Making sense of distressed debt in Asia – IFR

IFR magazine, July 2009

Is distressed debt in Asia an opportunity now, an opportunity to come or an opportunity missed? It’s all of them. It just depends on what part of the market you’re looking at. While restructuring specialists are only now beginning to see work coming through, those looking for the bottom of the market for distressed credit have probably already missed it.

Asia’s market and corporate behaviour has been consistently different from that in the US and Europe. Banks haven’t collapsed, nor has residential property on any widespread scale, and those countries with significant domestic demand are still boasting GDP growth of better than 5%. But it’s not immune: Standard & Poor’s managing director Diane Vazza noted in June that the number of corporate defaults in Asia Pacific in 2009 to date, at nine, already matched the all time record from the Asian financial crisis in 1998. This, Vazza says, “indicates a buildup of credit quality weakness unlike any the region has experienced since the end of its last full-blown financial crisis.” Negative bias – a forward-looking indicator S&P uses to assess the potential for downgrade – has risen to 32%, its highest level since 1999. “Even though Asian companies came into this period with generally lower leverage than their western counterparts, severe disruptions to exports continue to pose stark profitability challenges,” Vazza says. “Covenant headroom has also become narrower among corporates from weakening valuation of assets and intangibles.”

Distressed debt institutions find opportunity in a number of ways in an environment like this. Some look to find essentially good debt trading at dramatically oversold levels, and to profit from the rebound when it comes. Some purchase portfolios of non-performing loans from Asian banks and tidy them up or sell them on. Some assist with restructuring companies to keep them alive. But each of these approaches has a very different cycle.

The first camp, for solid high yield or convertible debt in Asia, is the one where the best chances may already have gone. “When is the right time to get into that market? The answer is two months ago,” says Robert Morse, CEO of Primus Financial, which runs a number of strategies including a fixed income fund which looks closely at distressed debt. “It’s questionable how much value remains at current levels. There’s been a significant rally and a lot of liquidity has flowed into the market; May was close to a record month for non-investment grade new issuance. The internal rates of return and yields to maturity have come down significantly already.”

Primus was unavoidably among those who missed it since it didn’t formally launch until April 29. Many others remained unsure on the sidelines waiting for worse; those in the market say that people who caught the best of it were private banking accounts, demonstrated by early sharp movements in the market being in small volumes. “You could draw the conclusion,” says one observer dryly, “that it was people who knew those situations very well.” Many big players were still deleveraging and suffering with illiquid books, so were unable to get back in; additionally the proprietary books of the multinational investment banks are out of action while those banks have more pressing needs for their capital.

Still, it’s by no means certain that we won’t see a change of direction at least some of the way back to the levels seen earlier this year. “One question has to be whether the markets, both equity and fixed income, have got ahead of themselves,” says Morse. His view? “I do think they have moved very far very fast. I’m not sure the underlying fundamentals justify it.”

At Standard Chartered, Paul Jurie, who heads the alternative investment group for the bank globally, agrees. “The consensus amongst bankers is that the rally has been too much too quickly,” he says. “Investors have not sufficiently differentiated between quality companies and those that are likely to experience refinancing difficulties.” On top of that, high yield bonds have rallied on very thin volumes with few sellers of any size, as investors hold out for bond buybacks from companies, or wait in hope of selling their bonds closer to the par value many of them bought them at.

Jurie notes, though, that the loan market is an opportunity still to come. “Lenders are still not really convinced that we have seen the bottom of the market,” he says. “There has been less provisioning than we would have expected by Asian banks. As a consequence, we have not seen banks selling loans at a discount, other than a few LBO assets in Australia. That will change in time.”

He adds: “A number of companies are currently breaching covenants, and some of these will later develop into principal and interest defaults. We expect to see more opportunity over the next 12 to 24 months.”

There are other potential problems ahead (or, from the distressed investor’s perspective, opportunities). In 2006 and 2007 around $1.5 trillion of LBOs were conducted, and much of the debt associated with them was connected to over-leveraged companies whose cashflows have come down and whose ability to service debt is now questionable. Much of it was sold to collateralised loan obligation (CLO) investors who, as Morse puts it, “don’t really exist anymore. A trillion dollars of bonds and leveraged loans are coming due between 2011 and 2014 and it’s not clear whether there will be a refinancing market for many of them.”

