China puts on a garage sale

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Those foreign investors prepared to pick their way through the rubbish on offer from China in the form of distressed loans may be able to uncover a few fantastic investment opportunities. They've done it before in other markets, but China offers its own unique challenges in seizing assets. It's certainly not for the faint-hearted. But those prepared to buy NPLs may benefit in other ways from the gratitude of the Chinese authorities.

"I have travelled all over China to see what they are trying to sell. And to be honest, I have seen some real garbage," says the banker. He looks out from his office in Hong Kong across to the mainland and continues: "But there must be some diamonds. The problem is we can't pay for those because we don't know where they are." 

For the first time the Chinese are permitting foreign investors to buy cheap assets through participation in auctions of non-performing loans. Selling the NPLs is crucial to cleaning up the banking system. Foreign investors have made huge fortunes elsewhere profiting from the pain of others - notably in the US savings and loans crisis in the early 1990s - by buying bad loans and seizing the underlying assets and collateral.

Can they repeat their successes and make big money in China's nascent distressed loan market? Base returns of 25% are bandied around but with so many unknowns the figure is almost meaningless. Pricing the assets is extraordinarily difficult and the government doesn't want to be seen to be selling China on the cheap. Yet the bad debt problem is massive and urgently requires new capital. Foreigners sense a chance to exploit this desperation.

Buying China on the cheap?
This month a groundbreaking transaction should be concluded. The deal, first broked towards the end of November, is the People's Republic's first public auction of distressed debt open to foreign investors. "You have all these deadbeats and the government has not been able to solve the problem. So why not bring in foreign bandits to help you get the borrowers in line?" says one banker.

However, despite authorities making all the right noises, and local newspapers working themselves up into a fervour, behind the headlines there is still confusion and contradiction over whether foreign investors will really ever be allowed to take control of underlying assets.

It leaves even many of the most battle-hardened vulture fund investors, for now anyway, extremely wary of taking the smallest of punts. But this is China, a country embracing radical and rapid reform - and perhaps the bold can seize a unique opportunity.

Following years of policy lending and banks operating without effective risk management departments, the country's financial sector is groaning under a mountain of bad debt.

Chinese banks have racked up an estimated $400 billion in non-performing loans. They could bring the whole China story and its emergence onto the world stage to a shuddering halt. It's something the government understands all too well.

In 1999, in an attempt to tackle the problem head-on, the government set up four asset management companies (AMCs) that were charged with sucking out a portion of the bad loans that were crippling the four state-owned banks. Over the past two years, the four AMCs - Huarong, Cinda, China Orient and Great Wall - have taken on board more than $170 billion-worth of bad paper, transferred at face value. And it is now up to these entities to recover what they can. They have a massive task confronting them.

China Huarong Asset Management Corporation is the largest of the four. Rmb407 billion ($49 billion) of assets have been transferred over to it from China's biggest bank, ICBC. But in two years Huarong has only managed to dispose of a tiny proportion, Rmb31 billion. It is open to the charge that progress is far too slow. "You have to put it into context," says Jack Rodman, a managing director at Ernst&Young, Huarong's financial adviser. "They had to set up a company that didn't exist - hire 2,000 people, find the files for over 180,000 borrower relationships, move them somewhere and put them into a computer system. Now that's tough."

Although this is quite an accomplishment, Huarong and the other AMCs know the importance of quickly getting international investors involved. Not only will this help speed up the disposal, it will also provide them with new technical knowledge and collection techniques that will help them improve their own recovery rates on retained loans.

Zhang Cai, China Orient AMC's general manager of debt management and market development, explains: "We go to a state-owned enterprise [SOE] and they say: 'I am state owned, you are state owned. I don't have to pay you back because we are brothers.' They always try their best to dodge the affair. With foreign investors, although it will still be difficult, it will be different." One foreign investor responds to this saying: "It will definitely be difficult because we have no idea if we can collect on these loans yet."

After winning the mandate to advise Huarong on its first international auction of the distressed debt it had taken over from Bank of China in 1999, Rodman gathered his troops about him. He decided to centralize the whole due-diligence process. It was a decision that involved collecting loan files with a face value of $2 billion from all over China. In March, these were dumped into a large room. "We put people up in a dormitory, and we basically created a factory that manufactured non-performing loan files that investors could bid on," he says.

At the start, interest from investors was high. There were 16 interested parties, 11 foreign and five local, who paid fees to gain access to the files. Nomura, Deutsche, Lonestar, GE Capital, Morgan Stanley, and Goldman Sachs were just some of the names digging around looking to strike it rich.

