China direct lending: Creative credit

China’s Science & Technology Innovation Board – also known as the Star Market – has emerged as an attractive liquidity channel for private equity and venture capital investors. Nearly 120 PE-backed companies have gone public on the Star Market since its inception in July 2019, more than twice as many as the next most popular bourse.

Now, though, questions are being asked about the reliability of the Star Market. In 2021 to date, 28 companies have withdrawn listing applications, including smart sensor maker Hesai Technology, artificial intelligence specialist Yitu Technology, and display developer Royole Corporation. It represents the continuation of a trend that began last December when 15 IPOs were canceled, a nearly fourfold increase on the previous month.

Oversight is lighter-touch on the Star Market compared to Chinese other bourses, to speed up the listing process. But the securities regulator has started challenging the suitability of IPO candidates and the quality of their information disclosure. It recently urged underwriters to scrutinize candidates more closely, vowing to punish those who try to bring “sick” companies to market.

For China credit investors, this has created a window of opportunity. Tao Ye, a managing director who works on the mezzanine fund at CDH Investments, observes that companies unable to go public are looking for alternative sources of capital to tide them over.

“So many companies have reached out for help in recent months, we can’t cover all the deal flow being created,” he says. “Some are introducing VIE [variable interest entity] or red chip structures for offshore listings. It might be a short-term phenomenon, but transitional funding is required to adjust corporate structures.”

Even if an international IPO is possible, preparation takes time. Private credit providers are a potential source of interim capital for companies that want to push ahead with M&A or other investments. Failure to act in a timely fashion could leave them hamstrung: equity structures can’t be changed once a listing application is made.

Broad opportunity set

This transitional investment opportunity offers a snapshot of a China credit universe that stretches well beyond the country’s infamous glut of non-performing loans (NPLs). Celia Yan, head of China and a co-portfolio manager for Asia Pacific private credit at BlackRock, identifies three key areas: growth financing, rescue packages for stressed companies, and consolidation financing for mid-sized corporates.

“In terms of private credit, China is a nascent direct lending market compared to developed markets with low product penetration,” she says. “There is a strong demand for private credit solutions, but non-traditional financing channels are underdeveloped and few in number. This means you can get an attractive risk-adjusted yield premium.”

This view is endorsed by other industry practitioners, who note significant improvements in downside protection in recent years. A special situations loan will typically be asset-backed with a loan-to-value (LTV) ratio of 30-50%. In contrast, direct lending in the US is often unsecured. Even when collateralized, the LTV might be 70-80%, according to Benjamin Fanger, founder of ShoreVest Partners, a China-focused credit investor.

China also appears to be leading the way on returns, with CDH’s Ye claiming that a 12-15% IRR is achievable. In the US and Europe, returns tend to be in the single digits.

Moreover, yields are rising. Fanger observes that the interest rates corporate borrowers are willing to pay on direct lending products has been rising continuously since 2017. He links this development to the clampdown on shadow banking in China.

Outstanding total social financing (TSF), a broad measure of credit in the economy that includes off-balance-sheet financing was RMB284.8 trillion ($44 trillion) at the end of 2020, according to the People’s Bank of China. Bank loans accounted for two-thirds. By this point, shadow banking was already in retreat, with the China Banking & Insurance Regulatory Commission estimating total assets fell to RMB84.8 trillion in 2019 from RMB100.4 trillion in 2017.

Regulators have also pledged to more effectively monitor the lending activities of large technology companies and small lenders backed by local governments.

If the scaling back of shadow banking created a financing vacuum that contributed to a better return profile for private debt players, COVID-19 has only widened it. “Market shocks and policy changes often lead to funding gaps that private credit investors can fill. Greater dispersion and upside potential exists primarily in sectors heavily impacted by COVID-19,” says Blackrock’s Yan.

The pandemic was responsible for an uptick in ShoreVest’s special situations business, with returns on these investments reaching 15-18% in the past six months, up from a pre-COVID-19 level of 10-12%. One explanation for this is the Chinese government’s relatively mild fiscal stimulus efforts compared to those rolled out in the US.

“In 2009, the Chinese approach was to flood the market with cash, while the US approach was to recognize the pain immediately,” says Fanger. “This time, the positions are reversed. Chinese companies felt an immediate impact, but in the US direct lending funds and distress funds are still waiting for a market-entry opportunity.”

Picking winners

Other private debt opportunities are created by a reluctance on the part of banks to do business with certain kinds of corporate borrowers, because these companies are either too small or they operate in industries that are difficult to underwrite. New economy start-ups are a classic example because they have few assets to serve as collateral. 

“Some consumer brands that have very good growth potential, they have little to collateralize. A factory could be worth RMB10 million, but the bank factors in a 50% discount and offers only RMB5 million,” says CDH’s Ye. “That’s where we can enter the game.”

The firm is careful in selecting borrowers. First, the target industry must have high-growth characteristics. Second, healthy corporate cash flow is prioritized over high levels of collateral, because CDH wants assurances that there is sufficient liquidity for it to recover principal capital plus interest. In certain situations, hybrid equity and debt products are available, which allow for upside potential as well as downside protection.

All investors stress the importance of acting through a local team with a high degree of autonomy. Routing decision-making through New York may lead to a loss of credibility in the eyes of borrowers and rob a team of its nimbleness. “Even by the time Information on a deal reaches Hong Kong, it’s usually been looked at by everyone in China,” one investor observes.

Having people on the ground also helps private debt providers stay abreast of regulatory developments. “You may think a matter can be resolved in three months, but in the absence of good communication, it takes another six,” Ye adds. “That directly impacts your IRR. With credit investment calculations, the devil is in the detail. The loss of a few points could be decisive – that’s the key difference between debt and equity investments.”

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• Topics
• Greater China
• Credit
• China
• private debt
• Structured finance
• ShoreVest Capital Partners
• BlackRock
• CDH Investments Management