IPOs and Catalysts/Events, Global Equity Research Ltd

Arun George

IPOs and Catalysts/Events

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Global Equity Research Ltd

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<p><a href="https://www.smartkarma.com/entities/27267" target="_blank" data-smartkarma-citation="entities:27267:1">CNFinance Holdings Ltd (1640496D US)</a> is the second largest home equity loan provider among non-traditional financial institutions in China. CNFinance funds its loans primarily through a trust lending model with three trust company partners. It is backed by <a href="https://www.smartkarma.com/entities/27026" target="_blank" data-smartkarma-citation="entities:27026:1">Fanhua Inc (FANH US)</a>, a 21% shareholder. It has filed for an NYSE IPO to raise $200 million.</p><p>CNFinance's key metrics have gone backwards primarily due to the tightening regulatory environment. The growth in loan origination volume has steadily declined from 262% in 1Q17 to -28% in 1Q18 and net interest margins have compressed as interest expenses have grown faster than interest income. CNFinance’s filing for an IPO is presumably driven by its confidence that it is now on the cusp of a renaissance. Unfortunately, CNFinance’s fundamentals continue to be mired in uncertainty due to regulatory changes:</p><ol>
<li>CNFinance’s trust lending model could fall foul the Guiding Opinion, a new regulation, which states that the maturity dates of loans and funding sources should be closely aligned. CNFinance’s trust company partners set up trust plans with a term of one to three years. In contrast, the average tenor of CNFinance’s loans increased from 4.2 years in 2016 to 5.5 years in 2017. The regulators could view this as creating a duration mismatch between an investor’s expected timing of exit and the maturity date of the loan.</li>
<li>To comply with the Guiding Opinion, FOTIC, the primary trust company partner, introduced in November 2017 an updated loan agreement with borrowers (2017 FOTIC Loan Agreement). The new terms give FOTIC the option to demand repayment of the loans before the maturity of the underlying trust funding. CNFinance tries to reassure that the FOTIC option is a non-issue as borrowers have few alternatives. However, we do not share this optimism. First, if the borrowers are unable to repay the accelerated lump sum payment caused by the option exercise, it will increase the delinquency ratio. Second, the repeat borrowing rates could decline due to the hassle faced by borrowers to pay off the existing loan and reapply for a new loan.</li>
<li>The Guiding Opinion also casts uncertainty on CNFinance’s ability to legally guarantee the trust products, potentially undermining current funding sources. Historically, CNFinance would guarantee the investment return of the senior unit holders of trust products. However, the Guiding Opinion prohibits such guarantees of trust products. To be compliant, CNFinance adopted new “credit strengthening services”. It is not entirely clear how credit strengthening services are different from the historical arrangements as CNFinance continues to guarantee the trust product. Worryingly, CNFinance notes that “<em>we may be required to further modify such arrangements with the trust plans, which could materially and adversely affect our business</em>”.</li>
<li>New regulation has blocked CNFinance’s important funding source for subordinated units. CNFinance is required to subscribe to the subordinated units of the trust products. Repurchase agreements accounted for 76% of the funding of subordinated trust units in 1Q18. CNFinance has repurchase agreements with a private equity fund and third parties through local financial exchanges. However, new regulations stipulate that private equity funds shall no longer engage in new loan business from February 2018. While CNFinance can continue to work with its existing private equity partner, it is unclear if this arrangement will be sufficient to fund future subordinated units.</li>
<li>New regulation leads to a rise in delinquency rates and NPL ratios. Due to new regulations, CNFinance had to adopt a more disciplined debt collection effort which delayed the recovery of delinquent loans. As a result, CNFinance’s delinquency ratio more than doubled from 5.38% in 2016 to 11.04% in 1Q18. In the past, in the event of a default, CNFinance was able to quickly dispose of the collateral through a power of attorney that was signed by the borrower. Due to recent regulatory changes, CNFinance had to stop this practice. As a result, the overall disposal time for collateral is now longer, which increased the NPL ratio from 1.50% in 2016 to 1.75% in 1Q18.</li>
</ol><div class="content-highlight"><p>Overall, on a fundamental basis, we believe that it is a question of when, not if, the changing regulatory environment will once again adversely affect CNFinance's business. Consequently, we would sit out this IPO until CNFinance can demonstrate two to three quarters of stability or growth.</p></div>

