Alibaba Group Holding Ltd., Market Cap (as of 26/09/2014): $222.98bn

In September 2014, the Chinese e-commerce Alibaba secured its place as a major global company by completing the world’s largest IPO with a price of $68 per share. Due to a very strong demand, the bankers running the deal decided to sell to the investors more shares than originally planned in order to stabilize the price in the market. Accordingly, the issuance was increased by 15%. However, on September 19, Alibaba’s shares debuted at a price of $92.7 and closed at $93.9, with an increase of 38% over the IPO price of $68. Through the offering Alibaba raised $21.8bn at a valuation of about $168bn. Yet, a few hours after the IPO launch, Alibaba’s market cap was already over $228bn.

The difference between the IPO and the opening price on the first day of trading was $24.7(+36%) making the issuance look heavily underpriced since about $9bn were left on the table. It is interesting to note two aspects: the split between primary and secondary shares and their allocation to investors. Pre-greenshoe, the issuance comprises 320.1m American Depositary Shares (ADS) split between 62% secondary units, pre-existing shares sold from pre-IPO investors, and 38% primary units, newly issued shares. The greenshoe has added ca. 48m ADS, 15% of the pre-greenshoe units, with a split of 54% primary and 46% secondary units. Among the selling shareholders: Yahoo (139.4m units), China Investment Corp (14.3m units) and founders Ma (15.5m units) and Tsai (5.2m units). According to people familiar with the deal, the allocation of shares was very concentrated: around 25 investment firms got more than half of the stocks and underwriters managed to restrict the offering to a group of no more than 50 large institutions. The rationale is to be found in the willingness of underwriters to prevent volatile trading in the first days after listing due to small investors with a short-term horizon “flipping” their holdings to pocket the gains.

More interesting is Alibaba’s ownership structure (more on this structure @ [edmc id=1912]VIE Structure – G.L.[/edmc]). What makes this IPO essentially different from other multi-billion dollars IPOs is that investors will not directly own any shares in Alibaba. In fact, in the People’s Republic of China (PRC) regulation over foreign investments in Chinese companies is very strict. According to the Foreign Investment Industrial Guidance Catalogue (2011 and revisions thereafter), prepared by the Ministry of Commerce and the National Development and Reform Commission, the Chinese market is divided into four categories when it comes to foreign investments permission: encouraged, permitted, restricted and prohibited.

The Telecommunications and the Internet sectors are classified as prohibited, and therefore, the companies that operate in these markets cannot directly offer their equity to foreign investors. However, thanks to a complex and creative legal structure, which was set up in the late 90s, Chinese companies in the prohibited sector were able to take advantage of the loophole in the legislation and to raise capital abroad. This legal structure is called “Variable Interest Entity” (VIE), which essentially employs two Special Purpose Vehicles (SPVs) and a series of entangled contractual agreements that artificially replicate an equity position.

The VIE structure employed for the Alibaba’s IPO is organised as follows. A first SPV (Alibaba Group Holdings Ltd.), which receives the proceeds from both foreign and Chinese investors, is incorporated in the Cayman Islands. This first SPV, which reflects the ownership structure of the VIE company, owns multiple SPVs which are incorporated in Hong Kong and which, after their incorporation, are allowed to invest is a series of Chinese holding companies. Finally, these Chinese companies, through a system of contractual agreements are able to control Alibaba. (See Diagram, Source: FT Research)

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Therefore, the shares offered in the IPO are the shares of the Cayman Islands-based SPV, which indirectly ‘owns’ the domestic company through this complex system of subsidiaries and agreements. There are clearly at least two risks in investing in such a structure. First and most important, there will always be a risk that a change in the regulatory environment can effectively restrict the SPVs from controlling the VIE company, thus destroying the entire structure. In fact, the core elements allowing this scheme to work are the contractual agreements between the Chinese investors, who legally control the company but transfer their rights to the VIE structure. In case of a contractual breach or of a change in the regulation, it is still not clear how the foreign investors could make their contracts enforceable and protect their interest, since the shares in the Group Holdings Ltd. have no direct control over the VIE company. Second, unlike in western companies where shareholders are able to directly elect board members, Alibaba’s board composition is determined by the management committee. Therefore, it is again unclear how foreign shareholders will be able to effectively control and influence the management of the company in order to align incentives and create shareholders value.

Regardless the fact that this structure incorporates many risks, given that the company and the shareholders are effectively subject to the laws of four different countries (U.S. for securities, Cayman Islands, Hong-Kong, and the PRC), legal consultations will undoubtedly be expensive and time-consuming. It is notable that Alibaba’s founder, Jack Ma, has himself used the ambiguity of the VIE ownership structure with Alipay, the payment processing company of the group, before. In 2011, Mr. Ma separated Alipay from the VIE structure, by transferring its ownership to a third-party holding company partly controlled by Mr. Ma himself. The reasoning for this spin-off was primarily to obtain the Payment Business License in the PRC. However, since the VIE structure is not prohibited in the PRC, the license might have been obtained without the spin-off. This type of transactions can expose investors to an array of opportunistic behaviours, whereby the PRC investors or the managers, can use the ambiguity to their advantage. However, thus far, such issues have been settled reinforcing the viability of the VIE structure as a mechanism to allow PRC companies to raise money abroad. Companies such as Baidu, Sina, Tudou all operate using the VIE structure, and all have been able to adeptly handle any legal issues, which should ease investors’ concerns, at least for the time being.

Underwriting team: Citigroup Inc., Credit Suisse Group AG, DeutscheBank AG, Goldman Sachs Group Inc., J.P. Morgan Chase & Co, Morgan Stanley.

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