Filling China’s lending gap

China’s 49 million small and medium size enterprises do not have access to traditional forms of lending, yet many need capital to grow domestically or expand offshore.

Banks prefer to lend to state-owned enterprises because they are perceived as lower risk than SMEs, says Conor MacNamara, partner at Adamas Asset Management, which is raising a $200 million mezzanine lending fund for China. Regardless of how credit-worthy some SMEs may be, many are effectively shut out of bank loans.

“China’s financial system allocates capital inefficiently, leaving many good companies without financing and bad companies with too much debt,” adds Benjamin Fanger, co-founder and managing director of Shoreline Capital, which closed a China-focused special situations/distressed debt fund on $303 million last month.

The markets don’t offer much liquidity either. China has a 600-odd queue (or four-year wait) for listing and since October IPOs have been frozen due to regulatory matters.

Robert Appleby, director of ADM Capital in Hong Kong, estimates there are roughly 6000 private equity deals in China and only 10 percent have been exited. He sees opportunity in offering liquidity to private equity-backed businesses that are stuck in exit mode.

“[The situation] leaves companies with private equity involvement with no form of exit,” Appleby says. “In some cases the fund life has terminated and now you’ve got a forced seller of a significant minority stake in a private company.”

Another opportunity is lending to mid-market Chinese companies that want to make acquisitions abroad. Appleby cited research from JPMorgan that forecast overseas direct investment to rise 10-fold in the next three years.  In 2012, China’s outbound investments totaled $77 billion, up 14 percent from the previous year, according to data from A Capital.

Risk is a key issue when providing financing to companies in emerging markets lending, sources agreed. Firms address it on several fronts.

Due diligence takes between six months and two years and is well above what is considered standard, Appleby adds. It includes legal, financial, environmental and personal investigations. “The type of due diligence we do is very burdensome and extraordinarily detailed. Credit history may be checked by figuring out if the [entrepreneur] pays his electricity bills.”

Collateral, onshore and offshore, is used as a form of insurance in case the owner can’t pay back the loan. However, negotiation is the always the first – and preferred – step. In a few instances, ADM has seized assets serving as collateral, an “extraordinarily painful and prolonged process” in China and Southeast Asia, Appleby says.

Adamas, which also lends in China, asks for 1.5x collateral in the form of personal guarantees, real estate or business assets, though it must be offshore, MacNamara says. Chinese business owners typically hedge their companies by holding 25 percent of their assets offshore, so it is not difficult to get. “If we can’t get offered 100 percent offshore collateral, we move on.”

The firm also requires a board seat and joint control of the company bank account for any payments, MacNamara says.

Despite risks, sources believe the opportunity remains big. And although China is pressuring banks to open up lending to SMEs, no imminent innovations in financing are expected.

MacNamara estimates China has a $1 trillion in financing needs that aren’t addressed being addressed through traditional sources.

“It’s a huge shortfall that will take many years to cover.”