The former CEO of HKEx and veteran financier has invented a new asset class that helps fund “the little guy” – bricks and mortar shops that represent 70% of China’s consumer economy.
Charles Li has been an offshore rig worker in the North China Sea, a journalist with China Daily, China chairman of J.P. Morgan Chase as well as China president of Merrill Lynch, and chief executive of the Hong Kong Exchanges and Clearing Limited (HKEx). All that in one lifetime of taking risks and going places where few others have gone from his childhood in wind-swept Gansu Province, near the ancient monastic complex of Dunhuang.
“Throwing a party” at HKEx
Not long after joining HKEx in 2010, Li described running the Hong Kong stock exchange as like “throwing a party.” In a 2013 interview with Jeffrey Garten, dean of the Yale School of Management, he explained why. “The reason I use the analogy of a party is reflecting the unique circumstances,” he said. “China, as the second largest economy in the world, is a place that everybody wanted to be part of, and China needs and wants to be part of the world. And Hong Kong is this house right next to the big neighbor, and everybody’s comfortable with Hong Kong. China is comfortable with Hong Kong because it’s one country. And the rest of the world views Hong Kong as a completely international city, with rule of law and a free, competent, competitive capitalist system. So there is this historical period of time, where Hong Kong can be an agent of change, an accelerator of change, to bring people together.”
During his ten years at HKEx, Li made history. By 2020, Li’s last year at the stock exchange, Hong Kong ranked second in funds raised through initial public offerings globally, with $50 billion to Nasdaq’s $53 billion. Its market capitalization more than doubled between 2010 and 2020, with 2,538 listed companies with a market capitalization of HK$47 trillion ($6 trillion), compared to HK$24.3 trillion in 2010. Li had presided over the launch of the Hong Kong-Shenzhen Stock Connect, Hong Kong-Shanghai Stock Connect, and Bond Connect. In 2012, HKEx bought the venerable London Metal Exchange for $2.15 billion. In 2019, it tried and failed to buy the London Stock Exchange for $39 billion.
By the time Li left HKEx in 2020, it was the fastest growing stock exchange in the world. But what he decided to do next may be even more significant than shaking up the world of traditional finance.
Raising capital for Mr Judy
Li has been busy following his intuition that China’s 70 million small and micro businesses return capital extremely fast. They might not last more than a few years, but during the prime part of their short life cycle, they will be extremely profitable. And unlike the S&P 500 Index, where return on capital may be six or seven years, China’s shopkeepers return capital in one to two years. And unlike their bricks and mortar counterparts in highly urbanized societies, China’s digital payment system is ubiquitous. Cash flow can be tracked in real time.
“HKEx had a lot of success on the Wall Street model, where only a few thousand companies trade daily. The multiples are decided by us, and value is created or destroyed based on what we collectively think. As a result, we felt that model should not be the only one,” says Li. “The Wall Street model is like the pre-Internet retail model. Department stores can only put up a limited number of products for sale. The Internet connected everything online. In agriculture, the farmer who produces the rarest fruit can make a good living, because they can share produce within the season.”
“We all go to the department store to shop. The exchange decides who can list or not not. That’s our life.”
But just as life has had its twists and turns for Li, alternative finance doesn’t have to be all about giant companies and giant fortunes. It can also help the little guy – the lao baixing or “hundred names” in Chinese.
Li calls his brainstorm a “blue ocean of opportunity.” He cites government statistics that out of the 70 million stores in China, six million get closed and nine million open every year, for a net increase of 3 million stores. He calculates the annual capital expenditure, or capex needed for the 9 million is approximately 10 trillion yuan ($1.4 trillion), and only a fraction are financed by banks or traditional equity capital markets. “The rapid pace of returning capital, and the inability of Wall Street to provide the right product for them, simply means that this is a blue ocean that was never really tapped into by Wall Street,” Li said in an interview with AmCham e-Magazine.
When Li and his partner Gary Zhang, a financier and former Chinese provincial government official with the People’s Bank of China in Hainan, founded Micro Connect in 2021, it was as much a blue-sky concept – outside conventional thinking – as well as a blue ocean prospect. They needed an international exchange because they planned only to raise global, not domestic capital. Regional exchanges didn’t get it until they talked to Macau, which used a similar principle to tax casinos, as a percentage of their free cash flow margin. In December 2022, Macau approved the Micro Connect (Macau) Financial Assets Exchange (MCEX) to trade in the new asset class that Li and Zhang invented, daily revenue obligations, or DROs.
By May 2023, 4,000 small businesses became the first batch to list DROs on the exchange, including Li’s favorite, a hair salon called Mr Judy. A Mr Judy regional manager, Zhou Yingqun, was offered the chance to open a new shop with equity participation, and turned to Micro Connect to borrow the funds. Li likes it partly because it hires hearing and speech impaired shop workers to wash its clients’ hair, which together with head massages are its specialties and only services.
“They were popular with customers, because people want to do a good deed,” Li says. “So typically, if you’re one of these individuals, their bookings are always full.” Also, he adds, some people just want the quiet of a person washing my hair who won’t talk. “For the first time, working on Wall Street all my life, you felt that what you’re doing is creating some tangible differences in people’s lives.”
