Financial services in China: Carving a niche

David Liu, head of China at KKR, has been doing financial services deals since the country first opened up the sector to foreign investment. In 1993, he was part of the investment team at Morgan Stanley Private Equity Asia (MSPEA) that committed $35 million to Ping An Insurance.

Like many of the PE unit's early investments in China, it was predicated on what was then only a nascent trend - the emergence of discerning middle-class consumers who would drive demand for an array of products tied to quality of life, life insurance included. When MSPEA and fellow investor Goldman Sachs came to exit Ping An in 2005, the thesis was proven and they netted around $1 billion between them.

Fast forward 20 years and much has changed. China's financial services sector - and the regulations governing it - have evolved dramatically, which makes getting a piece of the action that much harder. Nevertheless, elements of MSPEA's original investment thesis still apply.

"Identifying the trend ahead of time is important," says Liu, referring to KKR's 2009 investment in niche financing specialist Far East Horizon. "When we first took a deep look at the leasing and small-to medium-sized enterprise (SME) financing space, we found it to be significantly underpenetrated. We thought if we worked with the emerging market leaders in this space, there would be significant room to capitalize on this future growth potential."

A KKR-led consortium that included Government of Singapore Investment Corporation (GIC) and China International Capital Corporation (CICC) paid $160 million for a 30% stake in Far East Horizon, a division of Chinese trading conglomerate Sinochem Group. The Shanghai-based company listed in Hong Kong in March 2011 and KKR upped its stake later that year.
It is not the only PE firm to venture into leasing, where market penetration is just 3% versus 15-20% in more mature economies.

One of Far Eastern Horizon's main competitors, UniTrust, is backed by TPG Capital. The private equity firm began a sale process for the asset, also based in Shanghai - earlier this month. UniTrust, which is expected to fetch $800 million, provides equipment leasing finance for SMEs in construction, medical and education and technology industries. The company was known as Nissin Leasing (China) until TPG acquired a 50% stake from Japan's NIS Group in 2007 for around $103 million. It added another 10% for $20 million in 2008.

Getting exposure

Anecdotal evidence suggests leasing and niche financial services as a whole is growing, yet private equity firms' ability to participate depends on where they can grasp opportunities in this broad and quickly evolving space.

Private equity has typically struggled to find investment opportunities in financial services, hampered not only by restrictions covering foreign activity in banking but also by the fact the industry is dominated by just a handful of state-backed players. This is underscored by Goldman Sachs, one of the last remaining non-strategic foreign investors in traditional banking, exiting the last of its stake in Industrial and Commercial Bank of China this week. The cumulative proceeds from the deal stand at $9.7 billion; it is difficult to image this being repeated.

While there is a dearth of opportunities in banks, AVCJ Research indicates that private equity deal activity in the non-banking financial services has increased. Since the 2008, investment in financial services, excluding banking and insurance, has increased year-on-year, reaching a peak of $6.8 billion in 2012.

Financial leasing services have emerged against a backdrop of heavily regulation in the traditional banking system where the China Banking Regulatory Commission (CBRC) has imposed strict requirements regarding capital adequacy, loan-deposit ratios, loan quotas and loan-loss reserves.

CBRC registration is required for leasing companies only if they are owned by commercial banks, of which there are 30; the remaining 400 fall under the Ministry of Commerce's (MofCom) purview and oversight is far less rigorous. 

Financial leasing is one of the most notable niches in a veritable cottage industry that has sprung on the edges of China's formal banking sector. This industry is commonly known as shadow banking, but the term defies definition due to the range of activities that fall beneath it. According to the International Monetary Fund's (IMF) financial stability board, shadow banking is "credit intermediation involving entities and activities outside the regular banking system."

Similarly, due to its informal and opaque nature, getting an idea of the size of the shadow banking space is difficult. A Moody's report estimates that the balance of outstanding shadow banking products is around RMB21 trillion ($3.4 trillion), equivalent to 43% of the total system loans or 55% of GDP in 2012. Financial leasing services account for around 2% of all shadowing banking.

The report also estimates the growth rate of core shadow banking services - defined according to the IMF's description above - exceeded a cumulative 75% over the past two years.

Part of this has been fueled by the liberalization of interest rates. "Interest rate deregulation has caused the interest rate spread to shrink and put pressure on banks, which has dragged down the entire financial services sector," says David Lin, managing director of Goldstone Investment, a unit of CITIC Securities. "We see that as a buying opportunity for some of the other sub-sectors, like property and casualty insurance, leasing - things that are less regulated and underpenetrated."

Expansion also owes itself to increasing demand for credit among SMEs, which already contribute close to 60-70% of China's GDP but receive only about 37% of the total financing. The growth of SMEs - there were more than 50 million in 2012, up from 21.9 million in 2002 - is far from matched by traditional banks' willingness to extend their customer base beyond large state-owned enterprises.

