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The Alibaba IPO: For Mom and Pop Investors, the Hidden Risks Are Real

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The name rolls off the tongue, but will investors just roll with the ownership structure set up by the Chinese Web retailer?

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It could be the biggest US-listed IPO ever, according to the Financial Times. A mix of Amazon (NASDAQ:AMZN), eBay (NASDAQ:EBAY), PayPal, and Google (NASDAQ:GOOG), says the Wall Street Journal. The "holy grail of the technology market," gushes the Telegraph.
 
Yes, Alibaba is coming to America. The Chinese Web retailer said last week that its initial public offering will very likely take place on US soil. Details remain sketchy, but the excitement is palpable. Alibaba has all the hallmarks of a rising tech star: fast growth, an eccentric CEO, and an incomprehensible business model. 
 
Even the name rolls off the tongue. Alibaba. Founder and boss-man Jack Ma claims to have chosen this handle because it's easy to spell -- no doubt anticipating the needs of Western journalists.
 
Alas, spelling out the risks associated with Alibaba isn't quite so easy. This is a company with deep ties to China's troubled financial industry, and heavy exposure to a waning Chinese economy. Alibaba gave up market share last year in Web retail and has come under the scrutiny of state regulators such as the People's Bank of China. With a US IPO, the Web giant appears to be betting on the blissful ignorance of American investors -- and these investors should be very worried about an ownership structure that gives them little say over a company that, in 2011, tried to fleece its largest backers out of billions.
 
Starting with the financial risk: Alibaba receives large royalty payments from Alipay, an online payments platform that it spun off several years ago. In the event that Alipay goes public, these royalties will turn into a large payout or, alternately, a large equity stake. And make no mistake, Alipay is a big deal: It handled $660 billion worth of transactions in 2012 and owns the largest asset management firm in China.
 
Alipay is also seen as a threat to China's banking system, a large portion of which is state-owned. The PBoC is considering regulations that would severely limit the use of third-party payment systems. Also coming under scrutiny is Yu'e Bao, a Web-based money market fund introduced by Alipay last year. The fund already claims some 80 million investors, and the Chinese media wants regulators to take action; one state broadcaster went so far as to call it a "bloodsucking vampire".
 
Accompanying the regulatory danger is economic uncertainty. China is rebalancing; the nation's leaders want to move away from the old drivers of growth, exports and easy credit. It's not yet clear how well the economy will weather this change, but it's likely to be a tough transition for Chinese businesses -- and, by extension, for Alibaba's business-to-business services such as 1688.com. The Wall Street Journal reports that corporate borrowing costs are up 50% versus a year ago, and last week Goldman Sachs (NYSE:GS) reduced its forecast for the Chinese economy to 7.3%, which would be the slowest annualized growth rate since mid-2009. 
 
Making heads or tails of these risks is going to be a tall order for investors who live half a world away. Nor is the consumer market much simpler. "In China, shopping is a social activity," an industry executive told Reuters, trying to explain why Alibaba gave up market share last year to brand-specific Web stores and socially connected rivals such as JD.com.
 
At the same time, Alibaba has been delisting counterfeit goods in preparation for its IPO, and the Chinese government is implementing e-commerce legislation that would do the same. It's hard to say what impact this might have on the company's growth. The most-cited source on counterfeiting appears to be a rather dated MIT study that puts fake goods at "between 15 and 20 percent of all products made in China," or around 8% of GDP.
 
Perhaps the most worrisome thing about Alibaba is its ownership structure, a factor that loomed large in its decision to go public in the United States. The US is relatively tolerant of dual-class share structures, which concentrate voting rights in the hands of management. Both Facebook (NASDAQ:FB) and Google structured their IPOs in this way (although I suspect that some public shareholders would be surprised to learn that they have no say in the running of either company).
 
This concentration of ownership is particularly troubling in the case of Alibaba, because American investors may find themselves with little recourse if the Chinese company acts against their interests. This is precisely what happened in 2011, when CEO Jack Ma sold himself Alipay for a nominal sum. Stakeholders Yahoo (NASDAQ:YHOO) and Softbank Corp. (TYO:9984) were furious. In the end they had enough leverage to demand fair compensation, but retail investors might not be so lucky.
 
None of which changes the fact that Alibaba is easy to spell and ripe for hyperbole. The Web giant benefits from a kind of asymmetry seen in other popular tech companies: The upside is obvious, while the risks are hidden and hard to quantify. Alibaba's IPO will no doubt be a big deal, but buyer beware.

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