"Investors in general don't understand the risk of VIEs," said Christopher Tsai, who runs hedge fund Tsai Capital. "This is being tested now. VIE structures are like black boxes. We don't know what's inside until we go through a full cycle of instability."
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A report a year ago from the U.S.-China Economic and Security Review Commission explained the risks of investing in these structures and why they were created.
The paper explains that these Internet companies do not get enough capital from China's banking system or stock market to expand and compete on a level equal to U.S.-funded global powerhouses so they need a way to get access to foreign capital.
The paper, written by policy analyst Kevin Rosier, explains how VIEs are set up:
"VIEs, usually based in tax havens such as the Cayman Islands, are essentially holding companies that link foreign investors and Chinese firms via a set of complex legal contracts. In theory, the VIE structure guarantees that economic benefits flow to the foreign investors; meanwhile operating control of the business remains within the Chinese firm, ostensibly to comply with Chinese laws."
The question that Tsai and others don't quite know the answer to is what happens next to these securities if the domestic sources of capital collapse, like what is happening now.
"It does seem that the government has lost control of the market and we are in a 1929-type crash situation," said Gillis. "This is a case of irrational exuberance that finally popped."
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If the Chinese market continues to crash, affecting the whole economy, companies like Alibaba (likely with guidance from the Chinese government) will be forced to change their business plans in order to make it through the tough times. These changes could include buying back stock, layoffs or cutting capital expenditures.
But U.S. investors will have no say in what steps should be taken.
And not only that, the Chinese government could suddenly wipe out these VIE structures. Says the commission's paper:
"U.S. shareholders face major risks from the complexity and purpose of the VIE structure. For example, the legal contracts that serve as the basis of the structure are enforceable only in China, where rule of law remains rudimentary. Though listing VIEs on U.S. exchanges is legal in the United States, they can be considered illegal in China. As Internet giants Alibaba, Baidu, and Weibo become synonymous with 'Chinese Amazon,' 'Chinese Google,' and 'Chinese Twitter,' risks could mount for unsuspecting U.S. investors who buy into their precarious VIE structures."
To be sure, Gillis and Tsai don't believe this plunge in Chinese stocks would give any reason for the government to deem these VIEs illegal, but the point is that no one really knows for sure.
And this uncertainty risk is certainly not priced into the shares, many of which are still up for the year despite the one-month pullback.
"I don't see them (VIEs) unraveling just because the market in China has corrected by 30 percent," said Tsai. "They are too much to the advantage of management and even though foreign investors don't understand all the risks associated with VIEs, they continue to buy them."
U.S. investors continue to buy them...until they don't.