A sector approach

While shadowing banking sector has largely been characterized by high-risk investments, the degree to which investors are exposed can vary. Financial leasing, for example, is subject to less regulation and practitioners' activities are often opaque, but many of the loans are secured by collateral that is not necessarily more risky than bank loans.

One of the ways financial leasing companies have sought to further mitigate risk is through targeting specific sectors. This approach has attracted many private equity investors. Last December, China New Enterprise Investment (CNEI) led a Series B round of financing for Juxin International Leasing, taking a 12.1% interest for $20 million. The company provides financing leasing services to customers predominantly in the education and healthcare sectors, offering tailored solutions for public higher education institutes and hospital.

"These two sectors still have a lot of financing needs, for example school s need to build new labs and upgrade their IT systems, while hospitals may need diagnostic equipment," says Stella Sheng, a partner with CNEI. "We are predominantly targeting this sector because there is a low default rate and they a good niche market with potential to grow in the mid-term."

Other players in the financial leasing space have taken a similar view. KKR's Far East Horizon, for example, also looks to finance SMEs in specialist sectors. "What they do is focus their resources on a number of really interesting and defensible sectors where there is good growth potential - such as health care and education - and where they know their customers inside out and they can provide real value to customers in addition to capital," says KKR's Liu.

He adds that Far East Horizon has posted 52% compound annual growth in net income over the last three years.

However, some commentators observe that investments like these are the exception rather than the rule in niche financial services. Even if the risk-return profile is appealing, getting into the space often relies on forming alliances with existing institutions. For Far East Horizon, this was Sinochem, a large and reputable SOE.

"I'm not sure if you can say in retrospect whether the deal would have been done if an SOE wasn't involved," reflects Robert Partridge, managing partner for transaction advisory services at Ernst & Young. "The problem with this space it is still regulated, so trying to go in on your own as a private equity house without a financial institution as a co-investor is very difficult."

At the same time, the segment is still in a state of flux. Shadow banking and niche financial services as a whole are growing in size and scope - and based experiences in other parts of the sector, this means greater regulatory scrutiny will follow. It remains to be seen how easy private equity firms find it to enter the space.

"Financial services are a huge opportunity because the oligopoly-like nature of the market has led to a certain lack of innovation," says Derek Sulger, managing partner at Lunar Capital.

"But I believe that sometimes you don't want to deal in areas that the Chinese government doesn't want you in. You can't be too bold without sticking your neck out. A lot of people have tried and failed to do financial services in China because the regulations don't welcome it."

 

SIDBAR: E-payment - Another way in?

China's third-party payment space has exploded in recent years. In 2012 the gross merchandise volume of transactions totaled RMB 12.9 trillion ($2.1 trillion), up a staggering 54.2% on the previous year and more than four times the level recorded in 2009.

As with other financial segments, the potential of China's large and expanding consumer population is too attractive to ignore for some venture capital investors.

Derek Sulger, managing partner at Lunar Capital, was one of the early movers in 2005, setting up SmartPay, which allows consumers to instruct electronic payments via an SMS or the web. "The business started on a simple concept: we had all these mobile phone-related businesses but you had to pay your mobile bill at the end of the month by going to the store," says Sulger "This was the challenge that gave birth to SmartPay trying to help automate the collection of mobile phone bills."

Recent VC deals in the third-party payment include DFJ DragonFund China's 2011 investment of over $5 million in YeePay, a China-based provider of multi-platform electronic payment services. YeePay, however, remains a very small player in the space with just a 3.5% market share. Alipay, an affiliate of private equity-backed Alibaba Group, is the dominant force.

The lion's share of the market (46.6%) is held by Alipay, an online third-party payment system affiliated with private equity-backed Alibaba Group, which received its license to set-up its e-payments systems from China's central bank in May 2011.

However, growth has been met with higher regulatory hurdles. At the end of 2010, the People's Bank of China decreed that non-bank payment service providers must be licensed; must use financial institutions as agents when transferring between one another; and must file financial reports and client information.

There was an added complication for all VCs in the space. As banking entities, payment providers couldn't use the variable interest entity (VIE) structure through which foreign investors have participated in the internet industry - where direct offshore ownership is prohibited so investors stay one step by placing sensitive assets into a separate onshore entity.

Alibaba blinked first, transferring ownership of Alipay to a separate company and thereby breaking the VIE that secured Yahoo and Softbank's interest in the asset.

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• Topics
• Technology
• Greater China
• Financials
• Expansion
• KKR
• Morgan Stanley Private Equity Asia
• CNEI
• Lunar Capital Management
• TMT
• Financial Services
• Growth capital