Investors back out quickly
It wasn't easy. When one investor asked to be shown one of the better assets, a big book with colourful pictures was pulled out and a photo of a three-year-old failed metal factory with state-of-the-art machinery was brandished. The problem was, the factory had been built in the middle of nowhere, 12 kilometres from the nearest road. Other assets included loans that had been extended to companies that hadn't been in business for years. "You would go and take a look at the address and there would be a run-down empty factory with a guy who had sat outside with a broom for the past four years," says one banker. "And the scary thing is that they were telling us this was representative of their other stuff. Since that was the case, there was no frigging way we were going to get involved."

By the time of the auction, according to Rodman, only three foreign bidding groups remained, including a consortium led by Morgan Stanley, made up of itself, Salomon Smith Barney and Lehman Brothers, KTH (a Hong Kong property firm) and Goldman Sachs. By the time the bidding was over, the Morgan Stanley Consortium had agreed to purchase $1.2 billion of bad assets at around 10 cents on the dollar. Goldman Sachs took $250 million at around 10 cents too. The rest went to local bidders.

One local bidder that eventually failed in the auction was China Chengtong Holding Company, a corporation with a close affiliation to the State Council. Despite eyebrows being raised because of the conflict of interest involved in Chinese officials being able to buy back assets at a huge discount, foreign bankers and accountants give assurances that this was not the case. It was mainly there to encourage greater domestic participation, they say.

The portfolios bid for were a mixed bag in terms of quality of assets and industry sectors. Rodman explains: "We tried to mix the better assets, those that had good collateral with good locations, with poorer assets that lacked these. We did this so we could get some value out of the less-desirable assets through the competitive bidding process." In short, it forced the investors to ascribe some value to poorer assets to be sure of winning the good assets. It's a familiar tactic of distressed sellers.

Rodman remains upbeat despite the fact that so many investors pulled out and offers his view as to why they eventually didn't enter the process. "To have an Asian participant of Nomura's prestige was exciting. But its strategy changed. For GE Capital the timing of the bid did not coincide with its board meeting. You have to respect its corporate discipline."

Distressed-loan buyers are used to the problem of inadequate loan documentation. Valuable experience was gained when acquiring the bad debts of nationalized banks of France and other European countries. But when potential investors picked up these loan files they realized the challenges facing them. They were staring at documentation that was so severely lacking that, says one accountant, who worked through numerous loans, even some experienced vulture buyers were shocked. "So many questions were generated," he says. "But our client wasn't getting enough answers for it to make a prudent decision so it withdrew."

Another banker complains: "We were asking someone for information and they didn't want to give us the records. And because they didn't want to give us the records we assumed the worst so it meant we couldn't get comfortable. If they are serious about getting the international investors in, this will have to improve."

Other investors, who also finally declined to take part, suggest that the reasons for withdrawing were much more fundamental. Not only were there problems while attempting their own due-diligence work but there was also, and still is, a great deal of uncertainty about the law on creditor rights and exit strategies. If investors did actually make any returns how could they get them out? There is so far no law allowing a foreign investor in Chinese debt to convert the returns of a loan held in domestic currency into foreign exchange and repatriate the funds.

To be fair to Huarong, this was a learning process for everyone involved. "Huarong was under incredible pressure. They went from nursery school to freshman in a four-month period," says Mark McGoldrick, Goldman Sachs's managing director, distressed debt, Asia. With the feedback from first-round investors it is already looking at ways to improve the system before its next auction.

The most serious issues revolve around the law. And these won't be so easy to iron out. All those involved, including Goldman Sachs and Morgan Stanley, were unsure of where they stood, and still are. There is constant speculation about the uncertainty of the bankruptcy guidelines, the protection afforded to state-owned enterprises, creditor rights and land usage rights. With all these uncertainties, no banker really knows if this is a real estate or a corporate play. Real estate specialists are to the fore in some bidding groups. But one group of real estate investors pulled out because "the difficulty in owning the loan to owning the real estate made us decide that this was more about corporate vulture hunting," says a managing director of the group.

Questions arise about social welfare costs, redundancies and how the retrenchment costs would be covered. One banker says: "When we were looking at those loans, we felt that a company that had stopped producing and had no staff and was just some building would produce higher returns than those still in operation. We wouldn't have to deal with all the fallout." Unfortunately because the pool of assets were varied it meant that it was impossible to just buy assets like these.

