China distress: After the boom

The seeds of China's current bad debt investment opportunity were sown seven years ago. With exports plummeting and consumer confidence wavering in the wake of the global financial crisis, the government took decisive action. A RMB4 trillion (then $586 billion) stimulus package was unveiled in late 2008 and banks were instructed to issue loans as fast as they could.

The subsequent pattern of events is familiar to investors the world over: the credit boom has been brought to a halt amid slower economic growth and credit tightening; banks are realizing that a swath of borrowers are not going to make good on their repayments; and asset management corporations (AMCs) are buying discounted portfolios of non-performing loans (NPLs).

Investors and advisors say the volume of bad loans is so large - the average NPL ratio of China's commercial banks stood at 1.5% at the end of June, up from 1.25% at the end of 2014 - AMCs will not be able to resolve them in house. More NPLs are therefore likely to be sold on to third-party investors.

"Banks are increasing their NPLs and under pressure to offload them. The AMCs have started buying quantities of loans and they will have to unload them to generate cash," says Ted Osborn, partner and head of business recovery services practice in Hong Kong at PwC. "You will see some market developments but I don't think you will see a lot of foreigners jumping in."

Osborn and others attest to significant foreign interest in China NPLs, yet the likes of Lone Star and Sankaty Advisors have yet to turn thought into substantive action, while Asia special situations GPs seem ambivalent towards the opportunity. But China-focused Shoreline Capital closed its third fund in June at $500 million and has already called the majority of the capital, most of it for NPL deals. An overspill vehicle of $200 million is also being raised.

Shoreline's success suggests that LPs buy into the notion that money can be made as China's credit cycle turns. The question is which GPs are willing and able to assign the time and resources required to master a challenging market.

History lessons

This is not the first time a large number of NPLs has been made available. Over 10 years ago, Beijing wanted to recapitalize the Big Four state-owned banks and four AMCs were created to absorb RMB1.4 trillion in distressed loans. However, most of the NPLs were transferred at 100 cents on the dollar and the AMCs were not set specific sales volumes. As a result, auctions often featured low-quality portfolios at price points that made them economically unviable for foreign investors.

AMCs remain the sole channel through which NPLs from domestic banks reach the secondary market. But current conditions differ from those of years past in several respects.

The legal framework has advanced and most loans now have proper documentation with collateral registered and a legal framework to protect the creditors - Wilson Pang

First, AMCs are under pressure to sell assets because banks are overwhelming them with new supply. Second, there are more AMCs with assets to sell; in addition to the four nationwide players, there are around 15 provincial agencies. It is also possible to approach banks directly and arrange transactions that are nominally routed through AMCs.

Third, the NPLs of 10 years ago were predominantly tied to state-owned enterprises, which meant that efforts to enforce security through the courts were often stymied by local political interests. The new batch of bad debts - which originated in 2008, with most of the defaults happening in 2011-2012 - are tied to a different kind of debtor and supported by an improved administrative infrastructure.

"The majority of these loans were made to individual entrepreneurs or corporations. The legal framework has advanced and most loans now have proper documentation with collateral registered and a legal framework to protect the creditors," says Wilson Pang, partner and head of the special situations team at KPMG China. He notes that in the past 18 months KPMG has helped domestic and foreign banks dispose of at least 110 NPL portfolios with an outstanding principal balance of more than RMB100 billion.

This tallies with Shoreline's experience. In the previous cycle, less than one third of the NPLs purchased by the firm were secured by assets that could be liquidated, and they often involved SOEs or companies that had ceased operating. Last December, Shoreline completed its first major deal from Fund III, acquiring several hundred NPLs for more than $150 million. Several other transactions have followed.

"The portfolios we are seeing now are much more highly secured, 60-85%, and 100% of the loans we have bought so far this year were to privately owned companies, not SOEs," Ben Fanger, co-founder and managing director at Shoreline, told AVCJ shortly after the fund closed. "Many of the borrowers are still operating, they just couldn't pay their loan back for a period of time."

