Twelve months ago, Evergrande Real Estate was sitting on top of the world. The Guangzhou-based developer was honing in on an initial public offering in Hong Kong worth US$2.1 billion, the largest ever by a Chinese property firm. Now it is fighting for its future.
Evergrande lost its shine when weakness in the Hong Kong equities market led to the IPO being axed in March, mid-way through the marketing process. But the company had been undermined by its own ambition months earlier.
"They acquired too much land before they did the IPO because that was advocated by the sponsors," said Carol Wu, an analyst at DBS Vickers in Hong Kong. "At the time, the larger the land bank you had, the better chance you had of raising funds from the equity market."
Evergrande’s expansion was bankrolled by debt – including money from pre-IPO investors said to include Merrill Lynch and Deutsche Bank – that the company expected to pay off with its listing windfall. Pre-IPO investments are typically structured as bonds, which turn from debt to equity once a company lists.
Evergrande wasn’t dissuaded by the initial setback in March. Thinking it could resume its IPO preparations later in the year, the company renegotiated its position with existing investors and took on additional debt from new ones. Investors were promised greater equity exposure as a reflection of the greater risk.
As projects continue to generate losses due to dried up sales, and with an IPO looking unlikely, Evergrande is back in negotiations with investors, according to lawyers familiar with the situation. The fear is that investors will call in their debts and liquidate the company.
"They have to find some way or compromise if the developer is to have a chance to survive," said a Beijing-based lawyer who represents one of Evergrande’s creditors. "If they don’t, something very bad might happen to the market."
As it is, the market remains precariously balanced. While Evergrande’s big payday hinged on a successful IPO, listed developers placed their faith in the uninterrupted growth of China’s property market. With banks and the debt and equity markets clamoring to satisfy their financing needs, these developers aggressively pursued new projects.
Now that these sources of capital have dried up, the developers need to find a way to tide themselves over until retail demand returns to the market. For many, this means only one thing: an asset sale. Prospective buyers are watching.
"We are helping clients look into purchases – sometimes it’s for projects that need finishing; sometimes it’s for projects that are already finished, but not yet sold," said Maurice Hoo, a partner in the Asia private equity group at Paul Hastings.
Much talk, little action
So far there has been very little deal-making. According to Rong Ren, CEO of private equity firm Harvest Capital, which has US$1 billion under management in two Greater China real estate funds, this is because things have not got "down to the ‘wow’ stage in terms of price."
"There is a standoff in the market," said Harry Du, a partner at law firm King & Wood in Beijing. "Some people say it will end early this year, but others expect it to take another six months. They are waiting to see who dies first, and then they go after the assets."
As Du admits, though, things are rarely that simple. While in the US, failure to keep up with payments leads directly to foreclosure, in China the process is slower. Developers are not selling off assets for 30 cents on the dollar because they don’t have to – at least not yet.
Evergrande and others may have got in over their heads with foreign investors, but Wu of DBS Vickers estimates that overseas money accounts for just 2% of total real estate investment in China. The bulk of financing comes from Chinese banks and, on the whole, they are not known for pressuring borrowers.
"There have been times when banks in effect help out borrowers or just don’t do much in terms of enforcing when refinanced loans are not being paid," said Ben Fanger, co-founder and managing director of Shoreline Capital, a private equity firm that has spent US$160 million on distressed assets in China since it was set up four years ago.
Smaller developers may ultimately be forced into discounted sell-offs, but Wu argues that some large players have reason to believe they can outlast the downturn. Even if it takes longer than expected for retail demand to return, developers can count on government support and banks that are being encouraged to lend more, rather than chase up existing debts.
To Jack Rodman, Beijing-based senior advisor to Westport Capital Partners, a US private equity firm that focuses on distressed real estate, the disconnect between developers and financial reality is responsible for many of the ills in China’s property market. He points to an unwillingness to follow the rest of the world in properly re-pricing assets and oversupply throughout the market as particular problems.
"In March 2006 I looked out of my window, saw all these cranes, and said there was a wave of non-performing loans (NPLs) looming on the horizon," Rodman said. "Now it’s a sea of ‘see-through’ buildings which could become a new wave of NPLs if the banks got tough."
Although Rodman has little appetite for real estate investment in China at present, he believes there is potential in restructuring investments made by foreign investors, essentially "straightening out the other guy’s mistakes."
These clients are often hedge funds looking to liquidate their holdings in developers that failed to come good on IPO plans, or private equity firms with short investment horizons that are unwilling to wait for improvements in the market. In some cases, the reasoning isn’t related to China specifically: The global financial crisis has left investment banks under pressure to add liquidity to their balance sheets while hedge funds are subject to increasing redemptions.
Market watchers report considerably less activity from hedge funds such as Och Ziff Capital Management, Citadel Investment and Stark Capital. Similarly, it is frequently reported that the likes of Morgan Stanley and Macquarie are putting assets up for sale. Property developers and sovereign wealth funds – basically anyone with a longer-term outlook – are often touted as potential buyers.
"In the last four months, we have seen a large increase in the number of opportunities coming from distressed Western sellers," said Fanger of Shoreline Capital.
Despite Chinese banks’ hesitance over foreclosures, distressed asset specialists insist there is money to be made, leveraging their expertise in extracting value from seemingly lost causes. Phil Groves, founder and president of DAC Management, which has about US$450 million invested in distressed assets in China, points out that although the amount of assets put up for sale is a fraction of the total, this fraction may still be larger than that of a smaller country with a fully functioning distressed debt market.
DAC’s biggest deal in China arose after a bank foreclosed on debts owed by a company that held a 50% stake in the Ramada Inn in the northeastern city of Dalian. DAC acquired the stake through the bankruptcy courts, bought out the other shareholder to gain full ownership of the hotel, and then set about upgrading it into a five-star property.
Investments are often made when project debts are outstanding but not yet non-performing, such as a bridge loan for an otherwise healthy company that is temporarily unable to raise funds.
Groves says the market really opened up when Beijing imposed restrictions on pre-sale financing, making developers commit more of their own capital to projects up front. If a developer runs out of money before a project is finished, an investor may step in and see it through.
"You are seeing now a lot of Chinese developers needing more money and the storm is going to gravitate toward the largest real estate developers," said Groves. "Private equity investors and other distressed asset people will give them cash to finish their existing projects."
Fanger describes Shoreline’s strategy as taking advantage of the inefficiencies in capital allocation and information arbitrage. A portfolio of real estate NPLs may include assets that are so widely dispersed or difficult to understand that the seller hasn’t the time to deal with them.
"It all depends on how anxious the person is to sell – they have to be more interested in cash than they are in the assets," Fanger said.
The bad debt burden
In the current climate, few people expect Chinese banks’ NPL ratios to improve.
In 2006, reports issued by several foreign investment banks and ratings agencies put the number of special mention loans (loans that are not non-performing but likely to become so) at US$300-400 billion. Property-related lending accounts for 40% of total lending and between 2006 and 2008, lending to this sector expanded by 35% each year, said Rodman.
His concern is that a new wave of bad debts will be added to the books and they will simply be moved around without being properly addressed. As a result, real estate developers would remain oblivious to the realities of demand and supply.
According to Michael Harris, chief operating and investment officer at Beijing-based Gao Fei Consulting, Beijing’s decision that banks should be more aggressive in their lending merely presented developers with a golden opportunity to borrow themselves into trouble again.
"With the possible exception of Shanghai, these guys have never gone through a real down cycle and they don’t really understand the long-term ramifications of changes in real estate market dynamics," he said.