Alibaba (and the billion thieves...)

There was yet another interesting IPO that took place the other day, one that will go down in history as being the biggest IPO to date. Well, to honest, I think there are many reasons why this one will go down in history, but perhaps the most noteworthy reason is that this is actually a Chinese company doing an IPO in the US. It is a huge event in that China has now outdone all the previous US tech company IPOs that have created so much wealth over the years, and perhaps the most significant marker to date that China is really becoming the leading global economic power. With investors already complaining that allocations have been far too limited, I can imagine as well that the stock price will spike in a spectacular fashion, and certainly overshadow what GoPro recently did.

I have to provide also some of my more cynical assessments here. For starters, one can question the huge surge in the stock price on the first day of trading, one that I will expect to continue over the coming days. It closed at almost $94, up nearly 40% from the IPO price. But then again, with so many potential investors being disappointed since they were not able to subscribe to any shares this was clearly to be expected. Nevertheless, Alibaba ended up being the biggest IPO in history so far, and I suppose as far as interest in the stock market goes this is positive. No, what really concerns me is that, even though this market valuation is actually based on something more real than what has been the case for GoPro, there is a potential risk that the Chinese Communist Party will expropriate the company and its shareholders.

What probably many BABA investors are not aware of, is that China bans foreigners from owning a majority interest in companies that Beijing calls “strategic and emerging industries”. To get around the law, Chinese Internet companies give shareholders rights to a “variable interest entity” instead of direct ownership. In Alibaba’s case, shareholders own a piece of a shell company in the Cayman Islands with a contractual right to a share of the profits.

The U.S. – China Economic and Security Review Commission, set up by Congress, warned against these arrangements in a June report: “This intricate ruse is a way of making the business appear to be Chinese-owned to Chinese regulators while claiming to be a foreign-owned business to foreign investors. Neither claim is technically true, and the arrangement is highly risky and potentially illegal in China.” Last year, China’s highest court ruled that variable interest entities amounted to “concealing illegal intentions with a lawful form.”

In its IPO disclosures, Alibaba acknowledged that if the Chinese government “deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions,” the company could “be forced to relinquish our interests in those operations.” Alibaba could also lose its operating license or variable interest entities if either is found to violate “any existing or future” laws. The Communist Party could wipe out that $22 billion by decree.

Most investors, and obviously Alibaba executives, believe there is now so much foreign investment in Chinese Internet companies through variable interest entities that Beijing wouldn’t dare jeopardize these property rights. But then again, one could also argue that if China would never do something like this because there is too much at stake, then why not change their regulations in order to make these structures legal and officially acceptable? As it stands today, there remains a potential risk that simply can’t be ignored.

So, while there have been many IPOs over the years within the tech sector that have raised capital on air, here we have the biggest one so far based on the hope that China will continue to close their eyes on this essentially illegal foreign investment. I suppose given how corrupt things are over there, it does seem likely that nothing major will be done to shake things up. But should the Chinese economy begin to falter, and there are more and more signs of this, I would not be surprised if they decided to take some more treasure from Ali Baba’s cavern…