I am very happy to bring back occasional weekend issues of the newsletter featuring guest contributors. At this point I do not know what the frequency will be but am hoping for at least once a month.

This weekend’s newsletter is an excerpt from Duncan Clark’s excellent new book Alibaba: The House That Jack Ma Built.

This timely excerpt is from Duncan’s chapter on the infamous 2011 transfer of Alipay to a new company, now called Ant Financial, without the approval of Yahoo or Softbank. Ant Financial is a hugely successful business that according to an April 8 Wall Street Journal report is raising money at a $60B valuation. As usual, Jack Ma got himself a very good deal.

Full disclosure: Duncan is a friend of many years and he gave me free copy of the book a couple of months ago as well as an invitation to his DC book party later this week. And if you click on the links in this issue to the book and buy it I get a commission as part of the Amazon Associates program, as noted in the Sinocism Disclosures.

Author’s Introduction:

Perhaps the most controversial episode in Alibaba’s history was the transfer of Alipay out of Alibaba Group into a domestic company controlled by Jack Ma. The transfer first became public knowledge in May 2011, ahead of new regulatory measures adopted by the People’s Bank of China (PBOC, China’s central bank) to implement a new licensing regime governing online payment platforms such as Alipay. Why had an asset that some analysts valued at at least $1 billion been transferred out of the Group for a mere $50 million?  Why hadn’t Alibaba’s largest shareholders – Yahoo and SoftBank – known about the transfer? If they had known – as Alibaba asserted – why hadn’t they informed their own shareholders?  The controversy rapidly degenerated, only to be resolved by a compensation agreement almost three months later. But by this point Yahoo’s shares had dropped 22%, and the viability of China’s quirky Variable Interest Entity (VIE) structure – the principle means for foreign capital to access China-based Internet companies in China – called into question. The incident complicated, for a time, the efforts of other Chinese entrepreneurs to raise funds overseas.  In this excerpt, from chapter eleven of Duncan Clark’s book “Alibaba: The House That Jack Ma Built”  the author explores the drama that put the otherwise immensely profitable relationship between Alibaba, Yahoo and SoftBank under strain as never before.

Excerpt:

Critics of the VIE structure, and of investing in Chinese companies in general, were having a field day. But did Alibaba in fact, as it was arguing, have no choice but to make the transfer?

Behind the scenes, when the crisis first broke, Jerry Yang was upset, but he remained calm. Masayoshi Son, however, was incensed. What was Jack thinking? To figure out what was going on, Jerry offered to fly to Beijing. Meeting there with a senior official at the PBOC, he was told that it was best he just “accept the situation.” When he pressed for an explanation, he was simply informed that the matter was “out of their hands.”

It was true that PBOC had introduced new rules, in June 2010, governing domestic third-party payment platforms on the Internet.  The rules set out a longer application procedure for foreign-funded companies than for wholly domestically owned applicants. PBOC had been debating the issue of foreign ownership of payment companies since 2005. But the rules did not exclude foreign ownership entirely.

Jack’s defenders argue that he was simply first to see which way the regulatory wind was blowing. Parking the Alipay asset into a domestic company that he controlled could insulate Alibaba from the risk that new licenses expected to be issued by PBOC would be denied to foreign-invested companies. In an effort to clear up the matter in 2014 ahead of its IPO, Alibaba justified the transfer by explaining that the

“action enabled Alipay to obtain a payment business license in May 2011 without delay and without any detrimental impact to our China retail marketplaces or to Alipay.”

