Happy Qi Xi Festival!

 

Nach all dem Weg, nach all der Zeit

Bist du die Frau in meinen Träumen

Und meine Heldin in der Wirklichkeit

The “Big Boys’ Market” VIEs—The “Myth” of Foreign “Ownership” of PRC Stocks

"Choose Your Investment Wisely
Not All Chips are Blue"

 

If I'm not mistaken (and as Madame Arqala could tell you, I often am), in his seminal work, Benjamin Graham made the observation above.  Along with the advice to carefully analyze a proposed investment before you commit funds. 

If you’ve been following recent financial news about the PRC government’s clampdown on private educational companies, you’ve probably seen comments about the Variable Interest Entity (VIE) structure which is typically used by companies in the PRC to access equity from foreign investors.

The VIE is used because under PRC law foreigners may NOT own stock in some sectors within the PRC.  Lots to be exact.

How does the VIE work or more accurately claim to work?

1. A PRC company wishing to access foreign equity markets establishes an offshore company with the same name as its own. The Cayman Islands is a “favorite” location.

2. The offshore company and the PRC-based company sign contracts that ostensibly (note that word) grant the offshore company legally enforceable rights to a share of profits of and a measure of control over the PRC company. These are portrayed as providing “the equivalent to ownership”. If you’re interested you’ll find a detailed discussion of the structure and the agreements in the two “warning” articles cited below.

3. The offshore company then issues shares to investors. Note these are shares in the offshore company not in the PRC company.

4. Net proceeds from the issue are upstreamed to the PRC company typically as loans in consideration for the contracts and agreements in point #2 above.

What are the issues with the structure?

1. As with other structures based on complex legal agreements that attempt to “work around” (or perhaps more accurately circumvent) law, they are inherently fragile.

2. The investors’ ownership rights are in the assets of the offshore company – those are solely the contracts and agreements with the PRC company—not in the assets of the PRC company. That is, the investors have no direct claim against the assets of the PRC company.

3. To enforce their constructive (or more accurately imaginary) ownership rights in the PRC company, the investors have to enforce the underlying contracts against the assets of the PRC company.

4. That legal action has to take place in the courts and under the laws of the jurisdiction where the PRC company holds assets. In both cases that is in the PRC.

5. “Small” problem with that. Under PRC law, foreign ownership of PRC companies is illegal.

6. Therefore, mechanisms that attempt to “get around” PRC law—the VIE and the various contracts and agreements that purport to give the rights of ownership-- are illegal.

7. And, thus, are not enforceable in the PRC.

This legal situation is analogous to the Peking University Founders Group offshore bonds debacle, chronicled here for Part 1 and here for Part 2

While for some time, the PRC authorities have turned a “blind” eye to the use of VIEs, that does not change the fact that these structures are illegal.

Whenever the authorities choose, they can enforce the law.

This month the PRC turned its “good” eye toward education companies. They will no longer be able to use VIEs.

That lead to a substantial drop in PRC “equities” listed on non Chinese markets.

As well as much angst among investors, some of them charter members of the “big boys” club that frankly should have known better.

The 31 July FT article Equities Watchdogs Bite. Investors Rethink China Stocks Strategy After Regulatory Shock (Harriet Agnew, Tabby Kinder and Hudson Lockett) contains a rather chilling quote.

“The VIE structure, which allows global investors to get around controls on foreign ownership in some Chinese sectors, has never been legally recognised in China, despite underpinning about $2tn of investments in companies like Alibaba and Pinduoduo on US markets.” 

First, you will note that there are some US$ 2 trillion in stock investments on US markets that use the VIE structure.

Second, that suggests that the FT journalists’ reference to a “rethink” is wrong because clearly there was no “thinking” at the time of investment.

Rather it was “faith-based” investment.

To be fair, some of this amount is via passive investing by funds seeking to track various global indexes that include these companies.

I’ve always thought it was a good idea for an index to only include investable stocks.

What is distressing about all of this is the simple fact that neither the FT article nor this post constitute an “overdue wake-up call” nor a “sobering fact”.

There have been many warnings about VIEs.

Here are just two:

• 2012 King and Wood Mallesons – A PRC/Australian law firm which described the structure as a “Sword of Damocles over their [foreign investors’] heads”.

• 2017 Council of Institutional Investors – a “buyer beware” alert.

If you look within these two articles, you will see further warnings in the form of prior actions taken by PRC authorities against VIE structures as well as some rogue activities, e.g., T2CN and GigaMedia. Or perhaps (?) more benign – Alipay and Alibaba.

All of these “wake-up calls” and “sobering facts” were clearly ignored.

• Over a prolonged period.

• To the tune of US $2 trillion.

Remind me again about the efficient market theory.

Don’t forget to also mention the role of the “sophisticated” investor in the markets.

I do really love a good laugh

Fourplay Silverado Tokyo Jazz Festival 2020 - All Three Lead Guitarists in One Session

 

Fantastic set:  all three of Fourplay's lead guitarists from inception with their order of participation as follows Lee Ritneour, Larry Carlton, Chuck Loeb.

Since Chuck's death, Fourplay has been without a lead guitarist.   

In 2018, they announced a "hiatus" which seems to have been prolonged by Covid.  

Hurry Back!

