Law of the jumble
Here’s a mystery: why doesn’t China have more corporate failures? Hedge funds, bank trading desks and lawyers have spent years waiting for financial distress. Many were disappointed after the giant fiscal stimulus of 2009 pulled companies back from the brink. An economic slowdown, as illustrated by the recent default of listed property developer Kaisa, has created new opportunities – albeit only for those with nerves of steel.
Spotting distress in China isn’t hard, but making money from it is. Kaisa, which has missed payments on a $500 million bond, shows the problem. China’s capital controls mean there are few ways for investors to shoehorn themselves into sticky situations. Kaisa issued bonds through an offshore vehicle which has no security over the company’s assets in China. Bank creditors are in a better position to resolve problems bilaterally. HSBC has already agreed to let Kaisa off the hook for now despite the company breaching the terms of a $51 million facility.
These flaws haven’t stopped many investors from piling into offshore Chinese bonds. Only when failure looms have holders typically realised that high yields were scant compensation for having little chance of being repaid. Buyers of offshore debt issued by LDK Solar eventually agreed to swap their bonds for shares in the troubled solar panel maker. Kaisa’s bonds have traded at less than 40 percent of their face value.
Loans made by banks in China have a better chance of recovering some value. Chinese lenders are probably sitting on hundreds of billions of dollars of unrecognised bad debt. For foreign investors, getting into that game mostly means buying debt at a discount from one of China’s four big bad debt managers, like Cinda and Huarong.
Once an investor does get hold of a claim, the game begins. In developed economies, where corporate failures are common, creditors tend to agree a “standstill” while a restructuring is prepared – often with the help of a court. Chinese insolvencies are more of a scrum. Creditors move in and freeze assets or lock up bank accounts, potentially making a bad situation worse. Investors hunt to find unpledged assets that would give them preference in a formal bankruptcy process.
In reality, things rarely get to that point. Insolvency proceedings are vanishingly rare, and numbers have been declining even though China’s bankruptcy laws are only eight years old. Instead, most investors hope they will be paid to go away. One reason is that it is often unclear how courts will treat foreign creditors. In the bankruptcy of steel producer FerroChina in 2009, foreign banks received the same treatment as their local counterparts. But in the case of Suntech, another troubled solar group, a Chinese judge blessed the transfer of offshore subsidiaries without foreign bondholders’ knowledge. The notorious collapse of Asia Aluminium in 2009 saw a Chinese court ignore an indicative buyout offer from Norsk Hydro in favour of a sale to the company’s management.
Even for local investors, another reason to avoid the courts is the lack of clarity over who is repaid in what order. That’s where politics comes in. China’s bankruptcy law puts secured creditors at the front of the line, followed by employees, with unsecured creditors last. In reality, local governments want to preserve jobs and avoid unrest. Workers or suppliers who can cause a major scene jump the queue.
The principle of nuisance value trumping actual seniority is especially relevant for Chinese property companies, which usually accept upfront cash payments from regular homebuyers. While these customers may be unsecured lenders, it’s basically unthinkable that they would be treated as such in the People’s Republic. A similar rule of thumb probably applies to contracts with building companies, who risk defaulting on their own obligations if they are not repaid, creating a local chain of financial pain.
Investors are undeterred. Hedge funds such as DAC Management and Shoreline Capital are among those buying up distressed credit. Returns on a gross basis can be as high as 25 percent a year, according to some investors. Goldman Sachs and Oaktree Capital have taken stakes in China’s bad banks, though it remains to be seen whether that will give them preferential access to deals. What’s clear is that as China heads for its slowest year of growth since 1990, there’s plenty of incentive to get creative when it comes to corporate distress.