SMALL BUSINESSES ARE NOT THAT STABLE AND FOR A SINGLE ONE IT’S VERY DIFFICULT TO PREDICT THE REVENUE; MAYBE IT CAN’T SURVIVE. BUT IF IT’S DIVERSIFIED, THERE IS LESS OF THAT IDIOSYNCRATIC RISK. — KE CHEN, CHIEF ANALYTICS OFFICER AT CSPI
When China started rolling back its ZERO-COVID policy, the early official numbers on the disease’s spread were so low that they were publicly ridiculed. But on a screen in his Hong Kong office in December 2022, Charles Li could see signs that more people were becoming ill.
Li’s information was coming from Micro Connect, a company he founded in 2021 after leaving his high-profile job as head of Hong Kong’s stock exchange. It has financed more than 10,000 small stores — including pharmacies — in 270 cities across China. In return, they hand over a fixed percentage of their revenue every day.
That provides a window into their takings. “We started to observe a very visible ” in pharmacies’ sales, Li tells the Financial Times. “That’s right after the big opening, and the sudden opening,” he adds, referring to Chinese President Xi Jinping’s decision to ease pandemic rules earlier that December. “The disease was spreading much, much faster.”
The episode is one of many examples of how Li’s new enterprise has built up a wealth of real-time, unfiltered data on how Chinese consumers are spending their money, drawing praise from economists frustrated at the growing opacity and unreliability of official statistics.
Its daily payments come from a diverse range of shops including hair salons, car washes, karaoke bars, convenience stores and noodle restaurants. As well as being a gold mine for data, Li’s company has turned those streams of repayments into tradable financial instruments, bundling them into packages that can be split into different tranches for sale to investors. In December, for the first time, a proposed loan secured against small shops’ remittances was given a preliminary credit rating — a solid “A.”
HSBC Holdings PLC and Bank of China Ltd., two of the world’s biggest banks, have already lent Micro Connect millions of dollars against the small stores’ cash flows — and Li is targeting hedge funds and asset managers next. He makes no secret of his ambition to “create a new asset class” and some of Hong Kong’s most senior bankers have described him as a “visionary.”
But there is also a risk that, in the longer term, Beijing may take a dislike to Li’s data factory if it shines an unfavourable light on the real economy. Skeptics have made unflattering comparisons with peer-to-peer lending, which was outlawed in China in 2021 after a series of scandals, while the complexity of the securitization process and its resemblance to the collateralized mortgage obligations that precipitated the global financial crisis have also generated concerns.
“The model will allow investors who don’t understand the risks ... to buy into projects that exceed their risk appetite,” says Wang Lizhang, a researcher at a unit of the China Association of Trade in Services, a government-linked think-tank.
Micro Connect counters that the product is only available to regulated financial groups, which the company says “should be sophisticated enough to make appropriate judgments on the risks.”
Before he became the boss of stock exchange operator Hong Kong Exchanges & Clearing Ltd. (HKEX) in 2010, Beijing-born Li had a varied career that included stints as a reporter at the state-owned China Daily newspaper, a lawyer at Davis Polk & Wardwell in New York, president of Merrill Lynch China and chair of Jpmorgan China.
At HKEX, he made his name with ambitious deal making — including the £1.4 billion acquisition of the venerable London Metal Exchange in 2012 — and the creation of stock and bond “connect” programs, which allowed international investors to trade mainland securities and Chinese investors to trade Hong Kong-listed instruments. But he left the exchange after his audacious £32 billion unsolicited bid for the London Stock Exchange was beaten off.
He founded Micro Connect with Gary Zhang, a financier and former Chinese provincial government official who has worked for The People’s Bank of China in the southern island of Hainan.
“We are both dreamers; we are both doers,” Li says of himself and Zhang. “I just do a little bit more dreaming and he does a little bit more doing.”
Micro Connect was a response to a problem endemic to small trading businesses in China: financing. Many only survive a few years and struggle to borrow money from the Chinese banks that dominate the market and prefer making safer-looking loans to state-owned companies.
Li says technology offers a solution. Since the stores’ customers pay digitally in a country that is now largely cashless, payments software can be set up to automatically divert a percentage of a shop’s total revenue to Micro Connect every day.
