China… in distress?

Growth is still the dominant investment story in China, despite last year’s ‘slowdown’. But there are some companies that end up getting left behind.

According to Benjamin Fanger, co-founder and managing director of Shoreline Capital, the Chinese government (both national and local) tends to dictate exactly where bank financing should go, regardless of how creditworthy companies are – which means that banks typically reserve loans for large corporations or state-owned enterprises.
Adamas Asset Management, which recently refocused solely on mezzanine lending to China’s small- and medium-sized enterprises, estimates that 96 percent of the country’s 50 million SMEs cannot get bank financing – and their unmet financial need totals around $1 trillion.

Many of these companies are not bad companies; in the West, they could easily qualify for loans. But the rigidity of China’s banking system often leaves them with no means of financing, Fanger explains. This has opened up an interesting opportunity for private equity firms: special situations investments.

“Now that China is facing a slowing growth rate, these types of opportunities have multiplied,” says Fanger.
Although most private equity firms have operated through minority stakes in China, special situations investors may want more control in order to make changes to the company when needed. 

That’s certainly true for Adamas, according to managing director and chief executive Paul Heffner. Though the firm only provides a 24-month loan to businesses that are not quite big enough for proper private equity investment, it always negotiates “control through debt”; so if the company defaults, Adamas will own the company outright.
“This structure allows us to be much more involved with the companies,” Heffner adds. Adamas always appoints its own chief financial officer for the company and sits on the board with veto rights.

Shoreline Capital has adopted a slightly different approach: all its SME investments are equity stakes, and while there is always some downside protection, the firm pays particular attention to the “upside potential” of its portfolio, says partner and general counsel Dannon Shen.

A typical Shoreline deal involves a company that is encountering some liquidity issues because a bank has declined to lend it more money. 

For adequate downside protection, Shoreline says it conducts more “labour-intensive” due diligence than most: Shen always verifies the company’s numbers with the local banks and even inspects the company’s buildings himself. The firm then goes through the Ministry of Commerce to arrange a capital injection not unlike a foreign direct investment.

Although Shoreline always takes a majority stake, it prefers to leave day-to-day operations in the hands of the company itself, and restructures only if the company badly needs it. “The basics are all in line [for these companies] – it’s often just problems of liquidity that constrains them,” Shen says.

The way both Adamas and Shoreline operate also helps them on exit. Since the former’s typical deal structure is closer to loans, the portfolio company can structure a buyback or even convert it to bonds. And if either of the firms manage to amass a controlling majority stake, it’s easier to push through a trade sale, as opposed to relying on China’s sluggish IPO market to cash out. At a time when realising investments is one of the biggest headaches for Chinese GPs, that’s a significant attraction.