An overlooked opportunity - China Investment … overlooked opportunity This proprietary research note is intended exclusively for use of the recipient. It contains confidential information.

An overlooked opportunity

This proprietary research note is intended exclusively for use of the recipient. It contains confidential information.

All contents are copyright 2015. www.chinafirstcapital.com [email protected]

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Credit vs. Equity in China: the Strengthening Case

For Debt

Anyone with even the most cursory knowledge of investing will know about the "equity

risk premium”. Stocks are riskier than bonds and

other fixed-income investments and so must

compensate investors by delivering over time a

higher rate of return. If equities didn’t deliver this

premium then few would bother owning them. So

the theory goes.

China private equity, though, has turned this

theory on its head. It continues to pour money

almost exclusively into equity investing while

achieving cash-distributed returns over the current

seven-year cycle well lower than a portfolio of

collateralized corporate or municipal debt in China.

PE in China has been averaging distributed returns

of 6%-8% a year, while fixed-income can earn

anything between 8-10% on municipal debt

(secured against government tax and fee revenues)

or 12-18% on securitized corporate lending.

Call it China's "equity risk discount". It gets to

the heart of one of the more deep-seated

disequilibria in China alternative investing -- the

money is now allocated almost exclusively towards

higher-risk and lower-return equity PE investing.

This report will examine some of the unique

attributes of China debt investing. Our conclusion:

on a risk-adjusted cash-distributed basis, debt

investing in China may continue to outperform PE

equity investing.

The recent outperformance by fixed-income isn't

just a statistical artifact. It reflects not only the low

distributions to LPs from equity investing, but the

often-overlooked fact that China now has the

world's largest high-yield debt market. Chinese

companies and municipalities are often paying

interest rates double or triple the rates similar

borrowers pay in all other major economies.

INSIDE THIS SPECIAL REPORT:

Credit vs. Equity

The Strong Case for Debt 2

China’s High-Yield Market:

Overtaking the World 4

China’s Loanshark Economy:

The Cost of Borrowing Takes Its Toll 6

China’s Big Banks

Treating Borrowers like Conmen 8

China Debt Mispricing:

Blackrock, Fidelity Get Burned 9

Caijing Magazine:

Chinese Analysis Highlights Policy Fix 11

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The risk-return tradeoff between debt and equity is

unique in China compared to the rest of the

industrialized world. Money should flow to China

fixed-income investing because of its high-yields

and lower risk. Debt is higher up the capital

structure than equity and so offers investors

greater protection against loss, both through

collateralization as well as liquidation preference.

Return data as well as China's legal system both

argue strongly in favor of investing in debt rather

than illiquid shares typically purchased by PE firms

in China. Despite this, there isn't now a single

large specialist international fixed-income debt

fund focusing on China direct corporate lending.

Partly this is because using dollars to lend to

Chinese companies is trickier than investing in

those companies' equity. There is a dense net of

regulations on lending money to domestic firms

that doesn't apply to equity investing. Another

reason, fixed-income investing in China will likely

involve a lot more work than writing a check to

buy company equity. It would require more

meticulous pre-deal diligence, especially tracking

cash flow and receivables, and then more active

and sustained post-investment monitoring.

Seen in a global context, China currently offers

fixed-income investors yields on collateralized

lending that are more attractive than anywhere

else in the developed world. The yields are also

better than what can be earned on debt investing

in underdeveloped places like India and Indonesia.

In the case of both these countries, AA-rated

corporate borrowers are paying around 9% a year

for securitized loans. In China, once fees are

bundled in, the rate is at least 300-500 basis

points higher.

China's corporate and municipal lending market

has undergone an enormous sea change in the last

three years, as China's big banks responded to

regulatory pressures by pushing a huge amount of

lending to the off-balance-sheet "shadow banking"

system dominated by their sister companies in the

stockbroking, trust and asset management areas.

Where borrowing from a bank may cost a borrower

an annual regulated interest rate of 7%-9%,

borrowing from the shadow banking system can be

twice as expensive and is basically unregulated.

Default levels on China shadow banking debt are

officially under 1%. Insiders claim the real rate is

troubled loans is probably higher, around 3%-4%.

That is comparable to bad debt ratios in the

shadow banking systems of the US and Western

Europe, where companies generally borrow for 3%

to 5% a year.

PE investors, not only in China, like to promise

their investors outsized returns. In China PE, firms

generally say they "underwrite to a minimum IRR

of +20%". In other words, they only commit

money when they are persuaded they are on an

inside track to earn at least 20% a year. From that

vantage point, the 13%-18% on offer from debt

investing may look dull and unappealing.

