There was a flurry of regulatory clampdowns during the month, but the two big ones were 1) authorities announced that DiDi (“China’s Uber”) was being investigated for violating data protection rules, and local app stores were ordered to remove its app – just days after its US IPO; 2) new regulations were issued for the private education sector – forcing them to become non-profit. The latter one especially stunned markets, and left investors pondering: if a government can unilaterally declare that entire sectors can no longer be profit-making, and ultimately wants to control capital allocation across the economy, what does this mean for the value of my Chinese equities?
The Northcape EM Fund has long had zero exposure to the Chinese internet and education sectors as we have been uncomfortable with the VIE ownership structure from a governance perspective, in addition to other ESG shortcomings. We have also viewed the risks of regulatory interference in these sectors as intolerable – given how important they are economically and socially in China, and the government’s desire to exert tight control over such areas.
Foreign ownership of these sectors has never been permitted according to the letter of the law in China, and the workaround has been for companies to employ the variable interest entity (VIE) ownership structure. A VIE enables foreign investors to invest in restricted sectors in China via a legally dubious structure that has never been formally endorsed by Beijing. In several cases where the Chinese counterparties have broken the VIE agreements, foreign investors have been left high and dry in the Chinese courts due to the illegal status of the VIE structure. High-profile incidents include Yahoo! having Alipay snatched from it by Jack Ma, and the GigaMedia, FAB Universal, and Chinachem court cases all favouring the local parties in VIE disputes.
Investing in a company where we do not have clearly defined ownership rights, and where a foreign government could suddenly, or arbitrarily deem our shares to be worthless, is not a risk we are willing to take with our clients’ precious capital.
Index risks highlighted
Chinese education companies collapsed in July – Gaotu Techedu (-79 per cent), TAL (-76 per cent), and New Oriental (-74 per cent) – in one month alone. These companies are all down at least 90 per cent from their highs earlier this year, and the latter two have lost their position as top 40 index constituents.
Index heavyweights such as Alibaba, Tencent and Meituan have all fallen approximately 40-50 per cent from their highs. We believe this is clear evidence that investors have been underestimating the governance and regulatory risks of investing in these sectors. We see risks that these companies could trade on even more depressed/lower multiples going forward.
The weighting of the Chinese internet and education companies in the MSCI EM Index has fallen from around 18.5 per cent at the start of 2021 to 14.5 per cent today. With their large index weights, we believe their downside has been exacerbated by forced ETF and index-related selling. There could still be further long-only and hedge fund selling in these names to come. Further, index providers could delete some of these companies as we move closer to the 2024 deadline for the Holding Foreign Companies Accountable Act, which will likely result in most of the 248 Chinese ADRs being delisted from US exchanges.
This all highlights the dangers of a passive equity investment in EM, whereby investing in an index tracking strategy by default provides near 40 per cent exposure to the China risk. Northcape employs an active, highly selective investment strategy for the EM equity asset class, which we believe more accurately prices the China risk and results in an appropriate portfolio weighting.
VIE risks now in focus
Other investors, we believe, are starting to wake up to the risks around VIEs. Bloomberg recently highlighted the disclosures in DiDi’s IPO prospectus:
“There are substantial uncertainties regarding the interpretation and application of current or future PRC laws and regulations,” said Didi’s prospectus, about the VIE structure. And if anything changed, it said, “the relevant governmental authorities would have broad discretion in dealing with such violation, including, without limitation: …revoking the business licenses and/or operating licenses of our PRC entities; … [or] requiring us to restructure our ownership structure or operations, including terminating the contractual arrangements with our VIEs.”
This is quite jaw-dropping when you read it for the first time. But similar language and warnings are contained in all the prospectuses and annual reports of US-listed Chinese companies that operate in restricted sectors and thus have VIEs – see below from Alibaba. In short, if the Chinese authorities were to deem Alibaba’s VIE illegal, it would essentially lose its entire business (much like the formerly for-profit education companies).
We have also heard from Chinese accounting/VIE experts that getting money out of the VIE structure is very difficult without incurring punitive tax rates (as high as 70 per cent). This may explain why companies with this ownership structure continue to raise capital offshore to fund expansion and have never paid substantial dividends.
As an example, Tencent’s dividend payout has averaged 11 per cent over the past decade and fell to 8 per cent last year. This is despite it having “cash and cash equivalents” in excess of $20 billion in each of the last four years (and $35 billion in 2020). This issue may necessitate an adjustment in how these companies are valued going forward.
It is hard to predict what will happen to the sector over the next few months, and anyone who tells you otherwise is kidding themselves.
Many thought the regulatory blitz was finished in the last week of July, but we have seen further announcements in August to date. It is possible that the regulatory crackdown could subside in the coming weeks, especially if China gets concerned that the impacts are spilling over into the domestic economy and individual livelihoods.
US regulatory developments also remain fluid. The US has already proposed to move forward by one year the deadline for the delisting of Chinese companies from US exchanges if they do not comply with PCAOB audits. Closer to this deadline, we expect the sector could face more uncertainty and volatility when it dawns on investors that this is actually happening. This is of course barring a last-minute U-turn from US authorities, but this looks unlikely at this stage.
If/when the US delistings finally happen, we believe investors will be forced to scrutinise these companies even more closely, and ask – how can I invest in a company that doesn’t submit itself to US audits (among addressing other governance shortcomings)?
We have had a longstanding zero exposure to the Chinese internet space given our concerns on governance and regulation. Recent events have further reinforced our decision to maintain our sustained high discount rate for China that reflects our sovereign risk concerns (spanning economic, political, and governance) of investing in the Chinese market. As such, we have a structural underweight to China, and zero exposure to China A-shares.
China equity risk premium reassessed
We sense the market is starting to come around to our way of thinking on China, based on the recent correction. However, average valuations in China (MSCI Golden Dragon China Index trailing P/E is 20 times) – still do not take account of the risks we believe. Based on our own sovereign risk modelling, China has one of the highest equity risk premiums in EM (approaching 18 per cent). This level is well above its 10-year bond yield of 2.9 per cent, which might suggest an equity cost of capital of 8-10 per cent to the casual observer. This is clearly a level that profoundly understates the risk of investing in the country in our view.
Current valuations to us suggest that the downside risks on China are still material if there are no systemic improvements in China’s policy settings and overall corporate governance. Specifically, the markets risk premium on China has the potential to deteriorate, seeing P/Es fall even further.
All this highlights the dangers of a passive equity investment in emerging markets. Country selection is critical when investing in EM, as is screening out weak governance – a key risk in the asset class that has been made clear amid the recent events in China.
Northcape Capital is the underlying investment manager for the Warakirri Global Emerging Markets Fund