Micro Connect has extended the concept by labelling that allows investors to slice and dice different types of shop by investor preferences. Their software can identify Shariah-law compliant businesses, for example, restaurants that don’t sell alcohol or pork. Says Li: “There are many ways for us to differentiate the different shops and they have many stories. I’ve had my hair washed at Mr Judy a few times and it was a really great experience, only about $10. And you’ve got great enjoyment from your lunch break.”
Sausage making for borrowers
In the first stage, by deploying its own equity capital, together with bank financing and reinvestments of recovered capital, Micro Connect has invested approximately $500 million in total across 13,000 shops in 200 cities in China. They took the funding to HSBC and Bank of China, and Li is targeting hedge funds and asset managers next. They used the initial sample to build MAP, which stands for Micro Connect-accepted protocol to allow investors to value expected cash flows and risks of DROs.
MAP “allows us to be able to disclose individually on a daily basis how every contract is performing every day, so that investors are able to understand any given portfolio,” Li says. “It’s like a salad bar, where you take some beef, you take some shrimp, other people just take vegetables, and then you put it on the scale and it tells you the calorie equivalent or the different price. We used the first stage to test different products, different sectors, different ways of collection, and use that to develop accounting principles, valuation principles and the lessons learned in risk management to build the initial toolboxes and systems so that we can enter the second stage.”
“The first stage was that we had a hypothesis that this was going to work, that a daily revenue contract works. And we needed to experiment with it to test the model and come up with a prototype,” Li says. “In the second stage, all 13,000 investments are put into an exchange traded facility, or ETF, so that investors who are just interested in buying noodle shops can do that, and we can recycle our capital.”
The basic way the exchange works is through back-to-back contracts. Micro Connect signs a Daily Revenue Contract (DRC) with the small business, swapping it into the tradeable financial assets, or DROs. Digital automation is already built into China’s payment infrastructure, so both investor and MCEX have transparency in real time. The borrower needs money to open a shop or expand, while the contract owner buys the right to future income for a limited time. The shop keeper commits to paying an agreed percentage of revenue daily until the original sum is repaid, with a reduced percentage if the shop owner completes payment before the end of the contract. If the store goes bankrupt first, investors get nothing. As the shops repay the funds, Micro Connect bundles them into packages that can be sold to investors as DROs.
The percentage of revenue required by the DRCs varies from shop to shop in different industries and segments and the unique financing needs of each, but Micro Connect typically requires that the percentage cannot exceed 49% of the shop’s free cash flow margin. This ensures investors’ interests are aligned with the shops’ capacity and willingness to pay.
“It’s like slicing IPOs, and we’re the sausage maker,” says Li. Unlike P2P lending, the banks fund a large pool of revenue contracts, or DROs, and the investors who buy the DRCs take the risk, providing capital to the part of the economy that desperately needs to grow.
The model is evolving, in ways that provide greater scalability and potential opportunities outside mainland China. One strategy is to work with landlords and mall operators, linking their tenants through the Micro Connect network that gives them more visibility into their tenants. The trick is to motivate the landlord by offering them capital to invest in their tenants, along with visibility into their tenants. Outside China, the same model could work if the landlord becomes a partner. Even in cash societies, the landlord has a vested interest in preventing leakage in the system that may keep them from collecting their rent.
The landlord strategy is still in testing, and Li says it will take at least six months to see stable data and how to get landlords organized. “I think there are still a few puzzles to work out,” he says.
Stacking investors by risk appetite
On the investor side, structuring tranches of funding to appeal to different types of investors is another puzzle. Micro Connect addresses this through bringing in banks at the top level, with an exchange traded facility that will take up a big chunk of the financing needs. Family offices may be interested in preferred mezzanine tranches with meaningfully higher returns, but some risk, because they are behind the banks in terms of priority.
“And then you have more like a traditional equity layer, that is likely to be taken up by hedge funds, some family offices, some endowment funds, and some patient funds over time. That’s really if we are scaling it up and it will be the best equity investment for anybody who wants high quality, low volatility and healthy internal rates of return in the upper teens and low twenties,” he says. “At the front end, we will need the traditional private equity funds and venture capital funds, because they can invest in the holding company brand by identifying early successes, but not have to come up with additional capital to build the shops to reach the IPO stage,” Li says.
Larger than life?
Li was born in Beijing in 1961 and had his first job at 16 as an offshore oil rig worker in the chilly North China Sea, where he was often hungry. In 1978, when college entrance exams were held for the first time after the Cultural Revolution, he got into Xiamen University where he studied English literature and met his wife. After graduation in 1984, he worked at China Daily for two years and applied to the journalism program at the University of Alabama in Tuscaloosa. He can still manage a southern drawl, but when he found out how difficult it was to get jobs in journalism, he switched gears and applied to Columbia Law School, where he took his JD degree in 1991 and practiced law until joining Merrill Lynch in 1994. By 1999, he was president of Merrill Lynch China, before joining J.P. Morgan Chase and becoming its chairman for China in 2003.
Li has both passionate admirers and at least a few passionate critics, but both would not hesitate to describe his career as extraordinary, including his most recent venture.
“It’s not uncharacteristic of people of my generation, that we were born in very difficult circumstances,” says Li. “But we were able to work quickly to get out of that and follow China’s path of expansion and growth and prosperity, going with the rise of China. “Our generation is probably the most fortunate in that we have seen hardship, so we always have a good perspective. On the other hand, our lives were not permanently disrupted, so that we could pursue our careers and opportunities without hindrance. We were lucky.”