Foreign banks and hedge funds flocked around Chinese real estate developers when the market was hot for both property in general (so potential valuations were high) and IPOs in particular (so investors had a way of realizing the stellar profits arising from these high valuations).
Now the property market is down and the IPO market is moribund. The developers used the funds supplied by the banks and hedge funds to expand their business, which left them with a stack of units they can’t shift and a stack of debts they can’t pay off. Meanwhile, the banks and hedge funds face balance sheet pressure back home, but can’t exit their investments.
We first touched on this issue in the March cover story of China Economic Review. Like the New York Times on Thursday, we used Evergrande real estate – a developer that has gone from being a potential IPO starlet to a financial liability in the space of a year – as a way in. However, the story stretches further than Evergrande and the property sector itself.
The banks and hedge funds invested in Evergrande through bonds that would convert to equity once the company listed. When this didn’t happen, Evergrande thought it was only a temporary setback – so it tapped its existing investors, and some new ones, for more cash. Investors were promised greater equity exposure as a reflection of the greater risk. As the IPO went from certainty to probability to snowball’s chance in hell, Evergrande slipped over the brink. Talks are underway to try and find a solution that doesn’t end in liquidation.
As the NYT article notes, the banks and hedge funds entered into these pre-IPO deals through offshore vehicles. They lent money outside of China to the property developers’ own offshore vehicles, which were set up as part of the international listing process. These loans were ultimately secured against the property developers’ assets inside China – but offshore creditor rights are not enforceable in Chinese courts. Resolving this through offshore courts is possible but time-consuming. As a result, foreign investors find themselves at the back of the queue when it comes to divvying up whatever valuable assets remain on the developers’ books (assuming this happens at all, given Chinese banks’ well-known reluctance to foreclose).
The onshore-offshore disconnect effectively puts more power in the hands of Chinese companies in terms of negotiating settlements. Just in the past couple of weeks, real estate developer Neo-China cut the early redemption price on US$167.8 million in convertible bonds from US$1.20 on the dollar to just US$0.40.
Meanwhile, Asia Aluminum agreed to a rescue package with mainland lenders conditional on foreign creditors accepting a cut-price deal on US$1.2 billion in bonds. The company offered US$0.27 on the dollar for US$450 million in high-yield bonds and US$0.13 on the dollar for US$727 million in payment-in-kind notes. The foreign investors kicked up a fuss and the mainland financiers pulled out in mid-March. With the liquidators looming, these investors now face getting little or nothing.
The big question is: How many other Chinese firms will try to wriggle out of trouble by ditching foreign debt on the cheap in the knowledge that the investors have limited recourse?