By Nina Xiang
When the world’s largest distressed debt investor Oaktree Capital Group announced last November that it would join hands with China Cinda Asset Management Co., Ltd., to invest in distressed assets in China and elsewhere, it left many questions unanswered.
In what kind of distressed assets will they invest? Which strategy will they pursue?
It’s natural to assume that with a partnership with Cinda, one of China’s four large state-owned "bad banks", non-performing loans will be part of Oaktree’s activities in China.
Earlier this week, I got a chance to ask Howard Marks, the humble and charismatic chairman of the US$93-billion-under-management firm. He was on his annual sweep through Oaktree’s Asia offices, making a one-day stop in Hong Kong meeting with staff and business partners.
As expected, Marks couldn’t provide a direct answer. "It’s going according to expectations," he says, referring to the partnership with China Cinda. "We are learning, working together and gaining positive experience."
But he did gave a little hint, when I asked if Oaktree is going to get involved with Chinese banks’ non-performing loans, which are expected to balloon to trillions of U.S. dollars in the next few years.
"Our partnership with Cinda positions us to potentially be involved," he answered with some trepidation.
That Oaktree may finally take the plunge in China’s non-performing loan sector is a shift in attitude for Marks, a veteran investor known for being extremely disciplined and cautious.
Since co-founding Oaktree in 1995, Marks has guided the firm through market ups and downs with a single-minded focus on risk control. The firm expanded slowly into new geographies and strategies over the years, diverging never too far from its core competence: corporate bonds and distressed debt.
When it comes to China, a market conditioned contrary to everything necessary for the success of Oaktree’s traditional strategies: a reliable legal system and a mature corporate bond market, Oaktree has been particularly careful.
Since opening an office in Hong Kong in 2005, Oaktree’s investment in China has been largely in private equity, including taking stakes in an unnamed Chinese mining company and buying out Taiwan’s golf club head manufacturer Fu Sheng Industrial Co.
Just two years ago, Marks was not so keen on investing in China’s distressed debt sector when we talked in his New York office under a giant oil painting of a boat dancing atop roaring waves.
"If you don’t know how property rights will be treated, then you should try to avoid situations that pivot on that issue," he commented about China’s investment environment then. "We don’t know how creditor rights will be treated in China, so we probably won’t invest (in China with our usual strategy)."
But since then, Los Angeles-headquartered Oaktree has achieved several milestone deals in China. It struck the strategic partnership with China Cinda, an asset management company established in 1999 to acquire and dispose of Chinese banks’ non-performing loans.
Cumulatively, China Cinda has handled over RMB1.3 trillion (US$210 billion) of non-performing loans, making it the best ally one can hope for in the area of distressed assets.
Oaktree was also among ten cornerstone investors in China Cinda’s US$2.5 billion Hong Kong IPO last December, further solidifying their partnership.
It was also among the first batch of foreign investment funds receiving quota in China’s Qualified Domestic Limited Partner (QDLP) last September, allowing Oaktree to raise RMB from qualified Chinese investors to invest in overseas markets.
With these major advances, it’s no wonder that Marks is feeling more comfortable about investing in China.
But more importantly, there are ways to contain risks in non-performing loan investments, despite China’s infamously messy and unpredictable legal systems.
First of all, working out a non-performing loan is a simpler legal process, compared with Oaktree’s classic take-control transactions through a bankruptcy and reorganization.
In a take-control deal, a distressed debt investor would purchase the debt of a troubled company at discount prices. The investor would usually convert its debt holdings to equity during a bankruptcy and the ensuing reorganization process, therefore taking ownership of the company, now reemerged from bankruptcy with a much healthier capital structure.
Investing in non-performing loans in China is less complicated. Usually, investors would buy packages of non-performing loans at significant discounts, sometimes up to over 90% discount of face value.
Then, as most of Chinese bank loans are collateralized with some kind of assets such as real estate, investors would find the assets being collateralized to the loan. They next go into the courts and put liens on the assets, in the hope of bringing the borrower to the negotiation table for a mutually satisfactory solution.
Benjamin Fanger, co-founder of local distressed debt shop Shoreline Capital, said that only about 5% of their investments end up in an auction of the assets, because the borrower most often can still squeeze up some money (not full face value, of course) to pay off the investors.
In addition, China’s legal environment is slowly improving. Shoreline’s Fanger says that investors can count an increasing number of legal processes with predictability nowadays, including putting liens on assets and fraudulent conveyance.
Not to mention reform objectives laid out during China’s Fourth Plenum to separate the courts from local governments in order to ensure the independence of the judicial system.
And, of course, the potential opportunities in China’s non-performing loans are gigantic. In the next few years, Chinese banks are expected to accumulate trillions of U.S. dollar worth of non-performing loans, as the Chinese economy and the property market undergo a structural transition.
It will be several times larger than the last non-performing loan cleanup during the early 2000s, when around half a trillion U.S. dollars of non-performing loans were created.
That could present one of the most lucrative opportunities for investors like Oaktree and China Cinda, if their partnership progresses as planned. With Marks’ prudence, there is no reason to doubt that it won’t.
