Some brief thoughts on ownership
I recently read a letter from Edelweiss Holdings that has both prompted some new thoughts and sharpened up some old thoughts about a crucial concept in finance – ownership.
The whole letter is worth a read, but this quote in particular threw bare some implicit assumptions that I had largely taken at face value:
“A promise to pay is not money. How many really understand this? We dress it up as a bank deposit, a treasury bill or some variation thereto and insist on calling it an asset. But we also laugh at the man who chooses to keep his cash in gold.“
The implications of that are fairly wide reaching, and you don’t have to agree with them. But I think it is totally true that very few assets in today’s world are unquestionably yours in every possible circumstance, and I think this comment exposes a major implicit assumption in financial markets.
Obviously there are things like credit risk and capital structure (debt > equity) which are understandable – the lender is the owner – but the wider implications of ownership are not something I’ve thought deeply about previously. What do you actually own when you own a share? Is it the same for a US share as for an Australian (or Chinese or Brazilian) share? Does your custodian (the place where you store your shares) have the ability to sell it or pledge it? What happens if the custodian goes bankrupt?
It’s necessary to distinguish between actual ownership (what the law says you own) and functional ownership (what you actually exert control over). I might own shares on a margin loan, but I certainly don’t have full control over them – and I won’t own them at all if I get margin called. Debt is the obvious way where ownership is illusory, but political and fiduciary illusions can be even more insidious.
Like everything in financial markets, the concept of ownership works most of the time. It’s at the extremes where ownership (and a separate but related concept – control) breaks down.
For example, the law (probably) says that you can take your money out of the bank whenever you want. But the physical nature of banks and fractional reserve lending means that it is physically impossible at many banks for every depositor to withdraw all of their assets at the same time. So you conceivably have a situation where your ownership is totally unquestionable, yet you cannot exercise the rights or enjoy the benefits of ownership.
There are relative degrees of severity of this concept (and laws and regulations to protect ownership), but at the extremes, you get Bear Stearns or a bank bail-in. How safe is your bank? How would you know? If you’re not an investor, have you even thought about it?
China is another good example. It is my personal view that China investors are largely buying that which cannot be sold – Chinese assets and cash flows. In the final analysis, I think that all Chinese businesses, cash flows, and even people are “owned” by the Chinese government. This might not be true in Chinese law, but I think it is probably functionally true, and it appears to be getting more true over time as the country increasingly cracks down on capital flight and political dissent.
Look at Alibaba. I don’t understand the company’s structure, but BABA shareholders essentially own a Cayman Islands holding company that “owns” the Chinese businesses via “contractual relationships”. Sometimes it owns a Virgin Islands company which owns these contractual relationships! However, a few key personnel are the actual registered owners of the Chinese businesses in Chinese law. Consider this statement from the latest annual filing:
“In order to further improve our control over our material variable interest entities, reduce key man risks associated with having certain individuals be the equity holders of the material variable interest entities, and address the uncertainty resulting from any potential disputes between us and the individual equity holders of the material variable interest entities that may arise, we are in the process of enhancing the structure of our material variable interest entities and certain other variable interest entities, or the VIE Structure Enhancement.”
That paragraph is pretty spooky, but the next sentence is the knockout:
Prior to the completion of the VIE Structure Enhancement, the variable interest entities were owned, or are owned, by a few PRC citizens who are our founders or employees or by PRC entities owned by these PRC citizens.
apologies for the formatting…am using a Mac for the first time and not sure how to correct it
So BABA is a company, where the primary assets are contracts with operating companies, that are wholly owned by PRC citizens, whose continued existence is presumably contingent on favourable relationships with the ruling party. The contracts themselves are of course dependent on Chinese law because – even if written in Cayman Islands / US law – how do you enforce them if the Chinese government or judiciary is unwilling?
I’m sure that’s a gross generalisation (deep throat ipo blog is all over it), but from an ownership perspective, surely this is massively problematic. It’s easy to overlook this type of risk because there’s a market in Alibaba shares that provides the illusion of ownership, but if for example there’s some kind of edge case, what are your chances as a shareholder of actually being able to apply your owner (“owner”) rights to these assets that you don’t actually own?
Surely you’d handicap the probability at marginally less than “snowball in hell rolling uphill”?
Ultimately your ability to control any of that asset is potentially circumscribed. Even in developed markets, the ability of shareholders to do anything without a major lawsuit is slim.
Think about the extremes. If the regulator was asleep or even just slow to react, and you were unable or unwilling to litigate, management and the board could do almost anything they wanted – and in some cases, they have.
Even ignoring the question of illegal or criminal behaviour, there must be thousands of examples of market participants giving up an element of control or ownership and having that come back to bite them: Storm Financial, Tricom, Bear Sterns, LTCM, etc.
I found that Edelweiss letter interesting because it prompted me to stop asking “do i own this asset” and instead ask “forget about the law, in what circumstances do I functionally not own this asset?”
Kind of like the old saying: “Tell me where I’ll die so I don’t go there”.
Food for thought.
I have no financial interest in any company mentioned. I do not have any financial interest in any Chinese companies. It’s possible my super fund has Chinese exposure that I am not aware of. This is a disclosure and not a recommendation.