But, China PE has not consistently delivered alpha,

not delivered these above-index returns. It has

only promised to do so. Fixed income investing in

China's high yield market, by contrast, has

meaningfully outperformed the S&P index. It is

where the alpha is in China.

The few funds that do focus on lending to Chinese

corporates almost only do convertible lending or

other types of mezzanine structures. Convertible

debt is often illegal under Chinese securities laws.

What’s more, company owners in China tend to

prefer less intrusive, less costly straight lending.

There’s also the huge uncertainty about any non-

quoted Chinese company ever getting permission

to IPO and so make the “equity kicker” liquid and

valuable. Straight securitized senior direct lending

to companies is what the China market most needs

and has shown will pay for. It also could boost

overall PE fund performance in China.

As a fund strategy, direct debt in China seems to

have a lot of positives. Preqin, a leading market

intelligence business for the alternative investment

industry, published a special report in November

2014 called “Private Debt” (click here to

download a copy). It summarized things this way:

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Private equity investing in China, both dollar and

Renminbi, has with too few exceptions delivered in

recent years mediocre distributions to Limited

Partners. All the while, however, fixed-income

investing has clocked consistent high cash returns.

Rules making it tough for dollar-based funds to

direct lend in China are being liberalized. The early

years of PE equity investing in China were similarly

challenging, but the earliest vintage China PE

funds turned in by far the highest performance.

Profit levels in the Chinese PE industry as a whole

never matched the deals done by these early

movers, even as China private equity AUM grew to

+$175 billion, based on commitments to investable

funds, mainly all targeting the same type of

“growth capital” equity deals.

China’s High-Yield Market Overtakes the World

Despite Polonius’s stern injunction in

Shakespeare’s Hamlet, “neither a borrower nor a

lender be”, now is a very good time to be debt

investor in China. Indeed, for those who can learn

the ropes and avoid the pitfalls, there is perhaps

no better risk-adjusted way to make money

anywhere as a fixed-income investor than lending

to larger Chinese companies. For now, China's

huge high-yield debt market is open mainly to

domestic investors. But a few brave hedge funds,

including it’s said Elliott Advisors, are now getting

into the business of lending onshore in China to

Chinese borrowers. China First Capital is involved

in structuring debt deals for Chinese companies.

Real interest rates on collateralized loans for most

companies, especially in the private sector where

most of the best Chinese companies can be found,

are rarely below 10%. They are usually at least 15%

and are not uncommonly over 20%. In other

words, interest rates on collateralized loans in

China are now generally pegged at the highest

level among major economies.

Borrowing money has always been onerous for

companies in China, with the exception of a few

favored large State-Owned Enterprises. All bank

lending in China is meant to obey orders from on

high, in this case China’s powerful banking

regulator the CBRC. In the last two years, partly to

meet new capital adequacy requirements as well

as damp down somewhat on credit expansion, the

CBRC instructed banks to cut back on new lending

and limit increases in lending to existing private

sector borrowers.

Banks' parent companies responded by vastly

expanding their off-balance sheet lending via the

"shadow banking system" in China. Over the last

two years, a huge proportion of lending both to

private-sector companies and local governments

has been securitized and sold as what are called

“Wealth Management Products”, aka WMPs, in

English, or licai chanpin, （理财产品） in Chinese.

This form of off-balance-sheet lending, usually

arranged and sold by Chinese banks’ sister

companies, their underwriting, asset management

and trust company businesses, has proved

enormously lucrative for everyone involved, except

of course the Chinese borrowers.

The growth in such lending has been little short of

astronomical. There is now $2.5 trillion in shadow

banking debt now outstanding in China, more than

the total amount of outstanding US commercial

“Direct corporate lending as an illiquid debt fund

structure has been the ongoing story within the

growth of alternative credit. Compared to mezzanine

and distressed vehicles which have operated in the

private equity financing segment for decades, direct

lending is more in line with the relatively

conservative risk appetites of the fixed income

investor. Direct lending vehicles have gone from

representing 19% of private debt fund types in 2010

to a considerable 42% in 2014 YTD, marking the

largest increase over four years. Exposure to this

profitable and evolving asset class may continue to be

attractive to institutional investors in a low-yield

environment.

The private debt asset class is offering a genuine

alternative to private equity funds with its reduced

risk profile and strong return offering.”

(Emphasis ours.)

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paper. It's been a great business for the bank

holding companies packaging and selling such

loans. They earn sales commissions and other fees,

as do domestic lawyers, accountants and domestic

rating agencies. These add 2-3% to the cost of

borrowing. Chinese savers who buy the securitized

debt are earning interest rates of 10%-14% on

corporate debt, and 6-10% on municipal lending.

