Is China pushing VCs out of third-party payment?

Last year, Ma added a less savory line to his resume: he became the first Chinese CEO to break a variable interest entity (VIE) contract, the structure through which foreigners invest in certain kinds of Chinese companies.

Ma’s actions, which only became public in June, were intended to offset regulatory concerns about foreign involvement in China’s third-party payment industry. He did this by transferring ownership of Alipay from Alibaba Group to a domestic firm of which he is the majority shareholder, thereby removing the subsidiary’s exposure to the VIE that secures Yahoo and Softbank’s financial interest in the parent company. The foreign firms opposed the move at board level, saying it rode roughshod over their investment agreements.

This apparent violation of shareholder rights and fiduciary responsibility sets a worrying precedent for venture capital firms that have backed third-party payment providers – and also for those that invest through VIEs in general.

“GPs tell LPs that there is a potential total loss scenario, which creates a wave of panic,” says Rocky Lee, managing partner for Asia at Cadwalader. “This is what gets me on the phone at 2 a.m. talking to LPs and funds in California. These guys may have 50 other portfolio companies with VIEs.”

Market leader

Alipay is without question the dominant force in China’s third-party payment market, having been introduced in 2005 to support Taobao users. It accounted for just over 50% of the $156 billion in transactions processed by all service providers last year, according to iResearch. Tenpay, owned by internet platform Tencent, is second on 20%, while no other competitor has a double-digit market share. By 2014, the market is expected to be worth $636 billion.

This rapid growth in transactions, which is taking place outside the formal banking sector, caught the attention of the People’s Bank of China (PBoC). Last year it announced that all participants would have to apply for licenses, and that those with foreign investors would be subject to separate review. The first round of licenses was issued in May, with 27 companies making the shortlist, including some that have in the past received foreign capital. Up to 30 more approvals are expected before the implementation deadline on September 1.

The PBoC has also indicated that foreign control over these companies will not be tolerated, either directly or indirectly through VIEs. “I believe the reason they are focusing on third-party payment is because it relates to the banking system,” says David Wang, a partner at Paul Hastings in Shanghai. “They are not ready for foreign investors to be controlling that aspect of the financial services sector in China.”

The approach is not altogether surprising. Given that PayPal falls under the remit of America’s banking regulators, it is understandable that China might want to extend its cap on foreign ownership of financial institutions to third-party payment providers.

According to people familiar with the situation, companies are broadly following one of three strategies: working with their foreign investors to find an alternative solution to the VIE; terminating the VIE contract and offering to compensate their backers at a later date; or telling investors that the contract is null and void and therefore no money is owed.

Apparently negotiations between Alibaba, Yahoo and Softbank are ongoing. It has separately been reported that Lakala has bought back shares owned by Morningside Ventures and other overseas investors. And sources tell AVCJ that local renminbi funds are buying into companies, trying to cherry pick those that are likely to receive licenses.

DFJ DragonFund China has invested over $5 million in YeePay, which claims to be the largest independent third-party payment provider, since 2004, accounting for roughly one-fifth of total funds raised by the company. Tony Luh, managing director at DFJ, says the situation has been discussed but there are as yet no plans to sever ties.

“The whole thing started with the Alibaba situation and their structure is a lot more complicated than ours and they have well known stakeholders in Yahoo and Softbank,” Luh tells AVCJ. “To us, it is business as usual – it’s like you hear an air raid siren on once in a while and then everyone senses things are normal.”

Mode of entry

DFJ’s investment in YeePay has always been channeled into the company’s offshore entity domiciled in the Cayman Islands. In ordinary circumstances, an entity such as this would operate in China via a wholly foreign-owned enterprise (WFOE), with profits transferred back to Cayman as dividend payments. However, direct foreign ownership is not permitted in China’s internet industry – where, until the PBoC’s intervention, third-party payment providers were deemed to operate – so a structure was created in parallel to the WFOE under VIE rules. The structure is owned by Chinese nationals, which means it is allowed to hold the relevant business licenses but does little else. The relationship between the WFOE and the parallel company is based on five legal agreements that are intended to secure the former’s economic interest in the latter.

Cadwalader’s Lee notes that VIEs are essentially a standard by which financial statements are consolidated and there are as many imperfect structures as there are workable ones. Classic flaws include a failure to comply with Chinese laws designed to prevent illegal round-trip investing and a failure to comply with rules governing tax, foreign exchange and M&A – or just a failure to inform the Chinese government of what is going on.

The genesis of the structure can be traced back to the China-China-Foreign (CCF) model through which foreign telecom operators made their doomed efforts to enter China in the mid-1990s. China Unicom, in need of capital to build out its network, invited the foreign firms to form joint ventures with third-party companies tied to its subsidiaries. The foreign telecom firms were given proxy control over the joint ventures, which were then contracted by China Unicom to provide services.

Beijing unilaterally cancelled the agreements in 1998, arguing that China’s WTO accession obligations required it to open up some industries to foreign investment, but not all. Class One telecom assets – networks and carriers – were deemed off limits due to national security concerns. However, Class Two assets, such as the internet and related services, were subject to less rigorous oversight and a revised version of the CCF emerged. Two years later, web portal Sina listed on NASDAQ through a VIE structure.

“The government was very particular about who could invest and where they could invest,” Luh says. “That is why you have the Sina model – it really started the wave of foreign investment in Chinese companies.” He adds that DFJ even uses VIE structures for transactions in areas where foreign ownership is not deemed sensitive.

Questions have been raised as to whether the VIE structure would stand up if tested in court. Difficulties have also presented themselves when the Chinese national who owns the license-holding firm departs from the official company without transferring his interest. This happened in 2001 when Wang Zhidong was fired from Sina and a similar scenario appears to have emerged this year at GigaMedia.

The implications of the revised approach to third-party payment companies are wider but all is not lost. Foreign direct investment is not completely outlawed in China’s banking sector – although it prefers investors to be banks – so it is possible that the PBoC will accept venture capitalists as small minority investors (minus the VIE structure). However, the payment company would still need to an internet content provider (ICP) license to do business. The Ministry of Industry and Information Technology last issued one of these to a foreign-invested entity over six years ago and hasn’t shown any indication that it will start doing so again.

The bigger picture

Such issues are likely to be resolved in due course, but it remains unclear what scars they will leave on the VIE structure in general. Wang of Paul Hastings insists that the restrictions are specific to third-party payment, but Lee of Cadwalader is more circumspect. He notes that permission to create a VIE is dependent on particular regulatory bodies and that third-party payment companies only ran into trouble when the PBoC decided that their activities encroached on the banking space. It is conceivable that ownership reviews could take place in other industries.

“For the internet, it’s pretty clear that VIEs are permitted – it’s only when you go into a new industry that there are potential problems,” Lee says. “Education is the next potential blow up. We can’t be sure what the Ministry of Education’s response will be to venture capital moving from vocational certificate education into secondary principal education. It might come out one day and say you can’t do it.”

Lee adds that his firm is already working on solutions to the VIE problem that are intended to operate independently of the regulators and lock in investors’ economic position. He envisages a new structure that co-exists with the VIE or acts as a backup to it.

Until such a model launches, venture capital firms are wedded to VIEs – and the tax liability protection and offshore structuring involved – and neither Luh nor Ian Goh, a partner at Matrix Partners, say their firms are scaling back exposure to the structure.

“It’s always a possibility that it will run into trouble,” says Goh. “The VIE allows you to list and fundraise, but does it enable you to enforce shareholders’ rights? There have always been some issues but the Chinese government will resolve it one way or another.” 

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Greater China
• Support services
• Financials
• Regulation
• Dragon Capital Group