The Chinese Corporate Structure That Terrifies American Investors

A major part of successful long-term investing is eliminating risk. The stock market has historically been one of the best-performing asset classes, but it is also one of the riskiest. No matter how stable a company is, economic declines, market shifts and even corporate malfeasance can be difficult to predict.

Investors that owned shares in American International Group (ticker: AIG) or Citigroup (C) prior to the housing crisis probably thought those blue-chip companies were relatively safe investments. In reality, every stock comes with its own unique set of risks.

For many top Chinese companies, one possible source of risk involves their unique corporate structure. U.S.-listed Chinese internet companies such as search giant Baidu (BIDU) and e-commerce giant Alibaba Group Holding (BABA) utilize a corporate structure called a variable interest entity.

Certain Chinese industries are heavily-regulated. Among the restrictions on these industries are limits on how much of the company can be owned by foreign investors. Chinese companies like Alibaba and Baidu list their stocks in the U.S. to tap the massive U.S. capital markets.

To get around foreign ownership restrictions, the companies establish intermediate companies registered outside of China. For example, Alibaba set up its VIE in the Cayman Islands, outside of the Chinese government’s jurisdiction. Once the VIE is established, the Chinese company and the VIE establish a contractual relationship in which the VIE received the profits from the Chinese company and its assets. In other words, the VIE has a contractual right to the Chinese company’s profits, but not the company itself or its assets.

While certain Chinese companies can’t list on U.S. stock exchanges directly, they can certainly list their VIEs. When American investors by shares of ticker BABA on the New York Stock Exchange, they are investing in Alibaba’s VIE, not the Chinese company itself.

On the surface, there’s nothing inherently nefarious about the VIE structure. It has been used by Chinese companies since SINA Corp. (SINA) went public in the U.S. back in 2000. However, there are important aspects of investing in a VIE that may trouble investors looking to mitigate risk.

First, since U.S. investors are not directly invested in the Chinese companies themselves, they have no voting rights or direct legal recourse against the companies. For example, Alibaba founder and principle owner Jack Ma is the one calling the shots. If Ma wants to turn Alibaba into a VHS rental company, U.S. shareholders can’t vote him out of power or sue him.

Second, the VIE structure was specifically created to circumvent Chinese laws. So far, that fact hasn’t been an issue, but legal loopholes are always at risk of being closed. If the Chinese government decides to ban the use of VIEs, there’s not much American investors could do about it.

Of course, if the Chinese government chose to ban VIEs, it would be devastating to Alibaba, Baidu and other companies that want access to U.S. investment capital. According to Convergex Group chief market strategist Nicholas Colas, such a ban would likely keep Americans from ever investing in Chinese companies again.

“While it may seem risky, keep in mind that Chinese companies do want to maintain their access to U.S. capital markets,” Colas says. “Arbitrarily changing the VIE structure in a way that hurts U.S. investors would end that access.”

It’s in China’s best interest to keep U.S. investors happy if its companies want to keep tapping the U.S. capital markets in the future. Today, Alibaba and Baidu have massive $237 billion and $59 billion market caps, respectively. Neither company has had any issues thus far with the VIE structure.

JJ Kinahan, managing director of client advocacy and market structure for TD Ameritrade, says the contractual and regulatory risks associated with established companies like Alibaba and Baidu are relatively low.

However, the VIE structure isn’t the only risk Americans face when buying Chinese stocks. Kinahan says it’s difficult enough for U.S. investors to understand the balance sheets and financial disclosures of many American companies, let alone Chinese ones.

“It is difficult for many people to understand how the companies in the U.S. make money,” Kinahan says. “This is an even more pronounced risk when dealing with a foreign entity, especially in a country where the government may influence what information is fully shared.”

Unfortunately for VIE investors, Americans’ skepticism may be having a subtle impact on the valuations of these stocks.

Since its record-breaking initial public offering in 2014, Alibaba has repeatedly been compared to (AMZN). While there are countless distinctions that can be drawn between the two companies, their core e-commerce businesses and focus on cloud computing make them reasonable analogs.

In the past four quarters, Alibaba has delivered year-over-year revenue growth in the 33 to 48 percent range, while Amazon’s revenue growth has been in the 22 to 31 percent range. Both growth rates are impressive, but Alibaba’s stock currently trades at a significant discount to Amazon’s in terms of both forward price-to-earnings ratio and price-to-free-cash flow.

“I think it makes sense for investors in these types of companies to realize that they’re not getting nearly the same transparency as they would from a large U.S.-based corporation,” Ritholtz Wealth Management portfolio manager Ben Carlson says. “That’s not to say that there is definitely something shady going on, but I wouldn’t feel as secure with the financials or accounting techniques.”

The valuation lag among many of these VIE stocks may simply be…

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