Peter's Perspective
12th March 2015 by Peter Churchouse

What you need to know when buying China

A couple of months ago we talked about the first high profile China listed company default in a piece titled “The Curious Case of Kaisa“. (Please take a quick read if you haven’t already – it’s important for anyone with any interest in investing in China).

We noted that information was scarce (welcome to China!), and how little insight we were able to obtain despite the fact this company was both well regarded and listed on the Hong Kong stock exchange.

There has been little improvement since then.

Now we are looking at a rescue deal from listed Sunac China Holdings Ltd. As a part of this, there will likely be a restructuring for holders of Kaisa’s US$2.5 billion of offshore debt.

In our original piece on Kaisa, we pointed out 4 lessons that this unprecedented event could teach us about investing in China.

I want to bring up one in particular again:

Offshore Investors get little protection.

“Kaisa is a mainland company with an onshore asset base. Offshore creditors (i.e. the holders of Kaisa’s offshore U.S. dollar bonds) get paid long after domestic investors.

Foreign entities cannot get legal security over mainland real estate assets.

Domestic creditors have the ability to freeze assets very quickly. As such, they are incentivised to move fast. And nearly 20 banks and trust firms have already requested a freeze on Kaisa’s assets from a court in Shenzhen.

As an offshore investor, get used to being at the back of the repayment queue. Your bond yields therefore need to provide adequate compensation for that.”

As part of the restructuring, Kaisa has offered the following to offshore bond holders:

  • Extend maturities of the bonds by 5 years
  • Cut the interest rate by as much as two-thirds
  • Defer interest for the first 2 years

What’s extraordinary here is that bondholders are sharing the brunt of this restructuring with equity holders.

Typically losses are absorbed by the riskiest parts of the capital structure first (i.e. equity, preferred shares, convertible bonds etc.) and then senior unsecured bondholders.

Here we’re seeing the ‘pain’ of this restructuring shared out between equity holders and bond holders.

Bond holders still need to vote on accepting the deal, but to say their feet were being held to the fire would be an understatement.

They can either accept these terms (or negotiate), or push the company into a full liquidation.

Now, anywhere else you have to believe that bond holders would balk at the idea of having restructuring terms forced on them like this while there was still value in the equity.

But there’s a key problem…

This is the first case of a default by a Chinese company listed offshore where bondholders are being asked to restructure in clear favour of the equityholders. There is no precedent.

Bottom line: nobody has any idea what the result of a liquidation will look like for offshore bond holders.

Kaisa are suggesting bond holders would only receive a few cents on the dollar.

And let’s face it, domestic creditors will get the better end of any deal here as well…

So the main conclusions to reiterate:

  1. Domestic lenders are likely to be treated better than offshore lenders in any debt blowups in China.
  2. In a default/distress situation, foreign debt holders have little claim on real estate assets in China. Don’t assume that a foreign investor/lender can exercise rights over fixed property assets in the way that might be possible in the developed world. That is highly unlikely, and specifically forbidden under law in most instances.
  3. China’s anti-corruption drive (which looks like the trigger for this event) can target anyone in any sector at any time. This pogrom is not over. The masses love it so the leadership will continue its purge. More heads will roll. More companies will suffer.
  4. The lawyers always win!

So does all this mean that we should abandon investing in China? Not by any means.

But we do need to remind ourselves that China is an emerging market. Yes, it is the second largest economy in the word today. But it is far behind the developed world in matters of transparency, corporate accountability, and rule of law.

You have to factor that in.

And I can’t emphasize enough the degree to which we are in uncharted waters here…

And bizarrely, if this case becomes a precedent, it would suggest a favouring of equity over debt.

Right now offshore bond holders in this case are facing a “heads you win, tails I lose” scenario.

In early May of last year we made a very non consensus call on the prospects for China real estate stocks. You have done well in the two stocks we highlighted. Both are offshoots of government enterprises.

You are up around 18% in China Overseas Land (688 HK) and around 29% in China Resources Land (1109 HK).

They are relatively close to their stop loss levels given the pull-back in the market. But even if we hit our stops, we’ll be taking double digit gains off the table.

Good investing,

Peter


Peter Churchouse Peter Churchouse is a widely respected analyst and commentator on financial markets with well over 3 decades residing in Asia. He spent over 15 years as Asia Strategist and Head of Research for Morgan Stanley as well as running a hedge fund. He shares his knowledge, insight and investment recommendations through his subscription publication The Churchouse Letter, along with his free newsletter Peter’s Perspective.
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