China fintech: Transition time

Online peer-to-peer (P2P) lending platform Jimubox launched three years ago with a view to plugging a gaping hole in China's financial sector: it serve small-scale borrowers that don't qualify for bank loans by matching them up with individual lenders who were willing to take a risk for potentially higher returns.

The problem was thousands of other market entrants were trying to do the same thing. Jimubox - which has received funding from the likes of smart phone maker Xiaomi, Shunwei Capital Partners and Temasek-controlled Vertex Ventures - responded by diversifying its business model. The company now has aspirations to become a one-stop, technology-driven wealth management platform.

Jimubox received a license to sell mutual funds online last year and it is working on a robo-advisory product with a view to providing automated asset allocation services. The company has also shifted the focus of its P2P platform from small enterprises to consumer finance, underwriting loans for purchases of travel packages and electronic goods rather than for corporate expansion projects. Over the last nine months, more than 422,000 consumer borrowers have signed up.

Industry consolidation will benefit larger platforms that are already well-funded and have significant market share. Because of the industry dynamics and the scramble for market share and growth, it's likely that few players are actually profitable in the P2P space. This means we could see some smaller platforms fail either by running out of money, or by having to pursue a bad business strategy just to stay afloat - Zennon Capron

"The P2P platform is a funding mechanism that allows us to build the consumer finance platform. At the end of the day, it's a consumer finance business financed by P2P platform," says Barry Freeman, co-founder and CFO of Jimubox. "That's really where we're transitioning right now."

For many early movers in financial technology, it is a case of diversify or die. While the industry is booming, it is also increasingly populated by large internet companies - such as Alibaba Group, Tencent Holdings and JD.com - that want to disrupt traditional financial services and traditional financial institutions that want to stay ahead of the disruption. VC investors have plowed hundreds of millions of dollars into fintech, but they must now reconsider their strategies in a fast-changing space.

"In overseas markets, the word ‘fintech' implies a technology-driven business model. But in China, we call it ‘internet finance' which is a different kind of animal - people are using internet as a marketing tool to carry out what are traditionally considered as shadow banking businesses," says Vincent Huang, founding managing partner of Juntong Capital. "However, the financial industry is not all about grabbing market share; you need strong risk management skills to survive. I believe the ones left standing in the long run will be large financial institutions and major internet players with large customer bases."

Losing its shine?

In dollar terms, China's internet finance industry continues to draw record amounts of capital from PE and VC investors. A report released by KPMG and CB Insights claims the amount deployed rose from $619 million in 2014 to $2.7 billion last year, accounting for 20% of the global total. Most of this capital went to online P2P lending platforms and payment services.

"Online P2P lending in China really started to grow in 2010 and for the first five years, the government didn't push to regulate the industry, which given the amount of money flowing onto some platforms and the level of risk, is surprising," says Zennon Kapron, founder of Shanghai-based financial industry research firm Kapronasia.

There were about 2,600 P2P lending platforms in operation at the end of last year, up from 1,600 in 2014, according to Online Lending House. Total outstanding loans came to RMB439 billion ($67.4 billion) in 2015, compared to RMB104 billion in 2014 and RMB26.8 billion in 2013.

Most of the top 20 platforms have received VC funding. AVCJ Research has records of 10 investments worth a combined $729 million in 2015, while the valuations for five more deals have not been disclosed. This compares to $139 million in seven disclosed deals in 2014 and just one investment of $1.65 million in 2013.

However, several sizeable scandals have taken away some of the industry's gloss. The most infamous, which saw Ezubao exposed as a Ponzi scheme and more 900,000 investors lose an estimated RMB50 billion, is potentially the biggest case of financial fraud in China's history.

"VCs invested aggressively when the market was hot. Some thought that online finance means maximizing lending volumes, but the key consideration when running these platforms are risk control and getting loans back. It takes time to assess a company's risk controls and many VCs are more mindful in their selections now," says Xiang Gao, founding partner of Banyan Capital.

The government has also responded by taking a significant step towards codifying the largely unregulated space. Last July, the first set of rules governing internet finance was released, covering basic conduct in internet payment, online lending, equity crowdfunding, internet fund sales, online trusts, insurance services and internet consumer finance.

