China's internet

Jordan McNamee's picture

Over the last 10 years, there are few companies in the world that have been as successful as Alibaba. Now commanding about 80% share of the Chinese e-commerce market, trading at under 20 times 2017 free cash flow (FCF) and growing at over 30% a year, it’s hard not to want to own such a fantastic business for what seems to be a reasonable price. Naturally you would ask yourself why such a dominant company, growing at this rate, is so cheap.

Some may say it is because of the fear of the Chinese economy rolling over or its main competitor, JD.com, incrementally stealing share from them over time by differentiating on logistics. Although both of these arguments could have merit, the most fundamental reason as to why we will likely never be shareholders is because of corporate governance and regulatory risk.

Corporate governance

Chinese internet companies that trade under U.S. listings are structured under something called a variable interest entity (VIE). In China, foreign investors are not allowed to own media companies, thus the only way you can own Alibaba in through this VIE structure. Under this structure foreign investors own a subsidiary. The subsidiary has an agreement with the owners of the Chinese media company (Jack Ma and Simon Xie) which funnels all profits of the media company to the foreign subsidiary in exchange for “technology services”.  It also receives options in the Chinese media company in exchange for a loan that is never drawn on. Synthetically, this gives foreign investors equity upside from the options and the cash flow of the business from the technology services contract. 
 
This structure is a grey market; it is not legal or illegal but has been the loophole that has allowed Chinese internet companies to raise foreign capital.

China has a lot of ownership rules that have already impacted Alibaba. In 2011, Alibaba divested Alipay to Jack Ma due to obscure new regulations requiring non-bank payment companies to obtain a special license to operate in China. Foreign investor-owned companies are unable to receive this license so a new structure was formed where Alibaba received 37.5% of Ant Financial (Alipay Parent) income or would receive 33% equity from Ant Financial when it decided to go public, if regulations permitted. The fact is, as an Alibaba shareholder, you don’t own Ant Financial but you might in the future if the government decides its ok.

As you can see the ownership structures are very complex and changing. The Chinese government is also looking into placing government officials on the board of every internet company so that they have closer ties with the country’s most powerful companies. This creates a lot of uncertainty as to what you own as a foreign shareholder or how the ownership structures can change in a short amount of time.

Jack Ma conflicts

Jack Ma, the visionary entrepreneur behind Alibaba, owns 7.8% of the company making his stake worth about $16 billion. He also owns 40% in the YunFeng Fund which is essentially his personal family office. This fund has co-invested in companies such as Alibaba Health, Ele.me and YTO express, all investments that Alibaba has also invested in. Alibaba covers the conflict by citing that Jack will donate all distributions from the fund to Alibaba charitable organizations. But why would Alibaba not just take that ownership so that Alibaba holders get the economic benefit of the investment? Sometimes it is because of regulatory issues where foreigners can’t own a majority of a specific type of company, other times there is no reasonable explanation.

Foreign shareholders of Alibaba could end up doing very well, and by no means are we saying to short Alibaba. Given the conflicts apparent throughout the corporate structure and potential for further Chinese government intervention, we choose not to be there. When we allocate capital for clients, we want to be owners of a business where management has interest aligned with our own and that does not exist within Chinese internet companies. Chinese internet foreign investors will always be treated as second class citizens.

Comments

Submitted by Harrison Schaefer on

Great summary. Especially good timing one week after the Economist publishes a glowing article of China's emerging net-giants! Caveat emptor of course...

Submitted by Sherry Cavallin on

Very interesting and a good reminder of "don't try this at home"!! Great having your expertise and diligence.

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