Shoreline Capital, one of the earliest investors focused on China’s distressed debt market, sees an growing number of Chinese property firms experiencing severe liquidity issues, which would provide new opportunities for distressed debt investors.
Traditionally, Chinese investors in the distressed debt market have mostly bought and sold non-performing loan (NPL) portfolios. Other strategies, including the classic debt-to-control method that involves acquiring the debt of companies under stress in order to take over the company via bankruptcy or restructuring proceedings, do not work well in China. Bankruptcies and restructurings of Chinese companies, which in most cases are state-owned enterprises, are more often a political and relationship exercise than legal proceedings.
A new set of strict rules announced by Beijing last month aimed at reducing risk in China’s US$15 trillion asset management sector is likely to limit the funding sources for Chinese property developers, especially smaller developers who mostly rely on this funding method, Tony Liu, chief operating officer of Shoreline, told China Money Network.
The new rules, which include removing implicit guarantees for wealth management products, stricter screening of qualified investors and leverage limits, are likely to put pressure on RMB investors in the distressed market as well. Many RMB-denominated distressed debt funds rely on trusts or underground financing to pool money in order to invest in NPLs, for example. The new rules mean capital supply to the distressed debt market will decrease, reducing upward pricing pressures and stabilizing NPL prices, Liu said.
Shoreline actively manages a RMB5 billion (US$789 million) RMB-denominated fund, in addition to overseeing US$1.5 billion portfolios.
Shoreline was founded in 2004 by Xiaolin Zhang and Benjamin Fanger, but the two co-founders parted ways in 2016 for undisclosed reasons. Fanger started ShoreVest Partners and launched a US$750 million fund last year to invest in Chinese bad debt, according to the two firm’s official websites.
Q：Where do you see the best investment opportunity in the Chinese distress debt market right now?
A: It’s definitely still non-performing loans (NPL), while we are also seeing single asset investments becoming more attractive and popular. For example, we have made 13 new investments from January 2017 until now, nine were NPL portfolio deals while four were single asset real estate projects.
Even though China’s NPL has been steady at around RMB1.7 trillion (US$268 billion) during the past few quarters, the special mentioned loans were relatively high at around RMB3.5 trillion (US$552 billion). Market consensus is that NPL will continue to grow in the next couple of years.
On the other hand, we expect opportunities will increase in the single distressed real estate assets arena. The Chinese government has initiated stricter asset management regulations that will limit funding supplies to the real estate market. Some property developers used to secure funding from trust products, but the new regulation will make it more difficult. The liquidity available to real estate developers, especially those second and third tier developers, will likely dry out. That will provide a perfect condition for distressed single asset real estate projects.
Q: How have NPL portfolio prices been changing?
A: From late 2016 to 2017, NPL prices have increased significantly because lots of new investors entered the space. Prices could be anywhere from 40 to 70 cents on the dollar during those time, almost double from perhaps before 2016.
But the new asset management regulation will impact the funding source of local RMB investment funds, which have been raising capital from high-net-worth-individuals and other funding channels. Some RMB funds are utilizing structured products (instead of a long-term fund structure) as their funding source and face liquidity fluctuations. The new regulation will impact the funding cost and source of these RMB funds for sure.
(Editor’s note: China’s central bank and other key financial regulators announced in April a new set of stricter rules to rein the country’s US$15 trillion asset management sector. Specific rules include removing implicit guarantees for wealth management products, stricter screening of qualified investors and leverage limits.)
Additionally, some RMB funds have bought NPL portfolios in 2016 (at high prices), and I’m aware that they have been aggressively conducting collections, but it’s not going so well. Partly because they are trying to sell some of the portfolios in order to meet their own liquidity needs (in a rush).
So for the past six months, we have seen NPL prices remaining stable at around around 35 to 40 cents on the dollar (depending on the asset), which means the market has cooled down a bit from the days of second half of 2016 and first half of 2017.
Q: How do you see NPL prices changing going forward?
A: I believe it’s not going to go down, and most likely will remain steady. Or if it’s going to increase, it’s not going to be as dramatic as in the past. Another big factor impacting future NPL prices is the "Big Four" asset management companies (AMCs), which are adjusting their strategy to go back to their fundamental business of NPL management. I don’t know how their re-focusing will impact market prices.
So for us, we have been expanding our network and deal sourcing to middle and western parts of China from eastern coastal areas of the country. Zhejiang, Jiangshu province and Shanghai are the traditional "hot zones" of NPLs, particularly for offshore investors. For the 9 NPL portfolios we acquired, only one was in Jiangsu province (in eastern China), while the other were across inner provinces of Anhui, Hubei, Shaanxi and Sichuan province, as well as in Heibei province and Tianjin city.
Q: Will your team buy NPL portfolios more aggressively if you think prices are close to the bottom?
A: I don’t think aggressively buying (timing the market) should be something we try to do. Traditionally, there are three ways to dispose NPLs. One is to auction off the collateral assets, second is to ask the borrowers to buy back, and the third is to sell the NPL to third-parties.
Historically, around half or over half of NPLs were disposed via selling to third-parties. From 2016, we started analyzing how those third-parties utilize the assets in order to find a way to realize higher returns. We reached a conclusion that we need to have better channels to reach out to the end-users of the assets.
So we have been expanding our team to build up our internal capabilities. We have almost 70 people now, up from around 45 people at the end of 2016. We have also expended our relationships with service providers, financial asset exchanges (where bad debt is exchanged assisted by an online platform in China), as well as potential customers and end-users of the assets.
For example, when we acquired a NPL portfolio of around RMB40 million in Tianjin in the second half of 2017, we were able to sell at least 90% of this portfolio at a premium two months later to a buyer referred by the Tianjin Asset Exchange Center. We were able to secure a very high IRR for this deal, because we expanded our network and tried directly to reach the end-users.
Q: What is your return expectation for your NPL investments?
A: Roughly 15% net IRR is a reasonable expectation.
Q: Could you explain how single-asset real estate investment deals are done?
A: We have done three to four single asset-real estate project deals. We acquire directly the debt of the project from the bank, and then obtain the ownership of the asset as the debt is collateralized by a piece of land or some construction in progress on top of that land. We could sell the project to a third-party who is interested in injecting money to complete the project, or we develop the project ourselves or team up with a partner to do this.
A lot of second and third tier developers have been suffering liquidity problems. We have acquired single-asset real estate projects in distress in smaller cities such as in Hainan and Yunnan province, instead of first tier cities including Beijing, Shanghai, Shenzhen and Guangzhou. These type of investments would be challenging for overseas investors, partly because ownership restrictions in China regarding certain assets being owned by foreign entities and partly because difficulties navigating the local relationship network.
Q: So where do you see mature enough opportunities for foreign investors then?
A: The Chinese distressed debt market is very big in terms of its size, so it can accommodate many types of investors. After the third quarter 2017, we have seen that NPL prices have been stable. If foreign investors can manage the challenge of the complicated local legal and relationship environment with local partners, then it’s still a good investment opportunity.
Tony Liu is chief operating officer of Shoreline Capital. Prior to Shoreline, Liu was at Fosun Group for four years, firstly as the vice department head of the group’s in-house due diligence team, then as chief financial officer of Fosun’s venture capital investment platform, Fosun Kinzon Capital. Before Fosun, Liu had ten years of experience working at PricewaterhouseCoopers.