When it comes to investing in China, I've seen a lot of "interesting" corporate structures. Nothing, however, has thrown me off more than recently listed online dating site Jiayuan.com
There's shady, and then there's this
Like a lot of Chinese companies, Jiayuan is organized so that owners of the Nasdaq-listed stock don't actually "have any direct ownership interests or direct voting rights in any of our PRC [mainland China] operating companies."
Because the Chinese government restricts foreign ownership of things like Internet services and online payments businesses, and won't grant foreigners a license to provide online dating services, the listed company simply has contractual arrangements whereby the operating companies in China, which are owned by Jiayuan's Chinese management team, agree to allow the management team at the listed entity to direct the operations at the operating entities and obtain "substantially all" of their economic benefits. (Though "substantially all" -- their words, not mine -- seems to be something less than all.)
If you're thinking this is complicated, confusing, ripe for conflicts of interest, and probably unenforceable in a court of law, you're right.
All of this is quite common, though. Many of China's best-known companies, including Baidu
This is even shadier
In fact, online gaming company GigaMedia
When GigaMedia sought to replace Ji, he effectively absconded with the company, refusing to give up any of the documents that another party would need to operate that business in China. Ji claims GigaMedia has no rights to the documents because the corporate structure they set up, the same general structure used by Jiayuan, Baidu, Sina, et al, is illegal. If the U.S. court agrees with him -- and I believe there's a high likelihood that it will -- then GigaMedia will likely be out of luck in China, and U.S. shareholders in many Chinese companies will have to face the reality that their shares, pending corporate reorganizations, are potentially worthless.
What will this do to valuations? I have no idea. It's unlikely, for example, that Baidu CEO Robin Li would run off with his company simply because he could. There's reputational risk in doing so, and Baidu also seems to enjoy the prestige and access that comes with a U.S. listing. At the very least, however, it's a huge unknown.
Even more uncomfortable
If this situation makes you uncomfortable, know that this isn't the only potential bomb ticking in Jiayuan's corporate structure. The company's registration statement further reveals a contractual relationship in China with a nonprofit entity known alternately as Shanghai Shiji Jiayuan Matchmaking Center or Jiayuan Shanghai Center.
This nonprofit was established by one of Jiayuan's operating subsidiaries and exists because the relevant Shanghai governmental authority refused to allow a for-profit entity to provide "marriage agency services" -- a term that may cover matchmaking, Jiayuan's core business. As a result, Jiayuan Shanghai Center has the license to do the actually matchmaking, and agrees to pay technology license and service fees to Jiayuan's operating subsidiary, which supports it. I guess that these fees amount to almost all of Jiayuan Shanghai Center's revenue, since it's supposed to be a nonprofit.
This seems like a convenient workaround for the company, and it was deemed legal by the company's Chinese legal counsel. But investors still don't know two things. First, how will regulators react when it becomes clear that the company is profiting from a nonprofit service? They could, among other things, fine the company or revoke its operating license -- events both potentially material to the financials and investment case here.
Second, who actually owns the Jiayuan Shanghai Center and its seemingly critical business license, and what are his or her incentives, motivations, and potential conflicts of interest? That information may come to light at some point, but when we talked to company representatives in June, they refused to identify the owner(s). If Jiayuan Shanghai Center walks off with its license, what will happen to Jiayuan?
The global view
Although it doesn't quite take a titanium spine to invest in China, it does require some thinking about how one can get comfortable with the existence of unknown unknowns. We've attacked this problem at Motley Fool Global Gains tactically by recommending investors only invest small amounts in a diversified basket of companies with China exposure, including some multinationals, and by avoiding companies with the most confusing and/or convoluted ownership structures. It seems the biggest China risk of all is whether foreign investors, when push comes to shove, will ever own the right to assets and cash flows in the country.
Jiayuan is a profitable business with a significant market opportunity, but its corporate structure ranks among the most convoluted I've seen. That's why this Fool -- acknowledging that some of my Foolish colleagues disagree -- is staying away.
Is Jiayuan too much risk for you? Let me know in the comments below.