Some of them profited handsomely from an eventful restructuring at Kaisa Group, the first Chinese property developer to default on its offshore bonds. Others talk nostalgically about the good old days when they could buy a portfolio of soured bank loans on the cheap.
But maybe for distressed debt investors the best is yet to come as many get ready to partake in the next “big short” in China now that years of credit-led stimulus are coming to an end.
The first big sign that something stinky might be around the corner in China is the jump in borrowing costs. Although Chinese corporate bond yields have recently retreated from their peaks, the yield on A-rated corporate bonds still hovers around the 11% mark, making it hard for most corporates to refinance their existing bonds. At this level, a surge in defaults cannot be too far away.
With the US Federal Reserve continuing to lift interest rates – seven quarter-percent hikes since December and another four projected later this year and next – and also eating into the global supply of capital by slowing offloading the trillions of dollars of debt securities it bought after the global financial crisis, borrowing dollars offshore is also getting more expensive and harder.
For distressed debt investors – investors who revel in the kind of risky debt no one else will touch – this is the stuff of dreams. Because amid the looming carnage as these refinancing pressures mount, they hope to save the fallen angels with solid businesses, or at least valuable assets, that are caught in crossfire – at a price, of course.
This subset of debt investor typically swoops on the bonds or loans of troubled companies, either betting on a swift recovery in these the beaten-down debt instruments or looking to take outright ownership of the business and its assets through a restructuring process.
They can bet on a single-name investment such as a troubled property developer running short of cash to complete a project. Alternatively, they can buy a portfolio of bad debt from one of China’s four big “bad banks” – including Cinda Asset Management and Huarong Asset Management – and bet on finding a couple of diamonds in the rough.
“In general, what distressed investors are looking for are companies that can make money operationally through their products and to meet ongoing working capital requirements, even though their short-term liquidity is in trouble, Zhang Zheng, chief executive of Lakeshore Capital, the onshore platform of Shoreline Capital, China’s largest domestic distressed debt fund by assets, told FinanceAsia in a phone interview.
Founded in 2004, Shoreline Capital is a pioneer in investing in China’s special situation and distressed debt market, currently managing $1.5 billion and Rmb6.5 billion ($960 million) for its offshore and onshore investors, respectively.
Whether it’s best to invest in a single distressed credit or a basket of non-performing loans (NPLs) remains a subject of much debate. But investors in single-asset situations, often property projects, generally pay a higher return, compensating for the added complexity of dealing with multiple parties including banks, asset management companies, trade creditors and the local government and tax bureau.
“Unlocking a single NPL situation isn’t easy,” Ted Osborn, a Hong Kong-based partner at PwC specialising in debt restructurings and bad debt in China, told FinanceAsia. “Usually the grander the scale; the more complicated it becomes.”
“For a single distressed credit, you may get an [internal rate of return] of 20% or more, compared with a return of 15%-20% for investing in a portfolio,” Osborn said, "But it's very hard to pull off successful single-asset deals, so most investors these days are focusing on portfolios."
From a risk management perspective, a portfolio deal offers investors a chance to diversify risk across different maturities and industries. It also provides some historical data for valuing the assets more accurately.
EYEING PROPERTY DEALS
Property developers, because of the nature of their businesses, are in constant need of capital to fund their projects. Unfortunately for them, though, the Chinese authorities have been curbing their access to onshore funding since last year, which in some cases is putting finances under strain.
At least two small property developers have defaulted on their bonds so far this year. Hong Kong-listed Wuzhou said in June that it defaulted on a $300 million bond, while Shenzhen-listed Zhonghong Holdings said in April it had defaulted on $360 million worth of outstanding debt.
Distressed debt investors, especially foreign firms, like property-related deals because the sector tends to be more liquid and easier to understand. However, foreign investors are not allowed in China to take ownership of the assets — under Chinese law, only Chinese citizens are allowed to own property.
“Regardless of whether you are a domestic or foreign investor, loans backed by property are preferred, including commercial buildings, shopping malls or factories. It is simple and easy to value and sell those assets,” Osborn said.
“Foreign investors of NPLs who buy in dollars can't take real estate collateral onto their books, they can only sell it, so investors wishing to enhance property collateral and later resell must buy the loan using renminbi through an onshore company."
