Hedge Funds Suddenly Winning on China’s Most Dangerous Short (2)

(Bloomberg) -- Stock traders who stuck with China’s most painful short sale are finally getting some relief.

After suffering through a 953 percent rally in shares of Yirendai Ltd. since mid-February, hedge funds and other bearish speculators were rewarded in the four days through Wednesday as the Chinese peer-to-peer lender sank 35 percent in U.S. trading. Holding on to the trade has been especially costly after annualized borrowing rates for Yirendai shares jumped to about 40 percent, the highest level among big Chinese companies tracked by IHS Markit Ltd.

Yirendai’s reversal from first to worst on the performance rankings of major Chinese companies marks the latest twist for a stock whose movements traders have struggled to explain. The intrigue has been heightened by an unexplained shrinkage in the supply of lendable Yirendai shares, a development that boosted costs for short sellers and made them more vulnerable to a squeeze.

"Yirendai is a relatively odd stock," said Wei Hou, a Hong Kong-based banking analyst at Sanford C. Bernstein & Co. "The share-price rally has been a mystery to me.”

Free Float

Theories for the surge abound. Some say it was driven by a jump in Yirendai’s second-quarter earnings; others argue fundamentals don’t tell the whole story. JL Warren Capital, a China-focused research firm in New York, alleges that Yirendai used an undisclosed employee stock-buying program to squeeze short sellers and curb the supply of lendable shares, citing as its source an executive at Yirendai’s parent company identified only by the surname Zhang.

Dennis Cong, Yirendai’s Beijing-based chief financial officer, denied that employee purchases had been fueling the stock’s advance. He added that new P2P regulations being cited for the shares’ recent drop won’t hurt the company.

P2P Risks

“If some people are suspecting that the stock price volatilities are driven by employee purchasing, then I think they should spend more time to understand the capital markets,” Cong said in a phone interview on Thursday. “They should do more homework.”

While it’s too early to tell if short sellers will ultimately prevail, a victory would come as a relief to China bears who’ve been rattled by a government-orchestrated shakeout of yuan speculators in January and a raft of mistimed bets against Hong Kong-listed Chinese shares in May.

The nation’s peer-to-peer lending industry has been an especially tempting target. Almost 1,000 P2P platforms have collapsed over the past year, including what Chinese authorities say was the country’s biggest-ever ponzi scheme.

While Yirendai’s business is legal, and it hasn’t been accused of any wrongdoing, the company’s status as China’s only publicly-traded P2P lender tracked by Bloomberg has turned it into an industry proxy.

For a QuickTake explainer on P2P lending, click here.

Yirendai makes money by connecting small borrowers with investors, charging fees on both sides of the transaction. The firm doesn’t hold onto any of the debt itself, though it has been setting aside cash in a reserve fund to help compensate investors when borrowers default.

The model has proven lucrative as millions of small-time borrowers -- often ignored by China’s state-owned banks -- turn to P2P platforms for financing. Yirendai’s net income jumped 226 percent in the second quarter from a year earlier to almost 261 million yuan ($39 million), as the value of loans arranged on its platform more than doubled.

“There is a certain level of fundamental support for the stock,” said Eric Xu, founder of North Oakridge Capital, which invests in U.S. stocks including American depositary receipts of Chinese companies. Xu said he cut his holdings by half after the shares reached a record at the time of $40, acknowledging that the speed of the rally had been “a little crazy.”

The stock, which debuted in December at $10, erased a gain of as much as 14 percent on Thursday to end the session little changed at $24.53 in New York.

Bears say Yirendai’s rapid profit growth masks a dependence on risky loans. Class D borrowers, the least creditworthy on Yirendai’s four-grade scale, made up more than 83 percent of the firm’s arranged loans in the second quarter.

“The model is not sustainable for the long term,” said Wang Wei, chief executive officer at Paretone Capital, a San Jose, California-based hedge fund investing in U.S. stocks including Chinese ADRs. “If the default rate goes up, it eats into profit.”

Those concerns have had little apparent impact on Yirendai shares until recently. The company rallied more than any other China-domiciled company with a market value exceeding $500 million from Feb. 11 through last week, according to data compiled by Bloomberg. The surge was all the more remarkable considering that LendingClub Corp., the most prominent online lender in the U.S., cast a cloud over the industry with the shock departure of its CEO in May.

It wasn’t just the gain in Yirendai’s stock that made life difficult for short sellers. Data from IHS Markit show the lendable pool of Yirendai shares has shrunk to about 424,000, or 5.7 percent of the outstanding ADRs, from almost 464,000 at the end of June.

Testing Waters

Paretone Capital’s Wang says he paid an annualized rate of 43 percent for a “tiny” amount of Yirendai shares on Aug. 18, just to test if the company could be shorted. He advised against taking a big position, saying the stock was too vulnerable to a squeeze.

Those who managed to execute the trade have held on to a majority of their positions. While outstanding short interest declined to 725,199 ADRs as of Aug. 15 from a record high of 1.34 million at the end of June, that’s still more than twice as big as it was before Yirendai began surging in February, according to the latest available exchange data compiled by Bloomberg.

The stock could have further to fall, if analysts’ share-price estimates are any guide. The average of three estimates compiled by Bloomberg suggests a 13 percent drop from Thursday’s close.

“We still see further downside,” Sophie Jiang, a Hong Kong-based analyst at Nomura Holdings Inc., said in an e-mail. Her price target implies another 39 percent slump. While Jiang said she doesn’t see much impact on Yirendai from the new P2P rules, she cited the stock’s valuation and the “relatively high risk profile” of the loans it facilitated.

(Adds details on share move in 14th paragraph and Nomura analyst’s rationale for price target in final paragraph.)

--With assistance from Jun Luo and Matt Scully To contact the reporters on this story: Lisa Pham in Hong Kong at lpham14@bloomberg.net, Ye Xie in New York at yxie6@bloomberg.net. To contact the editors responsible for this story: Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Philip Lagerkranser at lagerkranser@bloomberg.net, Michael Patterson

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