Chinese listing rules are under review. Here’s what investors should know

Samir Mehta, senior fund manager of Pendal Asian Share Fund

China’s authorities are re-examining rules around Chinese companies listing outside the country’s stock exchanges. Samir Mehta (pictured) – portfolio manager of Pendal Asian Share Fund – explains what it means for investors

CHINA is reviewing the rules that govern its companies listing on foreign stock exhanges. What does this mean for investors?

Before we consider this, it’s useful to understand three cross-currents affecting Chinese technology businesses and stocks:

1. Regime change under President Xi

The Chinese leader has articulated more forcefully than most that the Chinese Communist Party (CCP) is supreme. Jack Ma found this out to his detriment when he made a speech in which he was critical of regulators. It is acknowledged off the record by people in the know that a large shareholding in Ant Financial is owned by the Shanghai faction (those considered close to ex-President Jiang Zemin – a political rival of the current administration).

2. A clear ideological battle-line drawn under President Trump’s administration in 2018

I do not think this is a clear-cut ideological contest between capitalism (the US) and communism (China). The CCP is a Marxist-Leninist party which uses the tools of capitalism effectively. This ideological divide is more about superpower rivalry, and we happen to have a label attached to it.

3. Data is the real source of the current predicament for governments

The collection, use and security of data are now arranged around national boundaries. Any industry considered a national priority or subject to national security is now wrapped in data nationalism. Accounting oversight for US-listed securities (rightfully demanded by US Congress through the Public Company Accounting Oversight Board) flies in the face of data nationalism.

China reviews foreign listing rules

Chinese authorities are currently re-examining rules around listing outside China’s stock exchanges.

“Once amended, the rules would require firm structures using the Variable Interest Company (VIE) model to seek approval before going public in Hong Kong or the US,” Bloomberg reported recently.

The VIE model was pioneered by Chinese Internet company Sina Corporation in 2001 as a means to list its shares on the New York Stock Exchange in 2001. It set the stage for a flood of IPOs and capital raisings by Chinese companies in US capital markets.

Scroll down for an explanation of the VIE model.

Since 2018 I have considered any Chinese ADRs as risky for exactly this eventuality.

Hence, in the past two-and-a-half years, I have chosen to own stocks listed either on the Hong Kong or the Shanghai/Shenzhen stock exchanges.

I have a large underweight position in China, partly due to valuations, partly because of increased regulatory risks and partly on account of the tightening macro environment.

Following recent events I have to wait and judge whether Hong Kong-listed firms are likely to be dealt with as heavy-handedly as any US-listed Chinese stocks.

Pendal named 2020 Fund Manager of the Year in Zenith Awards.

Rationally speaking that should not be the case. The Chinese mainland now completely controls Hong Kong – but geopolitics and national security concerns can trump rationality.

The other big risk revolves around data and business models.

In the US technology behemoths operate in loosely defined spheres of influence (Facebook vs Amazon vs Microsoft vs Google). That is not the case in China.

Every large company and upstart challenger wants to encroach upon and compete against incumbents, using not just data but aggressive cash burn and sometimes harsh competitive tactics (monopolising users or suppliers via threats).

Moats matter

This requires a return to first principles – to understand what is the genuine competitive moat for a business.

And we need to analyse whether that moat is now threatened by Chinese government’s imposition of national security priorities. This is not going to be easy.

My fortune in positioning the portfolio with a large underweight in China allows me some breathing space. Markets by definition are fickle and move from euphoria to panic, as we currently observe.

I welcome that wholeheartedly. Consternation concentrates the mind.

Learn more: what is a Variable Interest Company (VIE)?

China’s Sina Corporation pioneered the concept of the Variable Interest Company (VIE) as a means to list its shares on the New York Stock Exchange.

The first Chinese internet company to do so in 2001, Sina set the stage for a flood of IPOs and capital raisings by Chinese companies from US capital markets.

It was an ingenious legal “contract”.

“It enabled Chinese companies to sidestep restrictions on foreign investment in sensitive sectors including the Internet industry,” Bloomberg columnist Matt Levine commented earlier this month.

“The structure allows a Chinese firm to transfer profits to an offshore entity – registered in places like the Cayman Islands or the British Virgin Islands – with shares that foreign investors can then own.”

Those were the heady days of globalisation, marked by China’s entry into the World Trade Organization (WTO). The internet was in its infancy while Asian economies were struggling from the aftermath of the financial crisis of 1997-98.

As that decade progressed, one catchphrase became increasingly popular: “economic decoupling”.

Most economic forecasters and market participants (myself included) hoped for or predicted the imminent cutting of the umbilical cord that joined Asia to the West. That moment of decoupling is upon us, although the contours are vastly different from what we envisaged.

Churchill’s characterisation of the Soviet Union in October 1939 as “a riddle wrapped in a mystery inside an enigma” is an apt description of the VIE structure.

Again quoting Matt Levine at Bloomberg (everyone should read his work):

“I have a soft spot for Chinese VIEs. The idea is that, under Chinese law, it is somewhere between “complicated” and “forbidden” for foreigners to own certain big important Chinese tech companies. This is a problem for those companies if they want to raise capital from foreign investors and list their stocks on foreign stock exchanges. But there is a solution. Ownership of a company is a complicated notion, a vague jumble of rights to elect directors, approve mergers, and claim a residual interest in the company’s cash flows. You could break those things up and sell them separately.

“Write a profit-sharing contract that says: ‘A will pay B all of A’s profits after expenses for the next 100 years, renewable at B’s option,’ and hey that’s a residual claim on cash flows. (Or something more vague: ‘A will pay B an annual consulting fee that B decides in its total discretion based on the economic value of the relationship,’ etc. Not technically a residual claim but what else is it?). ‘B will provide management services to A and A will follow B’s instructions,” hey that’s basically control. ‘B will have the right to appoint a majority of A’s board of directors,’ put it in a contract, it’s not actually stock ownership. Etc. Write some contracts that, bundled together, look like ownership, but aren’t ownership.

“With Chinese companies, this sort of thing is generally called a ‘variable interest entity’. You set up a company in the Cayman Islands that can be owned by anyone. The Caymans company enters into a series of contracts with the local Chinese company, giving it, not ownership, but certain carefully curated economic interests and control rights over the Chinese company. Then you list the Caymans company in the US, and people buy its stock, and they sort of pretend that they’re buying stock in the Chinese company — they sort of pretend that the Chinese company is a subsidiary of the Caymans holding company — even though really they’re only buying an empty shell that has certain contractual relationships with the Chinese company.”

About Samir Mehta and Pendal Asian Share Fund

Samir manages Penda’s Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

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About Pendal Group

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