So far, the approach to non-performing loans in China has been the one adopted by the US investment banks, with Goldman Sachs, Morgan Stanley, and most recently Citigoup, among the keenest to buy discounted assets. That involves buying up billions of dollars of distressed debt from asset management companies and state owned banks for less than 20 cents on the dollar. The corollary is usually the break up and disposal of the bankrupt companies to recover the debt.
But David Mahon, a New Zealander and MD of private equity firm Mahon China Investment, believes a different approach reaps better shareholder returns. He explains why.
The US investment banks have a difficult task ahead of them. They've bought billions of dollars of cheap debt, but people say they have had difficulty getting their hands on the underlying assets. You also deal in distressed assets: What is your preferred approach?
Mahon: We don't blindly invest in large portfolios of NPLs. We like to go in with the idea that it's probably more constructive to take a careful look at which firms are on offer instead of buying an assortment of different companies in one bulk purchase. This case by case approach, based on the commercial viability of each company, is very different from the larger banks' strategy.
Secondly, we don't have a slash and burn approach once an investment has been made. The goal of many distressed debt specialists is ultimately to break up the debtor firm, sell off the assets and to recoup a small amount of the face value, having paid even less for the debt in the first place.
Our approach is much more extensive than debt collecting. With board powers thanks to a majority shareholding and backing from the local government, we often advise and guide a management buy out process and the bringing the workers on board via equity participation or even sending in a hand picked CEO.
Some people would suggest that the debt, and the companies it emanates from, are both essentially worthless.
That's not true at all. It's an inaccurate generalization. The term 'Chinese NPLs' is in itself very misleading, since many of these loans made in the mid 1990's were not viewed as loans either by the banks or the debtors, but as allocations of capital under a planned economy. These policy loans were made by the state banks to an array of companies and were never viewed as commercial loans in the first place.
For that reason there are many good companies that were given capital sums a decade ago which are now called 'loans' and whose interest repayments are crippling. A more thorough examination of a distressed asset, possibly one held by the AMC, reveals many ways the foreign shareholder can unlock value without bankrupting the company.
A good example has been our focus on equities not the debt held by the AMCs. These companies offer many more creative solutions for exits but is still classed as a 'distressed asset' when it is in reality far from being one.
From the government's point of view, your approach is probably too piecemeal. The attraction of the approach by the US banks is precisely the wholesale offloading of debt by the banks and AMC.
Absolutely. I'm certainly not suggesting that China doesn't benefit. I'm talking more from the point of view of how to make money - from the investor's point of view. I think that it's going to take at least two to three years for the US banks to make money using their traditional approach. They have gone in assuming that regulations will be altered to suit them. It's been proven again and again in China that relying on a suddenly improving regulatory environment is extremely short sighted.
What makes you so suspicious of the slash and burn approach? It been successful in the past in Thailand and Korea, for example.
The limited appeal of the destruction of an enterprise apart, the process is especially risky in China because so much of the regulatory infrastructure is not there. Bankruptcy proceedings are still extremely slow. Ownership rights to assets, especially land, are still not clear. Despite some major improvements in the clarifying land rights, for example, the line from many government officials is ultimately that the land never belonged to an enterprise in the first place: it was allocated to the enterprise by the government. When the enterprise ceases operations for any reason, they argue the land should revert to the government - or the 'People'.
The South East Asian countries faced a similar situation, but a much better one in terms of the degree of regulatory sophistication and clarity of ownership of assets. Some of those countries had had open markets and financial systems for decades already.
The other aspect that is striking is the assumption that a foreign entity should have more luck than a local player in collecting debt or assets.
Yes. Remember the US firms can't carry out any of these operations on their own. They have to subcontract it out to local players and form a JV. But often these players are precisely the ones that sold the debt to the foreign companies in the first place; the local asset management companies and banks. There's a flaw in the logic there somewhere!
Also, foreign banks assume that just their name and connections will yield the necessary changes in national government cooperation. To succeed with investments far from Beijing foreign enterprises need to have a sustained approach that is locally focused. An open writ from Beijing's Central government won't always bring the privileges foreign investors might imagine.
Earlier, you emphasized land. Is that at the heart of the issue?
Very much so. Many of the enterprises that are overburdened by debt and probably barely functioning often have few valuable assets apart from the land they are built on. If the factory is built on the outskirts of a growing city, then the market value of that land is skyrocketing. It's the land that investment bankers want to get their hands on, but it's also the most difficult asset to seize.
Your approach is far more appealing to the local communities in which you operate, I would imagine.
Yes. As I mentioned, we try to work with existing managers and staff as much as possible. The characteristic of the firms we look at are simple: commercial potential being held back by some rectifiable flaw. That could be excessive debt, poor management, corruption or predatory behaviour on the part of local officials. We aim to put in place expertise to get rid of the imperfections and let the company grow. Only with this approach are Chinese banks likely to be willing to restructure any remaining debts or local officials begin to view favourably the foreign partners efforts.
Not only that; Mahon China has found that there are an array of profitable opportunities for foreign firms to work with distressed Chinese firms; through an injection of foreign capital not only can the companies grow but IPO opportunities in China and abroad are increasingly feasible. Stabilized and profitable companies are also very attractive for foreign manufacturing companies to invest in.
Does your approach mean plain sailing?
Unfortunately not! We have suffered at the hands of local governments along China's eastern seaboard. That area seems especially prone to abusing the relationship with foreign shareholders. The reason if very simple, I suspect: too much foreign capital flooding in has spoilt them. No longer does the local government feel they have to provide the same support which is critical for any restructuring we attempt to do. The worst offenders are the second tier cities in the eastern provinces, the spoilt children of China's opening up to foreign investment.
The reason is that there are fewer institutional checks and balances and the authority of provincial officials is weaker than in the provincial capital. Unfortunately, greed can spiral out of control. In fact, I would no longer invest in some of the eastern province such as Zhejiang, for example. I would prefer to go inland, Sichuan or Jilin province in China's north-west where value for money is far greater.
Now for the crunch question: How much do you pay for your assets? What is the key for you to decide to buy?
Our strategy is to look at specific growth sectors in the Chinese economy and picks the distressed companies that may or may not be owned by the AMCs or directly by a bank. We believe that thanks to the close work we do with each company, this more focused approach yields higher deal flow quality than if we were just signing big deals in Beijing.
The real key for us to decide when to buy is based on the seller's motivation: if stakeholders feel their interests and pressures they face are better respected by us, such willingness can prove profitable to all.
In contrast to the large scale approach of the investment banks, we have bought assets for significantly less than the 'Giants' have ever been able to.
And what's your exit strategy?
After hopefully guiding the Chinese company to greater profitability the company can be made attractive to a foreign or domestic industrial investor in an M&A type deal. In some cases domestic businesses are likely buyers because they understand the market so much better, but we also receive a lot of interest from foreign companies wanting to find a well managed Chinese partner.
Exiting through IPO is also an option. In some cases we originally look for an investor who can provide the capital sum to invest and then help the company list- a foreign investor who has purchased a distressed but still profitable asset at discount and then can list the asset.
However, our exit strategy is often less focussed on a listing than selling our holding in the offshore holding company to a foreign investors, or a Chinese entity.
