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Thursday, 21 February 2019

Living in hope

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Just as Chinese internet finance companies are gearing up for a capital-raising binge, a vast fraud in the poorly regulated sector has cast a shadow on rosy valuations.

The uncovering of a US$7.6bn fraud has rocked confidence in China’s fast-growing internet finance sector at a time when leading players are lining up to tap the public markets to fund their expansion plans.

On February 1, state-run Xinhua News Agency reported that Ezubo, a peer-to-peer lending company based in Anhui, had conned investors out of more than Rmb50bn through a Ponzi scheme.

According to Xinhua, nearly 95% of investment projects listed on Ezubo did not exist. Founded in July 2014, Ezubo, sometimes also transliterated as Ezubao, attracted money from about 900,000 investors with offers of interest rates of 9% to 14.6%. It then paid off some investors in classic pyramid-scheme fashion until the authorities launched an investigation last December after finding signs of tight cashflow.

In all, 21 executives were arrested, according to Xinhua.

The scandal comes as a number of Chinese internet finance firms prepare to tap the public markets after raising billions in private capital, hoping to ride global enthusiasm for “financial technology”, or fintech, investments.

The Ezubo fiasco highlights the risks facing investors in the fast-growing sector.

“We always know there is risk; what Ezubo has revealed is the risk is much higher than what most of people have thought,” said an investor, who several small Chinese fintech companies had solicited for funds.

“In only one and a half years, the company managed to con Rmb50bn from 900,000 investors with almost no real business. You can say it shows the tremendous growth of China’s P2P sector, but it also tells you the kind of risk you are facing.”

Ezubo, which purports to connect borrowers and lenders, is one of over 2,600 P2P lending platforms in China. Their rapid rise stems from a policy push as the government wants to channel more credit to small and medium-sized enterprises, which are relatively underserved by big lenders.

The National People’s Congress unveiled last March a countrywide “Internet Plus” policy to encourage the development of internet banking and e-commerce through the integration of mobile internet, cloud computing and big data.

Supportive policies have enticed many companies to enter the fray. According to Wangdaizhijia.com, a financial information website, the P2P market grew 288% in 2015 with transaction volumes of Rmb982bn.

High risk

The China Banking Regulatory Commission said last November it had found problems with more than 1,000 P2P platforms.

“Investors who have poured money into the industry may now want to take a serious look at what they have actually invested in,” said the investor.

Growing risks, tougher regulations, tumbling stock markets and a slowing economy have also cast doubts on the sky-high valuations of the big fintech companies.

Lufax, which has the backing of Ping An Insurance, completed its first round of financing last March at a valuation of US$10bn. In December, its valuation had ballooned to US$18.5bn after a second financing round of US$1.2bn.

The company invited bids for arranger roles last month for a proposed IPO of up to US$5bn. According to sources familiar with the process, banks have assigned a valuation of US$30bn–$40bn for their bids, which represents another doubling of the second financing round’s valuation if Lufax manages to list within this ballpark later this year.

“Lufax will, undoubtedly, experience super-high growth in the next few years, but will the public market be willing to pay a high premium over what is already a high valuation? It will depend on market conditions and, more importantly, whether Lufax can achieve that kind of high growth when the risk of the overall industry is growing,” said a senior investment banker.

Lufax handled trading volumes of Rmb926.4bn (US$145bn) in the first nine months of last year, Ping An said in its third-quarter earnings report. The amount, which includes wealth management products, as well as peer-to-peer lending, was nine times more than the same period in the previous year.

“The kind of valuation for fintech companies we are seeing now is unsustainable. China’s private-equity firms have abundant funds and they are eager to invest in something high growth, no matter the valuation. It will be interesting to see how public markets react to that kind of valuation,” said Anne Stevenson-Yang, co-founder of J Capital Research, which published a note in December predicting mass closures in China’s fintech industry in 2016.

In the latest round of financing, Lufax raised US$924m from new investors, and US$292m from first-round investors.

The round was multiple times oversubscribed, with participation from domestic and overseas investors. Investment units of Bank of China and China Minsheng Banking, and Guotai Junan (Hong Kong) were among the investors, according to the company.

Private placements from other companies are expected, including a new round of up to US$500m from Dianrong, one of the sector’s largest platforms, following a previous US$207m round last August.

Domestic access

To seek high valuations, some internet finance companies are looking at domestic floats. Lufax is considering a Hong Kong IPO, as well as an A-share listing, potentially on the new technology-focused board the Shanghai Stock Exchange is setting up.

The State Council gave the green light to the establishment of the new board last December to provide a fundraising venue for larger high-growth and innovative companies. The board is expected to open for business later this year.

Alibaba financial services affiliate Ant Financial Services Group, which runs the online payment platform Alipay, said last month it had launched a second round of financing, but did not reveal its fundraising target. Mainland media reported that the company had raised US$4bn last July, when it completed its first round at a valuation of about US$45bn.

Like Lufax, Ant Financial is planning to go public. It is eyeing a domestic listing probably on the new Shanghai board, according to sources close to the company.

Although many P2P platforms are eagerly looking at a domestic listing, bankers reckon that, with the exception of a few big fintech firms with solid corporate governance, internet finance companies are unlikely to gain access to domestic capital markets this year.

“The regulator is unlikely to allow P2P firms to list domestically until the regulations come into force,” said a banker.

Currently, only a few A-share-listed companies have either carried out P2P business or acquired related platforms, but no pure P2P company has been allowed to list domestically as yet.

Industry consolidation

On February 4, three days after the Xinhua report on Ezubo, the State Council said local authorities should monitor the P2P lending industry closely for signs of lawbreaking.

In fact, since the end of January, some Chinese banks like Agricultural Bank of China and China Merchants Bank have already notified third-party e-payment platforms that they will no longer support payments to P2P lending services.

The move came after the CBRC issued draft rules at the end of last December to regulate online lending platforms, aiming to control the growing risk. These set out detailed requirements on business management, risk control and information disclosure.

The draft rules also forbid P2P lending firms from pooling investors’ money without a defined purpose, providing guaranteed returns or selling wealth management products, insurance and trust products.

There will be an 18-month transitional period for P2P companies to get ready for the new rules after they are implemented.

Stricter regulations, along with a tougher operating environment, are expected to lead to an industry consolidation.

J Capital Research says a perfect storm is brewing for the sector as US interest rates rise, capital inflows into China turn into outflows and the country’s central bank continues to lower interest rates.

“Falling returns on investments, new regulations, non-sustainable business model … all these will lead to consolidation in the industry. Smaller players will be out,” said Yang.

The average interest rate on P2P platforms, for instance, fell 457bp year on year to 13.29% in 2015, according to a research report from Citic Securities.

In an attempt to grow before being pushed out of the game, some smaller players have opted for a US listing. China Rapid Finance, a P2P lender, plans to raise up to US$200m from a US IPO this year.

The disappointing trading performance of Yirendai, the first Chinese online P2P lender to list abroad, however, augurs poorly for similar floats. Since listing at US$10 last December, shares of the company had fallen almost 57% to US$4.32 as of mid-February.

Yirendai raised US$75m from its listing on the New York Stock Exchange.

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To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com .

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