Fourplay - Silverado - YouTube

From left to right:

1. Larry Carlton next to Nathan East (bass guitar) 
2. Chuck Loeb (RIP) 
3. Lee Ritenour 

MENA IB Fees by Country - Bring Out Your LHC

Just the Equipment to Detect Small Amounts or Particles

 

In my previous post, I showed that MENA IB fees are pretty much a rounding error in relation to global IB fees.

I thought it would be interesting to use the estimates in the Refinitiv MENA IB reports mentioned in that post to take a look at the “major” countries in this rather “minor” total amount of fees.

Just a short technical note.

Refinitiv estimates total IB fees for a country, a regional area, and globally. 

The free reports that I am using here and in the previous post are summaries. 

Full details are available from Refinitiv for a modest fee.

I’ve prepared two tables:

• USD amount of MENA IB fees by identified countries.

• MENA IB fees by country as a percentage of global IB fees.

In my illustrious career on the sellside, I have worked on single transactions that generated fees equal to these yearly fees.  Often multiples.

Note that the amounts above are expressed as percentages.  The decimal equivalent of Saudi IB fees for FY 2020 is therefore 0.0030.

A stark and bleak picture.

Dreams of IB fee “riches” in Saudi or the UAE seem a rather a long distance off.

Vielleicht am Tag danach Sankt Nimmerleinstag.

For the other countries even further in the future.

MENA Investment Banking Fees Still a Sideshow

Aisle 3 for MENA IB

Back in 2017, I posted that the prospect of “rich” Saudi investment banking fees would remain a prospect not become a reality for some time. And quoted some rather minuscule numbers for KSA fees as support for that contention.

In 2018, I took a look at 2017 MENA IB fees and noted that at US$ 912 million they were an estimated 0.88% (0.0088 in decimal terms) of global IB fees of US$ 104 billion. What might be charitably described as a rounding error. 

It’s time to revisit the topic to see what’s happened since then. 

Summary

The picture above tells the story.

1. In terms of IB fees and transactions, MENA IB remains a rounding error in the global IB market.

2. It is not currently particularly remunerative for major global investment banks. It’s more a hobby business or “dabbling”.

Source and Technical Note

I am using Refinitiv’s (in a previous incarnation owned by Blackstone and Thomson Reuters) reports.

You can access these reports here for the price of giving them your email address and some bits of personal data.

Note that these reports are based on R’s analysis and estimates.

On the latter point, take a look at the 2019 Global IB Report, that year’s fees are some US$ 100.974 billion. In the 2020 Report, 2019 fees (the comparative figure) are USD 107.762 billion.

Due no doubt to additional data available to R.

I have estimated 2018 MENA and Global IB fees using 2019 Reports and the percent changes shown from the past year (i.e., 2019). So an estimate of an estimate.

The same with individual bank fees.

So the usual caution about the numbers in those reports and in this analysis.

While they look precise, they aren’t. More directional than locational.

Analysis

MENA IB Fees Still a Rounding Error

In the first chart, a comparison of MENA versus Global IB fees.

Small beer.

But are there IB areas where MENA fees shine?

Not really.

Relatively and charitably speaking, syndicated loans are a “brighter” spot.

But that’s not more than just saying that a 10 watt light bulb is “brighter” than a 5 watt one.

The MENA IB landscape reflects

• the state sector’s dominant role in regional economies – a sector that has both economic and non economic drivers, with the latter often being more important in motivating corporate actions than the former

• a generally risk adverse rentier/comprador mentality in the private sector

The results are

• a greater orientation to debt (syndicated loans and DCM) than equity (ECM)

• a limited market for corporate control (M&A)

• the state sector’s ability to command low fees

The above are broad generalizations. One could respond that these conditions exist in other markets.

Indeed!

But in the most significant markets there are sufficient other customers to generate transaction volume at relatively higher fees.

In MENA this is not the case.

Importance of the MENA Market to Global Banks

In regard to Global M&A MENA is a small fish.

Clearly, for regional banks it is an important market not only because it is part of their natural market, but also because the fees represent significant earnings.

But what about the big boys?

I’ve selected four global banks based on their consistent position at the top of Refinitiv’s MENA IB fee tables.

Three of the banks typically are also in the five top positions in the Refinitiv’s Global IB tables. They are JPMC and Goldman Sachs who generally trade places in the top two slots Citi which is typically in the top five.

The final bank, HSBC, is typically in the third tier global position: ranking eleven to fifteen. Within MENA it has a stronger position. most often in the first position.

From the charts above, it’s clear that MENA is a hobby business for these banks.

HSBC as a third tier IB is no doubt happy to take IB fees wherever it can.

In my two earlier posts, I mentioned the drivers of IB participation in a market:

• Fees – Not only for the IB and its bankers’ remuneration but also as a “marker” of IB prowess in sales pitches.

• Transaction Volume – A similar market prowess badge for one’s pitchbook.

• Market Development – The hope that today’s loss leader will lead to a higher volume of higher priced transactions. Dream on in MENA.

• Global Positioning – Using transaction expertise/presence in one market with clients from another.

  • “We are a global firm with experience and knowledge across the globe”.

  • “We can help you in the UAE, KSA, etc.”

• Inward Marketing – Using one’s position in a market to sell product (debt, equity, etc) into that market.  

These factors probably explain the continuance of the MENA hobby.