Bank deposits in China offer investors government-

regulated interest of 1% or lower.

The shadow bank lending is mainly meant to be

fully-collateralized and in many cases, there’s a

third party default guarantee in place as well.

Shadow bank loans are almost all one-year term,

and can't be automatically rolled-over, so principal

needs to be paid back at the end of the term. For

borrowers, this means they pay interest for twelve

months but generally have use of the money for

eight to nine. During the time it takes to renew a

shadow bank loan, which is often one month or

more, companies generally have recourse only to

informal "bridge lending" in China, priced at 2% to

3% a month.

There is no organized secondary market for this

securitized lending, and it's been very lightly

regulated compared to bank loans which are

subject to various caps on interest rates and term.

In the last six months, however, the Chinese

government has signaled it wants to more actively

control the growth of shadow banking, particularly

securitized debt being sold to small retail investors.

The likely result is that it will become even more

expensive for Chinese companies to borrow. With

China's growth rate slowing and wage and energy

costs still rising, the high cost of borrowing is

having a more and more pronounced negative

impact on cash flow and net margins across

China's corporate sector.

The official default rate on such collateralized

lending is running at 1%, well below the rate in the

US, where companies above junk grade are

borrowing at as low as 3-4%, uncollateralized. It

seems likely that default rates will rise on shadow

bank loans in China. But, some factors should keep

default rates in check. For one, when a local

company gets into trouble, local governments will

often step in with new sources of capital to pay off

existing loans. Also, when Chinese companies

borrow, they generally need not only to pledge

most or all of the company's own assets but often

those owned personally by the company's main

shareholders. There is no real equivalent to

America's Chapter 11 law, no "debtor in

possession" process. So default can and usually

does reduce a company and its equity owners to

pauperdom. Hence, it’s to be avoided at all costs.

Note, some lucky Chinese companies own a

holding company outside China, often in Hong

Kong, BVI or Cayman Islands. These companies

can borrow or issue bonds in Hong Kong and so

generally pay interest rates of 4%-6%. But, the

Chinese government made this kind of offshore

structuring illegal in 2009.

Kaisa Group, a troubled real estate developer that

issued $2.5 billion in bonds in Hong Kong is now

threatening to default and has asked offshore

bond-holders to accept much lower interest

payments spread over much longer period. Kaisa's

domestic Chinese creditors it seems will not have

to accept such steep write-downs. This preferred

treatment for domestic lenders may not have been

fully understood by the institutions that bought

Kaisa's Hong Kong bonds.

So, how might international fixed-income investors

get into the domestic high-yield game in China?

There are ways for dollar-based investors to get

their capital in and out for this purpose. But, it's

far from straight-forward. Once that's sorted out, a

good strategy would be to cherry-pick the most

credit-worthy borrowers from among the hundreds

of thousands now relying on shadow bank loans,

and then negotiate a private loan directly with the

company's chairman and board.

The shadow banking system basically treats all

Chinese corporate borrowers the same. Most carry

the same AA credit rating and so pay the same

amount to borrow. The one-size-fits-all approach

also applies to maturities, types of pledged

collateral. Convertible or mezzanine structures are

mainly forbidden under Chinese securities law.

The yawning gap between the cost of collateralized

borrowing in China compared to the US, Europe

and much of the rest of Asia will really only narrow

when the Chinese government removes the

remaining restrictions and loosens regulations that

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make it difficult for foreign investors to swap

dollars into and out of Renminbi to lend to Chinese

companies. Until this happens, China's companies

will find more and more of their available cash flow

going to service debts. At the same time, China’s

new mass rentier class of institutions and

individuals will continue to live the high life,

earning interest payments beyond the dreams of

avarice for fixed-income investors elsewhere.

China’s Loanshark Economy

What’s ailing China? Explanations aren’t

hard to come by: slowing growth, bloated and

inefficient state-owned enterprises, and a ferocious

anti-corruption campaign that seems to take

precedence over needed economic reforms.

Yet for all that, there is probably no bigger, more

detrimental, disruptive or overlooked problem in

China’s economy than the high cost of borrowing

money. Real interest rates on collateralized loans

for most companies, especially in the private

sector where most of the best Chinese companies

can be found, are rarely below 10%. They are

usually at least 15% and are not uncommonly over

20%. Nowhere else are so many good companies

diced up for chum and fed to the loan sharks.

