Distressed debt managers eyeing Chinese market

Foreign distressed debt managers are watching the surge of non-performing loans on Chinese bank balance sheets for investment opportunities in a system that's long favored local managers.

According to some analysts, the stars are aligned now for foreign players to build on what has remained a negligible presence in China's NPL market, as the scale of bad loans increasingly tests the capacity of local distressed debt managers to absorb them.

It's reaching a “tipping point” where there's “enough bulk, enough opportunity” for foreign managers to begin looking seriously at Chinese NPL portfolios, said Keith Pogson, senior partner, Asia-Pacific financial services, with Ernst & Young in Hong Kong.

For PAG Ltd., a Hong Kong-based manager of private equity, real estate and hedge funds with $16 billion in assets under management, the time to strike is now — for an opportunity the firm conservatively pegs at $700 billion in bad loans to be worked out in the next four to five years.

In a July 26 interview, Eddie Hui, managing partner, absolute-return strategies, and head of PAG's China NPL push, said the success of Chinese policymakers this year in stabilizing the country's real estate market makes this an opportune time to buy NPL portfolios.

Investing in NPLs is essentially a trade on the real estate collateral underlying those loans, requiring “a strong understanding of ... what you can and can't turn into value at what point in time,” Mr. Pogson said.

Mr. Hui said he joined PAG a decade ago to build an NPL business, but focused instead on providing high-yield financing to midsized real estate developers after China's prior bad loan crisis got largely worked out by 2008.

Now NPLs have begun to look interesting again, reflecting the fallout from the 10 trillion yuan ($1.5 trillion) in stimulus money China's government unleashed to steady the economy during the global financial crisis, Mr. Hui said.

China's “NPL business has its ebbs and flows (and) the opportunity is getting more interesting again,” agreed Anil Gorthy, Hong Kong-based senior portfolio manager of Avenue Capital Group's Asia strategy.

Over the past decade, New York-based Avenue Capital has acquired more than $1.56 billion of nominal NPLs in China, representing more than 1,000 borrowers, Mr. Gorthy said.

Mr. Hui said factors providing an NPL tailwind now include:

ngrowing regulatory pressure on banks to clean up their balance sheets;

nthe fact that Chinese companies failing now are mostly small to midsize private enterprises, not state-owned enterprises;

nmoves into real estate development and other businesses by the big four “bad bank” asset management companies the government set up in 1999 to cope with China's previous NPL crisis, leaving them willing to sell more of the NPL portfolios they buy from banks to other distressed debt players; and

nthe continued maturing of China's court system in processing collateral claims.

While Mr. Hui declined to say whether PAG will move to set up a fund focused on investments in Chinese NPLs, lawyers in the region who work on private markets investment vehicles predict a number of such funds could be in the offing.

Damien Whitehead, a local partner in Hong Kong with New York-based White & Case LLP, said that during his latest trip to New York, two large asset manager clients told him they are now looking at “distressed opportunities in Asia, particularly NPLs in China” — something “we hadn't encountered even a year ago,” he said.

Dean Collins, a Singapore-based partner with law firm Dechert LLP, said his firm is working now to set up a fund to invest in Chinese NPLs. He declined to name the client.

Ernst & Young's Mr. Pogson predicted Chinese NPLs could increasingly be a magnet for the big private equity and venture capital funds struggling to put the large amounts of money they've raised to work.

Some market veterans are considerably less bullish.

With China, like Japan before it, “rich enough” to forgo forcing banks to sell their non-performing loans to investors at realistic prices, “I wouldn't be looking to the China NPL market as a potential boom anytime soon,” said Ted Osborn, a Hong Kong-based partner focused on restructuring, China NPLs and special situations with PricewaterhouseCoopers LLP.

It's likelier “we'll see a slow trickle of loans” coming to market — a tough environment for foreign distressed debt managers pursuing the 15% to 25% internal rates of return their limited partners are seeking, Mr. Osborn said.

Meanwhile, fund executives expecting China's distressed debt market to more or less resemble the ones they've experienced in Europe or the U.S. could end up being poorer, if wiser, Mr. Osborn said.

He said a smarter move would be for those funds to dip their toes in the water — with investments of $5 million to $10 million — to gain the experience needed to evaluate opportunities should China's government push banks to clean up their balance sheets more quickly.

Separately, the substantial footprint foreign managers need on the mainland to effectively value and negotiate NPL portfolio purchases, and then pursue collateral claims in local courts, should prove prohibitive to many, market veterans said.

The “skill set to execute any lending or credit or special situations business (in China) is intensive and local” — a hurdle that very few foreign players are likely to clear, predicted Robert Petty, managing partner and co-founder of Clearwater Capital Partners LLC, a Hong Kong-based firm with direct lending and distressed debt businesses on the mainland.

In an e-mail, Avenue Capital's Mr. Gorthy said building a Chinese NPL business requires forging relationships with distressed asset suppliers, such as banks and the “bad bank” asset management companies; putting together a network of due diligence service providers in the target provinces (with local law firms, valuation firms and financial accountants) to evaluate assets and collateral; and bringing a strong in-house local team with experience in China NPL underwriting, restructuring, evaluating legal options and negotiating exits to the table.

Those requirements have left many foreign aspirants hunting for local partners.

There's “certainly institutional interest in the space, but the perception is that you really need a strong local player to be involved because it will help with enforcement and deal sourcing,” said Dechert's Mr. Collins.

In January, New York-based KKR & Co. LP announced a strategic partnership with China Orient Asset Management (International) Holding Ltd. and China Orient Summit Capital to “co-invest in credit and distressed opportunities in the Chinese market,” according to a KKR news release.

KKR executives declined to provide details regarding the partnership's activities this year.

Mr. Gorthy said Avenue “is looking to partner with (domestic) asset management companies to offer solutions to banks on both single credit situations and NPL opportunities.”

Mr. Hui said PAG isn't in the market for a local partner. Instead, the firm has built a sizable platform to allow it to do “all sourcing ourselves,” to maintain “direct control of what we're doing,” he said. n