The fallout comes from the fact that many employees are still on payrolls despite not working. It means that if investors decide to foreclose a loan and put the company into bankruptcy in order to realize their collateral - which they still don't know if they can do - there is the chance they will have to pay three years' severance pay for each employee. It could be a long time before anyone makes good on any investment. One banker, who like so many refuses to be named, says: "The government knows that it has to get rid of the rubbish, but it's a contradiction, because it still wants to protect the SOEs."

China Orient's Zhang Cai takes a different stance and suggests that the government might have made promises with investors that it will deal with the burden of workers. That would be a very large and expensive compromise. "The government definitely showed some flexibility," says a banker involved in the transaction. "And it was not going to let this fail because it would tarnish the process."

Others who pulled out remained unconvinced. One drop out says: "When you sign the paper, the sweet nothings that the government whispers in your ear usually turn out to be just nothing." He adds: "The Chinese will want to keep the back door open and say 'sorry you can't close this factory because it's in the national interest to keep it open.'"

Many question whether Morgan Stanley and Goldman Sachs have really bought anything at all other than pieces of paper. One investor says: "Nobody has bought anything per se. What these two banks have agreed to do is to acquire a discreet portfolio of assets, conditional to a whole series of precedents." He explains that the loans are still not legally transferable and that the only transfer to have actually occurred is the one from the banks to the AMCs. He also points out that since third-party enforcement of the debt is also not legal it is impossible for Morgan Stanley and Goldman Sachs to collect on the loans. "The excitement about the deal far outstrips the reality," he says.

With all these problems to surmount, the prices offered proved a rude awakening for the Chinese. The initial view was that they could get people in to pay inflated prices because so many were showing an interest in buying. But dreams of getting 40 cents on the dollar were quickly shattered. Rumour has it that one bidder initially put in a bid of one cent on the dollar. "Our bid was pretty awful, but it sure as hell wasn't a cent," says one banker quickly.

Many of those investors that initially showed an interest simply couldn't determine a price. One accountancy firm says that it was impossible to use its normal techniques. "We used the normal criteria that we would apply elsewhere but we just couldn't come up with a value. We could have said two cents or nothing." The normal criteria include such things as standard of documentation; whether the appropriate seals have been used; evidence of cash movements; and enforceability of the underlying security. "It was a very frustrating and time-consuming exercise," he says. "And quite often chasing the assets down could not be justified on a cost-benefit analysis. At the end of the day having the right experience and contacts within the PRC is more important."

Saving face
Michael Harris, a partner with Andersen, believes that because investors were unable to come up with a price, it left them in a quandary. "There was real fear that if the investors had gone in with bids based on their pricing models, the bids might be so low that it might have done more harm than good and created a negative perception about themselves and their intent. For example if their offer was three cents it could have been perceived as carpetbagging." That suggests that some investors entered dangerous territory. They either dropped out or made serious exceptions to normal risk management procedures because of a fear of offending the Chinese and bought for non-financial reasons.

But Huarong was in a difficult position too. If it had shared all the information that it received on the cash bids with the finance ministry and the People's Bank of China, it could have been embarrassing. It could have faced a grilling about why its marketing and expensive roadshow had not pushed the prices higher. However it is also rumoured that the government told Huarong to sell at any price and so create the necessary catalyst. If the auction had been cancelled because of low prices, the whole issue of dealing with the debt could have been set back months. But 30 days after the original target auction date, Huarong came back out to revise the auction process and enter negotiation. Rodman says: "We had to reject all the conforming bids. We went back and forth trying to find ways how to carve this thing out." It was decided that if any of the debt workouts led by the foreign investors were successful, they would share some of the profits with Huarong.

David Bednar, the banker who led Morgan Stanley's bid, doesn't really provide a clear answer when asked how his bank came up with its valuation. "It was very much a ground-up approach. We have bought the loans of 250 borrowers and as well as studying the data provided by Huarong, we visited the collateral of over 50% of these." So it wasn't the shot in the dark that other bankers suggest then? "Not at all," says Bednar, "We pursued this on the merits of the transaction, based on our experience in this area and on the successes we have had in the region on similar types of deals."