Logic would suggest that the high rates price in

some of the world’s highest loan default rates. This

is not the case. The official percentage of bad loans

in the Chinese banking sector is 1%, less than half

the rate in the U.S., Japan or Germany, all

countries incidentally where companies can borrow

money for 2-4% a year.

You could be forgiven for thinking that China is a

place where lenders are drowning in a sea of bad

credit. After all, major English-language business

publications are replete with articles suggesting

that the banking system in China is in the early

days of a bad-loan crisis of earth-shattering

proportions. A few Chinese companies borrowing

money overseas, including Hong Kong-listed

property developer Kaisa Group, have defaulted or

restructured their debts. But overall, Chinese

borrowers pay back loans in full and on time.

Combine sky-high real interest rates with near-

zero defaults and what you get in China is now

probably the single most profitable place on a risk-

adjusted basis to lend money in the world. Also

one of the most exclusive: the lending and the

sometimes obscene profits earned from it all pretty

much stay on the mainland. Foreign investors are

mainly being shut out.

The big-time pools of investment capital —

American university endowments, insurance

companies, and pension and sovereign wealth

funds — must salivate at the interest rates being

paid in China by credit-worthy borrowers. They

would consider it a triumph to put some of their

billions to work lending to earn a 7% return. They

are kept out of China’s more lucrative lending

market through a web of regulations, including

controls on exchanging dollars for Renminbi, as

well as licensing procedures.

This is starting to change. But it takes clever

structuring to get around a thicket of regulations

originally put in place to protect the interests of

China’s state-owned banking system. As

investment bankers in China with a niche in this

area, we are spending more of our time on debt

deals than just about anything else. The aim is to

give Chinese borrowers lower rates and better

terms while giving lenders outside China access to

the high yields best found there.

China’s high-yield debt market is enormous. The

country’s big banks, trust companies and securities

houses have packaged over $2.5 trillion in

corporate and municipal debt, securitized it, and

sold it to institutional and retail investors in China.

These shadow-banking loans have become perhaps

the favorite low-risk and high fixed-return

investment vehicle in China.

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Overpriced loans waste capital in epic proportions.

Total loans outstanding in China, both from banks

and the shadow-banking sector, are now in excess

of Rmb 100 trillion ($15.9 trillion) or about double

total outstanding commercial loans in the U.S. The

high price of much of that lending amounts to a

colossal tax on Chinese business, reducing

profitability and distorting investment and rational

long-term planning.

A Chinese company with its assets in China but a

parent company based in Hong Kong, BVI or the

Cayman Islands can borrow for 5% or less, as

Alibaba Group Holding recently has done. The

same company with the same assets, but without

that offshore shell at the top, may pay triple that

rate. So why don’t all Chinese companies set up an

offshore parent? Because this was made illegal by

Chinese regulators in 2009.

Chinese loans are not only expensive, they are just

about all short-term in duration — one year or less

in the overwhelming majority of cases. Banks and

the shadow-lending system won’t lend for longer.

The loans get called every year, meaning

borrowers really only have the use of the money

for eight to nine months. The remainder is spent

hoarding money to pay back principal. The

remarkable thing is that China still has such a

dynamic, fast-growing economy, shackled as it is

to one of the world’s most overpriced and rigid

credit systems.

It is now taking longer and longer to renew the

one-year loans. It used to take a few days to

process the paperwork. Now, two months or more

is not uncommon. As a result, many Chinese

companies have nowhere else to turn except illegal

underground money-lenders to tide them over

after repaying last year’s loan while waiting for this

year’s to be dispersed. The cost for this so-called

“bridge lending” in China? Anywhere from 3% a

month and up.

Again, we’re talking here not only about small,

poorly capitalized and struggling borrowers, but

also some of the titans of Chinese business,

private-sector companies with revenues well in

excess of RMB 1 billion, with solid cash flows and

net income. Chinese policymakers are now

beginning to wake up to the problem that you can’t

build long-term prosperity where long-term lending

is unavailable.

Same goes for a banking system that wants to

lend only against fixed assets, not cash flow or

receivables. China says it wants to build a sleek

new economy based on services, but nobody

seems to have told the banks. They won’t go near

services companies unless of course they own and

can pledge as collateral a large tract of land and a

few thousand square feet of factory space.

Chinese companies used to find it easier to absorb

the cost of their high-yield debt. No longer.

Companies, along with the overall Chinese

economy, are no longer growing at such a furious

pace. Margins are squeezed. Interest costs are

now swallowing up a dangerously high percentage

of profits at many companies.