A small business could receive 100,000 renminbi (about US$14,100) upfront for a three-year term and agree to hand over 10 per cent of its revenue every day until the original sum is repaid, according to an example in a Micro Connect report. For the remainder of the three-year period, it could hand over three per cent every day.
Li is keen to stress that this financing is not a loan or a bond, because if a store went bust his company would recover nothing more. Reflecting this risk, a store might end up repaying significantly more than it originally received if it is successful.
For Quchashan, a milk tea shop whose original branch in China’s southwestern city of Guiyang is popular with local students, Micro Connect was a way to expand fast.
It has received about five million renminbi to grow from 29 branches to 100, a pace that operations manager Lina Dai says would have been difficult to achieve by relying on bank loans.
“For a small-business owner, it costs quite a lot when you first calculate it, but not entirely unacceptable,” Dai adds. Micro Connect “communicated with us many times to gain our trust, letting us understand this way of obtaining funds.”
The capital that Micro Connect hands to the stores comes from a US$200 million private fund that it raised from investors including university endowments and the super-rich, and from the HSBC and Bank of China loans.
What happens to the money flowing the other way is more complicated. Micro Connect has turned its contracts with the shops — which it calls “daily revenue contracts” — into “daily revenue obligations,” or DROS. These securities are essentially an entitlement to the cash flows from a small store’s repayments.
DROS from different businesses are bundled together and packaged into “daily revenue portfolios” or DRPS. So far, five such DRPS have been issued and the instruments can be traded on an exchange in Macau, a former Portuguese colony near Hong Kong that is better known for casinos.
Just like collateralized loan obligations, or the collateralized fund obligations that private equity groups use to securitize their assets, the DRP can be split into tranches. Buyers of the senior tranche get preferred rights to the cash flows from the stores’ repayments, but with lower returns. Investors in the junior tranche stand to receive higher returns for the increased risk they are taking. Li hopes that hedge funds will buy the riskiest tranches.
The company says 53 firms, including commercial banks, asset managers, wealth managers, hedge funds and private equity and venture capital groups have signed up to be “qualified investors,” able to buy and sell DRPS, on Micro Connect’s exchange in Macau. Most are based in Hong Kong, Macau and Southeast Asia.
In December, CSPI, a Hong Kong-based credit rating agency, assigned preliminary “A” ratings to a proposed loan backed by DROS. That is the third-highest rating on its scale of 11, which it says “denotes expectations of relatively low default risk.”
The individual stores that Micro Connect funds are not the type of institutions that rating agencies typically assess. “Small businesses are not that stable and for a single one it’s very difficult to predict the revenue; maybe it can’t survive,” says Ke Chen, chief analytics officer at CSPI and a former analyst at S&P Global Ratings. “But if it’s diversified, there is less of that idiosyncratic risk ... diversification is a crucial element in the ratings.”
The stores pay Micro Connect inside China and the money is then moved overseas using a cross-border foreign exchange process approved by China’s State Administration of Foreign Exchange.
HSBC has been among the larger names to take a bet on Micro Connect so far, extending a US$25 million loan to the company. Micro Connect used the funds, along with a separate 210 million renminbi (US$30 million) loan from Bank of China, to extend financing to more small businesses in China. HSBC declined to comment and Bank of China did not respond to a request to comment.
Richard Lim, chief executive of a group of 13 restaurants, has used Micro Connect’s financing — but admits that despite being an accountant, he does not fully understand its complex business model and is unsure who is buying his company’s cash flows or why.
“My revenue is my asset,” he told the FT at an event in Macau last year. “For me, it’s just a simple repayment.”
WE ARE BOTH DREAMERS; WE ARE BOTH DOERS.
WE WOULD LOVE TO HAVE GREEN LIGHTS ALL OVER THE PLACE, SO THAT WE CAN JUST DRIVE AROUND TELLING PEOPLE THAT WE ARE NOT RUNNING RED LIGHTS. BUT IN THE TERRITORY THAT WE OPERATE THERE ARE NO RED LIGHTS EITHER. — CHARLES LI, MICRO CONNECT
Song Xiangqian, founding partner of private equity firm Harvest Capital, is more blunt. “This is a typical loansharking business,” he said in a post on social media platform Weibo last October.
