Chinese debt markets – risky business

If creative enough, it is possible for foreign capital to successfully invest in Chinese private debt, industry experts told delegates at PDI’s inaugural Asia conference, Corporate Debt in China. However, the risks are significant and unpriced. 

Domestic issuers of debt and foreign investors are increasingly turning to high yield instruments such as the junk bond market and ‘trust’ loans. 

Chinese high yield, which offers both onshore and offshore structures, is the fastest growing market of its kind in the world, one industry expert told PDI. And more than 50 percent of issuance is by real estate companies, one of the most over-levered sectors in the country.

There is no agreement on whether returns are commensurate with the risks however, panellists highlighted. 

Investors are gambling on unofficial government support for issuers, ignoring the moral hazard of the situation.

Last year, bondholders in Shanghai Chaori Solar Energy Science & Technology were generously compensated by the state in October after the company defaulted, much to the disgruntlement of other larger creditors. And the involvement of the government and state-run banks in the restructuring was criticised for being unfair by some. 

Though the current trajectory is unlikely to last, the Chinese government has implied that it will wean the banking system off state support amid broader efforts to improve market mechanics. Moves in part prompted by economic slowdown and the growth of shadow banking. 

Kaisa Group Holdings, the latest Chinese real estate company to struggle, could be the first developer to default on its US dollar debt, according to S&P. The company was in a cure period after missing a payment at the time of going to press, but looked as if it could prove a test case for restructuring of foreign creditors in China.

How China approaches restructuring and enforcement is key for foreign creditors and the future of the market. Foreign creditors can struggle to recover anything in the event of default. 

But there has been some progress, delegates heard. “I’ve definitely seen huge steps forward,” Neil McDonald, partner at law firm Kirkland & Ellis, said. But like others he expressed scepticism over how quickly new initiatives will take effect.

Lack of transparency is a massive issue for investors in China. Deals with higher leverage usually carry third party guarantees, delegates heard. The framework in which they operate is unclear, however, they are unique to China and legally questionable. There is a disconnect between central government and local courts which exposes investors to the whim of parochial politics. And although improving, there is still very little “predictability of outcome”, according to Benjamin Fanger, chief executive at Shoreline Capital, a buyer of non-performing loans.

Offshore high yield bonds are often structurally subordinated. Bondholders can find that they are very low in the capital structure curtailing access to the underlying assets they thought they had as collateral. “The risk has been completely mispriced by the market … the high yield market is structurally very, very risky,” McDonald said.

McDonald argued that a “hands on” approach would be the more successful debt investment strategy in the long run. “Once you have ‘the chops’ [official company documentation] you can control the business and that’s the only way to enforce in China,” he said.

SLOWDOWN

Even though GDP slowed to 7.4 percent last year, China’s growth is spectacular compared to more developed nations. But as with the West in the early 2000s, much of China’s growth has been fuelled by debt. 

A lot of the lending has been in the real estate and infrastructure sectors with very little investment in operating companies, Darren Stone, vice president at AlixPartners, said. Non-performing loans in China are officially reported at around one percent but Stone estimated them to be around five to seven times that.

A huge mis-allocation of capital has taken place and it is unsustainable, many of the speakers across different topics iterated. There is still a lot of room to grow in China but it needs to occur at a slower and “safer” pace. And reform is paramount, all agreed.

Meanwhile, small- to medium-sized businesses in China are starved of capital, compounded by a mass withdrawal of foreign private equity funds in the last few years, many of which were burned by the difficult operating environment. ‘Shadow banking’ or alternative forms of lending from the banking sector have emerged to fill the vacuum.

The cost of capital in China is very high, according to Peter Fuhrman, chairman and chief executive of China First Capital. And the costs are “way beyond what companies elsewhere pay,” he said. “Where that is true, there is opportunity,” he continued. Interest rates are above 13.5 percent for a one-year trust loan, he said. 

Against this backdrop, the Chinese government is ready to reform and lift limits on foreign debt investment on a case-by-case basis, some delegates suggested. However, as with other rebalancing initiatives, implementation is a more drawn-out affair.

SHADOW BANKING

A report from S&P in June set off alarm bells with its estimate that shadow banking sector debt totalled between $4 and $5 trillion in 2013, or roughly 30 percent of the nation’s $14.2 trillion total.

However, one delegate dismissed the figures saying there isn’t enough evidence to back them up. Other panellists tried to allay fears about the alternative lending sector prompting a systemic crisis. 

State-owned and therefore regulated banks still dominate the market, Louis Kuijs, chief economist for Greater China, Royal Bank of Scotland, highlighted. Also, most debt in China is domestic, Kuijs explained, which shields the country from the risk of capital flight if some over-leveraged sectors crash.

More shadow banking in China isn’t necessarily a negative development, Shaun Roache, Hong Kong resident representative for the International Monetary Fund, told the forum. If done correctly, it will in fact broaden access to credit for many. With non-performing loans rising fast, China is also going to need a bigger distressed market, Roache said. 

He and others conceded, though, that China’s economy is not developed enough for shadow banking on a grand scale to succeed.

Fund managers currently lending in China include SSG Capital Management, Double Haven, Adamas Asset Management and EXS Capital. SC Lowy is also active in the high yield market. In the non-performing loans segment, Shoreline Capital and DAC Financial Management are breaking ground, and recent comments from Howard Marks, suggest his firm Oaktree is assessing the opportunities.

Firms providing credit or special situation solutions have seen a lot more opportunities over the last 18 months, Edwin Wong, managing partner and chief investment officer at SSG Capital Management, said. 

Fuhrman said the same: “IPO exit has evaporated… there has never been a more difficult time [for businesses] to get capital,” he continued, later adding that as a result, borrowing from friends is the fastest growing lending market in China. PDI heard it dubbed a national activity. 

Eric Solberg, chief executive officer of EXS Capital, said: “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.”

Market sources indicate that some of the incumbents are making returns of around 20 to 25 percent. Greg Donohugh, chief executive of Double Haven Capital (Hong Kong), warned that these numbers could create a false impression however, leading investors abroad to believe that returns are linked to debt risk when in reality it’s equity.

LP ALLOCATION

There is evidence that private debt investment opportunities in China are growing as the market evolves. 

It is very early days however. Other LPs speaking during the forum’s investor panel said that they would only allocate to private debt in China by way of a multi-credit strategy, as the asset class is still young with an unproven track record. Longer duration specialist credit platforms make a lot of sense, they said, but they demand the right skill set and local presence. 

The pool of people with the expertise to provide special credit solutions is limited. Local private equity groups are increasingly tweaking their strategies to be more special situation-like but ultimately they don’t have the expertise, said SSG’s Wong. 

Other barriers to entry include the flow of capital in and out of China. Henry Lee, founder and managing director of Hendale multi-family office explained that getting money back is 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?”

The allure of high returns persists, however, pushing investors to seek opportunities in the region. But to make an informed debt investment in China, a thorough understanding of all the nuances is essential – as well as plenty of patience. 

Lending in China remains a risky business.