Distressed & special sits report: NPLs in China

Regulatory change is putting China’s non-performing loan portfolios in the spotlight, but managers looking to service these loans may find it challenging,

Distressed debt & special situations report

The growing demand for distressed debt

Finding deals in the US

Innovative strategies

NPLs in China

Chasing yield in special situations

Downturns and distressed debt

Big-name private capital firms have started to make bets on China’s non-performing loans market. One reason is that the money set aside by banks for uncollected loans – the loan loss provisions – is increasing year-on-year. This means debts are being marked down to levels that allow private debt investors to acquire portfolios without the banks taking an additional hit.

With the likes of Bain Capital, Blackstone, PAG, Loan Star and Oaktree Capital Management all reportedly snapping up multiple NPL portfolios, Ted Osborn, a Hong Kong-based partner and leader of the restructuring and insolvency practice at PwC China, explains: “There is clearly a market and other foreign investors’ funds are actively looking as well.”

It is an observation shared by Andy Brown, a partner at Guangzhou-based distressed debt and structured credit specialist, ShoreVest Partners. He says his firm has worked with Bain Capital under a strategic relationship on its first NPL portfolio investment in China in Q3 2017.

“The [Chinese] banks have taken significant provision expenses to write down and mark-to-market NPLs,” he says, which arguably opens the door for distressed debt investors to purchase portfolios.

“I see a three- to five-year run minimum because of the sheer quantity of NPLs that need to get digested and pass through the Chinese banking and financial system”
Ted Osborn

Each NPL portfolio can have anything from 30 underlying loans to over a thousand, depending on how it is constructed. “The number of [NPL] portfolios is increasing, and the incremental size of each portfolio is also increasing,” adds Brown. ShoreVest confirms that the pipeline – measured by the asking price or deal value of portfolios – has tripled in the past year.

According to PDI data, the firm has been raising for its debut China NPL fund – ShoreVest China NPL Fund – with a target size of $750 million since June 2017. The China fund acquired its first NPL portfolio in November 2017. Banks record provision expenses to reflect the possibility that they may not recover full payment of loans from borrowers. Several large commercial banks in China have reported higher loan loss provision figures on their balance sheets for the last quarter, indicating lower credit quality.

According to Credit Suisse’s China Economics/Banks report published in March, China’s large commercial banks – including Industrial and Commercial Bank of China, Agricultural Bank of China, China Merchants Bank and China Construction Bank – are increasing their loan loss provisions.

ICBC, the largest bank in China by assets, put aside 87.9 billion yuan ($13.8 billion; €11.7 billion) loan loss provisions in the 2016 fiscal year. By this year that figure is expected to be closer to 120 billion yuan.

As China looks to de-risk its economy, tackling this large pool of NPLs is a priority. ShoreVest’s Brown estimates that over $80 billion worth of NPLs moved from banks to asset management companies during 2017.

From 2011 to 2016, commercial banks used 1.4 trillion yuan to absorb NPLs, according to an IMF Country Report published in December 2017. The NPL ratio has increased from about 1 percent in 2013 to 1.7 percent in 2017.

“Everyone knows the official NPL ratio is about 1.7 percent and even the CBRC recognises that this amount is understated,” says Osborn, who estimates the true NPL ratio is about 10 percent or even higher in the commercial banking sector.

That means there are a lot of NPLs that need to be brought through the system and resolved. The IMF’s report also points out that ‘special mention loans’, or opaque non-standard credit assets that Chinese banks categorise as one just above NPLs, peaked at 4.1 percent of loans in 2016.

Regulators have initiated several directives to shed the problem credit. Circular 46 is an initiative announced by the China Banking and Insurance Regulatory Commission (formerly the China Banking Regulatory Commission) last year that strives to prohibit fraudulent accounting practices and financial statement manipulations. The directive imposes more stringent supervision on Chinese banks and financial institutions with regards to different forms of arbitrage.

