Question: As more Chinese companies face debt and liquidity challenges and the authorities seek to deleverage the economy, how should investors assess investment opportunities?

Alastair Campbell

When China passed an Enterprise Bankruptcy law in 2006 applicable to both commercial enterprises and financial institutions, the expectations of investment banks and funds were raised accordingly. However, the criteria for the new courts to determine which of the available options – liquidation, restructuring or conciliation – should apply to applicants were not spelt out. Faced with a growing number of delinquent SOEs, the Supreme Court made clear that a fundamental purpose of the new law was to safeguard jobs though reorganization, rather than tackling underlying issues such as unconstrained leverage or overcapacity. Even in the State-owned financial sector the lack of accurate credit assessments gave rise to serious delinquents, and the minimal constraints on borrowing are now recognized as a critical source of weakness and risk for the whole financial system. A typical high-profile example is Peking University Founder Group, which entered administration owing US$16 billion to more than 400 financial institutions, despite having been granted a triple “A” rating.

The examples currently cited as guidance on the bankruptcy website of the Ministry of Justice involved reorganization with protection of employment, and that clearly remains the Government’s intention. In the non-State sector however, the last 2 years has shown a strong trend to liquidation: for example, in Zhejiang some 98% of cases were placed in liquidation in 2019. Whilst tightening liquidity, Covid 19 and US sanctions bear some responsibility, many debtor companies appear to have taken shelter in bankruptcy rather than negotiate directly with creditors. Some have used the facility as a ruse to avoid creditors, after hiding assets prior to applying for bankruptcy, and fully intend to relaunch their businesses subsequently. In the absence of case law and a paucity of senior judges with relevant experience, therefore, it is hard to envisage how the courts will serve as anything more than a recycling center for poorly managed enterprises rather than a platform which prioritizes the claims of creditors. Bloomberg estimates over US$10bn of defaults in 2021. If that proves correct, and the Government’s battle against leverage continues to restrict lending, then ironically the only option to raise funds or avoid insolvency may be to turn to foreign capital. However, foreign investors approaching such companies need to undertake deep diligence and analysis.

William Hay

China’s ongoing efforts to reduce systemic risk by deleveraging the economy have put pressure on companies to restructure balance sheets to repay borrowings. This policy offers nimble foreign investors an opportunity they might not otherwise enjoy to profit from this dislocation and develop ongoing onshore relationships. One sector that will not be attractive is the State-owned sector. Almost by definition, the State is committed to supporting every viable State-owned company, leaving little room for foreign investment. Attractive opportunities are likely to arise from better-run companies in the private sector. Being further from centers of power, these companies are at the back of the queue at the State-dominated local banks and therefore are likely to welcome funding provided by a foreign investor. Another set of opportunities will emerge from distressed companies that are not financeable on normal terms. Because local governments are keen to avoid unemployment resulting from bankruptcy, financing these companies inevitably demands close coordination with many different local constituencies.

Foreign investors without the experience and resources to navigate these challenges will be at a disadvantage. No matter the sector, foreign investors must remember the Chinese saying, “when you visit a new town, you must observe its customs”. Or, as the Americans say, “if you don’t know who the sucker is at the poker table, it’s you”. There is no substitute for hard work on the ground to prepare for investments. Investors not only need to underwrite the business and operations of their target, but they also need to assess the company’s position in the wider political environment. Is the company’s business model consistent with national policy (Example: Ant Financial and other “grey rhino” financial companies)? What is the reputation of the shareholders – and are there other economic or political actors behind the recorded shareholders? Foreign investors sometimes believe they can minimize the risks of investment in China through clever legal structures. It is useful to note that onshore Chinese investors generally do not follow this approach. Rather, the most successful investments flow from strong relationships between investors and management, with significant attention devoted to aligning the interests of all stakeholders. And never forget to keep one eye on the interests of the central and local Party.

Douglas A. Jaffe

A recent spate of Chinese corporate bond defaults is driving investor interest in a range of opportunities on the mainland. However, assessing these is not a straightforward proposition. Beyond the financial rationale of any deal are other considerations that may take precedence. For example, the nature of the company will tell you a lot about the decision-makers. An SOE or semi-SOE will have to answer to different stakeholders compared to a privately held company or one whose shareholders are more traditional investors. In addition, the true state of affairs, which is often not clearly understood, will also impact the scale of the restructuring or refinancing effort required. Investors may not be aware of just how indebted the company is or how serious are the cash flow issues. Moreover, the root causes of the company’s troubles are also important to understand. Were these the result of overexpansion, vanity projects, unanticipated crises like COVID-19, or other business decisions that may or may not fall within the realm of acceptable behavior.

Other factors include the viability of the business, the potential of large-scale redundancies in sensitive industries/locations, or the risk of a cascade of defaults due to cross-shareholding/pledging. The relationship of the company with local, provincial, and central government entities will also influence its ability to survive. Management that accepts responsibility and plays by the unwritten rules of the Party is likely to survive and while decision-making may no longer remain in its hands, the company will probably not be abandoned. And, once it appears it is not going to be left to fail, the difficult negotiations will then be carried out, and likely behind closed doors. The demands of creditors and investors will be balanced with the need to maintain social stability or other policy priorities. Foreigners may or may not find themselves disadvantaged by this process. If seen as mercenary enablers who led the proverbial lamb to the slaughter and helped finance the execution, they might be tasked with helping find or fund solutions, especially if they hope to expand their presence on the mainland. Understanding the political landscape is therefore crucial to assessing the viability and survivability of China’s growing number of ailing corporates.

RoseMary Safranek

Stability and predictability of rules, regulation and process are critical to the success of credit investing in any location. The foundation of the investment rests on the contractual obligation of the borrower to return money to the owners of capital. If the borrower does not fulfill the obligations of the contract, there is a process for the lender to enforce the terms of the agreement. The recent rewriting of rules and regulation in fintech in China should give every investor pause. Significant regulatory change just diminished the profitability of a business model by a third as a result of new higher capital requirements. Could such dramatic change happen to the business you just lent money? Why not? With the economics of the business significantly altered, will you, the foreign lender, be able to enforce the terms of the contract?

Investors also may want to think hard about how to participate in the refinancing opportunity. Is it big public deals for large companies where there might be secondary market liquidity? Or, is it smaller situations where the new lender may have a more important role and bigger voice? Some people like fish. Some people like chicken. The world is awash in liquidity. Low rates globally are sending investors on a search for yield. But if borrowers in China need fresh funds, it is the time to keep covenants tight or obtain more rights or obtain more and better collateral. For smaller private companies, debt deals have been backed by collateral that is titled to the lender and then earned back by the borrower. In the absence of corporate collateral, personal collateral from the company founder might help focus the lender on repayment. While the need is for domestic liquidity, offshore lenders can be creative. Are there ways to have non-PRC-domiciled collateral or cash flows underpin the loan? But at the end of the day everything has its price. Lending in jurisdictions with weak legal systems or nascent financial systems or rapidly developing political systems is commonplace. There is a risk premium. In the face of recent developments, international lenders looking at China may want to think hard about whether the risk premium they are getting paid in China is high enough.

RoseMary Safranek has been a pioneer in alternative investments starting with a Hong Kong family office in the mid-1990s. She has been responsible for allocating capital to a variety of global alternative investments strategies including distressed credit during the past 25 years. She also serves on the investment committees of several international family offices.