Asia distressed assets: Off the radar

There are 64 private equity distressed vehicles fundraising worldwide; collectively they hope to harvest $45.8 billion in commitments, according to Preqin. North America-focused funds top the list, with 35 targeting $34.7 billion. Next are the Europeans, with 15 vehicles seeking $8 billion. The rest of the world category – of which Asia is the leading player – boasts 14 funds, but their target is a modest $3.1 billion.

When a big-name advisor  commented, during a recent fundraising campaign, that the Asian private equity credit opportunity no longer held much interest, Benjamin Fanger, founder and chairman of China distressed debt investor Shoreline Capital Management, was unsurprised. But he found the assessment naïve. “It only tells half the story,” Fanger told the recent AVCJ Private Equity & Venture Forum in New York.

The argument that opportunities are few and far between is underpinned by three pronouncements: Asia’s strong macroeconomic fundamentals mean distress isn’t widespread; regional credit markets are underdeveloped, so there is a limited supply of secondary opportunities; and legal frameworks in certain Asian jurisdictions are substandard, and particularly weak on creditor rights, making enforcement difficult.

Robert Petty, managing partner and co-founder of Hong Kong-based Clearwater Capital Partners, counters that the size and depth of Asia’s credit markets isn’t commonly appreciated because of the paucity of public debt outstanding. When governments don’t borrow much internationally, there is no critical mass of benchmark government bonds and corporate credit that exists in the market isn’t widely tracked.

Estimates of how much corporate debt is outstanding in Asia ex Japan vary greatly. Petty cites an IMF projection of $19 trillion; others are much more modest, with another long-term regional distress player putting it at $4-8 trillion. Another way of assessing the magnitude of debt outstanding is to consider net new lending – and, on this basis, Asia certainly leads the way. In China and India, net lending has amounted to 20% compound annual growth over the past five years; in the US and Europe it has been flat.

On the cusp of change

“Finally some of the cracks in the lenders’ balance sheets are beginning to show. We think the number is maybe half a trillion dollars region-wide – i.e. 2%,” says Petty. “So the credit markets are big and getting bigger, while there are fewer players. Also, like any lending market, there are people who make mistakes: therein lies the opportunity.”

China is the most obvious focal point in this regard today, but it is unique only in its size; similar issues are faced by a number of nations in the region. Beijing responded to the global economic downturn by loosening monetary policy and expanding credit growth, allowing banks to double their loan books. Distressed opportunities disappeared, but in the last year they have started to return. China’s lending boom has given rise to inflation and asset bubbles, prompting the government to tighten the credit market, starving many companies of cash.

In late June, China’s National Audit Office estimated that local government debt totaled RMB10.7 trillion ($1.6 trillion), of which RMB8.5 trillion is funded by bank loans. Moody’s responded by suggesting that the calculation was as much as RMB3.5 trillion too low. It said that the number of non-performing loans (NPLs) on banks’ books could reach 8-12% of total loans, up from an earlier projection of 5-8%. Other loans, including those made to corporations, had an estimated delinquency ratio of 5%.

Shoreline’s Fanger says that his firm focuses on these “inefficiencies” in China’s lending market. He waits for Beijing to respond to a lending glut by restricting credit and then looks for special situations – companies suffering a capital vacuum and in desperate need of money.

Fanger expects to see “tremendous opportunities” in the property segment, but also in energy, among other sectors. In the six-month, fully secured bridge loan space, he has observed monthly interest rates that borrowers were willing to pay rise sharply from 1.5% to 4%, which is where Shoreline did its last deal late last year. “Four percent per month on a fully-secured deal,” Fanger enthuses.

Another source, who asked to remain nameless, quipped, “There are a lot of holes in the ground out there with liars around the top.”

Phil Groves, president of DAC Management, agrees this spells opportunity, but also sounds a cautionary note. Sourcing deals and working through resolutions remains a “high touch” business, so investors need to be prepared for heavy lifting to secure opportunities. “The Chinese market hasn’t yet attained the level of fluidity seen in Western distressed markets,” he says. “This means investors need to create an on-the-ground infrastructure to run a scalable distressed book.”

