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China debt: there’s more than meets the eye

CBD Building Complex in Beijing-adobe-nov2021

A plethora of private debt financing by developers should raise concerns

Debt-laden Chinese property developers looking to tie up private financings to redeem imminent maturities have all the makings of a perfect storm.

Real estate companies from the country have huge offshore debt maturing over the next two years, given they have been among the biggest sellers of dollar bonds in Asia ex-Japan recently. But with international bond market and loan market all but shut for the sector — thanks to volatility emanating from the debt crisis at high-profile firm China Evergrande Group — developers are increasingly seeking behind-the-door deals with private debt funds, GlobalCapital Asia understands.

There is little or no detail publicly available on these illiquid private deals, but they are understood to mostly carry onerous terms and pay rich pricing — both a cause for concern for market watchers.

Private debt financing, or direct lending as referred to in some parts of the world, has grown multi-fold globally since the global financial crisis of 2007-2008 put fresh curbs on bank lending.

At the end of 2020, direct lending — usually provided by non-bank lenders — crossed $412bn globally, according to estimates from Preqin. The financial data provider believes assets under management for the private debt industry in Asia Pacific can grow to $5tn in 2025 from $1.6tn in 2019, with China at the centre of this growth.

Due to its large scale and high margins, Chinese real estate credits have attracted many direct lenders, ranging from deep-pocketed global funds to mid-sized lenders. This has been even more critical recently. With numerous developers in distress, direct lenders have more opportunities to extract higher returns and better terms from the firms they still consider investible.

In November, Yuzhou Group, a Hong Kong-listed Chinese real estate company, is understood to have sealed a $625m asset-backed loan with Oaktree Capital Management. Some of the proceeds will go towards redeeming a $100m private bond.

A group of investors, among the largest holders of Kaisa Group’s offshore bonds, are also looking to pump in $2bn to the developer.

Direct lenders can have various funds under their umbrella to invest in a wide range of situations. For instance, New York-headquartered Marathon Asset Management has distressed funds, and in September, it bought dollar bonds of Evergrande.

GlobalCapital Asia understands that distressed situations-specialist SC Lowy has recently launched a China-specific vehicle to increase its exposure to the real estate sector. Morgan Stanley funds are also said to be actively engaging with developers.

Private debt growth

Direct lenders are usually take-and-hold investors, but it can also include banks that can sell-down their risk to other yield-hungry funds or use sophisticated hedging tools to minimise their exposure, while divvying up the risk. The biggest danger of private debt is its lack of regulation, and the fact that public bondholders are usually unaware of such debt.

This is, of course, not new for China. Property developers have in the past raised off-balance sheet funding, which look like equity but are debt-like in nature.

They have also given guarantees to joint ventures that borrow on behalf of the developer. In many cases, firms have also used special purpose vehicles to issue debt, so the debt won’t be included on the companies’ balance sheet. All ways to mask the amount of real debt the property companies have.

But private financing brings with it its own set of challenges and have strings attached.

The lack of transparency, for one, can have serious ramifications. This is especially as developers have $52.3bn and $45.9bn of offshore maturities in 2022 and 2023, respectively, according to estimates from CreditSights.

Additionally, private debt financing is backed by collateral, ranging from physical assets to shares of the owners. In the event of an insolvency, this debt can rank senior to others, handing down unfavourable treatment to other creditors and stakeholders.

Take the example of London-headquartered Indian firm Vedanta Resources (VRL). A year ago, it was in talks with Oaktree for a $1bn structured note ahead of plans to delist its India arm, Vedanta Limited (VDL). The three-tranche financing was to mature in 24, 30 and 36 months and pays around 13% in returns.

But the Oaktree notes have a pledge of equity of VRL’s offshore subsidiaries — Finsider International Co, Westglobe and Vedanta Holdings Mauritius II. In comparison, secured public dollar bonds sold by VRL that did not offer a pledge of shares of the subsidiary guarantors. Also, the Oaktree financing had strict terms for early repayment, such as a high make-whole premium.

Naturally, credit funds have all the right to protect their returns and interest of their shareholders, which include insurers, pension funds and sovereign wealth funds.

But borrowers and investors also have an obligation to be transparent about their dealings. The Oaktree financing for Vedanta, for instance, was taken at the unlisted holding company level. This meant VRL did not have to provide full details of the transaction. As the commodities cycle was on an upswing, VRL’s cashflows improved and it had an option of not fully using Oaktree’s facilities. But many Chinese property developers don’t have such an option.

Caution is key

Real estate firms are in desperate need for cash, and are tapping other avenues too, such as asset sales and raising fresh equity to shore up their liquidity. All this is being done in the hope that more easing policy measures and a rebound in the Chinese economy can stabilize their situation.

But this can quite easily backfire amid growing market volatility.

News of a new Covid-19 variant called Omicron hit markets globally this week. The Hang Seng Index shed 3.62% in the past five days, while the Shanghai SSE Composite Index and the Shenzhen Component Index lost under 1% each. Federal Reserve chairman Jerome Powell’s comments overnight in the US that it should plan to remove pandemic support at a faster pace also brought in some turmoil, with US stocks falling and the US Treasury yield curve flattening.

If developers continue to go down the private financing route at increasingly onerous terms, their future repayment pressure will only be higher.

History is laden with examples on how unexpected events can deal a blow to even the most well-established companies. Property developers need to take a cautious — and transparent — approach to their fundraising activities, or risk being caught out.