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The discount between the price of Naspers’s shares and the company’s underlying value has been stuck at a disproportionate 40% for some time now, to the chagrin of shareholders.
In essence, the market is valuing Naspers for its 33% stake in Chinese internet giant Tencent, and ignoring its digital TV business and sizeable e-commerce businesses.
While management has committed to narrowing this, it is not proving to be easy as Naspers’s e-commerce ventures (excluding Tencent) are currently not profitable, with the result that the market is unwilling to pay up for them.
Other options to narrow the discount, such as spinning off Tencent to shareholders, listing other underlying businesses, halting shareholder dilution, and removing Naspers’s control structure, have been examined by management, but are not attractive or realistic at this point in time.
These issues have been well ventilated and Naspers shareholders have opted, grudgingly, to accept them.
There is however another issue and potential risk that Naspers shareholders may not be aware of. This is the fact that it does not hold a direct stake in Tencent, the operating company. Instead it has a stake in an offshore holding company that is registered in the Cayman Islands. This company has a contractual relationship with the operating company, which guarantees Naspers rights to Tencent earnings and dividends – but not to assets or voting rights.
I am surprised how many Naspers shareholders are only now realizing that the NPN investment in Tencent is held through a VIE (variable interest entity) structure. This structure grants NPN contractual rights to earnings, dividends but no ownership rights over Tencent's assets.
— Delphine Govender (@Delphine_DG) February 7, 2018
The emergence of VIEs
Freed from the limitations of communism in the late Nineties, Chinese private sector companies found that local capital markets were inadequate to fuel their growth. However when they tried to turn to foreign investors, companies in ‘strategically sensitive industries’ found their wings clipped. In China, internet, financial services, telecommunications, energy, agriculture, transportation and education companies are prohibited from receiving foreign investment.
The desire of Chinese companies to sidestep these regulations combined with the willingness of foreign investors to fund China’s emerging enterprises through equity-type investment without equity ownership rights, provided the basis for the potentially unlawful VIE corporate structure.
What is a VIE?
In a nutshell it is an entity in which an investor holds a controlling interest that is not based on owning the majority of voting rights.
VIEs are increasingly common among Chinese companies, with the likes Sina, Baidu and Alibaba making use of the structure.
A report called Buyer Beware: Chinese Companies and the VIE Structure and published in December by the Council of Institutional Investors describes the structure as such: The structure consists of at least three core entities – a Chinese company with legitimate operations (referred to as the VIE); a wholly foreign-owned enterprise (WFOE) established as an intermediary in China; and an offshore shell company that lists on a foreign exchange (ListCo).
In Naspers’s case, Tencent is registered in the Cayman Islands and is listed on the Hong Kong Stock Exchange.
The structure of a variable interest entity
As the diagram clearly shows, investors need to understand that VIEs bring complexity, says Shamier Khan, portfolio manager at Element Investment Managers.
With that complexity comes a degree of risk that needs to be recognised. “VIEs are structures that were designed to circumvent Chinese law and operate using contractual arrangements rather than direct ownership,” he says. “The practice of using VIEs is now common and the Chinese government has turned a blind eye to it. But that does not mean the risk does not exist.”
What are the risks?
The obvious risk is that such structures are illegal. Thus any court is likely to rule that contracts signed under these conditions are void.
“How do you enforce contractual disputes in China where the operating company is? How would you enforce them in a legislature that opposes the VIE structure and sees the structure as illegal?” asks Drikus Combrink, portfolio manager at Capicraft Investment Partners.
“What if the shareholders of the overseas parent company and the VIE (onshore entity owning operating licences) have diverging views on strategic decisions?” he adds.
While Naspers has two directors on the Tencent board and the companies are known to work closely together, such disagreements are not unheard of. Consider the Alibaba and Yahoo dispute over the way that Alibaba spun off Alipay, which provides online payment services.
While the dispute was some years ago, it does highlight the fact that risks exist.
Contractual arrangements between the onshore subsidiaries and the foreign entities can mitigate some risk for investors.
For instance the offshore entities hold the intellectual property rights, domain names, trademarks, technology, software and other assets such as hardware and staff. The onshore subsidiaries, although they have the operating licences, cannot run the business without these hard and soft assets.
In addition, the founders and top executives of both Baidu’s and Tencent’s onshore companies own significant stakes in the offshore entities, reducing the likelihood of a significant dispute or breach of contractual agreements between the onshore and offshore subsidiaries.
The VIE structure represents a governance risk to Naspers shareholders that they need to be compensated for when determining the investment case. This governance risk can practically be translated into three main risks, says Khan. These are the risk of increased corporate tax leakage, the risk of government enforcement and lastly, owner expropriation. “It is difficult to say to what extent these risks will crystalise into value destruction but they must be considered when determining one’s margin of safety.”
However these risks are believed unlikely, considering the Chinese government’s global ambitions.
“If the Chinese government decided to take a hard line on VIEs it would be tantamount to a trade war and would be met with full economic sanctions from the West,” says Combrink. “China, being heavily reliant on exports and grossly unbalanced, will implode under its own weight. To negate VIE holder rights will be to hit the ‘self-destruct’ button.”
Is this structure likely to remain?
At some stage it is expected that the Chinese government will relook its laws on foreign inward investment. “The structure is inefficient and pushes up the cost of capital,” says Khan. “The government will have to relax the controls on corporate structures. Exchanging the VIE system for a dual share structure or something similar – without changing the voting rights of the original shareholders – could be a solution.”
What is the bottom line for Naspers?
The bottom line is that convoluted structures such as these, where legal rights fall into a grey area, always present a measure of risk. Though it would appear that the market has fully discounted this risk: the Tencent stake comprises more than 100% of Naspers’ current market capitalisation.
The agreement governing Naspers’s holding in Tencent is not disclosed. However the firm has reassured investors that there are no restrictions at all relating to its ability to sell any portion of its interest in Tencent.