China funds turn to special sits as growth slows

Firms focused on providing credit or special situations solutions in China are facing a growing number of attractive opportunities as the market slows down and businesses require capital, delegates heard at the Private Debt Investor China Corporate Debt Forum in Hong Kong last week.

“From a buy-side perspective, things have been a lot more interesting for us [over] the last 18 months or so. From 2009-2013 there was just too much hot capital running around in China so as a deep value investor we didn’t really find it that interesting,” Edwin Wong, managing partner and chief investment officer at SSG Capital Management, said.

“We’ve done a few things, but by and large it hasn’t been a very lucrative playground for us. That has changed quite a bit over the last 18 months – [there has been] a lot of slowdown, and a lot of it has been driven by the fact that a lot of the hot money has gone away or [become] inactive, especially on the RMB side.”

Between 2011 and 2012, vast amounts of domestic RMB private equity capital flooded the market, as shadow banking, wealth management funds and offshore money was also coming in to China.

“Now we are seeing some interesting value-driven opportunities, where you have to be ready to wade in and [deal] a little bit more with operations, be a little bit more concerned with control,” Eric Solberg, chief executive officer of EXS Capital, explained.

He added that while the firm strives for as much debt protection as possible, it still wants equity upside as well.

Private equity firms in China have also struggled to create value in their portfolio companies as growth has slowed, forcing them to seek more control or influence in their investments to generate returns. This trend is filtering into the private debt and special situations market too.

“China is quickly transitioning from a developing to a more developed structure, and the implications on industries and business cycles is all pretty profound so I think China can’t rely on growth anymore. China will obviously still grow, but it isn’t just about growth anymore – people will have to go much deeper into the strategies and have a much more differentiated approach,” Henry Lee, founder and managing director of Hendale, said.

But the need for additional value in providing special situations or debt solutions in China is welcomed by institutional private equity firms that have the expertise.

While there have been a growing number of bridge loans or simpler debt structures taken on in the domestic market, companies looking for sophisticated debt products only have a small pool of firms they can go to that really understand the financial engineering that goes into those situations, panellists explained. 

“There are a lot of RMB guys running around doing deals, but we actually don’t see them as competition,” SSG’s Wong said, explaining that even private equity players unable to find deals have tweaked their strategies into more special situations-like offerings.

“Especially the local private equity guys, they don’t have the skill set to do this. Private equity is out of favour right now so a lot of people are masking their strategies as private debt or special sits in China,” but ultimately they don't have the expertise to do this, he said. 

However, despite the array of opportunities, there are barriers to entry, particularly in currency exchange and getting money in and out of China.

“Over 90 percent of borrowings in China are in RMB, so the ability for them to take RMB funding [is crucial] and [if you can’t provide it] your opportunity set is much smaller,” Wong continues.

Lee offers an LP perspective, explaining that getting money back is also a concern.

“You want to make sure the money comes back out again. One can’t be naïve, thinking that it is always a given. That has been one of the biggest challenges over the years, especially when it comes to talking about security and [enforceability], obviously offshore creditors can’t have great [insight] into onshore assets – so who are they really lending to?” he said.

“It is faith-based, trust-based, [and] in the end, the GP only assumes a certain amount of risk because it is ultimately the LPs' capital.”