Oaktree struggles to capitalise on China distress

Despite a partnership with China Cinda, the distressed debt investor is finding it hard to put money to work in Chinese NPLs, reveals Oaktree Capital co-founder Howard Marks.

Debt distress is on the rise in China as the world’s second-largest economy slows but it’s been tough going so far buying assets on the cheap, Howard Marks, co-chairman and co-founder of Oaktree Capital, said on Thursday.

Almost two years after sealing a partnership with China Cinda Asset Management, one of China’s so-called bad banks, and earmarking $1 billion for distressed debt purchases, the joint venture has yet to make an investment.

Behind that failure so far to put money to work are a number of factors: the rarity of defaults in China where the avoidance of social distress remains a relatively high priority; the lack of transparent resolution processes and bankruptcy case law; and banks hanging on to dud loans.

“We’ve been actively looking,” said Marks at a press briefing in Hong Kong, but Oaktree hasn’t yet found any investment with Cinda that meets its criteria for a deal, such as a clear path to resolution. 

His comments come against a backdrop of a rising tide of problem loans at Chinese banks, which continued to lend in the wake of the global financial crisis at the government's behest to help sustain the country's fast growth.

“You’ll see substantial defaults. A lot of lending was done, a lot of building was done,” said New York-based Marks.

Chinese commercial banks reported Rmb1.09 trillion of bad loans as of June 30, up from Rmb694.4 billion in March 2014, according to the China Banking Regulatory Commission.

More bad debt at the banks is offsetting increased competition for non-performing loans from industrials; although that opportunity set is also ticking up due to over-investment and over-leverage by Chinese corporates, which is also resulting in distress, said equity and credit analysts. 

On October 30, mainland coal company Hidili Industry International Development said it would not be able to repay its outstanding US dollar bond issue after defaulting on Rmb6 billion ($947 million) of local loans.

“Hidili's non-payment of this debt will extend to most of its other obligations, mostly onshore bank loans, because the company does not have enough financial capacity to fulfil its obligations,” said Jian Cheng, an analyst at credit rating agency Standard & Poor’s, said in a report.

News of Hidili's default came just nine days after state-owned steel maker Sinosteel failed to make an interest payment on Rmb2 billion ($315.52 million) of its 2017 bonds.

For listed banks, equity analysts at Goldman Sachs forecast an average net new NPL formation rate next year in China of 0.93%. That alone implies an aggregate addition of about Rmb500 billion of net new NPLs per year.

In preparation for a potential surge in Chinese defaults Oaktree is gaining local experience and forging new partnerships. In July it partnered with Shoreline Capital Management to buy a parcel of non-performing loans for $168 million.

“These are small steps that we have taken so far to gain experience,” Marks said.

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Even though the number of defaults in China is starting to grow, deal sourcing for foreign distressed debt buyers is likely to remain difficult.

Foreign firms are not allowed to buy from Chinese banks directly. As such, established local national asset managers like Cinda remain the biggest conduits for supply, which means they can pick and choose from the pipeline.

After the last distressed asset selloff in the late 1990s, Chinese policymakers are taking a more cautious approach to allowing foreigners access to deals because assets were thought to have been sold off too cheaply, say market practitioners.
 
Even if deals are sourced, recovery in China remains slow, cumbersome and uncertain.

During the Asian financial crisis in 1998 Guangdong International Trust and Investment Corporation failed to pay the interest on its dollar-denominated bond. The subsequent recovery rate for investors was 53% and it took a long time for investors to see their money.

Even for Cinda it usually takes two to three years to gradually dispose of NPLs acquired and realise profits, analysts said. 

On the plus side, as it burrows into the market, Oaktree is also building relationships with China’s burgeoning number of high net worth investors.

Oaktree was one of a handful of foreign managers given permission to participate in the Qualified Domestic Limited Partnership, or QDLP, programme for the investment of domestic Chinese money outside of China. The money being raised as a result of that is going into distressed debt in Europe and the US in Oak Tree Opportunities Fund X, which Marks said is now almost closed.  

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