We investigate Chinese firms’ use of variable interest entities (VIEs) to evade Chinese regulation on foreign ownership and list in the U.S. We find that the use of VIEs for such ends is widespread, growing, and associated with valuation discounts of as much as 30 percent relative to Chinese non-VIE firms listed in the U.S. The discount varies predictably with events that change the risk of government intervention and managerial malfeasance, and is tempered by better oversight and lower regulatory risk. To protect shareholders, VIE firms are more likely to have these characteristics as well as to curry government favor by contributing to disaster relief and hiring excess employees.
The government of the People’s Republic of China (China or the PRC) faces a balancing act of limiting foreign control of sensitive sectors of the economy while providing access to foreign capital and expertise. To serve both goals, direct foreign investment is welcomed in some cases, but restricted or even prohibited in a range of areas, including subsectors within industries as varied as news and entertainment, education, manufacturing, medicines, mining, and internet access. However, Chinese firms in restricted industries face a scarcity of domestic capital and expertise that could potentially be mitigated by permitting foreign investment.
As a result, securities lawyers have designed corporate structures using variable interest entities (VIEs) that serve two fundamentally inconsistent functions: (1) satisfying Chinese regulators that the ownership and actual control resides with Chinese nationals while (2) convincing foreign investors that they have ownership and control rights. (Rosier, 2014). Chinese regulators are clearly aware of the issues with these arrangements, but have neither officially endorsed nor explicitly outlawed them, apparently preferring the ambiguity of permitting them to persist while retaining the prerogative to override them. (Gillis and Lowry, 2014).
This lack of direct control and legal ambiguity underlying the VIE contracts create three primary forms of risk for foreign shareholders (see Whitehall (2017) for a detailed discussion). First, because the VIE structure violates the intent of the law, government officials (representing the national government, a local government, or the judiciary) could invalidate (and in some cases have invalidated) the VIE structure and destroy much (or all) of the value of the foreign ownership. Second, because the explicit control resides in the hands of the VIE’s Chinese managers, they can act in their own interests at the expense of the foreign shareholders, such as expropriating firm assets, while leaving foreign investors with little (if any) legal recourse. Third, since foreign shareholders are not the legal owners of the VIE, any distributions carry uncertain tax consequences and face possible capital controls.
We investigate the equity valuation implications of VIEs by comparing valuations for 194 Chinese VIEs with Chinese-based firms that also trade in the U.S. (“non-VIEs”). As of 2013, 42 percent of the Chinese firms traded in the U.S are VIEs, representing 48 two-digit SIC industries ranging from agricultural production to motion pictures. A wide range of tests, including OLS regressions with industry- and time-fixed effects and controls for profitability and growth, and matched sample tests provide consistent evidence that valuations are substantially lower among Chinese VIEs. Our estimates suggest a discount (across multiple estimation approaches) of as much as 30 percent in valuations for the VIEs. The results are consistent with the notion that, while the VIE structure permits the government to maintain control over sensitive sectors, the associated risks substantially reduce the amount investors are willing to pay.
We next examine whether the valuation discounts we observe for VIEs reflect unobservable economic differences between the sub-industries in which VIEs and non-VIEs operate (i.e., between sectors in which foreign investment is restricted versus encouraged). We do so by analyzing a sample of Chinese-listed firms and compare valuations between those that operate in restricted sectors (which would likely need a VIE to list abroad) to those that do not operate in such sectors. We find that firms in restricted sectors have slightly higher average valuations, suggesting that the discounts we observe are not driven by unobservable economic differences in the sectors in which VIEs operate.
To provide corroborating evidence that risks associated with the VIE structure, as opposed to other economic factors, are important determinants of the valuation discount, we examine stock market reactions to events that affect VIE risks, including events that increase the invalidation risk of VIEs and events that increase the risk of asset expropriation by VIE managers. Results indicate that the stock prices of Chinese VIEs listed in the U.S. consistently respond in the predicted direction relative to Chinese non-VIEs listed in the U.S. Further, aggregated across all 12 events in our study, the overall magnitude of the stock price response is large (-25 percent to -30 percent), suggesting that the discounts associated with VIE risk are material, and that equity investors recognize the unique uncertainties associated with the VIE structure and update prices as the perceived risk changes.
Next, we examine cross-sectional differences in discounts. To the extent that the discounts we observe are driven by the risks associated with the VIE, firm characteristics that reduce the risks of internal governance issues (such as large auditors and a high level of institutional ownership) and government intervention (such as board connections with the Chinese government and high levels of media attention) should temper the discount. We find that these characteristics do remediate the valuation discount for VIEs relative to non-VIEs. To confirm those conclusions, we find that the stock price response to the prior events is sharpest among firms that are particularly exposed to VIE risks (i.e., firms with smaller auditors, fewer institutional investors, lower visibility, and weaker political connections). We also find that managers of VIEs are more likely to hire large auditors, attract more institutional investors and media coverage, and appoint more politically connected directors, consistent with their incentives to remediate the discount.
Finally, we examine whether VIEs respond to the implicit threat of government intervention by more closely adhering to government priorities. First, in the aftermath of two devastating earthquakes, the Chinese government encouraged firms to contribute to relief efforts. We find that VIEs were significantly more likely to donate, and made greater donations, relative to non-VIEs. Second, an important tenet of Chinese public policy is to promote social stability by maintaining high levels of employment. We find that VIEs have higher levels of excess employment relative to non-VIEs.
Gillis, P., & Lowry, M. R. (2014). Son of Enron: Investors Weigh the Risks of Chinese Variable Interest Entities. Journal of Applied Corporate Finance, 61-66.
Rosier, K. (2014). The Risks of China’s Internet Companies on U.S. Stock Exchanges. U.S.-China Economic and Security Review Commission Staff Report.
Whitehall, B. (2017, December). Buyer Beware: Chinese Companies and the VIE Structure. Council of Institutional Investors.
This post comes to us from Professor Justin J. Hopkins at the University of Virginia’s Darden Graduate School of Business Administration, Professor Mark H. Lang at the University of North Carolina at Chapel Hill, and Professor Jianxin (Donny) Zhao at Emory University. It is based on their recent paper, “The Rise of US-Listed VIEs from China: Balancing State Control and Access to Foreign Capital,” available here.