Indeed, on May 26, 2011, Alipay, now entirely domestically owned, was the first of twenty-seven companies to be issued licenses, awarded license number 001. But Jack’s critics charge that because PBOC also issued licenses to foreign-invested companies, such as Tencent’s Tenpay, the number two player in the market, then the argument that Alibaba had to transfer ownership of Alipay out of foreign hands doesn’t hold water. To this, Jack’s defenders argue that the comparison with Tenpay and other foreign-invested companies isn’t valid: Alipay already had such a dominant share of the market that it could not have expected such leniency.  There were thousands of companies active in the third-party payment market, but with the first batch of licenses issued in May, PBOC also issued a deadline—September 1, 2011—for all companies to either obtain their own licenses or merge with an existing license holder. Inevitably this generated a lot of tension. Companies that had operated in a gray area now found themselves being divided into black and white, based on whether they had foreign investment and had obtained a license.  Those that had not yet received licenses faced the risk of going out of business, and those that had received licenses but were foreign-invested were concerned that Alipay’s move threatened their own ability to IPO in the future, damaging the valuation of their business and, many feared, undermining the VIE investment structure on which so many Internet companies relied.

A number of Alipay’s rivals described to me a meeting hosted by PBOC soon after the licenses were issued, at which Jack was present. Many vented their unhappiness at Alibaba, but Jack remained silent. Yet even without the licensing issue, the reality was that too many companies were chasing after the oasis of fortunes to be made in payment riches.  This turned out to be a mirage: With fees as low as 1 percent of transactions, if licensing hadn’t thinned out the field, then competition would have done the job anyway. In this light, the Alipay incident—and the PBOC licensing regime it triggered—merely accelerated the inevitable: Many payment companies found themselves stranded in the desert, soon to run out of funding. One executive summed it up for me: “There were more ‘payment solution’ companies out there than consumer e-commerce companies. It was like being in a kitchen where there were more chefs than diners in the restaurant.”

In light of all of this, was Jack justified in making the transfer of Alipay to his control? Or are those who, to this day, criticize the transfer justified? Both sides of the argument relied on their interpretation of what the Chinese government, in the form of PBOC, had in mind. But that was clear as mud. PBOC had never said that foreign-invested entities could own payment platforms. But equally it had never said that they could not. One influential investor I spoke with summed it up: “PBOC were pissed. But Jack was very skilled at playing off  different factions. No one could do anything about it because PBOC’s rules were so vague to start with.”

Was something else going on that drove Jack to take the risky move of transferring Alipay out of Alibaba? The deteriorating relationship between Yahoo and Alibaba certainly didn’t help. Under Carol Bartz, relations had become so bad that she and Jack were not even on speaking terms. Instead they started to communicate with each other by issuing statements or in interviews with the media.

Eight months before the Alipay crisis erupted, Bartz stated that she had no interest in selling Yahoo’s stake in Alibaba and that Jack was merely trying to get “some of his stock back” ahead of an IPO that would value those shares much higher. Alibaba immediately fired back, via the media, denying any plans to get an IPO and laying out its efforts at good faith negotiations with Yahoo to buy back its stake.

The reality for Alibaba, though, was that if Yahoo didn’t like the price Alibaba was prepared to pay there was little Jack could do about it. Did this frustration play a role? Or was another looming issue the reason? Five years had passed since Yahoo’s investment. Part of the investment agreement, conceded to by Alibaba only after intensive negotiations, gave Yahoo the right to appoint a second director to Alibaba’s board in 2010. Furthermore, the agreement also stipulated that a majority of the board could replace Alibaba’s senior management. If a hostile Bartz gained the support of Jerry Yang, who although no longer CEO still sat on Alibaba’s board, and enlisted the support of Masayoshi Son, she could outvote Jack and Joe, imperiling their positions.  This was improbable—given Jack’s relationship with Jerry and Masayoshi Son, not to mention the difficulty for a foreign company to try to gain control over such an iconic company as Alibaba—but not impossible, especially if Bartz could strengthen her hand in negotiations over a sale of Yahoo’s stake. Yet even threatening such a move would have been highly destructive for Yahoo. “Then their investment would be worthless” is how another China Internet founder I spoke with put it.

In any case, the “nuclear option” never happened. As criticism of the transfer mounted Alibaba had little choice but to reach an agreement with Yahoo as quickly as possible.

From ALIBABA by Duncan Clark Copyright © 2016 by Duncan Clark. Reprinted courtesy of Ecco, an imprint of HarperCollins Publishers.

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