Not surprisingly, in China there is probably no

better business to be in than banking. Chinese

banks, almost all of which are state-owned, earned

one-third of all profits of the entire global banking

industry, amounting to $292 billion in 2013. The

government is trying to force a little more

competition into the market, and has licensed

several new private banks. Tencent Holdings and

Alibaba, China’s two Internet giants, both own

pieces of new private banks.

Lending in China is a market structured to transfer

an ever-larger chunk of corporate profits to a

domestic rentier class. High interest rates sap

China’s economy of dynamism and make

entrepreneurial risk-taking far less attractive.

Those running China’s economy are said to be

reassessing every aspect of the country’s growth

model. Those looking for signs China’s economy is

moving more in the direction of the market should

look to a single touchstone: is foreign capital being

more warmly welcomed in China as a way to help

lower the usurious cost of borrowing?

(Originally published in The Nikkei Asian Review, March 2015.)

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China's Big Banks: They Misprice and Misallocate

Credit While Treating Borrowers Like Conmen

Do you have the financial acumen to

run the lending department of one of China’s giant

state-owned banks? Let’s see if you qualify. Price

the following loan to a private sector Chinese

company. Your bank is paying depositors 0.5%

interest so that’s your cost of capital. The company

has been a bank customer for six years and now

needs a loan of Rmb 50mn (USD$8 mn). The

audit shows it’s earning Rmb 60mn a year in net

profits, and has cash flow of Rmb 85mn.

You ask the company to provide you with a first

lien on collateral appraised at Rmb 75mn and

require them to keep 20% or more of the loan in

an account at your bank as a compensating

deposit. Next up, you ask the owner to pledge all

his personal assets worth Rmb 25mn, and on top,

you insist on a guarantee from a loan-assurance

company your bank regularly does business. The

guarantee covers any failure to repay principal or

interest. What annual interest rate would you

charge for this loan?

If you answered 5% or lower, you are thinking like

a foreigner. American, Japanese or German maybe.

If you said 13% a year, then you are ready to start

your new career pricing and allocating credit in

China. At 10% and up, inflation-adjusted loan

spreads to private sector borrowers in China are

among the highest in the world, particularly when

you factor in the over-collateralization, that third-

party guarantee and fact the loan is one-year term

and can’t be rolled over.

As a result, the company will actually only have

use of the money for about nine months but will

pay interest for twelve. Little wonder Chinese

banks have some of the fattest operating margins

in the industry.

Chinese private businessmen are paying too much

to borrow. It’s a deadweight further slowing

China’s economy. Debt investing and direct lending

in China could represent excellent fund strategies.

The high cost of borrowing negatively impacts

corporate growth and so overall gdp growth. It is

also among the more obvious manifestations of an

even more significant, though often well-hidden,

problem in China’s economy: the fact that nobody

trusts anybody. This lack of trust acts like an

enormous tax on business and consumers in China,

making everything, not just bank credit, far more

expensive than it should be.

Online payment systems, business contracts, visits

to the doctor, buying luxury products or electronics

like mobile phones or computers: all are made

more costly, inefficient and frustrating for all in

China because one side of a transaction doesn’t

trust the other. One example: Alibaba’s online

shopping site, Taobao, will facilitate well over

USD$200bn in transactions this year. Most are paid

for through Alipay, an escrow system part-owned

and administered by Alibaba. Chinese shoppers are

loath to buy anything directly from an online

merchant. They generally take it as a given that

the seller will cheat them.

Most of the world’s computers and mobile phones

are made in China. But, Chinese walk a minefield

when buying these products in their own country.

It’s routine for sellers to swap out the original

high-quality parts, including processors, and

replace them with low-grade counterfeits, then sell

products as new.

Chinese, when possible, will travel outside China,

particularly to Hong Kong, to buy these electronics,

as well as luxury goods like Gucci shoes and

Chanel perfume. This is the most certain way to

guarantee you are getting the genuine article.

In the banking sector, loans need to have multiple,

seemingly excessive layers of collateral, as well as

guarantees. Banks simply do not believe the

borrower, the auditors, their own in-house credit

analysts, or the capacity of the guarantee firms to

pay up in the event of a problem.

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Disbelief gets priced in. This is one main reason for

the huge loan spreads in China. Banks regard their

own loan documentation as a work of fiction. It

stands to reason that if a company’s collateral

were solid and the third-party guarantee

enforceable then the cost to borrow money should

be at most a few points above the bank’s real cost

of capital. Instead, Chinese companies get the

worst of all worlds: they have to tie up all their

collateral to secure overpriced loans, while also

paying an additional 2%-3% a year of loan value

to the third-party credit guarantee company for a

guarantee the bank requires but treats as basically

worthless.

