The Vulture Investors, by Hilary Rosenberg

China could learn from the US experience of extracting value from corporate corpses.

This thoroughly-researched book, published by Wiley, offers some great insights into the world of distressed asset investing. The author chooses to follow a case study approach for most the book, with only the first couple of chapters focusing on the theory behind.

These first two chapters are very valuable and show how vulture investors have influenced the dynamics of chapter 11 filings, whereby companies with cash flow problems seek protection from their creditors.

Rosenberg points out that vulture investors have redressed the balance between management and creditors. Initially, she believes that management were favoured by the chapter 11 process, thanks to features such as allowing management the exclusive right to offer a restructuring plan, often prolonged indefinitely by a bankruptcy judge. Frequently management could push through its own reorganization plan since most creditors lacked expertise and the time to learn it, leading to the creditors having to suffer unfairly large losses.

But when professional 'vultures' or distressed asset investors buy the debt from the original creditors, management is suddenly faced with a much smarter and more determined opponent.

On the other hand, vulture investors, although able to provide quick cash to the original creditors, are also liable to create conflict. That is because they may be willing to settle for a lower repayment level (since they buy the debt at a discount) than any remaining original creditors.

Another common flash-point is the valuation of a company. Management usually deliberately underestimates the value of the company in order to get easy repayment terms from their creditors. Senior debtors will downplay the value of the company and argue that the bulk of the company's cash and assets should go to repaying the loans they made to the bank above all. Stock holders, who are last in the order of repayment priority, will argue that there is enough money in the company for their original stakes not to be totally written off.

But the beauty of the system is that compromise is vital for the process to succeed. Negotiations can be long and arduous, but it is rare for one party to hog all or most the gains. Plans for distributing assets and/or reorganizing the assets can only be put into practice after a majority has voted in favour.

The important thing is that the process serves to uncover value, which the original managers of the company may have overlooked through incompetence, or been unable to exploit for various reasons. Uncovering and exploiting new or undiscovered value is good for the economy since it avoids waste and avoids bailouts by the taxpayer the book argues.

Of course, the key question is who this excess value goes to. Vulture investors are unpopular precisely because the sources of value they uncover may go straight to their own pockets, making some vulture investors amongst the richest men in the world. The original creditors, the work force and the suppliers, may walk away with far less.

At the beginning of the market, this was certainly true. Pioneers, to an almost comically large extent of Jewish extraction, made huge amounts of money through the ignorance of the people they were dealing with.

But in a capitalist economy, such success quickly brings imitators.

These days, the inclusion of many different players following different strategies to uncover a distressed company's hidden value ensures a system of checks and balances and a fairer division of the spoils.

There are other advantages. Banks, unwilling to take a stake in an unfamiliar business on the basis of a debt to equity swap, can now sell off debt quickly and conveniently to third party specialists in valuing distressed firms, or to those investors who are interested in swapping debt for equity in order to take a controlling stake in the company. That frees up the banks to resume loans quickly to healthy companies.

Since the distressed market has grown, it has also become much more liquid, and valuations have risen in consequence. A more mature market also means that companies may move through the bankruptcy process much faster, sparing the pain inflicted on other stake holders, such as the work force and suppliers.

Vultures, despite their derogatory name, are actually optimists: Their interests are usually best met by the survival of the company. Only then can the bonds or equity they buy become a source of wealth.

How does this compare to the situation in China?

Perhaps the bewildered reaction of an official at a Chinese asset management company to the book serves as a clue.

"It's all about economics," he said," what about the administrative aspect?" he wondered.

In China, indeed, the 'administrative' aspect essentially refers to the government doing what it wants. Usually, that translates to ensuring workers, laid off by badly performing enterprises, get a certain amount of the value available.

That is partly to avoid unrest and partly because the labour market is such that laid off workers cannot easily find new work.

What happens to the rest of the value is a moot point.

The AMCs are the main players in the market, from the days four were set up in 1999 to buy large amounts of non-performing loans off the state banks and then dispose of it through debt to equity swaps or sales to third parties.

The obvious question is whether the AMCs can extract the same level of value as the process in the US. Remember that in the latter a clear valuation is achieved through the negotiations and conflicts of the numerous parties involved, all under the scrutiny of a bankruptcy judge who acts as an 'umpire'.

The second question is how that uncovered value is distributed.

China chose to introduce AMCs in order to buy bad debt from the banks at face value. That ensured the banks got a large cash infusion and got the debt off their balance sheets.

If the AMC does not carry out a debt to equity swap, the bad assets are normally sold off at auction or by negotiated settlement. Both of these processes have come under criticism in China for lack of transparency and sweetheart deals with both foreign and domestic investors.

The problem is precisely the 'administrative' aspect the AMC official was referring to. With the government able to basically do what it wants, value may accrue disproportionately to those favoured by the government, since the AMCs, and indeed many buyers of the debt, are government-run or affiliated to the government.

Unlike the US, China's market for bad assets does not provide a level playing field whereby new entrants can compete, drive up prices and prevent surplus value from going disproportionately to one player.