That said, he reckons the slate of opportunities is wider than it was five years ago. Specifically, these include a larger number of debtors who are not state-owned enterprises, and who owe money to lenders outside of China. NPL portfolios are now more balanced than those that defined the market from 2001-2007.

These kinds of opportunities are not exclusive to China. Rising borrowing costs and lackluster public markets in India – there have been 11 interest rate hikes since March 2010 while the major stock market index is down 10% – are driving capital-starved companies to cut buyout deals, hitherto a rarity, to secure cash.

A fresh swathe of NPLs is also thought likely as real estate developers, hit by a shortage of funds and a drop in property sales, struggle to repay their debts. Bank lending to the real estate sector rose 10.4% in the fiscal year ended March 2010 to INR5.8 trillion ($131.1 billion), accounting for nearly 17% of loan books, according to the Reserve Bank of India. Concerns over risk exposure have prompted banks to raise rates and ask for more substantial guarantees.

The presence of NPLs in Asia doesn’t necessarily translate into a myriad of distressed investment opportunities – realizing on their potential has often been elusive since the Japanese bubble burst back in 1989.

Once again, China is a case in point. The problem is that no one is sure how many of this new crop of bad debts will actually be classified as non-performing and made available to distressed investors. China’s banks have run into trouble before – they were technically insolvent after the Asian financial crisis – only for the government to bail them out. When the big-four state-owned banks were restructured ahead of their overseas stock market listings in the mid-2000s, hundreds of billions of dollars in bad debt was transferred to specially created asset management corporations (AMCs). The transfers were financed with government-guaranteed bonds.

Jack Rodman, a consultant who has worked on regional NPL portfolio auctions in China and Japan since 1997, is not optimistic about the market opening up this time around.

“I think China will use the AMCs again, or create another pseudo-AMC to take all this government debt, and maybe property loans, off the banks’ books,” he says. “I don’t think they’re going to sell it to foreign investors because in China they just don’t want foreigners to make money on state assets.”

Furthermore, most of the top-tier investors have already gone. “China thinks it dictates the value of its bad assets, and everybody just has to accept that. So they packed up and went to Europe, and then full circle back to the US,” Rodman adds.

The lineup for Allied Irish Bank’s sale of its US assets is a who’s who of international investors – including the likes of KKR, The Carlyle Group, Goldman Sachs and Blackstone. China, meanwhile, has continued in deep denial; it basically hasn’t reported any bad loans since it listed its banks, even though Chinese markets were off about 22% last quarter, making them among the worst performing in the world.

Asian bankruptcy codes

It would help, of course, if distressed debt practitioners were guided by a clear set of regional bankruptcy codes that offered a degree of certainty in assessing assets. A KPMG report on the topic, published in late 2009, notes that, historically, bankruptcy law developed on a country-by-country basis in Asia, reflecting different economic, cultural and social factors. And attempts at international standardization remain rare.

As a consequence, investors looking at multinational or large regional companies with assets and liabilities spread over several jurisdictions must grapple with widely different insolvency regimes. And in order to be effective across borders, office holders in an insolvency case need to have their authority recognized in jurisdictions other than their home. This is by no means straightforward.

A key issue in this context is how a given regime views insolvency philosophically. Creditors are crucial in countries with legal systems based on English law, such as those in Australia, Singapore and Hong Kong. By contrast, the emphasis tends to be more on rescuing the debtor in places like Japan, Korea, Indonesia, the Philippines – and certainly China, other sources tell AVCJ.

“The Chinese government has come out and admitted that 30% of government loans are not recoverable, yet they’re being carried at full value on banks’ balance sheets,” Rodman says. “The accounting firms just haven’t reflected this.”

