- “Ant Group is not a financial institution.” – Ant’s IPO Prospectus
When a company suffers a downward adjustment in its valuation, in finance-speak it is said to have “taken a haircut.” What happened to Ant this month is looking more like an amputation.
The failed IPO is merely a symptom. A sudden, severe reduction in the intrinsic value of Ant’s business rendered the offering non-viable. The IPO valuation –– at $317 Bn – could no longer be sustained. Ant may be worth just half what was projected a few weeks ago.
The de-valuation was not the result of a traditional business set-back. It arose from a regulatory change that effectively re-categorized the company… as a Bank.
Here’s the story.
By Any Other Name…
In June of this year, the company then known as Ant Financial Services changed its name, and became The Ant Group.
But why? This amazing enterprise had become in just six years the most valuable financial services provider in China, a model of the coming era of digital finance, on track to surpass the valuation of the world’s largest banks. It seemed all about finance.
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Ant’s offerings are tailored for the Chinese masses, from mobile and online payments, to insurance (including health insurance), money market funds and investment management – and lately, its biggest business has been ginning up mountains of easy credit for Chinese consumers and small businesses. It has been enormously innovative, and enormously successful. The company is held up as national champion. Its founder, Jack Ma, said to be China’s richest man, is often accounted the most famous living Chinese person, at least for those who live outside the country. He is usually ranked well ahead of Xi Jinping. (Google it.)
In October, everything seemed set for one more conquest. Ant was ready to roll out the largest public stock offering in history – an all-China deal, to go effective in both Shanghai and Hong Kong (and not New York), itself a signal event in the history of Chinese finance, and freighted with geopolitical triumphalism – until the Chinese regulators suddenly pulled the plug just two days before the scheduled debut. (I have detailed the scope and range of Ant’s business, the immediate and the deeper motives for the canceled offering, in two previous columns, here, and here.)
It was a stunning reverse, and the aftermath will be brutal. It is not merely a matter of a postponement (as many commentators have it), a little “headwind,” or a regulatory “tussle.” Ant’s enterprise value has been carved back perhaps as much as 40-50%. It is not merely a shift in sentiment or opinion (though it is that). there has been a fundamental alteration of the economics of the company’s leading business model – the consumer credit business. It redefines what kind of business Ant is in. Ant’s current structure will not survive the crisis.
What is Ant, Really?
Ant’s name change back in June pointed up a crucial revision of the company’s strategic messaging. Instead of emphasizing financial services, Ant wants to be seen as a Tech company, specifically a leader in Fintech (as it is increasingly called), described by the Gillian Tett of The Financial Times as “a feverish race underway at banks and tech companies to find ways to use big data and artificial intelligence in finance.”
There is a good case for Ant’s re-branding. Jack Ma Inc. has stormed market after market, applying advanced digital technology to sweep away the legacy bottlenecks in China’s financial system which had restricted the availability of many basic services and often stunted Chinese development.
Ant has grown by outgrowth. Each business model seemed burst its bonds to spawn the next one, to overcome some obstacle, or to exploit some fortuitous possibility. When Ant’s parent, Alibaba, was challenged to find ways to enable ordinary consumers to carry out their Amazon-style online purchases on its website – it didn’t have a trusted payment system at the time – the company invented Alipay, an online and mobile payment platform that swiftly dominated the digital payments business – which in turn became the foundation of Ant, spun off from Alibaba in 2014. Tapping into the enormous under-served consumer market in China, Ant now processes more transactions than Visa and Mastercard combined. It is disruptive innovation par excellence:
- “Alipay has drastically upended the payments world through its platform’s seamless integration across various third-party services… a fantastic example of how bold innovation and a novel approach can transform an industry.”
Next, to handle cash balances in customers’ accounts — the Yu’e Bao, or “leftover treasure” (and to keep the customers’ assets close at hand to fuel further spending) – Ant created “almost accidentally” what rapidly became the world’s largest money-market fund. From there, Ant branched into credit scoring – mining the big data from its own transaction flow to completely automate the assessment of a customer’s credit-risk and capacity. The natural next step was to offer that credit to its customers – which it could do based on artificial intelligence and analytics. Loan approvals could be executed in just minutes without involving actual human decision-makers. No need to bother with collateral; Ant’s loans are unsecured; the analytics handle the risk assessment. Ant found it could hand the loan off to some traditional bank, eager for the business and happy to take Ant’s technological say-so as to the borrower’s credit quality. Ant charged the bank a fee for this service and for the sourcing the loan itself, and avoided the need to tie up its own capital. In short order, originating these consumer loans became Ant’s biggest, fastest and most profitable business.