In the event a loan does go sour, the bank will

often choose to sell it to a third party at discount

to face value, rather than go to court to seize the

collateral or get the guarantee company to pay up.

The buyer is usually one of the state-owned asset

recovery companies formed to take bad debts off

bank balance sheets. Why, you ask, does the bank

require the guarantee then fail to enforce it? One

reason is that Chinese private loan-assurance

companies, which usually work hand-in-glove with

the banks, are usually too undercapitalized to

actually pay up if the borrower defaults. Going

after them will force them into bankruptcy. That

would cause more systemic problems in China’s

banking system.

Instead, the bank unloads the loan and the asset

recovery companies seize and sell the only

collateral they believe has any value, the

borrower’s real estate. The business may be left to

rot. The asset management companies usually

come out ahead, as do the loan guarantee

companies, which collect an annual fee equal to 2%

to 3% of the loan value, but rarely, if ever, need to

indemnify a lender.

Don’t feel too sorry for the bank that made the

loan. Assuming the borrower stayed current for a

while on the high interest payments, the bank

should get its money back, or even turn a profit on

the deal. Everyone wins, except private sector

borrowers, of course. Good and bad like, they

are stuck paying some of the highest risk-adjusted

interest costs in the world.

When foreign analysts look at Chinese banks, they

spend most of their time trying to divine the real,

as opposed to reported, level of bad debts,

devising ratios and totting up unrealized losses.

They don’t seem to know how the credit game is

really played in China.

Most of the so-called bad debts, it should be said,

come from loans made to SOEs and other organs

of the state. Trust is not much of an issue. SOEs

and local governments generally don’t need to

pledge as much collateral or get third-party

guarantees to borrow. A call from a local Party

bigwig is often enough. The government has

shown it will find ways to keep banks from losing

money on loans to SOEs. The system protects its

own.

Chinese banks should be understood as engaged in

two unrelated lines of business: one is as part of a

revolving credit system that channels money to

and through different often cash-rich arms of the

state. The other is to take in deposits and make

loans to private customers. In one, trust is

absolute. In the other, it is wholly absent.

Many Chinese private companies do still thrive

despite a banking system that treats them like con

artists, rather than legitimate businesses with a

legitimate need for credit. The end result: the

Chinese economy, though often the envy of the

world, grows slower and is more frail than it

otherwise would be.

Everyone in China is paying a steep price for the

lack of trust, and the mispricing of credit.

Blackstone, Fidelity and Other Pros Get Burned by

Chinese Debt Pricing

For all the media ink spilled recently, you’d

think the ongoing fight in Hong Kong between

severely-troubled Hong Kong-listed Chinese real

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estate developer Kaisa Group and its creditors was

the biggest, nastiest, most portentous blood feud

the capital markets have ever seen. It’s none of

that. It’s a reasonably small deal ($2.5 billion in

total Hong Kong bond debt that may prove

worthless) involving a Chinese company of no

great significance and a group of unnamed bond-

holders who are screaming bloody murder about

being asked to take a 50% haircut on the face

value of the bonds. The creditors have brought in

high-priced legal talent to argue their case, both in

court and in the media.

Nothing wrong with creditors fighting to get back

all the money they loaned and interest they were

promised. But, what goes unspoken in this whole

dispute is the core question of what in heaven’s

name were bond investors thinking when they

bought these bonds to begin with. Kaisa was if not

a train wreck waiting to happen then clearly the

kind of borrower that should be made to pay

interest rates sufficiently high to compensate

investors for the manifold risks. Instead, just the

opposite occurred.

The six different Kaisa bond issues were sold

without problem by Hong Kong-based global

securities houses including Citigroup, Credit Suisse

and UBS to some of the world’s most sophisticated

investors including Fidelity and Blackrock by

offering average interest rates of around 8%. If

Kaisa were trying to raise loans on its home

territory in China, rather than Hong Kong, there is

likely no way anyone would have loaned such sums

to them, with the conditions attached, for anything

less than 12%-15% a year, perhaps even higher.

Kaisa’s Hong Kong bonds were mispriced at their

offering.

It may strain mercy, therefore, to feel much

sympathy for investors who lose money on this

deal. Start with the fact Kaisa, headquartered like

China First Capital in Shenzhen, is a PRC company

that sought a stock market listing and issued debt

in Hong Kong rather than at home. Not always but

often this is itself a big red flag. Hong Kong’s stock

exchange had laxer listing rules than those on the

mainland. As a result, a significant number of PRC

companies that would never get approval to IPO in

China because of dodgy finances and laughable

corporate governance managed to go public in

Hong Kong. Kaisa looks like one of these. It has a

corporate structure, which since 2009 has been

basically illegal, that used to allow PRC companies

to slip an offshore holding company at the top of

its capital structure.

