Should investors be concerned about VIEs and ADRs?

The unexpected move by Chinese regulators to disallow the after-school tutoring industry from participating in overseas capital markets has raised investor concerns about the government’s stance on foreign investment in sensitive industries. This in turn has led to worries about variable interest entities (VIEs) and the delisting risk of Chinese ADRs.

There are over 250 Chinese ADRs, with a combined market capitalization of over USD 1.5tr. Pressure from US regulators regarding reporting requirements for ADRs could lead to delistings due to consistent non-compliance. Many Chinese internet companies have set up VIEs, which hold licenses to operate in China, allowing firms to bypass restrictions on foreign investments in some sectors. These areas include high-growth segments such as technology, telcos, education, and media. To satisfy foreign ownership restrictions, legally speaking VIEs grant no actual direct ownership of the underlying assets. Increased regulatory scrutiny of China’s tech sectors has raised concerns about the enforceability of VIE contracts in China. Also, converting share ownership from ADRs to their Hong Kong listing equivalent doesn’t circumvent risks related to VIEs, because many Hong Kong shares also utilize the VIE structure.

But while concerns about delisting and the legal status of VIEs are understandable, we think investors’ fears are unlikely to be realized:

VIE structures remain viable.

• The increased policy scrutiny should be read as a positive development for VIEs, in our view, as it likely reflects the gradual process of Beijing validating the structure. A recent government review of VIEs suggests Beijing recognizes the current structure. Our understanding is that the government still endorses the pursuit of a diversified capital base. As outlawing VIEs could harm China’s innovation and technology development, we don’t expect the government to pursue this course of action. Mainland China and Hong Kong regulators have made proposals that would endorse the listings of VIE entities on exchanges on the mainland or in Hong Kong, subject to new compliance and disclosure requirements.
• Our base case is that VIEs will continue to exist in the foreseeable future, but the Chinese and US governments will gradually demand greater transparency and disclosure. We believe this will serve the interests of both regulators and investors.

Relocation of ADRs likely to increase, but is manageable.

• Intensifying scrutiny by Chinese regulators of Chinese companies' overseas listings and continued regulatory pressure from the US will likely accelerate the “homecoming” trend of Chinese ADRs. While the US is expected to enforce the Holding Foreign Companies Accountable Act from 2022, Chinese ADRs have three years to comply, which we think is ample time to find a compromise. We also expect more ADRs to seek secondary listings in Hong Kong. This may also result in more companies selecting Hong Kong or mainland China for their IPOs. US/Hong Kong double-listed shares are fungible. Therefore, in the event of a US delisting, ADRs can be converted into Hong Kong shares.

Valuation impact of relocation of ADRs likely to be short term.

• The largest Chinese internet platforms derive negligible revenues from the US (e.g., Alibaba and Tencent <5%, Meituan and Baidu virtually zero). This means that the US has little influence on the underlying financials. Hence, the potential hit from a US delisting would only come from valuation multiples, which should be short-lived. Still, media attention, reduced liquidity, and a potentially diminished US investor base can lead to a significant discount. The share prices of the three Chinese telco operators that were banned in the US fell 10–20% in just a few weeks following the announcement. But for the Chinese internet leaders, we think any share price losses due to delisting will likely be recovered in a few quarters—once southbound Chinese investors get access to them.

So while ongoing regulatory pressure on China’s leading technology firms has prompted us to adopt a neutral tactical view on MSCI China, we do not expect regulatory action to undermine the strategic appeal of the Chinese market, and we continue to see longer-term upside for China’s new economy. Investors seeking China exposure can consider rotating into cyclical/value parts of the market, or areas that are less exposed to regulatory risks, such as greentech, consumer durables and services, energy and cybersecurity.

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