Phil Groves of DAC Management shares some of these reservations concerning the Chinese legal system, noting it can be disjointed and subject to the whims of judges and politicians, but he stresses that some types of debts are less subject to influence, and these are the ones investors should be chasing. “There is a method in the madness and an experienced investor can feel relatively certain of the path in many cases,” he says.

Special situations

An obvious solution is to avoid the courts and regulators as much as possible. Special situations investments – which one source describes as helping good businesses that have made mistakes get back on their feet – are a relatively bright spot in the distressed sector. Deals can be structured so that the asset or collateral gets transferred to the investor until repayment. This can be worth two or three times the initial investment.

Shoreline Capital, at least, claims never to have seen a default. “That’s because if they did default, we’d be in a much better position,” Fanger says.

Special situations investing retains its odd juxtapositions and components. For example, when Indian energy company Lanco Infratech agreed to acquire Griffin Coal Mining in Western Australia late last year, the latter had been in administration for a year and a half. The attraction was the target could supply approximately 4 million metric tons of thermal coal yearly, with the strong likelihood of being able to ramp this up to 15 million.

When Clearwater sold its stake in Griffin Coal at 2x its entry price, having funded the operation while it was in administration, Petty says the State of Western Australia thanked them for putting new management and long-term capital investment to work there.

Such an investment style can only grow, he feels, and that’s why they believe that “sectoral evolution” is the next big opportunity in the space – i.e. supporting Asian businesses as they go beyond national borders in search of new opportunities throughout the region, setting up operations in multiple locations.

“We follow these companies closely as they grow and borrow to expand,” Petty tells AVCJ. “Mistakes are often made as a part of such expansions and we can help the company live through those mistakes by providing rescue financing in a tight lending environment.” 

Distressed asset investors eye corporate fraud cases

Both India and China have been hit by corporate fraud cases in the last year, which offer openings to distressed investors.

In India, the revelation that a government minister sold airspace to mobile operators blew the lid off rampant influence-peddling among the business elite in terms of key government appointments and regulatory decisions. The resulting crisis in confidence has prompted investors to pull out their money, sending valuations down and distressed situations up, particularly among mid-cap companies.

“This situation creates great entry valuations and multiple opportunities for special situations players,” says Rob Petty, managing partner and co-founder of Hong Kong-based Clearwater Capital Partners.

China’s problems started last year when short research firms exposed financial irregularities at several US-listed Chinese firms. This prompted a wider attack on mid-cap Chinese companies listed on foreign bourses, notably those that went public in the US through reverse mergers.

A slew of firms have been accused of overstating revenues, exaggerating market positions, and shifting cash off the books through related party transactions. Those caught up in the scandal include China Forestry and China Agritech, both of which appear in The Carlyle Group’s portfolio, and Sino-Forest, which until recently counted Paulson & Co. among its investors.

Stock prices of mid-cap Chinese firms have fallen across the board, irrespective of whether they have been accused of fraud, or whether any allegations are true.

Tom Jones, co-head for Asia at Alvarez & Marsal, a global corporate restructuring consultancy, believes problems will emerge at even more companies – and asks what will happen to their creditors. Chinese firms that list overseas issue debt offshore, using onshore assets as collateral. If a problem arises, it is very difficult for offshore creditors to foreclose and get control.

As Jones sees it, even if the bondholder buys the debt at issuance and gets its principal back at maturity, that does not equate to an appropriate return for the risk taken. “This suggests the opportunity in distress is in the secondary market, after reality has set in and the price of the bonds has dropped,” he tells AVCJ.

Petty concurs, adding that the attitude of Asian banks is the most important factor in the secondary debt category. From a regulatory standpoint alone, it is just too expensive to hold work-out loans, meaning the banks just want to sell – and their present profit positions for the most part enable them to do this and take the hit.

Some bonds, including those tied to Sino-Forest, are trading in the secondary markets. There was some $2 billion of public debt available at $0.60 on the dollar; presently, however, trades are in the $0.40-0.50 range. “Most are still bank loans being worked on by 3-5 different people in the secondary market,” Petty says.

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• Credit/Special Situations
• The Carlyle Group