China’s $615bn distressed market lures foreign investors

China’s distressed debt market is opening up, providing opportunities for distressed asset managers seeking higher returns than the US debt markets are currently offering.

Private equity investors in distressed assets are looking to the Chinese market for non-performing loans (NPLs) to generate high returns as the Chinese government continues to open up its $615 billion NPL market.

Rebecca Hume, a lawyer with cross-border disputes firm Kobre & Kim, said: “One of the main drivers why offshore PE firms come into China’s market is that it’s getting harder in the US to achieve returns they would like to make. They see this as an opportunity to get into a market with more support from the Chinese government and more buy-in from Chinese banks. It’s extremely attractive for those who have the right appetite for distressed assets.”

The amount of non-performing loans (NPLs) in China has grown more than threefold from CNY 1.27 trillion ($195 billion; €174 billion) in December 2015 to almost $615 billion to date, according to data from Reuters cited by Kobre & Kim.

Rising NPLs in Chinese banks, according to a PwC report, are the direct result of an “unprecedented five-year debt binge and a slowing economy.” China is facing overcapacity in capital intensive sectors such as steel, cement, shipbuilding, and heavy machinery, which has triggered loan defaults by companies that borrowed heavily during the boom times and have now failed to repay their debt.

Another important factor that has made China’s distressed assets more attractive to offshore PE firms is the ability to invest directly, Hume said. “PE firms usually come in and partner with the big four asset management companies (AMCs) or companies set up to dispose bad loans, and invest directly – a situation where they eventually end up being in a primary situation as a lender. Rather than waiting for the Chinese lenders and creditors to be paid in full, the firms are actually up front and centre to try and recover their money back as a primary lender, as opposed to waiting to staying behind the scenes.”

Chinese regulators are also putting pressure on banks to clean up their balance sheets, particularly in relation to small to medium sized companies, in order to bring back investors’ confidence.

To address China’s debt problem, the People's Bank of China governor Zhou Xiaochuan said earlier this year that the government would allow six banks to securitise about $7.7 billion in NPLs and sell them to investors. In addition, the Chinese authorities are also “studying” a debt-to-equity swap mechanism, which would allow banks to exchange bad debt for stocks in the companies concerned. This move could help banks write off CNY 1 trillion in NPLs in three years, business magazine Caixin reported.

Earlier this year, global private equity firm KKR and state-owned firm China Orient Asset Management formed a partnership to co-invest in credit and distressed asset opportunities mainly in China’s real estate sector.

Hong Kong-based private equity PAG has also reportedly launched a distressed fund in China last month, targeting between $400-500 million, to acquire NPLs in China, according to PEI’s sister title Private Debt Investor.

While private equity investors are now investigating the China NPL market and may be excited by its prospects, Hume cautions that it is a shifting landscape, and “investors who are going into the market need to be prepared to have some skin in the game”.