In a previous article, I took a look at the standard holding structure for U.S.-listed Chinese companies, and noted the benefit of having multiple layers of intermediary shell companies located in tax havens such as the Cayman Islands and Hong Kong.
The inevitable "but..."
That doesn't mean you should assume that all complicated Chinese corporate structures benefit U.S. shareholders. Today's article looks at the seedy, gray underside of these complicated holding structures.
Let's look at China Wind Systems' (Nasdaq: CWS ) organization. The red font is my additional explanation, while the black font comes from company filings:
Source: Company filings. WFOE = wholly foreign-owned enterprise.
A quick reminder – these corporate entities are the business equivalent of Russian nesting dolls. The "China Wind Systems" entity is just a wrapper for the "Fulland" entity, which is itself just a wrapper for the "Green Power Environment Technology" entity, which, again, is just an empty shell filled by the "Huayang" entities at the very bottom. These Huayang companies are the actual operational businesses, and we speak of their financial results when we refer to China Wind Systems.
Between China Wind Systems, Fulland, and Green Power Environment Technology, there is 100% equity ownership, which means the shareholders of China Wind Systems also own both subsidiary entities.
So close, yet so far
But that's as far as your ownership stake takes you. The grayed-out arrow between Green Power Environment Technology and the Huayang companies and the words "Contractual arrangements" next to it mean that, among other things, equity ownership for U.S. shareholders does not extend all the way down to the operational companies.
Let me repeat that, just in case you didn't follow: As a shareholder of China Wind Systems, you do not own the actual operating company! Instead, you own contracts that stipulate, in their words: "the right to appoint senior executives of the Huayang Companies ... The Huayang Companies, in return, agrees to pledge their accounts receivable and all of their assets to Green Power."
The contractual arrangement is designed to mimic equity ownership. That's why, when you look at China Wind Systems' financial statements, you see the operational results of the Huayang entities, even though you don't own them directly.
Wait! Don't sell all your shares yet!
I can imagine that a few of my readers have already muttered profanities by now, but the situation is more complicated than "All Chinese companies are frauds!" I only singled out China Wind Systems because its holding structure was relatively easy to decipher. These contractual arrangements are much more common than most investors may realize. Look at Baidu (Nasdaq: BIDU ) :
The dotted lines between Baidu Online Network Technology, Beijing Baidu Netcom Science and Technology, Robin Yanhong Li, and Eric Yong Xu all indicate some sort of contractual agreement intended to mimic equity ownership. And if you thought Wall Street would run screaming from this tenuous arrangement, you'd be wrong.
Baidu has at least 19 analysts covering the stock, and shares of the Cayman Islands holding company are up almost 1,400% in the past five years! Argue all you want about valuation and fraud-this fraud-that, but I'll take a 14-bagger any day.
So is the coast clear?
I wouldn't be writing this article if I didn't think there were any risks to this arrangement. First of all, nobody, not the shareholder or the company's management, truly benefits from these types of arrangements. On the whole, while the situation can seem very sketchy, I don't believe that most Chinese management teams intentionally structure their companies in this way in the hope of one day severing those contractual ties with little more than an "oops." The Dada Portfolio wouldn't have purchased China Yida (Nasdaq: CNYD ) if I did, since they, too, have only contractual arrangements with a key operating subsidiary.
In truth, most of these arrangements are created out of necessity. As I mentioned in my last article, the Chinese government regulates business entities differently based on their ownership structure. PRC (People's Republic of China) corporate entities that are wholly owned by foreign companies (WFOEs) are governed and subjected to different do's and don'ts compared to corporate entities that are entirely domestically owned. For one thing, foreign investment in Internet and online advertising businesses is entirely forbidden!
Thus, a wholly owned foreign enterprise with direct equity ownership that reached all the way up to U.S. shareholders would not be able to operate a search engine, especially not a profitable one that derives revenue from online ads. Baidu couldn't exist any other way! Similar restrictions exist for many other industries, particularly in the technology sector, which is why the preponderance of these contractual arrangements apply to Internet or IT companies.
Intentions aside, these are clearly gray-zone loopholes. Baidu, China Wind Systems, and many others clearly state in their risks sections: "PRC laws and regulations governing our businesses and the validity of certain of our contractual arrangements are uncertain." And that's not just an obligatory disclosure.
Late last year, NetEase.com (Nasdaq: NTES ) , the Beijing-based video game company that operates the Chinese version of World of Warcraft, found itself caught between two feuding government departments regarding the legality of its being a U.S.-listed (and thus, U.S.-shareholder-owned) company operating in the highly restricted Internet services and online games industry. As the legitimacy of NetEase's operations came into question, the stock dropped almost 30% on fears that these contractual arrangement loopholes might finally be closed. That said, the company's shares have since bounced back, after China's government decided that the workaround could continue to exist.
And the moral is...
As with most things regarding China, there are no right or wrong answers, no black or white; just shades of gray. That's a huge risk that, understandably, most people don't and shouldn't take on. At the same time, where there's risk, there's opportunity. You don't find 14-baggers by looking where everyone else is looking, and agreeing with what everyone else is saying. Wal-Mart is a great company, but the stock has only grown 11% in five years. That 2% annualized CAGR doesn't even beat U.S. inflation!
With the Dada Portfolio, we don't have any illusion of being great white knights or socially conscious capital allocators. Our goal is honestly quite simple: We want to deliver great returns and have an awesome time doing it. We define risk as the possibility of permanent capital loss, and we control it the only sensible way we know of -- from our wallets. We don't run away from it, but we do demand an appropriate potential upside as compensation for taking it on.
All that said, we very, very strongly believe in investing carefully. If you take nothing else away from this article, please keep this statement from recently IPOed vegetable producer Le Gaga (Nasdaq: GAGA ) in mind:
Your ability to bring an action against us or against our directors and officers, or to enforce a judgment against us or them, will be limited because we are incorporated in the Cayman Islands, because we conduct substantially all of our operations in China and Hong Kong and because all of our directors and officers reside outside of the United States.
Translation: "Hey guys! If something happens and you get screwed, don't expect to be able to do anything about it!" That's a straightforward lesson with relevance beyond Chinese companies alone.