(Bloomberg Markets) – It’s hard to find a bigger bull on China’s delinquent debt than Benjamin Fanger. The Mandarin-speaking founder of ShoreVest Partners, an asset manager based in Guangzhou, built his business around the idea that money must be earned from the growing pile of distressed loans. He says the opportunity is greater now than at any time in the past 15 years since he began analyzing China’s NPLs, or NPLs. He predicts that it will only get bigger.
Fanger also says that the market of more than 1.5 trillion dollars is full of pitfalls. If you don’t have experience, it can be very risky, says the 43-year-old former from the University of Chicago’s Booth School of Business, whose team bought more than 15,000 Chinese NPLs. since 2004.
China’s distressed debt is attracting more and more global attention, with default increasing even before the coronavirus pandemic and the government of President Xi Jinpings removing restrictions on international investors. In an era that could turn out to be another global economic crisis, Chinese debt seems safer counterintuitively, says Fanger.
Oaktree Capital Group, the credit investment giant led by Howard Marks, opened a wholly-owned unit in Beijing in February to buy NPLs. The potential rewards are juicy. The Fangers team has generated double-digit internal rates of return on all of its NPL portfolios, according to a ShoreVest offering document seen by Bloomberg Markets. For comparison, the Bloomberg benchmark for junk bonds in the United States returned about 6% before a virus-induced peak in late March. In Europe, the rates of certain corporate bonds are negative.
Global fund managers who are desperate for yield have a growing universe of downed Chinese debt. The country had $ 1.5 trillion in non-performing loans and other stressed assets at the end of 2019, according to PricewaterhouseCoopers. And S&P Global Ratings estimates that delinquent loans could jump $ 800 billion if the coronavirus epidemic turns into a protracted health emergency.
Even if China’s economy rebounds quickly, crime may continue to increase. The ruling Communist Party, which has enabled one of the biggest credit booms in world history in the past decade by providing implicit guarantees to borrowing companies, is now trying to pull the brakes. Decision makers have made it clear that bailouts are no longer a no-brainer; even some public enterprises fail to fulfill their obligations.
But buyer, beware. Veterans of distressed investments in the West may find their reading books of little use in China. Bloomberg Markets therefore asked Fanger, Marks and other specialists how to navigate the minefield. Below are some key points to remember.
Avoid social unrest
This is one of Fangers’ guiding principles, and it applies to more than just layoffs and idle factories. When he talks about property debt, for example, he avoids situations that could force people to leave their homes. If a developer finds himself in a cash position and has contractual purchase and sale agreements with families who are thinking of buying units, when you go to court to enforce the law, the court may delay, he says.
Another delicate area: companies that have issued debts to individual savers via asset management products or peer-to-peer lending platforms. If retail investors invest in mezzanine debt sold through these products and you buy a senior loan, there can be social unrest if retail investors know they are going to be wiped out, says Fanger. Result: think carefully before buying this senior loan. While the Chinese government has shown an increased willingness in recent years to let its citizens bear the brunt of poor investment choices, the authorities are still reluctant to make decisions that could send angry people out onto the streets.
State support issues
One of the biggest challenges in buying Chinese corporate debt is connecting borrowers with government, says Soo Cheon Lee, chief investment officer at SC Lowy, a bank and investment firm focused on credit. China is not about finances, but about relationships, says Lee. It is the engine behind much of the liquidity available to a business. You really need to understand the local landscape, and it is difficult for foreign players to understand who has this connection or support from the state.
Sometimes a Chinese company seems to be in dire straits, arriving at the last minute with the money for a debt payment, says Lee. For most companies in Asia, we know two weeks before if they have financing or if they will restructure, he says. I think it is very unique for China not to be able to predict a fault.
Some companies are not what they appear to be, says Lee. If you are truly a state-owned enterprise, he says, you will continue to get support from government or state-owned banks. But when we look at companies that claim to be public enterprises but which are not really public enterprises, we find that they are experiencing difficulties.
Develop local expertise
For CarVal Investors, which oversees about $ 10 billion in credit and alternative assets, becoming familiar with China meant tapping into the local knowledge of struggling debt specialist Shanghai Wensheng Asset Management. The two companies have teamed up to purchase two portfolios of non-performing loans since 2018.
Today, there are investors and national service agents who have experience, which opens up a much better opportunity if you can team up with a smart local investor, says Avery Colcord, CEO of CarVal based at Singapore, which has spent about two decades in China. He says the firm would like to buy more NPL but has taken a cautious approach after aggressive offers from some national managers have pushed ratings up. At Oaktree, Marks says that the company is also evolving slowly while strengthening its local expertise. We felt our way and we were getting used to a new market, he says.
Sweat the details
A major advantage of having a strong local team is that they are more likely to notice the little things that can make or break an investment, says Ron Thompson, CEO of Alvarez & Marsal Asia, who leads the practice of restructuring businesses. Real estate transactions, in particular, often require extreme levels of due diligence. If you have the whole building, it’s easier, but if you only have the third floor, you have to figure out who owns everything else, says Thompson. You have the third floor, but the elevator can be controlled by the debtor or the mafia. Will you be able to access the floor? Who else can buy it?
Smart borrowers will frequently structure their debt to give them leverage. For example, you take a block of land, divide it into five, and deliberately default on the middle piece first, says Thompson. It is really worth nothing because there is no access. And then the debtor will buy it back, gradually aggregate it and pay only the market value on the last piece.
Thompson highlights the importance of hiring lawyers who know their way around the national justice system. While the Chinese authorities have pledged to move towards a more efficient and predictable process for dealing with defaults and restructuring, judges in the poorest small provinces are more inclined to help unsuccessful entrepreneurs. Going further for local information is essential in China, says Thompson. There are things you could miss without it.
Liquidity is key
Distressed debt managers in China sometimes overestimate the liquidity of a loan guarantee, says James Dilley, a Hong Kong-based partner at PricewaterhouseCoopers. This is crucial because selling assets is often the only way for creditors to get paid back quickly.
Many distressed situations relate to real estate, which requires understanding the local real estate markets. It might be easier, for example, to find buyers for a building in the more developed provinces of China’s east coast, such as Jiangsu and Zhejiang, than in the less populated inland cities. Some investors have seen their yields suffer because property sales have taken longer than expected, says Dilley, and getting it right is essential.
Wee and Choong Wilkins are credit market journalists for Bloomberg News in Hong Kong.
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