Alibaba, China’s largest E-commerce firm, is fast approaching its initial public offering (IPO) in New York. The IPO is expected to raise billions of dollars, perhaps becoming the largest tech IPO in history. In the months leading up to the IPO, there was extensive speculation over whether the company would choose Hong Kong or New York as the location for its offering. New York eventually won out when Hong Kong rejected Alibaba’s unusual corporate governance scheme. Missing from the debate was a much more basic question, why can’t Alibaba list in mainland China?
We have devoted previous posts to outlining the travails of the Chinese stock market. Equity markets have performed poorly since 2007 due to a combination of the lingering effects of a speculative bubble, corporate governance concerns, and excessive intervention by regulators. But none of this explains why China’s burgeoning internet giants, certainly amongst the country's most innovate and dynamic firms, have chosen to forsake domestic exchanges.
Alibaba’s public filings provide a clue. The IPO prospectus states “although not currently allowed under PRC law, rules and regulations, we many conduct a public offering and listing of our shares on a stock exchange in China in the future.”
What laws and regulations are preventing Alibaba from listing on its home stock exchange? It comes back to China’s restrictions on foreign ownership. While much of the manufacturing sector has been opened to foreign investment, large swathes of the service sector remain relatively closed, most notably information technology and finance. Foreigners are prohibited from majority ownership in Chinese internet firms.
These restrictions are circumvented by structures called variable interest entities (VIEs) whereby the economic benefits of a corporation are passed along to a third party via a series of contracts. Japanese conglomerate Softbank and US-based Yahoo use this structure to exercise effective “ownership” over the majority of Alibaba.
This sort of corporate structure works well for rapidly growing Chinese firms in restricted sectors that are trying to attract outside capital. The VIE structure has been used by many of China’s premier tech firms, including Baidu, Tencent, Youku, and Sohu. The common denominator amongst these firms is that subsequently they all chose to list on overseas stock exchanges (including Hong Kong).
The reason for listing overseas is that the same VIE structure that works so well in bypassing foreign ownership restrictions does not translate well to domestic IPOs. For Alibaba to list in Shanghai, the VIE ownership arrangements would have to be dismantled and Softbank and Yahoo would need to divest some of their holdings. Even assuming this is what the two companies wanted, the amounts sold during the process of a domestic IPO could be in excess of what the domestic market is able to bear. In comparison, a New York or Hong Kong listing with full access to the world’s capital markets is more appealing.
The larger takeaway from all of this is that policies often have unintended consequences. Restrictions aimed at keeping control over sensitive industries are often circumvented via legal loopholes. To add insult to injury, these same legal loopholes can push companies further away from the grasp of domestic regulators by pushing firms to raise capital overseas. Thus policies aimed at preserving control over specific sectors can end up having the opposite effect. A globally-owned and funded Alibaba will be more difficult to monitor and control. Another side effect is that languishing Chinese equity markets are deprived of some of the country’s most promising companies.
Further opening up the service sector to foreign and private sector investment is the next frontier of Chinese economic reform. Greater competition in finance, information technology and other services is essential for revitalizing China’s economy during a period of declining growth. Moreover, existing restrictions on foreign and private sector investment are ineffective and counterproductive. The openness to competition that turned China into the world’s manufacturing powerhouse should be applied to service sector. Maybe then when China’s next internet super star is ready to go public, it won’t have to leave home to do so.