Fairy Dust and Chinese Stocks
I think it would be interesting to put together a derivative contract that mimics the performance of certain small businesses in certain cities across the United States and let’s investors buy the instrument/vehicle/contract but never ever have ownership in the businesses themselves. This is exactly what happens when you buy stocks in Chinese listed companies.
Under Chinese law, it is illegal for foreigners to own certain big important Chinese tech companies. Almost every listed Chinese company investors can buy outside of China is through a structure called VIE — Variable Interest Entity. It’s like a derivative contract with zero real ownership in the company.
Here’s how it works. A company like Didi Global sets up a company in the Cayman Islands that can be owned by anyone. This company enters into a series of contracts with the local Chinese company, giving it certain carefully curated economic interests and control rights over the Chinese company, not real ownership. Then you list the company on the Nasdaq or NYSE and people buy its stock, most not knowing that they have no rights at all in the actual company. The company is more or less an empty shell with a loose contract.
So, fairy dust…
Of course, the fairy dust could be worth more and more as the company grows. Even in the United States, owning public equities doesn’t mean a damn thing unless you have a controlling interest. China would never allow anyone that level of control. With that in mind, there are more than 240 Chinese companies listed on US exchanges with a total market cap exceeding $2 trillion (USD) and most of these companies are tied to contracts held in shell companies in the Cayman Islands.
Do you see a problem?
Of course, there are plenty of big name investors that love these VIE’s. Charlie Munger and Monish Pabrai both hold a lot of Alibaba (BABA) and Chase Coleman’s Tiger Global Management has over 7% of their portfolio in JD.com (JD), which is perfectly fine as long as there isn’t corporate fraud or even just legal slight of hand that would be detrimental to the shareholders. This is the reason why so many Chinese stocks in the same space and generating similar revenue and profit as American based stocks sell for discounts in the market.
Know the risks…
The VIE stocks could go zero while the underlying real business remains fine. I don’t think that would happen since China would have to screw over a lot of people globally to stomach that; however, the SEC is now requiring certain disclosures to be made on IPO docs. The structure is illegal under Chinese law, which has not stopped companies from using it thus far. China is a communist capitalist country where property is allowed to be privately owned; however, if history is any indicator, how long that will last is anyone’s guess.
