International exposure is key to building a well-diversified portfolio, but foreign companies can pose problems you wouldn’t find in the United States. Take, for example, a common solution to foreign ownership bans on China-based companies: the variable interest entity (VIE).

Chinese e-commerce company Alibaba is preparing for an initial public offering on the New York Stock Exchange. Alibaba’s sheer size (a total value estimated at more than $200 billion) has drawn a lot of investor attention, but some of that attention comes in the form of concern. Alibaba uses the VIE structure, and a recent article in The Wall Street Journal reported that a US government commission found that US investors face “great risks” if they buy shares of companies structured this way. (1)

Lives are not new. Chinese Internet companies began using this structure in 2000 as a solution to Chinese restrictions that prohibit foreigners from investing in certain sectors, including telecommunications. To avoid breaking the rules, non-Chinese investors own an overseas listed business entity, which owns a subsidiary located in China. The Chinese subsidiary then owns one or more nationally licensed companies, which are VIEs. In Alibaba’s case, US investors will buy shares in a Cayman Islands entity called Alibaba Group Holding Limited. This entity will have a contractual right to the profits of the Chinese company, but will not own the assets of the company.

While this structure has been maintained up to now, the risks identified by the commission are not negligible. Because the company’s ownership is indirect, foreign investors must rely solely on contractual agreements to ensure they retain the economic benefits of ownership in the China-based company. These contracts would have to be enforced through the Chinese legal system in cases where shareholders believed their rights had been violated, a process that has historically been difficult for outsiders.

Even with these contracts in place, foreign investors have relatively little control. For example, in 2011, the Chinese entity Alibaba overruled the objections of Yahoo Inc., a large shareholder in the offshore entity, and divided up the assets of a payments unit to bring them under the control of the company’s founder, Jack Ma. Alibaba said the transaction was necessary to ensure China’s central bank would allow the payment unit to continue operating and ultimately reached an agreement with its shareholders, The Wall Street Journal reported. (2) While some investors view the VIE structure as the cost of doing business in China, the lack of control it implies calls for caution.

Still, investors run a similar risk with shares of US companies that have a majority shareholder, whether or not they are the founding shareholder. Investors sometimes decide that being at the mercy of the majority shareholder is a price they are willing to pay to invest in a certain company. Some private equity firms, including The Carlyle Group, KKR, and The Blackstone Group, have also gone public through a limited partnership structure, where investors receive a portion of the proceeds but remain at the mercy of the general partner as to business decisions. That being said, choosing to buy a company with limited control in the United States comes with a number of rules and regulations designed to protect minority investors. While these are not bulletproof, they do offer some reassurance. Investing in Alibaba or another VIE-structured Chinese company means relinquishing not only control, but also transparency.

Perhaps most worryingly, the Chinese authorities have never formally confirmed that the VIEs are legally valid. If the Chinese government sees fit to challenge the legitimacy of companies using VIEs, there is little a foreign investor could do. While China has a vested economic interest in preserving companies as big as Alibaba, investors are relying on the Chinese government’s self-interest without a legal safety net. Some observers have warned that Chinese legal precedent suggests that VIEs may fall if challenged.

This is not to say that investors should always avoid companies structured as VIEs at all times and in all circumstances. Asia-focused equity mutual funds, as part of a well-diversified equity portfolio, can provide diversified exposure to thousands of different companies, we can live with less exposure to investments in VIE structured companies like Alibaba.

But watch your exposure to shares of Chinese companies, regardless of how they are structured. There are reasons to be wary of the risks of investing in a place that doesn’t always uphold the rule of law or corporate governance principles we take for granted in the United States. The investor-hostile structure of the VIE is yet another reason to proceed with caution.

Sources:

1) The Wall Street Journal, “US Report Casts Doubt on Legal Structure of Alibaba and Other Chinese Firms”

2) The Wall Street Journal, “Alibaba founder’s recent deals raise flags”