July 16, 2014
Interviewed by: David Snow
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Credit, Distress and NPLs in China

Veterans of the Chinese private capital market from Shoreline Capital, Clearwater Capital, and EY discuss the conditions for credit investing in China, including the sale of non-performing loans, distressed opportunities, and the rise of China’s shadow-banking system.

Veterans of the Chinese private capital market from Shoreline Capital, Clearwater Capital, and EY discuss the conditions for credit investing in China, including the sale of non-performing loans, distressed opportunities, and the rise of China’s shadow-banking system.

Credit, Distress and NPLs in China

Private Equity in China

David Snow, Privcap:

We’re joined today by Rob Petty of Clearwater Capital Partners, Ben Fanger of Shoreline Capital, and Bob Partridge of EY. Gentlemen, welcome to Privcap. Thanks for being here.

I’d like to take advantage of the fact that both Rob and Ben are involved in very specific strategies in Asia—particularly in China—that involve credit and special situations. I’d love to hear about what’s going on with regard to those strategies. Let’s briefly give an overview of those strategies, starting with Ben. Can you encapsulate your firm’s approach to the market?

Ben Fanger, Shoreline Capital:

Sure. As far as credit in China goes, there are three things we do. First, there are non-distressed private-lending opportunities. This means the company’s not in distress, but they’re willing to pay an unreasonably high cost of capital because of inefficiencies in the flow of capital in China.

The second opportunity is distressed private lending, which is where the company (not because there are inefficiencies in the flows of capital and credit in China but because they have encountered some distress-causing situation) is willing to pay private equity lower returns for senior secured financings.

The third is secondary—it’s basically distressed debt we purchase from financial institutions in China. Each of these includes nonperforming loans.

What’s very interesting today is that we’re at a point of China’s economic history where all three of these things are happening at once because their drivers (economic deceleration, misallocation of credit) are alive and well. The third driver is banks recognizing the nonperforming loans and actually wanting to sell them. It’s an interesting time for those things.

Snow: Rob, what is your firm’s strategy?

Rob Petty, Clearwater Capital:

Clearwater is a Pan-Asian credit investor with over 13 years and five different offices in Asia. We don’t do Japan, but we think about three different, broad strategies. First, secondary credit. We’re buying any set of cash flows generally at a discount in our secondary credit. That could be a loan or a bond, and could be onshore or offshore, but Pan-Asian secondary credit.

We also do what we call “direct lending,” similar to private lending as Ben described. We do direct lending where we are writing our own documents and lending and we do that either offshore or onshore. We have a big business doing it in China and in India—our direct lending business. Our third arena is what we call “restructuring” or debt for equity swaps. That’s generally distressed and distressed for control, where we’re going in at 30, 40, or 50 cents to the dollar and restructuring. That’s the full arena of what we do across our private equity-structured, locked-up capital funds.

Bob Partridge, EY:

Ben’s comment about the misallocation of credit—that’s a clear driver in terms of entrepreneurs and seasoned companies looking for alternatives. What we’re seeing is more established players—and Clearwater’s a good example—where they’re getting more track records and more creative in finding deals. The seasoned players there are the ones we’re seeing driving an uptick in activity as opposed to more macroeconomic conditions.

Snow: Let’s talk about deal flow, again, starting with Ben. Thinking across the categories of drivers of deal flow, what has been the most notable recently as far as opportunities coming to your firm’s attention?

Fanger: We are reaching a point in the cycle where MPLs are surfacing and being sold. During the credit boom that happened in 2009 and ‘10, where China doubled their loan book, I was telling investors and so forth that there would be a lot of nonperforming loans coming out of this. But, obviously, it’s not an opportunity until banks actually recognize them. They go into default, and banks recognize them and sell them. That’s exactly what we’ve seen in the last 18 months or so.

Last year, banks sold twice as many nonperforming loans as they did the year before. This year, my conversations with the AMCs or bad banks that also buy MPLs have been that they plan to buy twice as many this year as last year. We certainly had a period where we didn’t do any nonperforming loans for four years because it was credit boom time, not surfacing in MPLs.

The other factor is just the size of the opportunity, where today the estimates are between $1 and $3 trillion of NPLs. When Rob and I did a few MPLs back in 2005 and ‘06, the estimates were half a trillion dollars. So, we’re between two and six times the number of NPLs today. They will be recognized over the next decade, so that’s one opportunity.

The other is that deceleration is causing companies across China in various industries to be willing to pay private equity-level returns for debt. That dislocation in China right now has even brought in growth-oriented private equity investors to try to access the opportunity.

Snow: Rob, how do the factors Ben described play out in your strategy?

