China fintech: Follow the consumer

One month after its $900 million IPO in October, online micro-loan provider Qudian saw its share price fell sharply. This followed a government crackdown on the consumer cash loans business, which accounts for most of Qudian's revenue, and an investigation into data leaks on the company's website. Shares in Qudian and PPDai – a peer-to-peer platform that also provides cash loan products and went public in November – are currently trading at a 50% discount to the companies' IPO prices. 

For many, the crackdown was a long time coming. Issuance of cash loans, also known as payday loans, has increased dramatically in China, led by online platforms. They offered short-term, unsecured loans to consumers for any purposes, often at interest rates of 30% or more. The latest iPhone was just a couple of clicks away for the typically young adult clientele. 

Inevitably, the system was abused. Borrowers started taking out new loans to pay off existing ones, resulting in a spiraling debt problem. Amid local media reports that one college-age errant debtor had taken his life, regulators responded by banning online internet platforms from providing cash loans without first obtaining details of the planned use. 

Despite this heightened scrutiny, venture capital investors remain positive about the long-term development of China's consumer loans market. They recognize that large cross-sections of the population are still underserved by traditional banks and internet finance platforms are well-positioned to offer solutions. Loans earmarked for specific consumption purposes such as travel, agricultural services, and education financing are seen as having particular potential.

"The addressable consumer lending market – particularly for those high-frequency, small value transactions – is big in China. Many areas have yet to be fully covered by traditional financial services providers. For example, you can't pay in installments for a 10-day stay at a five-star hotel. Innovative online finance platforms can bridge the gap," says Herry Han, a partner and co-founder at Lightspeed China Partners.

Rapid expansion

Total outstanding consumer loans in China, excluding mortgage loans, reached RMB7.2 trillion ($112 billion) in 2016, up from RMB5.2 trillion the previous year, according to official data. Consulting firm Kapronasia estimates the market is expanding at an annual rate of 30%. 

Cash loans is the fastest-growing segment, with volumes reaching RMB1 trillion in the first nine months in 2017, a six-fold increase on the total for 2016 as a whole. As of last November, about 2,700 online platforms were offering cash loans to nearly 10 million clients, according to the National Committee of Experts on the Internet Financial Security Technology. 

Qudian is an example of how lucrative the business can be. The company was launched in 2014 as a platform that combined e-commerce and lending functions, allowing college students directly purchase consumer items – from smart phones to sports shoes – and pay for them in installments. When online platforms were banned from issuing loans to students in 2016, the company shifted its focus to more financially independent young consumers. It started offering cash loans as well as installment loans. 

Thanks to a tie-up with Alibaba Group-owned Ant Financial – which invested in the company in 2015 – Qudian has access to Alipay's large user base and personal credit records. Cash loans are deposited into users' Alipay accounts a few seconds after credit assessments are completed. Driven by rapid expansion in this particular market area, Qudian generated RMB1.44 billion in revenue in 2016, up 570% year-on-year. It also swung from a net loss of RMB233 million to a net profit of RMB577 million. 

"We were surprised by the amount of profit this new wave of internet finance start-ups can generate –their predecessors couldn't do it," says Raymond Wang, a managing partner at law firm Hylands. "These platforms sourced capital from various channels, including traditional banks, online P2P, and even loan sharks, and made a profit by charging high interest rates on the cash loans they offered." 

The way forward

The concern for regulators is that online cash loans will turn into a broader economic liability. These platforms are sourcing the capital they use to make loans from traditional financial institutions. If the previous problems surrounding borrower defaults were to return at greater scale, the damage could be substantial. As such, micro-lenders have been warned against charging annual interest rates above 24% and financial institutions have been barred from lending to the platforms. 

Furthermore, online lenders are expected to refocus on installment loans and start tracking how these loans are spent. Shortly after the introduction of these regulations, Black Fish, a provider of credit and installment payment services for individuals to purchase apparel and electronics, received a $146 million Series A round from the likes of Lightspeed, Morningside Venture Capital and Jafco Asia. The company plans to expand into other consumer verticals, such hotel and flight booking services. 

"Once a consumption scene has been created, such as buying train tickets, an online lender can track consumer behavior and payment records. These data could help the online lender develop effective risk management and risk pricing capabilities," says Lightspeed's Han.   

Combining e-commerce and consumer loans is a logical and popular customer acquisition strategy among internet finance companies – financing e-commerce purchases is estimated to account for 35% of the overall consumer loans market. Alibaba and JD.com have launched online credit card services that offer offers zero-interest installment loans for consumer items. 

Suggestions that their arrival could trigger a battle for market share among the country's internet giants are premature. As it stands, Alibaba and JD.com's activities are limited to supporting shoppers on their own e-commerce platforms, while other emerging technology players like Meituan-Dianping have yet to penetrate the market. Uncertainty over government policy is seen as the reason for their hesitance.

"Now there is a window time for start-ups to address some consumption scenes that haven't been covered by tech giants," says Wei Zhou, a founding partner at China Creation Ventures, which has backed financial technology companies such as JD Finance and Rong360. "When the policies are clearer, the big guys will also enter the space, squeezing out smaller players. That's why we look at start-ups that can develop advanced technology, which allows them to outpace tech giants."   

SIDEBAR: Online payment - Data drama

Each of Alibaba Group, JD.com, and Tencent Holdings has used its core consumer internet business as a stepping stone to financial services. With so many willing buyers for their goods, it is natural for these platforms to look for ways to help people pay for them. As a result, Alibaba's Alipay and Tencent's Tenpay together control more than 90% of China's mobile payments market.

Other internet upstarts have sought to establish a presence in the space through investments in payment companies. JD.com acquired Chinabank in 2012 to develop its self-owned payments system, while Xiaomi invested in payment service provider Jiefu Ruitong. In late 2016, Meituan-Dianping purchased VC-backed Qiandaibao. Since then, ride-hailing app platform Didi Chuxing reportedly bought mobile payment player 19Pay for RMB4.3 billion ($622 million). 

"When companies like Didi have achieved dominance in their core businesses, they want to expand into other industries. Internet finance is the most popular area," says Felix Yang, a consultant at financial technology research firm Kapronasia. "In terms of online payment, I don't think new players will be able to influence Alipay and Tenpay's current positions. And this isn't a market in which they want to compete. New tech giants want to develop other financial services after acquiring the payment license." 

The starting point for any of these services is data. Didi and Meituan-Dianping are high-frequency transaction platforms – they have multiple touchpoints with consumers over the course of a day – but they don't have comprehensive statistics on user behavior because payment records are managed by Alipay and Tenpay. Moreover, Meituan-Dianping is competing with Koubei, an Alibaba affiliate company that offers a range of local services, and doesn't want a rival monitoring its transaction revenues. 

A total of 243 companies own at least one of the seven types of third-party payment license available in China, from mobile payments to online payments. Licenses cannot be traded, so many of these investments have been about buying a company that has one. E-commerce is only the starting point. Lending and wealth management are both of interest, as evidenced by Meituan-Dianping establishing Yilian Bank shortly after acquiring a license. 

The challenge for other internet companies is that license owners now have a clear understanding of the value of their assets. "Acquiring a company that owns third-party payment licenses has become so expensive and start-up companies can't afford it. They have to rely on Alipay and Tenpay when they start their businesses," says Herry Han, a partner and co-founder at Lightspeed China Partners. 

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• Topics
• Greater China
• Technology
• Financials
• Early-stage
• Regulation
• China
• Financial Services
• Lightspeed Venture Partners
• Morningside Technologies