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  • KPB & Co Research

Summary

  • Microsoft is in talks to buy the TikTok service in the United States, Canada, Australia, and New Zealand.
  • The potential ban on TikTok is a part of a move to get the Chinese to negotiate a trade deal.
  • The risk of data on US citizens ending up in the hands of the Chinese government is remote but possible.
  • Current owners of TikTok prefer an independent spin-off as opposed to a complete sale to Microsoft.
  • TikTok is currently owned by ByteDance which is founded by Chinese Entrepreneur Yiming Zhang.

Growing Tensions Between Beijing & The US

The battle between the United States of America (USA) and China has been brewing for a number of decades, and only recently reached fever pitch when President Trump took office. On the way to becoming the second largest economy in the world, China developed a reputation for being the best at copying technology from major industrialized nations and cheap labour. Pundits claimed that by repeatedly copying technologies from multinational corporations and governments, China has been able to gradually refine their home-grown talent and knowledge base, such that today, Chinese industries are operating on par with most of their global counterparts. The jury is still out on how much, if any, technology China stole over the years, but there have been numerous unproven accusations. 

Through the infamous business strategy of off-shoring, many US businesses have also sought to re-locate their manufacturing capacity to China, as a means to reduce labour cost and boost profit margins. The result of all this is that today, China has become an integral part of the supply chains of some of the largest companies in the world (Apple, Ford, GM), and with that came improved government finances and a booming middle class. In addition, China joined the ranks of the most technologically advanced nations, with many arguing that in time, they may even overtake the USA. At the same time, Beijing limits the ability of western businesses to set up shop in their country. Businesses from a foreign territory that seeks to establish an enterprise in Beijing has to do so through a 50-50 joint venture with a partner who is a Chinese resident. In many cases, where western businesses are allowed to set up an enterprise, they are only allowed to do so under strict monitoring and censorship which makes it impractical for them to actually "break ground".

With expanding wealth, China has also sought to become a bigger influence in the geopolitical sphere. They have often tag team with Russia on the United Nations Security Council and vote against policies that further western interests in Syria, and other areas. Even more compelling is the fact that China has been investing large sums of money into infrastructure projects in Africa, The Caribbean, and South America. Chinese influence has also extended into capital markets where they have provided bi-lateral loans to many governments in developing countries. These moves along with the massive spending on their military ( China is the second largest military spender in the world, followed by Russia) make China a formidable force in international affairs and politics.

President Trump, upon taking office, launched an offensive against Chinese economic interests. He sought to renegotiate a trade deal that is viewed as hugely beneficial to China and a key tool through which China was able to build up a trade surplus with the USA. Issues around the enforcement of intellectual property (IP) rights were also plugged into trade negotiations, IP rights which would have allowed American companies to protect trade secrets and intellectual property from Chinese expropriation in China. Nevertheless, the Chinese, perhaps putting up passive resistance, have been slow to acquiesce to the demands of POTUS, leading to a tit-for-tat battle of increasing tariffs on both sides of the table (US imposed tariffs on US$450Bn of Chinese imports), as each seeks to change the other's calculations. As the tit-for-tat battle ran its course, the war escalated to a ban on Chinese firms Huawei and ZTE under the guise of "protecting national security, and Intellectual property". It appears that today, TikTok is just another unfortunate Chinese company that got caught up in the crossfire.

Data Privacy Accusations

There has been no tangible evidence that suggests that China is gathering data on the citizens of other countries, or stealing intellectual property, as much of what we have seen are mere speculation and conjectures. The ban on Huawei is underpinned by accusations that the company created backdoors in its wireless equipment that allows surveillance by the Chinese government. These accusations have since been expanded to include corporate espionage to steal intellectual property. The ban prevents US companies such as Google, and Microsoft from doing business with Huawei, putting the financial stability of the firm into question. Senior executives at Microsoft have sought to determine the means through which Huawei was allegedly able to accomplish these infractions, but to date, no evidence has been furnished. A reasonable person would be inclined to think that if this were true, it would be advantageous for US companies to know how so they can improve their own systems. There are even reports in some reputable UK newspapers that Donald Trump negotiated for the UK to ban Huawei without the UK having much evidence.  In the past, lawsuits have been filed against Huawei for copyright infringement, but such incidences occur quite often in the technology space globally and are not particularly specific to Chinese companies.

It is clear that many of these allegations have yet to be proven in a court of law, but that does not mean that the Chinese are innocent. As Donald Trump seeks to re-balance the scale of US trade, the appropriate question to ask is should he wait for the evidence to surface. Allegations of the Chinese theft of IP have been around for many years, and have been the subject of many debates at the World Trade Organization (WTO), and the US Congress but few real actions have been taken. At the same time, the US has claimed to be a beacon of democracy, and with this background, it is expected that pursuing such allegations through the channels that were established for such purposes would be the appropriate thing to do. Looking beyond the consistency of democratic values, it is also clear that unilaterally targeting Chinese corporations undermines the institutions that were set-up to establish world order and avoid wars.