Petty: Ben articulated it well. To put it similarly in my own words, there are two really interesting things. One, the scale of credit in China is, as he rightly said, doubled. It is such an enormous market that people forget the scale, right? It’s $20 trillion of total credit in the system. That’s a very interesting opportunity set to think about today.

The second piece—as we’ve all read in the newspapers, it’s a reality on the ground—is the appropriate and real evolution of the banking system. The state banks are being pulled back and restrained in many different sectors in terms of what they’re doing and the trust banking sector. So, there are 60-odd trust banks that have been the middle-tier lenders to small- and medium-size enterprises and have filled that gap. Clearly, they have regulatory constraints and have pulled back, specifically in what’s called “entrustment lending,” where they’re selling instruments.

The curtailing and appropriate regulatory constraints on this big credit boom are happening and have been happening for the better part of two years. It helped the regulatory environment because that leads a host of companies to look for alternative credit.

The way we think about it, we actually just do direct loans. We are lending money directly to companies who are unable to get through for all the different regulatory constraints and the pullback of capital in a fairly typical evolution of a banking system where, frankly, getting money is tight. You can charge appropriately for that and you can also write good documents.

Snow: A follow-up question: while the government is clearly encouraging the reins to be pulled back on these lenders, are they also being supportive of private lenders to go in and fill the gap? Have you had conversations or have you seen evidence that that is the case?

Fanger: This so-called “shadow” banking system or the market of private lenders in China is in the eyes of the government two things. They like one and don’t like the other. The part they like is private flows of credit that support economic growth in China, especially, for instance, with privately owned companies who can’t get bank loans and so forth, which is what Rob does and we do, to some degree.

Why do we know they like that? They have increased the ways you can do it. They’ve talked about how they encourage it.

The side they don’t like is off-balance sheet credit risk for the banks, where a trust company is set up and funded by the bank raising capital from their retail investors. Those retail investors expect to be able to get their money back at the end of this year, but then the trust company invests it in illiquid, long-term kinds of things. That produces off-balance sheet credit risk for their banks. It also produces the potential for social unrest, if those people protest.

It also produces two opportunities for people like me and Rob. One, trust companies that have to sell their loans even though they’re performing because they have to pay these short-dated instruments back.

The other thing it produces—as these get increasingly controlled as Rob alluded to—is that people in the shadow banking system who are getting their loans from the trust have to go to somebody else and pay a bit higher cost of capital for it.

Petty: To answer the question directly, yes, you can actually look and find regulatory statements from as high as the state council who came out in December and wrote a four-page memo. You need to translate it into English, but it says, “Shadow banking is appropriate; we’re going to see difficulties, but it is fundamental to development of a financial system.” There is a series of regulatory announcements you can cite that clearly show they’re aware of this, they’re regulating this, and they want to help it grow, but in an appropriate manner as you would think a regulator would like.

Snow: Final question. Rob, you mentioned that one of your strategies is a “distress for control” strategy—does that work in China? Can one acquire debt and eventually take control of the company and realize a private equity-style return?

Petty: Again, my quick answer is that we haven’t seen it yet, so, no.

Snow: Why not? Is it a court or legal issue?

Petty: The minute you’re stepping into what I call a “state bank” set of shoes, the old adage still holds in China: “Good company, bad balance sheet.” If it’s a good company and a bad balance sheet, it’s probably best run by someone other than us trying to get into at a good price.

There are some cases. Sino-Forest is probably the benchmark story of distress for control. That team is trying hard to run that business, so I wouldn’t say “No.” Would I say there’s a whole industry of it and it’s gotten to the degree of sophistication of the western world? Not yet, but I do see a path for that beginning. But I wouldn’t say it’s an entire industry, though Ben may disagree.

Fanger: I absolutely agree that I’d much rather be in a position where it’s a good company, bad balance sheet, and I don’t need to swap out management, all of that. That’s not a strategy in China, yet you see a lot of it. There are other types of controls you can employ. One is for direct lending—you can be a cosigner on the bank account. You can have assets transferred into your name as collateral until they repay you. You can structure in the things the paper is supposed to do with that conveyance.

Petty: I absolutely concur with that.

Fanger: The second thing you can do in China, which you can also impose certain pressure through the legal system if you are holding distressed debt. If there are 10 things you can do in U.S. courts to enforce your rights as a creditor, you might only be able to do four things with predictability in China. Certainly, I wouldn’t want to be in a position where one of those is to kick out the entire management team and replace them and so forth. But, the four things I can do with predictability are the reason we’ve returned capital to our investors. As long as you’re just sticking to those things you can actually do from a practical standpoint, that’s where controls work, but not control of the entire company.

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