dollars, of course, into leadership pockets.