China distress: Second cycle

If CITIC Capital were preparing to raise a $2 billion fund to invest in Chinese distressed assets, it would likely represent the largest pool of dry powder earmarked for the strategy since Avenue Capital Group sought to deploy one-third of its $3.1 billion fourth Asia fund in Chinese non-performing loans (NPLs). That bold ambition, announced in 2006, was unrealized as deal flow proved sparse.

Contrary to reports, CITIC isn’t yet ready to set a target for the mooted distress vehicle, but it has assembled a team to look at such opportunities, with a focus on real estate. Last month, Warburg Pincus went a step further, establishing a joint venture with local player Hande Group to pursue special situations investments in real estate projects. The JV will have initial capital of $1 billion and wants to reach $5 billion within three years.

It amounts to further evidence that investor appetite for China distress is on the rise again. Smaller, overleveraged real estate developers are said to be teetering on the brink due to a market slowdown that has pegged back property prices in major cities. Property is relevant to the NPL investors as well, given that it serves as collateral on most debts. As of June 2018, commercial banks were holding RMB2 trillion ($282 billion) in NPLs and $493 billion in “special mention” loans showing signs of stress. A further $620 billion had already been transferred to the asset management corporations (AMCs).

NPLs are an old story. The first cycle started in 2001 and ended in 2007 when a government-orchestrated process to sell off bad debts faltered and Avenue, among others, was left with nothing to do. The second began to gain traction in 2015, supported by better quality loans – typically collateralized and involving private businesses rather than state-owned enterprises – an improved enforcement infrastructure, and AMCs that are more inclined to sell rather than try to resolve NPLs.

It prompted a hiring spree among the foreign banks and funds, with the likes of Lone Star, Oaktree Capital Management, PAG, Goldman Sachs and Bain Capital Credit (BCC) deepening their talent pools. Nevertheless, there were still several questions outstanding. Would the government force the banks to act? Would there be enough large-cap deal flow? Would rising local competition distort pricing?

While there is undoubtedly plenty for local players to feed on – small portfolios and oddly structured deals – foreign investors aren’t starving. According to PwC, they invested $1.5 billion across 20 deals in the 18 months to September 2018. Three more came in the final quarter, taking the total for 2018 alone to 15. It identified several contributing factors: Beijing wanting to clean up the banking sector; the sheer volume of NPLs; and AMCs being forced to return to their core NPL trading, having come under scrutiny for engaging in riskier business around shadow lending and leveraged financing for offshore M&A.

Jonathan Lavine, co-managing partner of Bain Capital and CIO of BCC, adds that the government and regulators now have a long-term plan for selling NPLs. “They know they need to attract private capital and they need people to be able to build scale. They also know there’s some concern that if you buy a portfolio, 30% of it will turn out to be fraudulent. So, the portfolios are now cleaned, adjudicated, and there are rigid processes. Implicitly or explicitly, I suspect somebody has studied what worked and didn’t work in Europe,” he told AVCJ last November.

A variety of scenarios could still see this relatively orderly system once again grind to a halt – and even if it doesn’t, foreign investors that fail to invest in local sourcing and execution capabilities might find their progress thwarted. Indeed, many groups are still hedging their bets, talking up China but still managing global or regional pools of capital to ensure flexible mandates. 

This applies to Avenue as much as the rest. Towards the end of last year, the firm completed a reboot of its Asia franchise with a $450 million fundraise. The team has made investments in China, but also in Australia, Indonesia, and India.

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• Topics
• Greater China
• Restructuring
• Credit/Special Situations
• Fundraising
• China
• Distress
• CITIC Capital
• Bain Capital Asia
• PAG
• Oaktree Capital
• Goldman Sachs
• Lone Star Funds