Regulation crackdown
Several provincial banks have been fined under this supervision, including Guizhou Renhuai Maotai Rural Commercial Bank and Guizhou Zunyi Huichuan Rural Commercial Bank. Each incident can incur a fine of between 450,000 and 500,000 yuan.

“We have been aware of this accounting regulatory issue for a long time,” a Hong Kong-based partner at an international law firm tells PDI, requesting anonymity.
The lawyer notes the possible beneficiaries of this regulation: other large banks. “What is happening today is that the government does not push these lenders to [mark non-performing assets as bad debt on their balance sheet]. The second, is that there is a self-perpetuating mechanism in place where one entity props up another entity,” the lawyer says.

His analogy is that if a bank made a $100 million loan to a provincial government to build a governmental headquarters building that generates no revenue, at some point the loan will need to be paid back. If no payment obligations are made, then the lender should account for that loan on its balance sheet as non-performing.

“So, at some point, there should be a reckoning, but I just do not know how soon,” he notes, adding: “A bad loan is a bad loan. I do not care how you characterise it on your books.”

Making business sense
So, how can we know how much of an NPL portfolio makes business sense to foreign distressed debt specialists?

When acquiring NPL portfolios in China, the first step is to negotiate with the financial institutions on what the portfolio assets are going to be, the Hong Kong-based lawyer explains. They might decide that a significant portion of the underlying loans either should not be in the portfolio or should be ascribed very little value.

“In terms of pricing, it really depends upon the quality of the loans that you are trying to buy. It is not about ‘paying 30 cents on a dollar’, but rather, paying a price that will allow you to receive a fair return on your investment,” the lawyer adds.

Banks can securitise packages of loans and keep the senior tranche as an investment product. These packages can carry high ratings which is beneficial for banks to meet the capital requirements. They can also sell junior tranches to off-balance sheet wealth management products.

However, Kingsley Ong, a Hong Kong-based partner at Eversheds Sutherland, a London-headquartered international law firm, says securitisation of the NPL market has not yet taken off in China “because it costs more to do the securitisation than exposing those assets to asset management companies”.

He thinks the authorities will be more likely to focus on developing and liberalising the current asset management company structures. “I think Chinese regulators will be more focused on expanding existing asset management companies, by potentially allowing more flexibility for acquiring and selling down the NPL portfolios to investors,” Ong adds.

“The number of [NPL] portfolios are increasing, and the incremental size of each portfolio is also increasing”
Andy Brown

Distressed debt managers can get their principal back by working with borrowers and refinancing their outstanding loans or causing partial repayments. That way they can exit by gradually decreasing the portfolio size. However, it is still too early to judge whether the market can facilitate the entire process. “Everything comes down to what you are paying for [the assets], how much the liquidation value is and how long it takes to get resolved. So, to achieve targeted returns, it is about time and realisation of cash,” Brown says.

Most transactions are partial exits by existing investors – as new investors enter – rather than entire portfolio sales. Negotiation challenges between seller and buyer can also prolong the time that it takes to exit from the investment. Only authorised asset management companies that can bid on the bank NPLs.

According to Brown, there are currently around 174 asset management companies. The number increased by 18 from last year. These companies are given ‘quotas’ to both buy NPLs from the banks as well as dispose of NPLs into the marketplace at economic prices.
Ong also points out that there are only a limited number of asset management companies authorised to buy NPL portfolios from Chinese banks.

“Foreign investors still need pre-approvals to invest in NPLs in China,” he says. The asset management companies would also need to get approvals to sell down those loans to foreign investors.

“I see a three- to five-year run minimum because of the sheer quantity of NPLs that need to get digested and pass through the Chinese banking and financial system,” Osborn notes.

Although banks aggressively write-off and dispose of large volumes of NPLs via asset sales to state-owned asset management companies, it is doubtful if market participants will be able to see a value-add that distressed debt specialists can bring to troubled corporates in the form of operational turnarounds, as the regulatory infrastructure still needs to be ramped up.