Too much money chasing China distress

Funds are rapidly raising cash to invest in soured Chinese loans but a few leading private market investors question whether the capital can be put to work profitably.

Fund managers are raising billions of dollars to scoop up soured loans as growth in the world’s second largest economy slows, but a full-blown Chinese debt crisis remains a distant prospect.

Private equity firms KKR, PAG, and Baring Private Equity Asia are all raising funds from investors, hungry for the extra yield offered by alternative products such as non-performing loans (NPLs).

Boston-headquartered Bain Capital has already raised $557 million for special situations in Asia, according to a regulatory filing. In May it bought a portfolio of NPLs in China worth $200 million.

However, as yet the pickings are slim. 

Chinese economic growth at around 6.5% annually is still relatively strong and there is  less pressure on banks from regulators to deal with toxic loans than in Europe, so there are probably more opportunities elsewhere in distressed debt.

Beijing has not set specific targets and timeframes on debt reduction. As a result defaults are rare in China and banks hang onto dud loans.

“I see no brush fire in China; I see no event that is going to stimulate growth in NPLs,” said Jay Wintrob, chief executive officer of Oaktree Capital Management, the world’s biggest distressed debt investor.

Also, China in 1999 set up asset management companies --  Cinda, Huarong, Great Wall and Orient – to absorb the toxic loans of the country’s biggest commercial banks. These so-called bad banks have first dibs on NPLs and at the moment they have enough spare capacity to lend.

Huarong, for example, has a joint venture with Asian distressed debt investor Clearwater Capital Partners to lend to Chinese firms struggling to secure a loan.

“There is certainly plenty of supply but the vast majority of that supply is not available for sale,” Wintrob said. Oaktree has so far invested in just four NPL pools in China, in one case with Cinda.

Disappointment ahead? 

Pension funds, insurance companies, and other asset owners are switching out of publicly traded fixed income markets into private credit at a time when more than $7 trillion worth of sovereign bonds offer yields below zero.

One credit strategy dominates investors’ choices right now: distressed debt. In a typical credit portfolio, investors have allocated 38% to distressed debt according to alternative assets data base Preqin.

“There is too much capital at the beck and call of managers for distress in China,” Juan Delgado-Moreira, a managing director at private markets investor Hamilton Lane, told FinanceAsia.

The Pennsylvania-headquartered firm has advised on $15 billion worth of investments and manages $4 billion in the asset class itself. It prefers to back special situation funds or direct-lending strategies over China NPL funds.

Broadly speaking, investors have calculated that China’s high leverage ratio means that the number of NPLs sold by banks will naturally rise. At 134% of GDP, China's corporate debt is the highest among large economies globally, according to credit rating agency Standard & Poor’s.

“The size of the credit market in China has gown at least four fold since 2008 and that’s just the official statistics,” Wintrob said.

Investor polls by FinanceAsia in association with HSBC and S&P have shown consistently that investors furthest away from Asia tend to expect the fastest rise in defaults across China. The latest survey in April 2017 showed 34.5% of investors expect defaults to rise in Asia, overwhelmingly in the Chinese property sector.

Pressure needed 

China’s legal framework is also daunting for would-be NPL investors. The country’s bankruptcy law only came into effect in 2007.

Investors have struggled to navigate China’s unpredictable court system, hampered by the lack of transparent resolution processes as bankruptcy law evolves.

“These are countries [China and India] where the legal system, bankruptcy code, [and] the sanctity. of the rule of law are still under development,” Oaktree’s Wintrob said.

The heart of the matter is that China’s state-owned enterprises (SOEs) implement the national agenda and are also the heaviest borrowers. So there is little incentive for a local government to push for the recovery of a loan, when most of the China’s businesses are ultimately state-owned.

SOEs produce one-fifth of economic output while taking out 40% of bank loans.according to Standard & Poor's credit rating agency. Their overall debt leverage ratio is twice as high and their profitability materially lower than that of their private counterparts, S&P said. 

"China allows moral hazards to persist by providing implicit, or even direct, support to highly indebted SOEs. Few SOEs and their managements have advanced by voluntarily instilling financial discipline and low debt leverage when government policy is skewed to promoting the growth, scale, and global rankings of China Inc.," S&P Global Ratings credit analyst Christopher Lee said in a report dated September 29.

Investors hope that will change but they do not know when change will kick in. “As the government gets used to this Darwinian process, separating the best businesses from the worst businesses, I think you’ll see opportunities increase,” Wintrob said.

While most funds, such as Oaktree, only charge fees on capital they have managed to invest at some point investors could lose patience. Capital committed to a fund manager cannot be used elsewhere for other private, illiquid investments. 

So far Asia has been a bigger market for Oaktree to raise money than to invest money. “Probably the best opportunities today are in Europe in NPLs,” Wintrob said.

So if the capital you manage is not the most patient then it may be best to put your money elsewhere.

“Don’t just wait at the gates of China for distress,” said Delgado-Moreira.
 

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