Backing David against Goliath: Creating China’s future business

By any measure, China’s huge army of small and medium enterprises (SMEs) plays a crucial and irreplaceable role in the continuing story of the country’s explosive economic growth. Official government figures show that SMEs are responsible for 80 percent of the country’s urban employment, generate more than 60 percent of its GDP, and contribute more than 50 percent of all tax income paid to the exchequer. They are already more than 50 million strong, having doubled in number in the seven years to 2012, and are continuing to grow apace.

Yet thanks to the voracious capital-funding requirements of the giant state-owned enterprises (SOEs) that still dominate the economic landscape, few SMEs have access to senior debt through traditional means. According to the state-controlled publication, China Daily, more than 90 percent of China’s SMEs are unable to secure the funding they need to increase market share and strengthen their balance sheets from bank lenders. What’s more, research from Standard & Poor’s and Deutsche Bank shows that while corporate lending markets in the US and Europe equate to more than 150 percent of GDP, that figure in China was until recently just 40 percent, indicating huge potential for further commercial credit growth. This is the opportunity niche filled by Adamas in the Chinese corporate lending market – we are supplying the Davids of today with the credit weaponry they need to become the Goliaths of tomorrow.

Over the five years since its inception, Adamas Asset Management has assembled award-winning teams with more than 40 people across its Hong Kong and Shanghai offices, and created a sharply-focused structured-finance strategy to provide credit funding to the very best of these growing Chinese SMEs. For sure, the opportunities for supplying private credit or cross-border direct lending to mainland China’s corporate borrowers are quite diverse, and alongside the mushrooming growth of unregulated online peer-to-peer lending they are usually lumped into the pejorative framework of ‘Chinese shadow banking’. At first glance, potential investors may be forgiven for assuming direct lending to Chinese companies is highly risky, and in many – if not most – cases, they may be correct. But as Adamas has shown with dramatic consistency, when cross-border loans are meticulously structured, underpinned by definite, legally-recoverable hard-asset collateral (as opposed to share pledges), with a strict emphasis on robust loan documentation, and careful legal preparation for possible enforcement on defaults, it becomes possible to provide senior secured unlevered loans with minimal risk that routinely generate annual net returns of 15 percent to 16 percent.

OVERCOMING RISK

China is not alone in presenting commercial and political risk, but there is no point in pretending past calamities have not heightened international wariness over the ever-present potential for fraud, corruption, weak contractual enforcement and legal ambiguity.  Adamas entered China five years ago with its eyes wide open, recognising the risks, but also armed with the knowledge that with careful preparation the environment actually provides strong and robust legal procedures on the one hand, as well as the chance to implement solid operational and procedural safeguards on the other. Across its financing platforms, Adamas’ team has invested in 54 SMEs within China, successfully exited from 42, and experienced only five delays in repayments of principal or interest since 2010. In each of those five cases, Adamas immediately commenced legal proceedings in the Chinese courts, with the result that all five defaulters subsequently agreed to repay outstanding sums either ahead of court action or as a result of judicial decisions.

Of course, litigation is never easy. Even a successful action is bound to be both stressful and time consuming, something equally true in Western jurisdictions. Litigation is a facet of doing business anywhere, and often bears the hallmarks of a contact sport: it is necessary to be both mentally prepared for, and to embrace, this critical aspect of structured lending in China.

But the country has now progressed to a clear recognition of the function and importance of badly-needed foreign investment capital. Among other recent advances, cross-border lending reforms introduced last year by China’s State Administration of Foreign Exchange (SAFE) have strengthened offshore lenders’ rights over the security, and are underpinned by clearly formulated litigation and enforcement procedures, alongside non-litigious options and procedures. The experiences of Adamas to date have shown that in the arena of cross-border lending, at least, China has made solid progress towards promised legal reform. 

And while there are inevitably many nuances and intricacies of detail involved in the litigation process, Adamas has found that in practice it becomes very difficult for local courts to challenge or overturn contractual obligations if appropriate pre-lending steps have been set in place correctly. Those arrangements include obtaining personal guarantees and hard assets, as well as amendments to borrowers’ articles of association to ensure rights of control as and when may become necessary, underpinned by step-in rights to take complete control of a borrowing company as an extreme resort. Adamas invariably insists on stringent operational undertakings to minimise the chances of legal enforcement becoming necessary. This means insistence on a whole raft of protection mechanisms, including, but not limited to, joint control of all borrower bank accounts, the inclusion of Adamas directors on borrower boards, rights of veto over major corporate decisions, and such crucial details as retention of the borrower’s company chop in escrow. To most outsiders, the crucial importance of the company chop – the equivalent of a corporate seal in the West – is not understood. But in China, the completion of any contract, however small, is entirely dependent on, and subject to, the imprimateur of the company chop over and above individual signatures. No chop, no new agreements with third parties.

SUCCESSFUL STRUCTURING

Adamas also has a special investment vehicle in China, allowing it to inject and repatriate capital in and out of China, and to accept pledges of hard onshore assets with the backing of a bank acting as an administrator to register and enforce pledges and collateralisation. This, in our opinion, is a game changer because historically most foreign lending has been underwritten by share-pledge collateral only.

A typical deal size for Adamas is less than $20 million, averaging around $15 million, with a loan-to-value ratio (LTV) below 50 percent. For Adamas, those parameters work on several levels. First, while the borrowers are not small by any means, they are equally not so big as to hold undue influence over local dignitaries and legal processes. At the same time, they are more likely to offer strong growth prospects, while Adamas can more clearly form a perspective on whether they are run well by strong and motivated management teams willing and able to assist in securing and repaying the loan.

Adamas likes to say its investment policy is industry agnostic, we favour the consumption story attached to an emerging middle class set to grow to over 500 million within the next decade.  Anybody who has travelled to China’s major cities will have witnessed firsthand the lust for higher living standards and improved quality of life.  Adamas has provided structured debt for several well-run growth companies in the leisure and health sectors, with several successful exits. One example was debt financing for a pharmaceutical business to establish ginseng cultivation, an important ingredient in traditional Chinese medicines, which yielded a gross IRR of 25.53 percent. Last year, Adamas exited another project involving a resort company that provides second homes in Moganshan, located within a nature reserve near Shanghai, meeting demand for holiday homes away from the madding crowd.  In and out of the project within a year, Adamas achieved a 33 percent gross IRR.

EXPANSION THROUGH PARTNERSHIP – PING AN

Adamas has to date focused its lending on the Shanghai/Zhejiang region, where it has worked to build the strong network of connections needed to source and implement effective loan deals. But we were delighted to announce the signing of a non-binding memorandum of understanding with Ping An Group to form a joint venture company focused on the provision of growth capital to aspiring Chinese entrepreneurs. The new initiative will expand our coverage to all major cities in China and brings us into partnership with one of the most respected Chinese private financial institutions, which has over RMB3 trillion in assets under management.  We envision working with Ping An Group to underwrite, syndicate and jointly manage collateralized loans with senior and subordinated tranches to meet the investment requirements of a broad range of institutional investors.  As the credit markets develop, our goal and commitment is to work with Ping An Group as a leader and trusted partner for private credit in Greater China.

About Adamas Asset Management: Adamas Asset Management (HK) Limited is an award winning investment group that provides structured funding for growth enterprises in Greater China and developed markets across Asia.

With Assets Under Management of approximately US$620 million, Adamas manages US$, RMB and JPY funds for institutional investors, family offices and shareholders of Adamas Finance Asia Ltd, a company listed on the AIM market of the London Stock Exchange (ADAM.LN).