"The framework isn't comprehensive, but it tries to give a definition of internet finance which comprises seven segments. The concept was very blurred before. People perceived internet finance as being all about online payment and P2P lending. We are now seeing the industry become more diversified," says Raymond Wang, managing partner at law firm Anli Partners.

Different segments have also been placed under the remit of different regulators. For example, P2P online lending and online payment are now the responsibility of the China Banking Regulatory Commission, while online fund sales and equity crowdfunding are controlled by the China Securities Regulatory Commission.

In addition, the government is encouraging banks to provide custodian services for online transactions. This should help address two key concerns with P2P platforms. First, many practitioners essentially behave like unlicensed banks. Rather than functioning as genuine intermediaries by sourcing borrowers and placing them in front of prospective lenders, they collect lenders and then look for borrowers. Second, in the absence of traditional risk controls, they have put these lenders into high-risk investment products.

For example, in 2013 Jimubox entered into a strategic partnership with Hebei Financing Investment Guarantee, the country's second-largest financing guarantee company, and channeled numerous projects onto its platform. Last year, the government-backed entity was ordered to cease operations due to contract violations involving several projects. As a result, it was no longer able to guarantee nearly RMB50 billion in outstanding loans. Although Jumubox said that the projects on its platform were healthy, it suffered reputational damage. It now uses China Minsheng Bank as a custodian.

Custodian arrangements bring online lending transactions within the official banking system, reassuring investors and raising the bar for new entrants so that it is harder to achieve scale. Meanwhile, illegal practitioners should be squeezed out of the industry.

"Industry consolidation will benefit larger platforms that are already well-funded and have significant market share. Because of the industry dynamics and the scramble for market share and growth, it's likely that few players are actually profitable in the P2P space. This means we could see some smaller platforms fail either by running out of money, or by having to pursue a bad business strategy just to stay afloat," says Kapron of Kapronasia.

Indeed, the $2.7 billion cited in the KPMG report was highly concentrated in a number of mega deals each worth more than $100 million. Since the start of 2015, the largest investments have focused on companies with links to traditional financial institution and large internet players. They included Ping An Insurance-backed P2P lending platform Lufax, Alibaba's Ant Financial, JD.com's JD Finance, and Zhong An Insurance, which was set up by the founders of Alibaba and Tencent.

Fintech 2.0

Alibaba, Tencent and JD.com are looking to leverage their technological advantage over the country's asset-heavy, slow-moving state banks that must add online components to offline businesses. Their origination activities are fully internet-oriented and risk management is underpinned by vast amounts of data drawn from their core businesses on small-scale borrowers. Traditional banks do not have this information because they have historically favored lending to state-owned enterprises.

Ant Financial, which has more than 400 million annual active users, operates a number of financial products linked to Alibaba's Taobao and Tmall e-commerce platforms, including Alipay, money market fund Yu'e Bao, credit service Sesame Credit and internet bank MyBank. It is also aggressively expanding its ecosystem by launching venture funds to support mobile app developers and online finance start-ups.

Online retailer JD.com and social-networking platform Tencent have similar strategies. For example, WeBank was launched by Tencent a year ago as a direct competitor to MyBank.

Lufax, meanwhile, represents an attempt by Ping An to create an online financial services footprint. Established in 2012, it operates two platforms: Lufax.com, a standard P2P business that matches borrowers and lenders, using a Ping An subsidiary to review risk and provide guarantees; and Lfex.com, a financial assets trading platform that focuses on corporate investors and financial institutions. The goal is build an "exchange of exchanges" that interacts with every industry participant.

However, Ping An is seen as the exception to the rule among traditional financial institutions. According to one fund manager, the nature of the company's ownership - it is classified as a private enterprise - means that senior management is properly incentivized to explore new avenues of growth. In contrast, the major state-owned banks are typically characterized as focused on stability rather than innovation.

"It is difficult for traditional financial institutions to attract and retain talent, because they can't offer attractive employee shares scheme as some start-ups do," says Anli Partners' Huang. "In the short run, we can't really tell whether established institutions can outperform internet players because it depends on them providing a better user experience."

At the same time, the internet giants face challenges of their own. The ecosystems that deliver user data are a source of strength but also a potential bottleneck in terms of providing new services. Jimubox's Freeman notes that his firm has won a lot of business in digital lending because this is an area that the large internet companies currently are not able to look at.

