High-yield debt: Missing the wood and the trees


Chris Leahy
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China-focused forestry company falls behind in land acquisition.

There’s little money, yet, growing on MFF’s trees in China
Investors in a Morgan Stanley-sponsored high-yield issue for start-up Mandra Forestry Finance (MFF) are restive. A $195 million issue of high-yield notes in May 2005 at par has slid to 85c on the dollar since issue last May.

Behind the drop is the delay in the acquisition of plantation lands in China’s Anhui province that has set back the company’s business plan by some nine months, according to Standard and Poor’s credit analyst Mary Ellen Olson, prompting S&P in March to issue a negative outlook on its initial B rating.

“We’re obviously concerned about their ability to repay the bonds,” says Olson. “They’ll start to feel the heat about six months before the first [interest] payment and we’ll be taking a much closer look at them then.”

The first interest payment on the notes not covered by an escrow account is due on May 15 2007, at which point the company must also meet certain covenants, including minimum acquired acreage of 140,000 hectares. According to S&P, as at March 31, Mandra had acquired just 17,231 hectares. S&P is now doubtful whether MFF’s cashflow can increase enough to make interest payments.

“We’ve asked management directly if they’re in violation of any covenants,” says Olson, “their answer was ‘no’.”

MFF is the financing arm of Mandra Forestry Holdings (MFH) a company established by Zhang Song-yi, a Chinese entrepreneur and formerly a managing director of Morgan Stanley. Zhang remains an advisory director of Morgan Stanley, Hong Kong. He controls 75% of MFH.

Canadian-listed Sino-Forest Corporation an operator of commercial forestry plantations in China, advanced a subordinated loan to MFH of $15 million in exchange for a 15% stake. Sino-Forest also has an option to buy out the rest of the shareholders in specified circumstances.


Morgan Stanley owns the remaining 10% of MFF and was the sole sponsor, earning a 3% fund-raising fee and a corporate finance fee of $10 million. The latter fee was exchanged for a 10% stake in MFF. Morgan Stanley did not invest in the notes.

According to S&P, Zhang negotiated the acquisition of forestry assets with government in Anhui province, China. Investors are puzzled by the failure to meet acquisition targets, particularly given Zhang’s relationships.

“More than 90% of commitments to purchase forestry rights have failed,” says a hedge fund manager. “No one expects 100% success, I’d be prepared for 50%, but not wholesale failure.”

MFH blames initial management appointed by Sino-Forest, which has now been replaced. Following an internal audit, most signed preliminary contracts for land were cancelled. Zhang says the company has acquired more than 50,000 hectares of land in the two months since new management took over and started to work closely with another local government. He remains confident. “We’re trading strictly within our covenants,” he says, “and I’m very comfortable with the 140,000 target outlined in the document. I’d like to get to that as soon as possible.”

Sensitive to investor concerns, the company and Morgan Stanley recently held a site visit. Now they claim investors are comfortable with progress made on the new business plan. But not all are satisfied. “They’ve been making acquisitions, that’s good,” says one institution that attended the presentation, “but there’s been no information on the quality of the land and they refused to allow investors to appoint our own independent assessor.”

That is not true, Zhang says. “The plantations we’re buying have to meet strict criteria in the bond documents,” he says. “Independent consultant Jaakko Poyry Consulting has confirmed they are all within those parameters.”


Zhang says the government’s incentive is driven solely by economic considerations. He vehemently rebuts any suggestion of wrongdoing. “The key officials are all supportive,” he says, “and we have no interest in taking over land where the farmers are not supportive. These are vast areas. If farmers choose to stop you planting, there’s not much you can do.”

Zhang insists that all investors will remain whole on interest and principal, although he admits that the delays will affect MFH’s equity value, perhaps by as much as 30%. That in turn will reduce investors’ overall return, since the notes were issued with warrants in MFH.

Meantime, there is little investors can do but grumble. The notes hardly trade and finding a price is difficult.

Although the company might yet make good on its promise, the difficulties with investors suggest that such an intricate start-up transaction is better suited to the private market. One competitor seems to think so. “Some of the recent Morgan Stanley [high-yield] deals have been bold,” says the debt head of one US bank. “It’s the type of deal that we’d have done as a structured loan and we usually participate as a lender.”

Morgan Stanley has done much to push Asian high-yield debt. The Mandra deal seems to sit at the very edge of its envelope.

Morgan Stanley officials declined to comment.