Nowadays, it appears that banning Chinese companies is the go-to tool to resolve international disputes, perhaps due to the precedence that has been set by the US government. India recently banned 59 Chinese apps (including TikTok, WeChat, and Weibo) citing: 

These Apps are engaged in activities that are prejudicial to sovereignty and integrity of India, defence of India, security of state and public order.
— Government of India (July 29, 2020)

It is important to note that this ban came two weeks after a skirmish at the border shared by India and China led to the loss of 20 Indian lives, and an unknown number of Chinese lives. The confrontation occurred after tensions build-up over a new road India built in Ladakh leading to concerns about national security among both parties.

ByteDance, TikTok And An Ambitious Founder

America was built on the dreams and aspirations of brave entrepreneurs, and so philosophically any entrepreneur that has global ambitions whether they live in another country or not should be able to operate in the country without much resistance. At least some people in America believe in those sentiments as a significant amount of the capital that has been provided for Yiming Zhang to build his company came from US investors (KKR, Sequoia Capital, General Atlantic, Coatue). Nevertheless, in the crazy world of geopolitics, there are exceptions to the rule, especially within a context where such unfeathered access is not reciprocated by the country in which the entrepreneur resides. The US is a very large market with relatively high incomes, which makes it the most attractive market in the world. Foreign entrepreneurs who come to America implicitly sign a social contract where they agree to obey the law, provide jobs, pay taxes, give back to the community, and in exchange are able to repatriate profits back to their home country. This type of social contract is profitable for both foreign and domestic countries in most cases, but if it is a one-sided affair this contract leads to a balance of payment problem where more money leaves the country than what comes in.  It is just unfortunate that Yiming Zhang has to pay the price for a tug-of-war between Chinese and US foreign policy, an entrepreneur who undoubtedly has done a great deal of work in building a US$100Bn conglomerate.

Is ByteDance AND Tiktok in bed with china?

The Trump administration would have us believe that banning TikTok is due to the fact that China could legally obtain access to private data on US citizens or to military secrets when army officers use this app personally. Given China's history of censorship and surveillance, such concerns do appear legitimate, but it is also quite convenient for Trump as he seeks to use all leverage to push forward his trade agenda with China.  As one news agency puts it:

The idea that the hottest social app now is powered by Chinese-owned AI is, well, less than comforting, considering how China employs technology for surveillance, censorship, and the tracking of minority groups at home
— Ryan Broderick on BuzzFeed

The timing of the accusations is also apt as there has been rising negative sentiments about China due to the belief that, COVID-19 originated from China, China is responsible for the largest data breach in US history - the data breach of Equifax, and that China is imprisoning Uighur Muslims because of dissent.

Bytedance is a holding company of various apps that stretch across various verticals in social media, video, content aggregation, and collaboration tools. Each app appears to be specific to a particular region with very little intermingling between Apps. According to the corporate website, the company owns the following:

  • Douyin: Douyin is China's leading destination for short-form mobile videos. It empowers everyone to capture and present the world's creativity, knowledge, and moments that matter in everyday life, presenting a wide and diverse range of content on the platform.
  • Toutiao: A popular content discovery platform in China. It offers users a unique, personalized, and comprehensive content experience, enabling them to discover and explore topics of interest, ranging from sports and entertainment to agriculture and history.
  • TikTok: TikTok is the leading destination for short-form mobile video. Our mission is to inspire creativity and bring joy. TikTok has offices across the globe, including Los Angeles, New York, London, Paris, Berlin, Dubai, Mumbai, Singapore, Jakarta, Seoul, and Tokyo. About 100 million users come from the US.
  • Xigua Video: One of China’s most popular video applications that enable users to discover, enjoy, and share a wide range of video stories, both short-form, and long-form.
  • Helo: One of India's leading social media platforms is available in 15 languages including Hindi, Telugu, Tamil, Malayalam, and more.
  • Lark: Currently available in Japan and Singapore, Lark combines a multitude of essential collaboration tools in a single interconnected platform, including chat, calendar, content creation, cloud storage, and app management.
  • BaBe: BaBe is Indonesia's leading news and content app. It offers personalized news and entertainment content from more than 1,000 publisher partners, across over 20 categories. We aim to provide a comprehensive and trustworthy source of news and information, in an app that is reliable, engaging, and easy to use.