The speed of all these developments was powered by Ant’s high-tech approach to everything, so different from the straitened and laborious procedures of traditional Chinese banking (which Ma recently and perhaps unwisely derided as gripped by “a pawnshop mentality”). China’s billion-plus, financially virginal consumers offered Ant a wide-open market, ready to spend, hungry for easy credit.
Ant’s rise is astonishing, inspiring, revolutionary – we are told by the South China Morning Post that “China Is Poised to Become the Word’s First Cashless Society” (which is likely true, and is led by Ant). For some it may be frightening…
- “Martin Chorzempa at the Peterson Institute of International Economics think-tank noted that large parts of China’s financial system have been reorganised around technology platforms. ‘It’s the western bankers’ worst nightmare of what would happen under an open banking system. Essentially, the banks lose their direct relationship with the customer and all of it is mediated by the platform.’”
And so – almost in the blink of an eye, Ant has become a giant in financial services, astride the Chinese market, and ready perhaps soon to similarly overrun the stodgy bankers elsewhere.
That was exactly the problem.
A Lesson in Valuation: The Importance of Category
In the mind of the market – that is, the consensus of investors large and small – the valuation of any investment prospect is first and foremost about category. What kind of business are we talking about? Hardware or software? Foundry or fabless? Content or distribution? Asset-lite, or capital-intensive?
The category question for Ant is: Are you a Tech company, like Amazon, Apple, Google…. or are you a Bank? The press has sometimes been puzzled.
- “China’s Ant Group, about to make the biggest public sale of shares ever, poses a basic conundrum: what kind of company is it – a financial colossus or a tech giant?”
This matters because the market gives very different valuations to these two categories. In the 2nd quarter of 2020, in the U.S., the Tech sector of the S&P 500 carried a price-to-earnings multiple of almost twice that of the Finance sector.
In other words, if a “Tech” company earns a dollar (per share), the market awards it almost twice as much value (in share price) as it gives to the same EPS dollar earned by a “Finance” company.
Which club would you rather belong to?
Breaking down the sector further, the differences are stark.
Thus, if Ant is seen as a tech company, a Fintech company, like PayPal, it may be worth ten times more than if it is seen as just another pawnshop… excuse me, as a regular Chinese bank.
So, Which Category Does Ant Belong To?
For Jack Ma and Ant’s management and shareholders, the answer is clear, and urgent.
- “Ant had gone to great lengths to brand itself as a tech firm, not a bank. It describes its business as “techfin”—ie, putting technology first—not fintech. In the lead-up to its listing, it asked brokerages to assign tech analysts, not banking analysts, to cover it.”
The name change was part of this campaign. The IPO prospectus touted the fact that 60% of its employees are engineers and programmers. The CEO announced that “digital technology is part of everything we do.” The investment banks underwriting Ant’s IPO (led by the usual American suspects) assigned “Tech teams, not finance bankers” to the deal, and Ant received “tech-style pricing.” For a while it seemed to be succeeding. Ant has been accepted by most outsiders as a Fintech company. The very day that Ant’s deal was pulled, the Financial Times (one news cycle late) published an encomium to the company’s “object lesson in how to build consumer-led, data-infused digital business” and suggested that even Jeff Bezos “must admire” their example. After the offering was canceled, the view persisted. The FT’s lead editorial the next day still framed it as a tech-war: “Ant’s failed IPO points to wider clash on fintech.”
But the financial regulators weren’t buying it. A former member of the China Banking and Insurance Regulatory Commission, Ji Shaofeng, wrote
- “Although Ant is trying to phase out of its financial identity and emphasise itself as a digital technology firm, the dominant part of its revenue, which comes from its credit business, and its high leverage ratio have always attracted the wide notice of both regulators and the capital markets.”
The significance of this problem began to sink in. “Beijing Wants to Treat Ant Like a Bank and Its Value Hangs in the Balance” — the Wall Street Journal headlined.
