While China has clamped down on Shadow Banking, there are still companies making plenty of money outside of the banks - often in extremely risky ways. One that has caught our attention is the NYSE listed Noah Holdings (NYSE:NOAH). On the face of it, things look fine. Profits in the third quarter of 2015 rose 22 percent on 31.4 percent increase in revenue. Since Noah is intermediating financial flows outside of the banking system, all of its business comes from Shadow Banking.
However, our research shows that Noah has delved into increasingly unsafe investments as it chases profits in the Shadow Banking market. As more non-banks jump into Shadow Banking, returns have fallen, forcing rising competition for decent investments. For Noah, problems include: 1) volatility of its client base; 2) increasing non-transparent investments in private equity; 3) Higher asset allocation in China's property bubble; 4) Reliance on non-transparent related party investments. Let's take a look at these issues.
Lower Returns to Shadow Banking
As a result of increasing competition, the expected annualized interest rates of the majority of new WMP issuance has declined from 5%~8% to 3%~5%. For instance, WMPs with an expected annualized interest rate of 5%~8% and 3%~5% accounted for 13% and 79% of total new issuance in Q4'15, which was the reverse in Q1'14, when each accounted for 79% and 15%, respectively.
Volatility of the Client Base
Although the YoY growth of the company's registered clients has remained above 30%, the number of active clients is very volatile, and actually turned negative for the first time in Q3'15. In Q3'15, active clients amounted to 4,014, representing a change of -1.9% YoY and -34% QoQ. we were told by a relationship manager at a competitor of Noah that a large portion of the newly registered accounts were actually created by the company itself to embellish the operating metrics, although we cannot prove this.
Out Go Bonds, In Comes PE
The annual growth of the aggregate value of wealth management products distributed by the company has slowed from 64.2% YoY in Q1'15 to 41.8% YoY by the end of Q3'15, which implies a QoQ decline of 7.8%. In order to maintain the growth of its wealth management business, Noah almost quadrupled the proportion of private equity related WMPs from only 10% in Q3'14 to 39% in Q3'15. As a result, the proportion of fixed income products dropped significantly from the peak of 74% in Q1'14 to 29% as end of Q3'15.
Property Is Now Property is King
Although the proportion of assets in real estate was largely cut at the beginning of 2015 to hedge against the cool-down of China's property market and economy, real-estate still accounted for 40% of total AUM. "We found investors have become concerned about China's property market even as the government launched a series of new policies to save the market by accelerating inventory clearing in some T1 cities. This could be the biggest downside risk for Noah's asset management now, though they turned to PE funds as the new focus," said an investment specialist at an international asset management company. Notably, the proportion of private equity fund of funds (FOF) significantly increased from an average of 22% in late 2014 to 34% and 42% in the second and third quarter, respectively.
The Rise of Related Parties
The largest proportion of high-risk real estate funds and fund of funds are actually managed by the company's own asset management platform, Gopher. Back in Q1'14, Gopher only contributed 39% of total transaction value while third party contributors generated 61%. That has reversed. In Q3'15, the transaction value from Gopher was Rmb17.8 billion, accounting for 68% of total value, nearly triple that in Q1'14.
There are many red flags in Noah's business model. Noah competes with many other Shadow Banks, including state owned Trusts, and online financial firms. Investment banks and commercial banks also sell wealth management products that are off-balance sheet and effectively make them into quasi-shadow banks. The state owned banks are fully supported by the Chinese government. Investment banks, some of which are listed, have other sources of revenue apart from financial intermediation through Wealth Management Products. In contrast, Noah's entire revenue depends on Shadow Banking business. As competition has increased, returns have declined. The market is getting more difficult
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.