Q&A: Where Adamas sees value in China's NPL market

And why it thinks investing in a Chinese NPL portfolio is like buying a deep out-of-the-money call option and why distressed funds could become tomorrow's property developers.

Barry Lau, chief investment officer of Adamas Asset Management, talks about the opportunities he sees in China’s distressed debt market and why distressed credit specialists will be in the box seat when it comes to driving the consolidation of China’s property market.

The former proprietary collateralised loan trader at BNP Paribas made his name by betting on a turnaround in Kaisa Properties’ defaulted US dollar bonds. The success of this call raised Adamas's profile and helped it to attract Ping An Group, with which it formed a joint venture targeting credit opportunities across growth, distressed and special situations credit investments in China. 

Founded in 2009, Adamas is a Hong Kong-based private credit specialist with deep experience in investing in over 70 stressed, distressed and special situations credit opportunities in China. It has over $1 billion of potential firepower at its disposal (based on its existing funds and the new Adamas Ping An Opportunities Fund offering) and focuses on providing credit to private sector companies in China and special investments, primarily in Guangdong and Zhejiang provinces.

Q What’s your assessment of China’s bad debt problem?

A The distressed debt market in China is predominately occupied by the four big four asset management firms – Cinda, Huarong, Great Wall and Orient – as well as a group of local 57 AMCs. Of course, there are a few local distressed debt funds such as Shoreline in this very niche market.

For both offshore and onshore investors, there are two ways to get into China’s distressed debt market. First, you can get into a single credit situation, usually in commercial or residential property projects because there is enough liquidity and transparency in this sector.

Another way is to buy a bundle of non-performing loans from the big four AMCs, which I don’t think has much value for foreign investors. In short, it is questionable whether foreign investors can do better than the local AMCs in sourcing, valuing and managing NPLs.

Let me use a poetic metaphor. 97% of an NPL portfolio is bones which don’t have much value. There is no certainty behind the 97% because it comprises loans associated with sectors that may be subject to market cycles. A sector that may be favourable today may turn out sour in the end, [in the same way that] a distressed loan in the commodities sector today may turn out quite favourably five years later, or it may go even worse.

In fact, one’s bet is that one has greater information asymmetry and can have a high level of conviction that the 3% of the portfolio can generate a very high internal rate of return (often can be triple digits) over a short period of time, which may compensate for the lower IRR relating to the other 97% of the portfolio. Therefore, buying a debt portfolio is a quick way to gain access to a pool of soured loans, with the understanding that the remaining assets in the portfolio may improve over the next few years. It is like buying a very out-of-the-money call option, which may or may not hit the exercise price during the fund life.

I think liquidity is one of the major challenges for the distressed debt market. The ongoing developments of the securitisation market may resolve this issue but the market is not active as the concept of NPL securitisation is still new in China.

Q What's the current state of the market?

China’s distressed-debt market has become more commercialised in recent years. Once dominated by the big four AMCs established in 1999 to take over the bad debt from the country’s big four lenders, the market today has more than 57 regional AMCs while sales channels for bad loans now include online auctions (including a Taobao auctioneer for bad loans!), over-the-counter trades at local exchanges as well as NPL securitisation.

China’s bad debt, measured by non-performing loans and special mention loans, reached Rmb5.12 trillion ($773 billion) at the end of 2017, up from Rmb4.16 trillion in 2015, according to the China Banking Regulatory Commission.

At the end of the first quarter of 2018, the figure increased to Rmb5.25 trillion. In China’s asset-backed securitisation market, Chinese banks issued $2 billion of ABS with bad loans as underlying assets last year, which was 17% lower than the full year of 2016. 

Q What’s your investment strategy? Are you also keen on buying an NPL portfolio?

A We have only done single-asset investments over an investment cycle of three to four years. Traditionally we source deals from our proprietary channel and obtain the ownership of the asset.

Across our financing platform, we have invested into 70 special situations in China and we have only had five defaults, which we have pursued in the Courts of Law in China, and we have won favourable judgements for all of them and were able to fully recover both the principals and interest [owed on] our loans.

Q Adamas is a US dollar fund. How would the renminbi weakness impact your investment performance?

A  Yes, we are operating a US dollar fund but we lend and receive in US dollars as well. There is no impact for us. We have a vehicle to transfer money into and out of China under a quota system pre-approved by the People’s Bank of China and State Administration of Foreign Exchange.

Q How do you differentiate your business model?

A  I think what differentiates distressed debt investors is their ability to source deals and their negotiation skills. For us the partnership with Ping An has definitely helped us in sourcing and opening a lot of doors in China. I think a lot of the deal sourcing in this distressed debt market relies on personal connections, as the market is not very transparent.

I think our niche is our understanding of a few selected Chinese cities and provinces such as Shanghai, Guangdong and Zhejiang. Other funds have a wider geographical exposure in India and frontier markets.

Where do you see the best investment opportunities in China’s distressed debt market?

A  As the growth momentum in China starts to slow there will be more companies going bust. In terms of specific sectors, there will be more consolidation in the property sector going forward, as the largest ones will continue to take market share and refill their land banks from the small players through acquisitions. But the property market has become a major source of financial risk, which is subject to more regulatory clampdowns in the future.

Of course, we must pay attention to the impact of property prices on macro control policies. As the competition continues to heat up, I foresee more distressed funds will eventually become developers, taking a more active role from financing to home sales.

Q What’s your return expectation for your investments?

A  We aim to have an IRR of 15 to 20% after fees for single-asset situations. Our hurdle rate is 8%.

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