The No-Skin-In-The-Game Problem
The problem is that Ant’s consumer credit business is based on what is called the originate-to-distribute model. The originator finds the customers, extends them credit — unsecured loans, remember — and then sells those loans to banks. It is the banks that assume the risk of non-payment. Ant charges a fee, which offsets its minimal capital commitment, keeps a big slice of the interest payments (evidently as much as 30-40%) and books the profit – 48% of the company’s total net earnings come from this business unit (according to the IPO prospectus).
Credit – the classic banking “product” – is the cornerstone of Ant’s value proposition, for its customers and for investors. Ant’s credit creation business of course dovetails with its payments business (Alipay), which feeds back into Alibaba’s e-commerce flow. Brilliant. So says The Financial Times
- “Its fast-growing consumer lending business [is] a crucial driver of sales and the source of its rich market valuation.”
But it begins to seem unfortunately familiar. For this is the same kind of capital-efficient credit machine that was the engine of the sub-prime mortgage fiasco in the U.S. leading up to the 2008 financial crisis. It is now recognized to be dangerous business model, and not just for Ant but for the larger financial system risk it creates (as described in my previous column).
In September, the regulators brought the hammer down. They imposed a new requirement forcing originators of credit — and they meant Ant in particular — to keep at least 30% of the loans on their own books.
This is decisive. It turns Ant into a Bank with a capital “B.” A very capital-intensive bank. The 30% reserve requirement is practically punitive. By comparison, the Dodd-Frank Act (passed in the U.S. after the 2008 crisis) imposed just a 5% requirement on mortgage originators, which seems to have been effective.
How much of a discount will this impose on Ant’s value? There are two answers: the “fundamental” answer, and the “category” answer.
Regarding fundamentals, the size of the value-ectomy depends on exactly how much capital Ant would have to set aside to meet the regulatory requirements. Analysts are beginning to address this.
- “Iris Tan, senior equity analyst at Morningstar, said in her “base-case” scenario of light-touch regulation, Ant might be able to limit loans on its balance sheet to 5 per cent of the total. That would still lower its return on invested capital and could bring Ant’s valuation down by 10 to 15 per cent, she added. Ms Tan’s estimate assumes that regulators would require Ant to source 30 per cent of loans itself but allow it to avoid holding most of them on its balance sheet, possibly by securitising the loans and selling them on to other parties, among other measures. But ‘based on a regulatory trend of treating fintech players more like banks,’ Ant could be forced to hold 20 per cent of the loans on its books in a worst-case scenario, she added, potentially cutting its valuation by 45 to 50 per cent.”
Victor Galliano, a former Barclay’s analyst, has built a bottom-up, sum-of-the-parts model, which currently yields a “base case” valuation of about $250 Bn – down about 20% from the IPO offering price. His more pessimistic case projects a 33% de-valuation.
Sentiment and “category” also play a role in the determining the size of the “haircut.” The impact of the “category” shift is suggested by the valuation metrics show above. “Chinese bank” is not a label for a high-flyer.
As to investor sentiment, it was white hot. Ant had the $3 Trillion order book lined up behind the IPO. It was set to show a strong first-day gain, typical of Chinese IPO’s. Several studies have found that Chinese IPO’s gain 24% to 66% on the first day of trading.
To gauge the true extent of the damage, therefore, we should take some account of the under-pricing that was built into the offering. Several analysts projected prior to the IPO cancellation that Ant would likely have ended Day 1 with a valuation of $400 Bn or more. In light of this lost upside, the value-ectomy looks even larger.
Finally, another lens on Ant’s loss of value is the drop in the parent company Alibaba’s own market capitalization. Alibaba trades on the New York Stock Exchange. Its share price fell 18% in three weeks, a reduction of about $130 Bn in value. Alibaba owns 33% of Ant. It is hard to draw precise conclusions from these numbers, but taken at face value, this figure would suggest that the market may have been anticipating a post-IPO valuation – when stable trading could settle on a meaningful price – of $450 Bn or more – now in question. In any case, between Ant and Alibaba, Jack Ma did not have a good day.
Ant will end up spinning off or divesting the consumer credit business. The price of regulatory compliance is too high, and it is not really in Ant’s or Alibaba’s interest to compete as a conventional bank. Ant really is a Tech company, but if they want to get a Tech company valuation, they will have to uncouple from this baggage train of risk and regulation. It would seem that this is really what the regulators themselves are after. Their over-played, over-heavy hand – 30% retained exposure, when 5% might have sufficed – makes this pretty clear.