Opportunity cost

In contrast, a number of regional special situations players are more focused on restructuring companies that are at the brink rather than resolving debts against groups that have already slid into default.

According to Sabita Prakash, business development director at ADM Capital, the firm was heavily involved in NPLs across the region following the Asian financial crisis in 1997. This was largely because the target companies had solid fundamentals but faced short-term liquidity problems due to broader macroeconomic conditions. Now, she says, the low-hanging fruit has gone away.

"A number of these assets are distressed for other reasons - they have been mismanaged, they were overambitious, or there are governance concerns," Prakash explains. "Those assets are harder to rework and restructure because the will of the management has to be ascertained; you need to have companies on your side as a lender for the restructuring to be successful."

This doesn't amount to a hard no on China NPLs; more a preference to stand back and assess whether conditions will deteriorate further, to the point that it makes economic sense to reenter the market.

Much like ADM, Clearwater Capital Partners currently favors working with companies of reasonable scale that are cash flow positive and can deliver a more consistent return profile. "Realizing 10 or 20 cents on the dollar through a legal court process is painful, and uncertain in terms of timeframe," Rob Petty, the firm's managing partner, recently told AVCJ. "We would much rather lend to the number five player in an industry that is having a weak quarter or year but still makes money."

Indeed, by targeting companies that can still be turned around, bringing in the strategic and financial muscle to make this happen, and participating in the equity upside, special situations GPs can achieve the returns they require.

Investors made money last time around due to real estate appreciation and renminbi appreciation. Neither of those things are in play at the moment. You are back to how it is in other markets, trying to figure out how much you should pay, and China is so unpredictable on the collection side - Ted Osborn

"If it's just an NPL portfolio and they want to make a straight return it might be hard for them to get 20-30% without any equity upside," KPMG's Pang explains. "Also, if there are many NPLs in the market, the time required to get back the principal investment through litigation might be unpredictable. There are so many litigations taking place so it takes longer for courts to give judgments."

Identifying an attractive entry point is also complicated by uncertainty over pricing. According to Pang, the average price at which banks transferred NPLs to AMCs was 35-45 cents on the dollar in 2014, and since the start of 2015 it has fallen to 30-35 cents. However, several of the international investors looking at the market are asking for 10-20 cents and they are willing to be patient.

To Shoreline's Fanger, though, NPL pricing can be deceptive. "If you are getting loans at 20 cents on the dollar rather than 15 cents the immediate reaction is that they are more expensive. But the important metric is what percentage of the highly probable collections are you getting," he says. "In my mind, discount to principal balance is quite irrelevant. It really depends on what you are buying."

The local angle

Making such assessments without people on the ground can be challenging, and in this respect GPs must decide how many resources they want to put towards the China NPL opportunity. Loan portfolios not only require substantial due diligence pre-investment, but investors also need management systems in place to realize value from NPLs.

Shoreline has approximately 40 people in China and there is an expectation that other foreign investors will build their own teams over time and become more active in the market. PwC's Osborn agrees there will be more participation but he is not convinced it will lead to success. Making money takes time and effort, and foreigners - unless they can develop a wholly local persona - remain at a disadvantage when it comes to collecting on debts in China.

"Investors made money last time around due to real estate appreciation and renminbi appreciation," he says. "Neither of those things are in play at the moment. You are back to how it is in other markets, trying to figure out how much you should pay, and China is so unpredictable on the collection side."

The real competitive threat - or, indeed, a partnership opportunity - may well come from domestic pools of capital, which are increasing in size and number. These groups often have the local knowledge required to unlock a difficult resolution situation, but they may also offer a strategic angle that means time-consuming asset realization is no longer necessary. KPMG's Pang notes that he has been approached by numerous Chinese corporates seeking to buy NPLs within a particular industry.

"This could open up the market by minimizing costs and identifying new exit channels," he says.

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• Topics
• Credit/Special Situations
• Greater China
• Restructuring
• Restructuring
• Distress
• Shoreline Capital Management
• China
• ADM Capital
• Clearwater Capital Partners
• KPMG
• PwC