Even though the bids were so low, Rodman, the champion-come-salesman of Chinese distressed debt, doesn't agree that China is being sold off unnecessarily cheap. And he doesn't accept that Huarong should not have come to the market until the legislative issues were resolved. If it had waited, many argue, it would have enhanced the value of the assets put up for sale. "In Japan, the first deal was three cents on the dollar," says Rodman. "And this was an education process." He then goes on to try to explain what the prices really mean. "This is a present-value game. In essence Morgan Stanley is paying 10% cash immediately. After if it gets a return on its investment it will then go 50-50 with Huarong. This protects Huarong against the investor making a huge windfall."

Rodman estimates that at the end of the day Huarong will actually be able to claim a 22% recovery on this first deal. To provide that implies the new investors will make more than a 200% return. But not only does it protect Huarong, it also allows the investors to spread their risk and they retain Huarong to help them work out and collect.

The joint-venture structure may not have been ideal for the new investors, with the seller retaining an economic interest. But there is a suggestion that Morgan Stanley and Goldman Sachs walked away with some assurances in return. Perhaps the government did promise, as some have suggested, that it would deal with sensitive employment issues. Another banker close to the deal gives another reason why the banks would enter the joint venture structured transaction. "If I get my money back and get a 10% return, I am more than prepared to give away some of the cashflows because I want the learning curve," he says.

Executives at the other AMCs have looked on at the Huarong deal and are openly relieved it wasn't them leading the way. Some even offer the opinion that Huarong did actually come too soon, affecting the price. However Wang Haijun, executive director in Cinda Asset Management's investment banking department, offers a different opinion. "Foreign investors just don't have good enough knowledge about China's NPL market," he says.

Sellers running out of time
But all the AMCs understand that they too will have to enter the international arena soon. And it seems they are being leaned on by powers from above. "The State Council wants us to speed up the process. We can't wait three or four years because the depreciation of our assets will continue until they are worth nothing," says Yu Heyen, general manager of the international department at China Great Wall Asset Management Corporation.

Heyen looks nervous when pricing is mentioned and acknowledges that assets will be sold at a steep discount. But he believes that lessons learnt from Huarong's sale may help pump up the price of their assets. "Huarong was good for China," says Heyen. "But we will be more open with the information. Unlike Huarong, we want to allow on-site research rather than just giving them the file. Investors will not buy things they know nothing about."

While Great Wall and Orient admit quite freely that they do lack experience with international investors, Wang of Cinda refuses to do so. He claims that Cinda went into the international market and pulled in foreign investors as long ago as last April. "Huarong seeks publicity. We do things very quietly. But I cannot name our investors because they do not want the publicity," he says. He is also unable to give exact figures on how much was sold, what was sold and at what price. "We don't class exactly what a foreign investor is. I also can't say whether we sold our assets at a steep discount. But we did sell them at the right price." And despite the market seeming so far only to consist of three foreign investors guessing, he adds: "The price was the market price."

It becomes obvious that competition between the AMCs is getting serious. They are all chasing after the same money. Whenever Huarong's name is mentioned Wang quickly tries to pour cold water on what it has accomplished. He says: "It is not important to know who was first to attract foreign investors. That is totally useless. And anyway, most people understand that Cinda is a lot more successful in selling assets to foreign investors." He is unwilling, or unable, to provide any evidence.

With so many unanswerables about investing in this embryonic market, the question does arise as to why any institution would want to invest in these assets now. "Investing in NPLs is a specialised art form and as such has generally less competition than other investment asset classes. One can make excess returns for the underlying risk and not suffer such volatility," explains Merrill Lynch's Robert Kissel, managing director of global principal investments, Asia Pacific region. That may be true of developed markets but China is an unknown. But with the time and money spent, it seems that investors knew before the process began that they wanted to set up platforms in the country. Some suggest that Morgan Stanley and Goldman Sachs are merely trying to buy the favour of the government.

Valuable restructuring mandates and equity deals will be coming up for grabs. "The pricing and process were meaningless. It was all about a firm wanting to be in China and buying good relations," says one corporate financier. Morgan Stanley's Bednar responds: "Of course, playing a major role in any high profile transaction will inevitably enhance our franchise in China. That is very welcome. But we also hope that they would respect the commitment we are showing." But does Bednar believe they will actually make money? "We hope it is an attractive investment," he says. When questioned about what attractive means on the first such investment in China, Bednar won't answer but says: "We will plot a reasonable risk premium."

Another banker is more direct: "Those assets that Goldman and Morgan have will earn around 30% to 40%. And that is a home run. They will make a ton of money because it's the same in every market." Even though he sounds so sure, his bank decided not to get involved in the first deal.

