Bain Capital has figured out a way to make fat returns investing in Chinese non-performing loans: hand pick loans backed by saleable property and turf out dead-beat borrowers who are big employers.
Bain Capital Credit, the fixed income arm of Boston-headquartered Bain Capital, said on Monday it had bought a portfolio of non-performing loans (NPLs) in China worth $200 million.
The US firm bought the loan portfolio from one of China’s state-backed bad loan banks, China Huarong Asset Management, a person familiar with the matter said. Bain Capital declined to comment on the identity of the seller.
Bain Capital Credit spent weeks conducting due dilligence on the relatively large pool of assets, working out which borrowers had put up saleable real estate as collateral for their soured loans.
Most bank loans in China have some form of collateral, which makes them attractive to investors, provided they are able to enforce collection. People's Bank of China statistics show that, among commercial banks in the country, total non-performing loans amount to over $180 billion. According to accountants KPMG, the majority of the collateral underpinning these non-performing loans is real estate.
Bain Capital Credit negotiated a portfolio of loans mainly backed by real estate in Jiangsu province, which has the second-highest GDP of Chinese provinces, after Guangdong.
The properties put up as collateral include commercial retail, hotel and industrial real estate, according to the person.
Deals that are backed by secured collateral such as land and real estate properties generally have higher recovery rates than those backed by unsecured loans in China. To be sure, recovery timing is also uncertain and makes cash flow projection tricky but Bain Capital Credit will seek to sell the properties onto others as soon as possible and return capital to its own investors.
Bain Capital Credit also carefully extracted borrowers from the portfolio that were big employers in China. Courts are unlikely to risk political censure by enforcing collection of assets from say, a factory in a small town in China, as avoiding social unrest remains a relatively high priority for the Communist Party.
Not all of the portfolios of loans on sale in China are backed by quality collateral. Bain Capital Credit raked over about 20 portfolios, bid on a couple of them, before landing this sizeable deal.
One of these challenges for all investors is that NPLs are a highly idiosyncratic asset type - no single non-performing loan is the same, and they do not share a common default driver.
It takes plenty of manpower to sift through a portfolio of loans, which could number in the hundreds, to assess the likelihood of recovery. Bain Capital Credit, founded as Sankaty Advisors in 1998, is a global credit specialist with approximately $33.5 billion in assets under management as of January 1. While this is its first NPL purchase in China it has sealed similar transactions around Asia and has a strong track record of returning capital invested in private equity deals across the Middle Kingdom to its investors.
Few investors can buy in size like Bain Capital Credit, which brings down transaction costs.
“Bain Capital has deep expertise in complex transactions involving non-core and troubled assets,” Barnaby Lyons, a managing director and head of Asia for Bain Capital Credit, said in a press release.
Guangzhou-based ShoreVest Partners, a veteran NPL investor in China, will act as Bain Capital Credit’s master servicer on this portfolio; as such it will manage the assets and help resolve the loans in the portfolio alongside other service providers onshore in China.
Time is right
Distressed debt is on the rise in China as the world’s second-largest economy slows. Ratings agency Moody's Investors Service downgraded China on May 24 as it expects China's financial strength will erode over the coming years, with economy-wide debt continuing to rise as growth slows.
China’s loan book has quadrupled in size since the Global Financial Crisis of 2007 to 2008. ShoreVest estimates excess debt in the econmy at $3.1 trillion and growing.
Bain Capital is joining other big-name funds who are spotting opportunities amidst the country’s growing financial distress.
Oaktree Capital sealed a partnership with China Cinda Asset Management in 2014, another of China’s bad banks, and earmarked $1 billion for distressed debt purchases. KKR said last year it had teamed up with state-owned enterprise China Orient Asset Management to tap into the growing number of distressed real estate opportunities in China.
But there are still few foreign investors active in China’s distressed debt markets, compared with, say, in the US and in Europe in relation to the size of the market. Banks have shuttered many of the proprietary trading desks that used to trade NPLs.
A number of factors are behind the failure to put money to work so far: the relatively young bankruptcy law which first came into effect in 2007, the rarity of defaults and banks hanging onto dud loans.
Investors have struggled to navigate China’s unpredictable court system, hampered by the lack of transparent resolution processes as bankruptcy law evolves as well as by interference from local government officials concerned about protecting jobs.
Ultimately there was little incentive for a local government to push for the recovery of a loan, when most of the China’s businesses were ultimately state owned.
There are signs this is changing and the infrastructure for enforcement growing. First, government support towards state-owned enterprises (SOEs) is weakening, illustrated by the defaults such as that of China Railway Materials in April last year, as the government looks to market forces to prop up economic growth. It is also encouraging banks to dispose of their NPLs.
“We are well positioned to capture the significant opportunities arising from China’s large and growing NPL market,” said Kei Chua, a managing director and head of China and North Asia for Bain Capital Credit.
At the same time banking documentation and loan registrations have improved, as has China’s NPL enforcement infrastructure.
In the major cities of China there are now dedicated bankruptcy judges, but there is still a lack of experience in the provincial courts. The difficulty mainly lies in getting judges to accept cases, which are miniscule in number compared to how many companies just disappear.
Courts’ increasingly efficient resolution of NPL cases has made it easier for investors to predict timing and cash flows. There is also greater transparency in the property market regarding land title ownership and registration of collateral.
One banker estimated recovery rates are between 30 and 40 cents on the dollar for onshore secured debt.
Big institutional investors, such as insurance companies and pension funds, are increasingly keen to put money to work in private debt which offers more risk but a higher yield than secondary market bonds. Bain Capital is in the midst of raising its first Asia credit fund, the person said.