And it is in the niches beyond the reach of mainstream providers that venture capital investors such as Banyan, Lightspeed Venture Partners, Morningside Ventures and GGV Capital say they are looking for opportunities. Start-ups are emerging in multiple online finance verticals, ranging from upstream and downstream B2B transactions in construction to specialized consumer finance plays in automobiles and property to anti-fraud technology and big data.

"There are a couple of dominant players in China's financial technology space. But there are also small and medium-sized players - which may not always get huge IPOs or raise large funding rounds - targeting different parts of the value chain. They are trying to have an impact on insurance, wholesale financial products or corporate banking. Some funds look at the big players but there are also many small players that people are investing in," says Egidio Zarrella, clients and innovation partner at KPMG China.

Consumer angle

These players are also receiving investment from large internet companies precisely because they have successfully targeted particular niches. Qufenqi is a case in point. The consumer goods platform, which launched in 2014, targets college students by allowing them to pay in instalments for smart phones, computers and other electronic devices purchased online.

The company raised several rounds of VC funding from the likes of BlueRun Ventures and Source Code Capital, as well as Shenzhen-listed games developer Kunlun Tech. In August last year, Ant Financial came in and since then, the start-up has expanded its offering in collaboration with and Sesame Credit. Fenqile, which has a similar business model to Qufenqi, added JD.com to its roster of VC backers last year.

Indeed, if there is one segment attracting investors above all others, it is consumer credit. As was the case with Jimubox, the starting point is often P2P lending. Ex-TPG Capital executive Yunnan Liu set up Yooli.com as a P2P lending site in 2013 but then spun out the second-hand car financing business as Meli Jinrong. The company, which has received backing from Morningside and Sequoia Capital, now also covers consumer electronics purchases and home rentals.

"Online finance actually doesn't present a huge opportunity along the lines to what we have in e-commerce and the online auto markets," Liu previously told AVCJ.

For Hong Kong-based WeLab, its lending platforms are akin to a technology proving ground. The company wants to become a software provider to third-party clients; it already has 2-3 partnerships in place and will start work this year on initiatives with e-commerce platform Ule and Postal Savings Bank of China. When WeLab closed its $160 million Series B round in January, founder and CEO Simon Loong noted that the methodology and data accumulated in P2P "have an application in other financial products, which means above and beyond lending."

ING Bank participated in that WeLab investment, several months after Standard Chartered Private Equity co-led a $207 million Series C round for Dianrong, a longstanding P2P player. This was said to be the first investment by a traditional bank in a Chinese internet finance platform, and it is perhaps no coincidence that Dianrong is also positioning itself as a service provider. The company wants to help underdeveloped financial institutions get into online finance and has forged several partnerships with Chinese banks.

"They [traditional banks] have witnessed the fast growth of the sector. I feel they want to partner with us, otherwise there would be a big fight between the internet players and offline institutions," Soul Htite, CEO and founder of Dianrong, told AVCJ at the time. "We can leverage their networks and customers, as well as their understanding of the market and regulatory environment."

The move from P2P lending into consumer credit makes sense because it allows fintech start-ups to differentiate their business and find openings where the large players are not yet as competitive. Supporting this transition also represents an opportunity for VC investors now the lending platforms that consumed much of their capital are no longer so viable. Nevertheless, it remains to be seen how long they have before the dynamic shifts again.

The innovative start-up that partners with a traditional financial institution today becomes an acquisition target for that same institution tomorrow. There will be exits, but the onus is on investors to stay ahead of the curve in what appears to be industry hell-bent on consolidation as it lumbers into the internet age.

"Some small technology players will be bought by state-owned enterprises (SOEs) - they complement one another," says Juntong's Huang. "Over 90% of traditional financial institutions are state-owned and corporate culture is less likely to encourage innovation. Meanwhile, asset-light start-ups need traditional institutions' licenses to operate in areas such as securities, insurance and credit loans. That's a good way out for many start-ups and VCs behind them."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Greater China
• Technology
• Financials
• Venture
• Early-stage
• China
• Financial Services
• Banyan Capital
• Ping An
• Growth capital
• Lightspeed Venture Partners
• GGV Capital
• Alibaba Group
• Tencent