CNFinance Holdings Ltd (1640496D US) is the second largest home equity loan provider among non-traditional financial institutions in China. CNFinance funds its loans primarily through a trust lending model with three trust company partners. It is backed by Fanhua Inc (FANH US), a 21% shareholder. It has filed for an NYSE IPO to raise $200 million.CNFinance's key metrics have gone backwards primarily due to the tightening regulatory environment. The growth in loan origination volume has steadily declined from 262% in 1Q17 to -28% in 1Q18 and net interest margins have compressed as interest expenses have grown faster than interest income. CNFinance’s filing for an IPO is presumably driven by its confidence that it is now on the cusp of a renaissance. Unfortunately, CNFinance’s fundamentals continue to be mired in uncertainty due to regulatory changes:
CNFinance’s trust lending model could fall foul the Guiding Opinion, a new regulation, which states that the maturity dates of loans and funding sources should be closely aligned. CNFinance’s trust company partners set up trust plans with a term of one to three years. In contrast, the average tenor of CNFinance’s loans increased from 4.2 years in 2016 to 5.5 years in 2017. The regulators could view this as creating a duration mismatch between an investor’s expected timing of exit and the maturity date of the loan.
To comply with the Guiding Opinion, FOTIC, the primary trust company partner, introduced in November 2017 an updated loan agreement with borrowers (2017 FOTIC Loan Agreement). The new terms give FOTIC the option to demand repayment of the loans before the maturity of the underlying trust funding. CNFinance tries to reassure that the FOTIC option is a non-issue as borrowers have few alternatives. However, we do not share this optimism. First, if the borrowers are unable to repay the accelerated lump sum payment caused by the option exercise, it will increase the delinquency ratio. Second, the repeat borrowing rates could decline due to the hassle faced by borrowers to pay off the existing loan and reapply for a new loan.
The Guiding Opinion also casts uncertainty on CNFinance’s ability to legally guarantee the trust products, potentially undermining current funding sources. Historically, CNFinance would guarantee the investment return of the senior unit holders of trust products. However, the Guiding Opinion prohibits such guarantees of trust products. To be compliant, CNFinance adopted new “credit strengthening services”. It is not entirely clear how credit strengthening services are different from the historical arrangements as CNFinance continues to guarantee the trust product. Worryingly, CNFinance notes that “we may be required to further modify such arrangements with the trust plans, which could materially and adversely affect our business”.
New regulation has blocked CNFinance’s important funding source for subordinated units. CNFinance is required to subscribe to the subordinated units of the trust products. Repurchase agreements accounted for 76% of the funding of subordinated trust units in 1Q18. CNFinance has repurchase agreements with a private equity fund and third parties through local financial exchanges. However, new regulations stipulate that private equity funds shall no longer engage in new loan business from February 2018. While CNFinance can continue to work with its existing private equity partner, it is unclear if this arrangement will be sufficient to fund future subordinated units.
New regulation leads to a rise in delinquency rates and NPL ratios. Due to new regulations, CNFinance had to adopt a more disciplined debt collection effort which delayed the recovery of delinquent loans. As a result, CNFinance’s delinquency ratio more than doubled from 5.38% in 2016 to 11.04% in 1Q18. In the past, in the event of a default, CNFinance was able to quickly dispose of the collateral through a power of attorney that was signed by the borrower. Due to recent regulatory changes, CNFinance had to stop this practice. As a result, the overall disposal time for collateral is now longer, which increased the NPL ratio from 1.50% in 2016 to 1.75% in 1Q18.
Overall, on a fundamental basis, we believe that it is a question of when, not if, the changing regulatory environment will once again adversely affect CNFinance's business. Consequently, we would sit out this IPO until CNFinance can demonstrate two to three quarters of stability or growth.

CNFinance IPO Preview: A Renaissance that May Not Come

China

CNFinance Holdings Limited provides mortgage financing services. The Company offers home equity loan facilities and micro financing solutions to small enterprises. CNFinance Holdings serves clients in China.

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CNFinance (CNF US)

CNFinance IPO Preview: A Renaissance that May Not Come

CNFinance Holdings Ltd (1640496D US) is the second largest home equity loan provider among non-traditional financial institutions in China....

Arun George

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