Homebuilders in China face a record $26.5 billion of onshore and offshore debt that matures in the second half of this year, and another $45 billion of debt to repay next year, data from Dealogic shows.
But venturing into real estate-related distressed debt is not without its risks.
Taking a more cautious note, Zhang said: “China’s property sector is definitely the most sought-after one for many investors, but the sector faces lots of regulatory and macro risks such as government policy to curb home prices.”
“For example, transaction in the property market in Hainan Province has dropped significantly since the local government launched new policies to curb prices and transactions in April.” He added. “We have to take a judgement call on the magnitude of policy directions,”
RENEWED INTEREST
Although China’s distressed debt market has been drawing a lot investor attention, few landmark deals have been done over the years.
The mixed picture towards China’s distressed debt market underscore both vulture and fear of the asset class. Back in 2015 when Kaisa Group became the first Chinese property developer to default on its dollar bonds, dropping lots of interest from foreign investors to play a more active role in the market.
In truth, outright corporate defaults remain a relatively rare event, in part because of the Chinese government’s intention to bail out some of the commercial non-viable government entities or state-owned enterprises.
News Oaktree, the world’s biggest distressed fund manager, had formed a joint venture partnership with Cinda, the first Chinese asset management to float publicly, generated some excitement in 2013. Two years after, Howard Mark, chairman of Oaktree, admitted the Chinese distressed debt market was more difficult to crack on than he originally thought.
To be sure, bond defaults in China are still remarkably rare. There have been about 22 so far this year, representing less than 1% of the outstanding corporate bonds in China, compared with 49 defaults in all of last year, according to data provider Wind.
But with credit growth in China slowing since last year and the month of July on track to more than double the previous monthly record for the scale of onshore bonds entering default, the vultures are once again buzzing with excitement.
Along with Oaktree, foreign investors like Blackstone, PAG and Bain are among those actively looking for deals in the market, according to industry sources. Blackstone last year bought a $200 million NPL portfolio, its first-ever deal in the Chinese distressed space.
The carcass distressed debt specialists could potentially tuck into is huge and growing. The total amount of soured debt in China, combining NPLs and special mention loans, reached Rmb5.12 trillion at the end of last year, up from Rmb4.16 trillion in 2015, according to the China Banking Regulatory Commission. The so-called special mention loans are the overdue loans that could become nonperforming.
Zhang of Lakeshore Capital reckons that both domestic and foreign investors are fighting it out on more or less the same battlefield because all investors get their NPL portfolios from the big four AMCs.
What probably sets them apart is local knowledge and the ability to integrate different troubled companies. “Going forward, I think what separate us from others is our ability to integrate different troubled companies,” said Zhang, who manages a team of 80 investment professionals across 12 Chinese offices.
Generally speaking, the value of an NPL portfolio, which comprises both secured and unsecured loans, is now 60 cents on the dollar, compared to 10 to 20 cents back in 2000 when the industry first got going, highlighting the growing interest in this notoriously opaque market.
Foreign investors, on the other hand, benefit from being big.
“The comparative advantage foreign investors have over domestic investors is that the Chinese AMCs – the major supplier of NPL portfolios – prefer working with foreign investors as, unlike domestic investors, they have sufficient cash to deploy for large deals,” according to PwC’s Osborn.
The average acquisition price of portfolios sold to foreign investors is normally $80 million to $120 million. “Domestic players can’t come up with that kind of money and pay in cash.”
Also important is the fact China has been easing the restrictions foreign institutions face for entry into Chinese banking, financing and capital markets. As part of Chinese President Xi Jinping’s call to deepen reform of the domestic financial markets, China has lifted the cap on foreign ownership of a Chinese bank from 20% to 25%, while increasingly the maximum foreign holdings in stockbroking and futures firms and life insurance companies to 51% from 49% previously.
And for the distressed debt market, the Shenzhen foreign exchange bureau is promoting a pilot programme for foreign investors to engage in the cross-border transfer of banking NPLs, according to Shengzhe Wang, a counsel at law firm Hogan Lovells.
“With the expansion of the pilot programme to other regions, foreign investors have more opportunities to invest into the distressed debt market in China,” Wang said.
This story has been upated to clarify Shengzhe Wang's position
