China’s Market Offers Promising Distresse

China’s Market Offers Promising Distresse

​*This article is taken from the 2020 Preqin Global Private Debt Report. For more expert commentary on the private debt industry, please visit preqin.com/gpdr 
Non-performing loans are growing as new regulations limit financing for the real estate industry, says Lakeshore Capital

China’s economic transformation is creating new opportunities for investors in distressed debt. Non-Performing Loans (NPLs) – which can offer stable returns with downside protection– are increasing as Chinese companies grapple with an economic slow down that has impacted their cash flows and reduced their ability to repay debt. China’s NPL ratio, a key indicator for this market, has been climbing steadily over the past five years, rising from just under 1.1% in July 2014 to 1.9% in September 2019, according to the China Banking and Insurance Regulatory Commission (CEIC). 
The growth of the NPL market in China stems from both economic and regulatory changes. A major economic shift is the steady increase in China’s total debt-to-GDP ratio. This has been rising steadily since 2009, when the government implemented an RMB 4tn stimulus package in the after math of the Global Financial Crisis. The cash infusion has resulted in excessive corporate debt financing, leading to over-capacity in many capital-intensive sectors, including the manufacturing and mining industries.On the regulatory side, there have been state initiatives to boost NPL recognition aspart of the central government’s efforts to reduce bureaucracy, deleverage the economy, and increase the efficiency of the financial system. Indeed, we see more NPL deals surfacing as the shadow banking system is shattered under the deleveraging mandate. 
To facilitate the transfer of NPL transactions from bank loan books to the secondary market, the Chinese Government has set up more regional asset management companies (AMCs). At the same time, regulators have implemented guidance to ensure that both national and regional AMCs focus on their core NPL business. These initiatives are helping to boost the supply of NPLs. 
NPL Opportunities in Chinese Real Estate 
More recently, we have seen new rules regulating and limiting financing for the real estate industry. As refinancing becomes more difficult, we expect NPLs in this space to grow. 
Real estate NPLs span various types of underlying assets, such as commercial complexes, offices, land, apartments, and factories. More importantly, most real estate NPL portfolios include a significant number of tangible collateral assets, which means investors benefit from high intrinsic values from these distressed debt offerings. NPLs backed by residential properties for example are especially attractive; since the underlying houses and apartments are appealing investments for the general public, this type of loan can be priced higher and has better liquidity. 
A promising source of real estate deals is China’s online auction market. Savvy investors may find properties located in the prime regions of first- and second-tier cities, trading at 30-50% of replacement costs. Currently the online auction market is still small, as potential buyers unfamiliar with NPLs tend to stay away from auctions altogether. But we believe that there is significant potential for growth, and that’s why we created an online platform to connect sellers with prospective buyers. By investing in a judicial auction serviceprovider, which serves over 400 courts across the nation and has access to data on foreclosed properties, we aim to surface new opportunities for NPL investment. 
Key Guidelines for New Investors 
For investors new to China’s NPL market, there are several guidelines to bear in mind. First, it is crucial to consider the legal intricacies involved inconducting an asset appraisal. On the bright side, the legal framework is continuing to improve. Timelines for litigation, asset foreclosure, and enforcement are generally well defined. 
However, the market varies across different regions in China. Local government transparency as well as the local culture and affluence levels all affect the ways deals are executed. Deals in different cities may require customized approaches. In the end, NPL resolution is a people business; to be successful practitioners need to understand the local market well, and they need to have extensive networks, so that they can connect to the right people. 
A second point to bear in mind is the importance of maintaining price discipline and resisting the instinct to follow the herd. This can be especially challenging for investors who are new to the Chinese market. It can be tempting to bid for deals in already popular locations, but the result is increased competition and higher prices. That’s why we believe it’s vital for international investors to partner with local players, who can use their proprietary networks to identify reasonably priced assets in attractive regions. 
Today, the stars are aligning for Chinese NPLs to start bearing fruit. As the supply of bad loans increases, there will be a growing pool from which to cherry-pick good deals. This makes China’s NPL market an exciting opportunity for institutional investors, both local and international.