The bigger issue, though, was that bond buyers

clearly didn’t understand or price in the now-

obvious-to-all fact that offshore creditors (meaning

anyone holding the Hong Kong issued debt of a

PRC domestic company) would get treated less

generously in a default situation than creditors in

the PRC itself. The collateral is basically all in China.

Hong Kong debt holders are effectively junior to

Chinese secured creditors. True to form, in the

Kaisa case, the domestic creditors, including

Chinese banks, are likely to get a better deal in

Kaisa’s restructuring than the Hong Kong creditors.

This fact alone should have mandated Kaisa would

need to promise much sweeter returns and more

protections to Hong Kong investors in order to get

the $2.5 billion. Investors piled in all the same,

and are now enraged to discover that the IOUs and

collateral aren’t worth nearly as much as they

expected. Kaisa bonds were, in effect, junk sold

successfully as something close to investment

grade. As long as the company didn’t pull a fast

one with its disclosure – an issue still in dispute –

it’s fair to conclude that bond-buyers really have

no one to blame but themselves.

At this point, it’s probable many of the original

owners of the Kaisa bonds, including Fidelity and

Blackrock, have sold their Kaisa bonds at a loss.

Kaisa’s bonds are trading now at about half their

face value, suggesting that for all the creditors’

grousing, they will end up swallowing the

restructuring terms put forward by Kaisa.

If the creditors don’t agree, well then the whole

thing will head to court in Hong Kong. If that

happens, Kaisa has threatened to default, which

would probably leave these Hong Kong

bondholders with little or nothing. Indeed, Deloitte

Touche Tohmatsu has calculated that offshore

creditors in a liquidation would receive just 2.4%

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of what they are owed. The collateral Kaisa

pledged in Hong Kong may be worth more than the

paper it was printed on, but not much.

The real story here is the systematic mispricing of

PRC company debt issued in Hong Kong. It’s still

possible, believe it or not, for other Chinese

property developers with similar structure and

offering similar protections as Kaisa to sell bonds

bearing interest rates of under 9%. Meantime, as

discussed here, Chinese property companies in

some trouble but not lucky enough to have a

holding company outside China are now forced to

borrow from Chinese investors, both individuals

and institutions, at 2%-3% a month. This is from

widely-practiced though theoretically illegal loan

sharking in China. It’s a common way for Chinese

with spare savings to juice their returns, allocating

a portion to these direct “bridge loans”.

It’s a situation rarely seen – investors in a foreign

domain provide money much more cheaply against

shakier collateral than the locals will. Kaisa’s

current woes are part-and-parcel of at least some

of the real estate development industry in China.

Kaisa seems to have engaged in corrupt practices

to acquire land at concessionary prices. It got

punished by the Shenzhen government. It was

blocked from selling its newly-built apartment units

in Shenzhen. No sales means no cash flow which

means no money to pay debt-holders.

Kaisa is far from the first Chinese real estate

developer to run into problems like this. And yet,

again, none of this, the “politico-existential” risk

many real estate development companies face in

China, seems to have made much of an imprint on

the minds of international investors who lined up

to buy the 8% bonds originally. After all, the

interest rate on offer from Kaisa was a few points

higher than for bonds issued by Hong Kong’s own

property developers.

Global institutional investors like Blackrock and

Fidelity might control more capital and have far

more experience pricing debt than Chinese ones.

But, in this case at least, they showed they are

more willing to be taken for a ride than those on

the mainland.

Curing the Cancer of High Interest Rates in

China -- Caijing Magazine

While China’s recent performance as an

innovator may be a disappointment, averaged

The cost of borrowing money is a huge

and growing burden for most companies and

municipal governments in China. But, it is also the

most attractive untapped large investment

opportunity in China for foreign institutional

investors. This is the broad outline of the Chinese-

language essay published in March 2015 in Caijing

Magazine, among China’s most well-read business

publications. The authors are China First Capital’s

chairman Peter Fuhrman together with Chief

Operating Officer Dr. Yansong Wang.

Foreign investors and asset managers have mainly

been kept out of China's lucrative lending market,

one reason why interest rates are so high here.

But, the foreign capital is now trying hard to find

ways to lend directly to Chinese companies and

municipalities, offering Chinese borrowers lower

interest rates, longer-terms and less onerous

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collateral than in the Rmb 15 trillion (USD $2.5

trillion) shadow banking market. Foreign debt

investment should be welcomed rather than

shunned, our Caijing commentary argues.