As can be seen from the set of apps listed above, TikTok is distributed only in the western world, while a similar App Douyin is distributed in China.  Through repeated communications, the company has made it clear that each of the servers that house the data of users are located in the countries in which they operate. A TikTok spokesperson said that:

Our $1bn creator fund supports US creators who are building livelihoods from our platform. TikTok US user data is stored in the US, with strict controls on employee access. TikTok's biggest investors come from the US. We are committed to protecting our users' privacy and safety as we continue working to bring joy to families and meaningful careers to those who create on our platform.
— Tik Tok Corporate Relations

In the event that people do not trust the management of the company, you can rest assured that the board of directors of Bytedance consist mostly of investors from western countries particularly the US. The board comprises of the following:

  • Yiming Zhang - Founder CEO and Chairman of the Board
  • Arthur Dantchik - Founder, managing director, and management committee member of Susquehanna.
  • William Ford - CEO of General Atlantic.
  • Philippe Laffont is the founder and portfolio manager of Coatue Management.
  • Neil Shen is Steward of Sequoia Capital and Managing Partner of Sequoia China

In addition, the corporate structure of the Bytedance gives it some degree of independence from Chinese authorities, albeit the Chinese government can exercise authority over those apps that are registered in the China App Store. Bytedance is a Cayman registered limited liability company that is partially owned by Yiming Zhang. This type of organizational structure is similar to that of Alibaba, Weibo, IQIYI Inc, and many other US-listed Chinese companies.

Bytedance Corporate Structure
Bytedance website

By all indications, it appears that ByteDance is not well designed to accommodate surveillance and control by the Chinese government, yet TikTok is facing a lot of heat on issues of corporate espionage and breach of data privacy laws. 

A Potential Forced Sale

In no uncertain terms, the Trump administration gave ByteDance an offer they can't refuse. They MUST sell the US division of the company to another US company or face a ban on operating in the USA. So far Microsoft has emerged as the preferred bidder perhaps because Microsoft has always been sympathetic to Chinese interests. President Trump later revealed that Microsoft was in the process of buying 30% of the organization, but he much rather a 100% purchase. In any event, Microsoft released a statement saying:

Microsoft fully appreciates the importance of addressing the President’s concerns. It is committed to acquiring TikTok subject to a complete security review and providing proper economic benefits to the United States, including the United States Treasury. Microsoft will move quickly to pursue discussions with TikTok’s parent company, ByteDance, in a matter of weeks, and in any event completing these discussions no later than September 15, 2020.
—Microsoft Corporate Relations (Aug 2, 2020)

In the deal that Microsoft is structuring, they intend to purchase and operate the TikTok service in the United States, Canada, Australia, and New Zealand. As part of the deal Microsoft has to address what is called "national security risks":

Microsoft would ensure that all private data of TikTok’s American users is transferred to and remains in the United States. To the extent that any such data is currently stored or backed-up outside the United States, Microsoft would ensure that this data is deleted from servers outside the country after it is transferred.
—Microsoft Corporate Relations (Aug 2, 2020)

There are a number of issues that are quite unusual about this deal. First, Microsoft is not really solving a data privacy issue which is the main purpose of the transaction, to begin with. ByteDance did mention that most of the data is already on servers in the USA, and a back-up may exist in New Zealand but the issue is really China's access to that data, and obviously China does not have control over any of the jurisdictions mentioned. Second, President Trump is requesting that the US Treasury get a large percentage of the sales price as compensation for making the deal possible. Obviously, such an arrangement will likely eat into the fees investment bankers will charge but even more important is that I doubt there is any precedent for such actions.

​​

The deal is quite unusual, and will likely engender a lot of anger and frustration in China. The app has an estimated valuation of about US$50Bn and is hugely addictive among teens. Base on estimates provided on TechCrunch TikTok is said to have 800Mn active users globally, 100Mn of which comes from the US, Germany 4.1Mn, France 4Mn, UK 3.7Mn, Spain 2.7Mn and Italy 2.4Mn. Given how hugely addictive the App is the user base is likely to continue growing at a phenomenal rate, which will create significant future value for shareholders. Under such circumstances, it is difficult to see the Chinese going away without a fight. The Chinese authorities are already requesting an audience with the WTO, and are also threatening trade retaliation. Knowing how Donald Trump runs the Presidency it is quite likely that this what Trump wanted to happen as it will likely bring the Chinese to the table in order to negotiate a truce.

​Conclusion

​In light of the developments over the past few weeks, it pretty clear that there will likely be additional developments between now and September 15. It is difficult to see the Chinese sitting idly by while witnessing a mafia-style asset grab. The Chinese will respond, but they don't have a strong hand as they are heavily dependent on the US to fund their booming export industries.  In this regard, the most likely course the Chinese will take is moving on to phase II negotiations on the trade deal while lobbying the WTO for restraint on America.


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