More than 2,000 years after China built the Great Wall to keep barbarians at bay, investors are still surprised at Beijing’s unfriendliness toward foreign creditors.
From 2003 through 2007, more than US$100 billion poured into China through complicated offshore structures in tax havens like the Cayman Islands, British Virgin Islands and Hong Kong. Much came from global institutional investors who tasked alternative investment managers with allocating a percentage of their portfolios to high-yield opportunity funds, emerging markets and real estate.
Everyone wanted a piece of the “China Dream,” but in recent months they have woken up to the realities of a deteriorating global economic environment. Institutional investors are forcing redemptions of their investments from high-yield, high-risk markets due to current portfolio level de-valuations.
Given China’s comparative resilience in the face of the global financial crisis, it seemed like a good place to meet redemptions and liquidity needs by selling positions. However, as many institutional investors and hedge funds are now discovering, it was much easier to get money into China than to get it out, regardless of their creditor rights.
Investment in China can be a slow and difficult process. Beijing has long been wary of foreign investors and imposes strict controls on foreign direct investment and offshore loans. Unable to resist double-digit GDP growth, strong renminbi appreciation and even stronger real estate expansion, investors still wanted in – but they were keen to circumvent the cumbersome regulatory processes and they wanted exit strategies with liquidity. Offshore structuring appeared to be a solution, but it was conceived against the backdrop of a bubble in the real estate market – where much of the foreign money was headed – that had been building for many years.
In March 2006, I warned investors that 1 billion square feet of residential and commercial projects were underway in Beijing alone, more than three times all the commercial office buildings in Manhattan. But local banks and foreign funds were keen to provide cash, so developers continued to build unabated. That same year, the government tried to rein in what had become a runaway market. The lending spigot at local banks was cut off, interest rates and down payment requirements increased and a variety of anti-speculation taxes were imposed. The bubble began to burst, with markets in south China the first to suffer in early 2007. But that did not deter developers in Shanghai, Beijing, Dalian, Tianjin, Chongqing, Chengdu from buying more land and continuing to build. Their ambitions finally caught up with them last year, as sales began to dry up nationwide.
China’s 65 listed real estate developers have seen their share prices fall by as much as 80% from the highs of November 2007. Despite government efforts to engineer a revival in the residential market, buyers are only responding to steep price cuts. Many of these listed developers are hemorrhaging cash and have turned to non-banks and gray-market lenders to shore-up their capital base.
Although questions have been asked of certain developers’ ability to service debt issued on the international markets, it is unlisted firms that have caused the most trouble. An initial public offering (IPO) promised untold riches and so these developers expanded aggressively, fattening the goose before it was served up to the public. They needed capital and foreign investors were happy to provide it. Investments were structured offshore and the money came onshore through preferred equities and convertible bonds issued by offshore companies with real estate holding companies in China.
Under the media glare, many large developers missed their IPO deadlines and now face disgruntled investors, both onshore and offshore. Alternative investment managers who structured these deals now face redemptions from investors, and busted covenants and debt defaults from Chinese developers.
It seems clear from the offering circulars that few of the investors or developers knew what they were getting into. The developers gave personal guarantees, pledged unlisted shares, issued “no-IPO put options” – anything to get their hands on the funds to grow and prepare for the IPO. They also agreed to pay punitive escalating internal rates of return, going from 30% to 70%, if the IPO was delayed by 18-30 months.
However, the alternative investment managers who relied on “contractual” guarantees to protect their interests appear to have overlooked the clause in the offering circulars that clearly states that offshore creditor rights are not enforceable in Chinese courts. Neither are judgments in foreign courts binding on Chinese corporations or citizens, nor could these judgments be enforced in China without litigating from start.
Many of the international law firms that developed these structures are now advising clients not to enter into the legal jungle that is litigation in China. Yet the same firms recognize that by the time the offshore judicial process is complete, Chinese developers would have effectively transferred all assets with any unencumbered value, or allowed onshore creditors to slap asset preservation orders on any remaining assets.
In my view, the international law firms are being too pessimistic. Foreign investors can use the Chinese legal system to enforce their offshore creditor rights, seize collateral, freeze assets to keep them from disappearing, enforce guarantees and at a minimum bring Chinese entrepreneurs to the negotiating table.
Most Chinese real estate developers sleep soundly as they have faith in the 2,000-year old protections afforded by the Great Wall. The foreign barbarians remain camped outside, engrossed in never-ending inconclusive creditor meetings to try and find answers to their investors’ most basic questions:
– What is the status of my investment in China and what is the condition of the Chinese partner?
– Is the original investment strategy still viable in today’s economic and financial climate?
– Should I continue to hold, sell or invest additional capital, and if so is there a realistic business plan I can evaluate?
– If I continue to hold or invest is there a way to get closer to the company and its assets onshore to remedy some of the defects inherent in the offshore structures?
– How do I limit my liability, and eventually is there a plan to get my capital out of China?
– Are my interests and those of the alternative investment manager still aligned?
My advice to foreign investors facing these challenges: act now. Chinese business partners will inevitably satisfy local creditors first, encumbering a foreign investor’s secured assets without a moment’s hesitation. Investors must rectify the defects in their offshore structures so they are able to use local courts to their advantage, and then rely on Chinese litigation tactics to reach settlements with their local partners.
The end game is to develop a capital preservation and exit strategy which can lead to an informed business decision to invest, sell or stay the course. Achieving this goal hinges on legal leverage and how best to wield it.