Friday letter: Learning lessons

In the upcoming March issue of Private Debt Investor, we drill into different aspects of the Chinese debt market. There are definitely opportunities there for savvy investors, but there is also a reminder of how not to go about private debt provision.

It’s a lesson that in the wake of the global financial crisis shouldn’t really need to be learned, but humans don’t have long memories and are driven more by short-term incentives than long-term planning. And as private debt is still developing as an asset class, the anticipated wave of defaults in China is a good reason to remind ourselves.

This week, Kaisa Holdings, a Chinese real estate developer, revealed that at the end of 2014 its debt burden stood at $10.4 billion, about $3.5 billion more than was recorded in its last financials from 30 June 2014.

The company has declined to comment publicly on where the extra debt came from, but it certainly wasn’t raised from the public offshore bond market. Some analysts have postulated that the credit was provided by the Chinese shadow banking system and held off balance sheet until the currently ongoing restructuring process forced Kaisa to disclose all debts and engage with all creditors.

Non-bank lending in China has grown at an incredibly rapid pace over the last seven years and reached around $7 trillion last year, according to an estimate by Moody’s. Moves by authorities to cap bank rates offered to depositors pushed many savers towards higher yielding investments. And because China’s banks are state-controlled and have concentrated their lending power towards the state-owned enterprises, the fast-growing SME sector was left out in the cold when it came to financing. 

Conditions were perfect for non-bank lenders to step into the void – which shouldn’t be a bad thing. But recent history wasn’t heeded. Trust companies sprang up and began structuring loan products to sell to investors while keeping no exposure to the underlying asset themselves. Their incentive was to lend as much as possible to earn fees, not to apply proper underwriting standards.

Remember the NINJA loans that made up much of the subprime US mortgage market and helped shake financial markets to the core just a few years ago? Well, it’s the same story all over again.

The unregulated shadow banking sector now poses a threat to the world’s largest economy as it undergoes a painful transition from investment-driven growth to a more consumption-driven, lower-growth model.

For the same fundamental credit failures and structuring problems to arise in two of the world’s largest markets less than a decade apart shows that we mustn’t place too much faith in the idea that history will not repeat itself.

And as a growing and unregulated alternative lending source, private debt funds must continually remind themselves that credit standards are key. It cannot be a transactional business; managers must focus on their underlying assets whether they are in Shanghai, Paris or Chicago.