Although $100 million sounds like a large amount to invest into such an unknown, when the figures are broken down no investor has really put that much on the line. Morgan Stanley essentially sold down its risk - 40% of the money came from the IFC, and Morgan Stanley, Lehman Brothers and Salomon Smith Barney are rumoured to have actually put in only $5 million to $15 million each. "I met one of the guys involved in the deal from Morgan Stanley the other day and he said that they basically took the money out of the petty cash box," says one senior banker.

Other bankers suggest that it's all about grabbing first-mover advantage. Getting first option on a market and gaining valuable competitive advantages in understanding the process, the assets and subsequently the values is all-important. The more facts known about the risk, the higher investors can take their bid. Those that refer to this theory give Korea as an example. They point out that many believed Goldman Sachs to be seriously deluded when it first entered the Korean distressed debt market. The validity of corporate guarantees was unclear since it had never been tested. But Goldman ended up making substantial returns on its $25 million investment for the first couple of years. When others decided that they too wanted to hitch their wagon to the Koreans, Goldman with the knowledge it had accrued, strolled in and won the next four auctions from under its competitors' noses.

But China and this deal are different. Morgan Stanley and Goldman Sachs may not have generated first-mover advantage. Morgan Stanley stands accused of involving too many other investors and future competitors in the deal. Another banker also adds: "In a country as large as China, and where the supply of NPLs far exceeds the demand by foreign investors, the opportunity to invest at reasonable prices without being at a competitive disadvantage will exist for a reasonable amount of time."

McGoldrick at Goldman Sachs disagrees. "There are hundreds of questions that can't be answered just sitting in Hong Kong and Tokyo. In effect what we can do with this investment is work out what a fair market value is, figure out the legal system, find out where the stuff trades and whether there is liquidity."

Morgan Stanley's Bednar adds that the steep learning curve that they went up others will have to go up too when they enter the market. "We are the first to have real world resolution experience in China. The experience we are now gaining means we will be ahead of the curve in our ability to price future portfolios. This is a significant advantage." If this is the case then it's no surprise that despite losing the major portfolio to Morgan Stanley, Goldman was still happy staying in and picking up the scraps left by its rival.

Even though the signing ceremony has yet to take place, and the jury is still out as to whether it will ever be a success, bankers, accountants and investment funds are all eager to know when the next offerings will appear. At the end of December, Orient did manage to sell Rmb1.8 billion for a cash payment of Rmb21 million in a negotiated settlement, and is already rumoured to be putting a new package together for foreign investors of around $1.5 billion. When it will be put up for sale is not certain.

Great Wall is also apparently preparing a portfolio of NPLs that is to be marketed in two months. An international roadshow is also being touted. However, a sale may not occur until three months after that. But again details and plans remain extremely unclear. "We are thinking about selling Rmb7 billion-worth of loans, but there may be other loans injected into the portfolio. A final decision hasn't been made, " says Heyen. He does claim though that international interest is already high, and reels off a list of names. Merrill Lynch, Goldman Sachs, Rabobank, Crédit Lyonnais, and Bank of America have all apparently made enquiries.

Cinda has signed memoranda of understanding with Lonestar, Deutsche Bank and Goldman Sachs. Rodman believes the AMC may be able to get three transactions away this year in the form of negotiated settlements with these players. He is also hopeful that Huarong will be able to get another $600 million sold by the end of the year. But details are sketchy. Andersen's Harris is hoping that this will be the year that there will be a flood, but is pessimistic about what really will appear. "The question is how much stuff can come until we get clarity that would impact the transactions."

Market flood unlikely
Brian Cheung, partner at PricewaterhouseCoopers, definitely doesn't believe that there will be a huge amount of assets entering the market. "I understand that the AMCs are commercial entities that need to recover enough to survive. But to flood the market would be illogical until the transparency is there."

With a possible market size of half a trillion dollars, roughly the same size as the US's Resolution Trust Corporation which dealt with the S&L fallout, the potential for the market to develop is huge. And the usual suspects are leading the charge. In 1995, Morgan Stanley and Goldman Sachs entered China's markets while others stood by and watched. They all ended up getting caught in the two banks' wake. This time around the same thing could happen. And as one banker says: "Morgan Stanley's strategy is not stupid. They put a few million dollars into the market and lose half of it, so what? It's the future option that they are buying and that could be a massive opportunity. They now have the know-how before anyone else and that gives them the power to price."

Banks that decided not to follow them could be left lamenting their decision. And with the speed of change that is taking place in China, that feeling of regret could descend on them sooner than they think.