Looking at VIE structures

August 20, 2012 | RP

Variable Interest Entity (“VIE”) structures were first introduced by Chinese companies listing in the US as far back as the year 2000 when SINA had its initial public offering on the NASDAQ. Effectively the VIE structure means that equity holders have a somewhat indirect financial interest in the revenue and earnings stream and do not actually have a claim on the assets of the company in question.

Certain industries in China, including the internet industry, are heavily regulated and substantial foreign ownership of their assets is either severely limited or prohibited by the Chinese government.  As a result, the VIE structure became a necessity for these companies to list on overseas exchanges.

For industries and companies which were deemed by investors to be “asset light” this was not perceived to be an issue because the majority of the value of the company was not derived from a claim on assets anyway, but instead was derived from a claim on future revenue and income streams. Over time, as investors became more comfortable with investing in VIE structures, the use of VIE structures became more accepted even for companies which were deemed to be “asset heavy”.  This could arguably be described as an oversight by many investors who did not understand the nature of their investment or the fact that they had basically no claim on the underlying assets of the company in which they were investing.

In any event, it should be noted that the use of VIE structures was explicitly designed to circumvent foreign investment in certain industries and companies. It has been a clever solution, but obviously the Chinese government is well aware of the practice and is said to be evaluating the use of VIEs going forward.  The Chinese government has never explicity approved the use of VIE structures, but likewise it has not yet explicitly disapproved of their use either. As of August 2012, the consensus opinion among investors seems to be that China would be unlikely to take restrictive actions against existing companies which are structured as VIEs simply due to the fact that there are so many of them in existence and due to the fact that the financial interests involved are already massive.  For example, Baidu (BIDU) alone has a market cap of nearly $50 billion and happens to be a VIE.  However, the likelihood of government action restricting future use of the VIE structure is seen as being increasingly likely.

More recently, the US SEC has begun taking a closer look at VIE structures. In July 2012, New Oriental Education (EDU) announced that it was the subject of an SEC investigation regarding the specific details of its VIE structures.  Investors briefly turned cautious towards all Chinese VIE structures due to fears of a wider spread action by the SEC which would have a far broader impact than just on New Oriental.   If the SEC were to take broader action against all VIE structures, presumably they would have to deal with the same implications as the Chinese government, namely that the number of companies and the market value that they represent are enormous.  Any broad based action would cause an immediate and very substantial dislocation in the markets.

News of the SEC investigation into New Oriental’s VIE structure caused an immediate plunge in the share price of over 30%.  As would be expected, shares of other Chinese VIE structures, including Baidu and Sina, fell to multi year lows due to these short term concerns.  However the concern seemed to be short lived.  In the weeks following the New Oriental announcement Chinese internet companies consistently posted stronger than expected financial results and the majority of them experienced a fast and steep rally.

There is still some lack of clarity on the details surrounding the SEC’s specific concerns with New Oriental and the potential for broader, more general SEC concerns over use of the VIE structure.