If Chinese rules are one day liberalized, a waterfall

of foreign capital will likely pour into China,

attracted by the fact that interest rates on

securitized loans here are often 2-3 times higher

than on loans to similar-size and credit-worthy

companies and municipalities in US, Europe, Japan,

Korea and other major economies. The likely long-

term result: lower interest rates for corporate and

municipal borrowers in China and more profitable

fixed-income returns for investors worldwide.

China First Capital has written in English on the

problem of stubbornly high borrowing costs in

China, including here and here. But, this is the first

time we evaluated the problem and proposed

solutions for a Chinese audience -- in this case, for

one of the more influential readerships (political

and business leaders) in the country.

The Chinese article can be downloaded by clicking

here.

For those who prefer English, here’s a summary:

high lending rates exist in China in large part

because the country is closed to the free flow of

international capital. The two pillars are a non-

exchangeable currency and a case-by-case

government approval system managed by the

State Administration of Foreign Exchange (SAFE)

to let financial investment enter, convert to

Renminbi and then convert back out again.

This makes the 1,000 basis point interest rate

differential between China domestic corporate

borrowers and, for example, similar Chinese

companies borrowing in Hong Kong effectively

impossible to arbitrage. Foreign financial

investment in China is 180-degrees different than

in other major economies. In China, almost all

foreign investment is equity finance, either through

buying quoted shares or through giving money to

any of the hundreds of private equity and venture

capital firms active in China. Outside China, most

of the world's institutional investment – the capital

invested by pension funds, sovereign wealth funds,

insurance companies, charities, university

endowments -- is invested in fixed-income debt.

The total size of institutional investment assets

outside China is estimated to be about $50 trillion.

There is a simple reason why institutional investors

prefer to invest more in debt rather than equity.

Debt offers a fixed annual return and equities do

not. Institutional investors, especially the two

largest types, insurance companies and pension

funds, need to match their future liabilities by

owning assets with a known future income stream.

Debt is also higher up the capital structure,

providing more risk protection.

Direct loans -- where an asset manager lends

money directly to a company rather than buying

bonds on the secondary market -- is a large

business outside China, but still a small business in

China. Direct lending is among the fastest-growing

areas for institutional and PE investors now

worldwide. Outside China, most securitized direct

lending to good credit-rated companies earns

investors annual interest of 5%-7%.

For now, direct lending to Chinese companies is

being done mainly by a few large US hedge funds.

They operate in a gray area legally in China, and

have so far mainly kept the deals secret. The

hedge fund lending deals have mainly been lending

to Chinese property developers, at monthly

interest rates of 2%-3%.

China First Capital can see no benefit to China

from such deals. Instead they show desperation on

the part of the borrower. A good rule in all debt

investing is whenever interest rates go above 20%

a year, the lender is taking on "equity risk". In

other words, there are no borrowers anywhere that

can easily afford to pay such high interest rates.

The higher the interest rate the greater the chance

of default At 20% and above, the investor is

basically gambling that the borrower will not run

out of cash while the loan is still outstanding.

Interest rates are only one component of the total

cost of borrowing for companies and municipalities

in China's shadow banking system. Fees paid to

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lawyers, accountants, credit-rating agencies,

brokerage firms can easily add another 2% to the

cost of borrowing. But, the biggest hidden cost, as

well as inefficiency of China's shadow banking loan

market is that most loans from this channel are

one-year term, without an automatic rollover.

Though they pay interest for 12 months, borrowers

only have use of the money for eight or nine

months. Spend then hoard, this is China’s business

cycle.

China is the only major economy in the world

where such a small percentage of company

borrowing is of over one-year maturity. This

imbalance in corporate and municipal lending –

long-term investment attracts only short-term

money – is a problem of ever greater magnitude in

China.

If more global institutional capital is allowed into

China for lending, these investors will likely want

to hire local teams, source and structure their

deals in China by negotiating directly with the

borrower. These credit investors would want to do

their own due diligence, and also tailor each deal in

a way that China’s domestic shadow banking

system cannot, so that the maturity, terms,

covenants, collateral are all set in ways that

directly relate to each borrowers' cash flow and

assets.

China does not need one more dollar of "hot

money" in its economy. It does need more stable

long-term investment capital as direct lending to

companies, priced more closely to levels outside

China. Foreign institutional capital and large global

investment funds could perform a useful long-term

role. They are knocking on the door.

© CHINA FIRST CAPITAL

Global outlook, China-focused investment banking for companies, financial sponsors

Tel: +86 755 86590540 Email: [email protected] http://www.chinafirstcapital.com