“Haven’t peer-to-peer lending and loansharking done enough harm to the Chinese people in the past?” Song added. He did not respond to requests to expand on his comments.
Micro Connect says its financing terms are set to reflect the risk that if a store goes bust it receives no more payments.
Because its financing is not classed as debt, it is not covered by China’s tough rules on private lending that cap the annualized interest rate at four times the country’s loan prime rate — a benchmark that stands at 3.45 per cent.
But Li acknowledges that if Micro Connect’s activities were to be classed as lending, it would “make it difficult” since he would “have to change the structure of the instrument.”
China’s regulators “seem to like what they see, but I don’t think they’re able to put this into any of their existing regulatory boxes,” Li says.
“We would love to have green lights all over the place, so that we can just drive around telling people that we are not running red lights. But in the territory that we operate there are no red lights either.”
Another significant risk to Micro Connect’s performance comes from China’s slowdown. CSPI, the rating agency, said it expected “downward pressures to persist due to the declining state of the property market and intensifying geopolitical uncertainties.”
Li says that in a slowdown, some customers “become less fortunate” and “move down to a cheaper restaurant,” but argues that as long as Micro Connect finances a suitably wide range of businesses, it will be sheltered. Whatever happens, he says, “you still need to have laundry, you still need to have your car fixed, you still have a haircut.”
Li is launching his model at a time when reliable data about China’s economy is becoming harder to access. The country last year simply stopped reporting youth unemployment after its gauge hit a record high, though it has since resumed publishing some of this data. Colin Hamilton, a London-based analyst at BMO Capital Markets, told the FT in January that it was “fair to say that we don’t believe numbers” on steel and pig iron output.
Yet the data about real economic activity in China that Micro Connect’s financing generates is a key part of its business model. The ability to forecast the revenues of China’s small businesses, at least at an aggregate level, was “the crux” of investing in its products, the company said in an explanatory document published in January.
“More than 80 million small businesses contribute to around 60 per cent of China’s GDP today,” Micro Connect said in the first edition of a newsletter about its data in October. “However, surprisingly, we know so little about them.”
Although the company acknowledges that its data is “by no means a definitive indicator of China’s overall consumption”, it has still chosen to make some of it publicly available, despite hinting in an investor presentation last year that it might charge investment groups for access. “By sharing our analysis, we hope to fill a gap in the overall understanding of China’s consumption sector,” it said.
Its “M-terminal”, a freeto-use financial data website with a black background reminiscent of a Bloomberg screen, shows that stores in smaller cities are performing much worse than those in larger cities on a monthly basis.
Another trend is that the cash flows of food and beverage stores have rebounded since the end of China’s ZERO-COVID policy but those of sports and leisure businesses are having a more difficult time.
Its data also showed consumer spending fell on average by 5.5 per cent during China’s important Golden Week holiday in 2023 compared with a year earlier. It flagged a significant drop in sales at the mainland-based Japanese restaurants it finances after some customers boycotted them in August.
“It’s getting harder to understand China because it’s closing up, particularly for foreigners,” says Diana Choyleva, founder and chief economist at forecasting company Enodo Economics in London. “You’re trying to put the pieces together ... this is absolutely a piece that could go into the puzzle.”
But like its financing, Micro Connect’s data on China’s real economy brings risks at a time when Beijing is increasingly keen to control the narrative about macroeconomic performance.
The company says it is “aligned with the government’s agenda of fostering entrepreneurship among the public for common prosperity,” adding that it is “paving the way for a new era of growth in China’s micro and small business market.”
A worst-case scenario for Li could mean the complex system he has financed and built could come tumbling down if the results it generates start to displease Beijing. So far, Li appears untroubled.
“If our sample becomes so large that it becomes representative enough of broader economic activities, then I’m sure people will pay greater attention to it, including government officials,” he says, though he adds that they too might welcome the data because of its accuracy.
“But it’s just currently a private company. I don’t think anyone cares that much.”