Written by Brenda Nakalema

Trouble for Chinese ADRs as U.S and China attempt to split ways

As far as public break-ups go, China and U.S seem to be the latest addition to the ever-expanding list. The …

As far as public break-ups go, China and U.S seem to be the latest addition to the ever-expanding list. The two countries took concrete steps towards reducing their financial ties as regulators from both countries initiated the delisting of Chinese companies from U.S exchanges. This move might serve as a warning of impending change in the global investment climate.

The Securities and Exchange Commission put a final stamp on rules paving the way for the delisting of companies that don’t comply with the U.S auditing disclosures within the three year transition period. One of the more popular companies affected by the staunch rules is the ride-hailing giant Didi Global (ticker: DIDI), whose much anticipated U.S public offering was ruined by Beijing’s cybersecurity investigation. Didi currently plans to delist from the New York Stock Exchange and move to its new home in Hong Kong just months after its US IPO.

Seemingly experienced investors have held on by the seat of their pants in an unprecedented situation brought on by Beijing’s increased scrutiny and action towards Chinese tech giants. In addition to this, investors have also had to grapple with an economic slowdown. As if to make an already tenuous situation even more challenging, competition between the two countries has amounted to a ton of pressure, forcing both countries to become less interdependent.

The break-up has caused many investors to see an allocation to China as a necessary diversification strategy- the marked selloff of Chinese stocks this year has majorly been by bargain hunters. However, the delisting is a clear indication to retail investors who heavily relied on U.S-listed Chinese stocks that they will need to find alternative ways to invest in China. According to sources, there are roughly 250 Chinese companies facing possible delisting as geopolitical forces shape the investment climate.

The variable interest entity, a corporate structure that up until recently had been utilized by Chinese companies listed in the U.S to skirt China’s foreign ownership restrictions, is now under serious scrutiny by regulators in both countries. The structure essentially gives investors a stake in a shell company with a contractual relationship with an operating company and therefore does not fall under the purview of Chinese law. The structure has drawn increased scrutiny as a result of the changing nature of the relationship China has with the US.

It will be relatively easy for institutional investors to convert ADRs to Hong Kong listings; the transition will not prove to be smooth sailing for retail investors. Some brokerage firms like Vanguard, Robinhood, and E-Trade don’t offer their users direct trading on foreign exchanges. However, a spokesman at Vanguard said the firm would explore options to assist their clients in liquidating in the event of a delisting scenario.

The threat has been perceived as loud and clear by some Chinese companies, including Alibaba Group Holding (ticker: BABA), JD.com (JD) and NetEase (NTSE), which have all secured secondary listings in Hong Kong.

“The DIDI situation obviously brought home the point the stocks will be moving. If you are a retail holder and can’t take Hong Kong shares, then you are left in a situation where you liquidate,” says Leon Eidelman, manager of the J.P Morgan Emerging Markets Equity Fund, which holds mainly Hong Kong and A-listed shares.

Aside from the antics related to the changes in the geopolitical environment, a lot of money is at stake with this shift in investment. Goldman Sachs Group reports an estimated $700 billion of Chinese stocks owned by institutional investors across different exchanges. Of that, roughly $250 million is held in Chinese ADRs. Brendan Ahern, KraneShares Chief Investment Officer, says the firm is yet to convert ADRs that have Hong Kong listings in their funds like the KraneShares CSI China Internet exchange-traded fund (KWEB), partially because the underlying index is yet to make the change.

For retail investors still holding Chinese ADRs, now might be the time to assess what options they might have available. Although the DIDI case will act as a guideline, it’s still unclear how the delistings will play out. One of the options might be for Chinese companies to go private and buy out existing shareholders or opt for duo-listing and eventually delist from the US. They could also possibly get the ADR cancelled by the custodians and receive stock traded on Hong Kong or another exchange in return.

Some of the largest companies without a secondary listing in Hong Kong yet like Pinduoduo (ticker: PDD), will likely have to find a new home, especially as the Hong Kong exchange eases its listing standards. Plan B is not as straightforward for the smaller companies- those that lie within the ADR bracket. Carson Block, Muddy Waters’ short-seller, asserts that Beijing could facilitate the acquisition of smaller companies because Hong Kong might lack the liquidity to absorb all the companies.