China's NPL sell-off switches tack

John Cahill, partner in the real estate group of international law firm, Paul, Hastings, Janofsky & Walker LLP, discusses new niche markets in China''s great NPL sell-off.

What do you see as the new trend in NPL disposal?

Cahill: The international multi-million deals that caught much of the attention last year and earlier on. They typically involved specialist funds or leading investment banks buying directly from the asset management companies, which were set up to take over bad loans from the state banks. This trend is similar to what happened in Taiwan, Thailand and Korea.

However, the current deals in China have been bedeviled by a number of issues, in particular, the extremely low price which the investment banks favoured in order to compensate for the risk they were taking on. In many of the large portfolios auctions that Paul Hastings participated in, we found that bidders didn't offer the minimum price the AMC's were holding out for. Local investors often complained the price was too low, and have subsequently proved willing to buy these assets themselves, although on a much smaller scale.

So in fact, we are currently seeing lots of one-off deals between the AMCs and what are often the managers of the businesses the AMCs have taken over. They know the assets and are willing to pay a bit more for them.

That's quite different to the investment banking approach where the debt is purchased and the assets sold off as quickly as possible through foreclosure or securitizatio. Do you focus on any particular asset class?

We believe people are overlooking an interesting niche in the travel market segment - hotel industry assets. As China becomes more affluent, there's likely to be a boom in domestic travel. So far, there have only been small-scale, often one-off, transactions to local buyers. But that could change next year when amendments to the WTO rules permit foreign companies to own low-end hotels without a joint venture partner.

Currently, it's a restricted industry, so foreign investors have to take the joint venture route. That's not going to change completely next year, since the high-end hotels will still be exempt from the requirement of having a joint venture partner..

For example, Oriental AMC has over 200 hotels they have been able to acquire and have opened up their own hotel management company. We are speculating that with a couple of 100 hotels in their portfolio up and running, they could put that up for auction next year.

In the interim, we're seeing one-off deals like the sale of the Beijing Olympic Hotel, which attracted over 100 international and local bidders.

We believe the next step will involve these hotels being sold off in bulk, as chains. Perhaps flagged as a Marriott or even a European or Japanese chain.

So we could see a shift from the luxury foreign hotels, which dominate foreign investor attention to something far more mass-market. Because it's the mass-market hotel, which the typical Chinese businessman usually frequents, this is where we believe some tremendous opportunities lie.

What's the typical quality level of the hotels on the market?

In the portfolio mentioned earlier, perhaps 30 might be adequate to change into a Marriott Courtyard Hotel, given a fair bit of investment. The balance could be turned into a motel chain, like Motel Six in the US, for example.

What's the typical business model of these budget hotels?

It's been done before in the US, by a company named Chartwell, which took over many budget hotels. This type of hotel will often be fairly basic, it may not even have a cafeteria or a gym, so staff costs are low. It's not necessary to hire a concierge or great chef. They just provide a clean, safe place to spend one night or more.

Who do you typically represent?

We'll represent the foreign investor or the local buyers. Our business strategy is to staff and grow our China offices with talented local people rather than a lot of expats. We have a solid list of Chinese companies we represent.

Have you done a lot of deals in this area?

There have been a couple of big ones. One of them is Rmb 2 billion. It's an interesting transaction. The company is indebted to the bank and the bank is not allowed to take a write down on the debt, even though the hotel hasn't paid any interest for seven years.

The banks need special regulatory approval to write down their loans, which is the opposite of Western practices, where banks are forced to write down bad debts on their books. That's the role of AMCs, which have special exemptions in terms of writing off debt.

We have also completed some deals of around $10 million in Guangzhou and elsewhere.

An interesting factor is that hotels seem to be increasingly viewed as status symbols by Chinese entrepreneurs. The Hilton Hotel in Shanghai was recently bought by a thirty-something Chinese entrepreneur, paying well over market price.

So was the Chinese decision not to sell off assets in a fire sale to foreign investors justified?

That's an interesting question. The foreign investors were bidding, say, at $0.05 on the dollar, while the local investors might offer $0.30 cents on the dollar. The local investor knows the local market and he's focusing on specific assets. Remember that, typically, a foreign buyer at an international auction buys into a portfolio of good, mediocre and bad assets. In some of the negotiated, one-off deals between the AMCs and the local investors, the local buyer targets a specific asset, not a pool of assets, so he's prepared to offer more.

Do these negotiated deals encourage under-pricing? How does such a transaction work?

The AMCs have lists of assets that are broken down by region on their website. You can look up the assets in your region, spot something interesting and call up the AMC.

The AMCs don't seem to have had any problems in relation to what might be seen as underselling. In fact, by dealing with the higher paying local investors, they have obviously made the right choice.

Remember that in the US as well, negotiated deals take place between regulators of bankrupt assets and investors. Details are often not published, but they have a code of conduct, and are possibly more transparent than Chinese entities. But, in my experience, the people in the AMCs seem very concerned about not being perceived as selling national assets under market rate to foreigners.

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