The Risky Business of Investing in Chinese Tech Firms

Jesse Fried is Dane Professor of Law at Harvard Law School and Matthew Schoenfeld is a Portfolio Manager at Burford Capital. This post was authored by Professor Fried and Mr. Schoenfeld.

While Washington and Beijing battle over trade, a worrisome cross-border financial link has largely escaped scrutiny: Americans now collectively own most of the public equity of China’ biggest tech companies, including Alibaba, Baidu and Weibo. This relationship is strange (imagine if the Chinese owned most of Amazon, Facebook and Google). It’s also extremely risky, at least for American investors.

China’s tech darlings began tapping U.S. investors in the early 2000s, when mainland capital markets were unsophisticated and the strict profitability requirements of PRC exchanges shut out most fast-growing tech firms. To list in Shanghai, for example, a firm had to show three years of profitability. Nor was Hong Kong a viable option, as until recently it banned the use of dual-class structures favored by tech entrepreneurs. So off to New York went Baidu, JD.com, Alibaba, and dozens of other Chinese unicorns and near-unicorns thirsty for growth capital. There, they found Americans eager for exposure to China and its explosive growth. With few alternative China pure plays, investors jumped at the opportunity to invest in these Chinese tech firms’ IPOs.

The corporate structures that emerged from these IPOs were technically proscribed by the PRC’s tough laws restricting foreign investment in the internet sector. But Beijing turned a blind eye because funding this critical industry domestically was fraught with risks. Unlike in the U.S., China’s stock market is dominated by retail investors. Cash-burning startups in hypergrowth mode are harder to value—even for sophisticated, institutional investors—than mature ones. They are therefore more vulnerable to violent price swings. Instability is dangerous for autocrats, especially in a country without a sturdy social safety net.

The relationship seemed like a win-win: U.S. investors got to own fast-growing companies, while China obtained funding for its young tech companies without destabilizing manias and panics. But the symbiosis began to break down as these hypergrowth companies matured. American investors became dispensable, and thus vulnerable to expropriation.

It started around 2014 with a wave of confiscatory “take private” transactions led by Chinese controlling shareholders. The objective was to delist U.S. shares at low buyout prices and later relist them in China at a much higher valuation.

Consider the July 2016 take-private of Qihoo 360, an internet security firm. The founders squeezed out U.S. shareholders at $77 a share, reflecting a value of $9.3 billion. Confidential fundraising materials for the privatization trumpeted a return of up to 500% by 2019, but this ultimately proved conservative: The company relisted ahead of schedule in February 2018 at a valuation north of $60 billion, yielding a 550% return. Qihoo’s chairman personally made $12 billion upon relisting, more than he claimed the entire company was worth 18 months earlier.

Public investors in a firm with a controlling shareholder always face the risk of an unfair take-private. But investors in U.S.-listed Chinese companies are particularly vulnerable. Most incorporate in the Cayman Islands. This jurisdiction affords investors much less protection than Delaware, home to most U.S. companies. And Cayman and U.S. judgments are not enforceable in the PRC, the location of these Chinese firm’s assets, records, and insiders. Chinese controllers can thus squeeze out the minority on terms that would make American controllers blush.

In Cayman-domiciled Qihoo, for example, only 21% of minority shareholder voted in favor of the July 2016 take-private. In Delaware, such a take-private would have triggered entire fairness review, requiring insiders to prove that both the process and price were fair. Cayman does not have this type of judicial review, so Qihoo’s Chairman and President, who together controlled 61% of voting power, were free to ram the deal down shareholders’ throats and then reap a windfall profit.

More than 60 U.S.-listed Chinese companies, most Cayman-incorporated, have been taken private since 2013.

Investors in large-caps like Alibaba and Baidu have felt safe from this type of expropriation because the companies seemed too big to be taken private. But China’s regulatory apparatus started taking an ax to the tech behemoths this year, sending their share prices into free-fall.

Alibaba’s burgeoning e-payment business has been stifled by a series of curbs. NetEase, an e-gaming company, has been subject to a freeze on government approval of new games. Search giant Baidu has been probed unrelentingly over “subversive” content. All told, the four largest U.S.-listed Chinese tech firms—these three plus JD.com—have lost more than $125 billion in market capitalization, about 20% of their value, since March 30.

It is unlikely regulators would be as aggressive if Chinese retail investors, rather than Americans, were holding the bag. In fact, Beijing may be deliberately tanking these companies’ shares to pave the way for Chinese investors to acquire interests at lower prices.

It’s no secret that Beijing remains focused on bringing its largest crown jewels home. In March the Chinese Security Regulatory Commission unveiled a pilot plan to encourage overseas-listed Chinese companies valued at more than 200 billion yuan ($31.9 billion) to float shares in China while remaining listed overseas.

The Big Four qualify. But to date none has participated in the pilot program. Beijing may be waiting for their stock prices to fall further to ensure that the retail investors who buy newly floated shares are protected from further losses. Once local investors have bought into Alibaba and its peers on the cheap, Beijing may relieve the regulatory pressure.

Thus, American investors are essentially forced to pick their poison; if they hold shares in anything but the largest Chinese firms they risk being pushed out for pennies on the dollar in a Cayman go-private. But if they own the crown jewels like Alibaba and Baidu, they may face death by a thousand cuts as China’s regulators take aim.

Despite the warning signs, American investors continue lining up for Chinese initial public offerings. In fact, Chinese companies raised more than $8.5 billion in U.S. markets in 2018, the most since 2014. Among the most recent debuts: In December 2018, Tencent Music Entertainment went public in the U.S., raising about $1 billion at a valuation exceeding $20 billion. Let’s hope investors have priced in all of the risks.

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One Comment

  1. reader
    Posted Monday, February 4, 2019 at 10:48 am | Permalink

    Clear eyed piece on an important topic.

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