Australia will be at the heart of this. In terms of single asset distressed trading, “the most opportunities are in Australia,” says Stephen Le at Deutsche Bank. “Private equity firms have been very active in Australia and have done LBOs across all industries there in the last five years when leverage was cheap.”

Another important corner of the market is non-performing loans (NPLs). An example of an active investor here is Cube Capital, which runs a dedicated Chinese NPL platform as part of the QBridge fund, an open-ended fund launched in 2006 with $149 million under management, investing in Chinese NPLs, distressed real estate and special situation investments. “It’s a huge market,” says Thomas Holland, portfolio manager of the fund. “We estimate there is US$300 to 600 billion notional in the system.” Also, a lot of money has left the area with the financial crisis, putting the supply/demand dynamics in favour of those who are still around.

It’s not an easy market for an international player to compete in: so much depends on the local servicing partners on the ground in China, without whom the business can’t work efficiently. Additionally, bad loans in China are passed on to four state-owned asset management companies but a combination of the size of the market, a lack of incentives and political sensitivity tend to make it inefficient so that prices often don’t reflect supply and demand. On top of that, China is not known for the strength of its legal system.

Foreign players differ in their views on what these barriers mean. Standard Chartered’s alternative investment group has been active in Asian NPLs for eight years and has been a significant buyer of distressed single credits and portfolios in China, India, Thailand and Malaysia among other places, recently buying NPLs from Maybank, Thai Military Bank, SBI and ICICI. But in China, “we deliberately stayed away from the roulette business of buying Chinese NPL portfolios,” Jurie says, instead focusing on providing liquidity to companies with sound businesses but poor capital structures, helping them turn around. “There are only a few foreign investors who are actively buying portfolios,” he says. “The majority of the early entrants have either closed or refocused their businesses.”

Additionally, the Chinese NPL industry is very localised at a provincial level. “In order to effectively collect or restructure, you need to establish servicing platforms staffed with local people in the provinces. In most other Asian countries you can service from the capital city. It’s a very people intensive business.”

Holland agrees with the challenges but thinks that it creates an opportunity for those who have addressed them. “You need a domestic servicing partner and how you structure that relationship is really key to how you make it work,” he says. “You have to make sure the interests are fully aligned.  Identifying the right partner, structuring and testing the relationship, having it mature, in addition to all the financial structuring for repatriation and tax issues – it’s a one to three year process. You can’t just get a Bloomberg and think you can participate in the opportunity.” QBridge’s fund is invested primarily in portfolios in and around Shanghai and Beijing. In Deutsche’s case, it has a joint venture with China Huarong Asset Management Corporation called Rongde Asset Management.

Besides, there clearly will be more bad loans to come: Chinese loan growth is in some cases likely to run as high as 30% this year, and even if NPL ratios remain the same, the absolute number of bad loans is clearly going to increase.

Jurie’s preference for non-China NPL deals does have a hurdle: lack of deals. “We are still actively seeking to invest in stressed or turnaround transactions, but it has been quite difficult to convince lenders to take a discount, or equity holders to dilute their shareholding,” he says. Banks take time to accept drops in prices, and in Asia the banks themselves were generally in better shape than those in the west because of their experience from the Asian financial crisis.

If NPL opportunities do appear among Asian banks, it’s more likely to be in the consumer sectors such as cards and unsecured loans, or in country-specific areas such as residential lending and construction in Korea, or consumer stress in Taiwan.

The other opportunity for bankers is in restructuring. “What is unique in Asia is that almost no restructurings happen in a bankruptcy process,” says Ivo Naumann, managing director of the Shanghai office of Alix Partners, whose specialisms include corporate turnaround. “Everything happens in out of court restructurings. The bankruptcy process in Asia is not that well established.” He sees business coming from two areas: investments within private equity portfolio companies with tight banking covenants that are starting to be breached; and pre-IPO investments through offshore lending structures, which have run into trouble with the IPO markets being shut. Both sides are far quieter than in the US or Europe but, as Naumann says, “in Asia we are at the beginning rather than the end.”

In particular, those companies with heavy exports to the US have been hit hard, and even if America bounces back Naumann thinks US consumers will still start saving at least 7 or 8% of their disposable income, which would take away a trillion dollars of consumer spending at a stroke.

The peak of the default and restructuring cycle is being delayed by the fact that Asian markets are generally flush with liquidity. Chinese loan growth continues at a pace, the local currency bond markets appear to be back, and in many countries the state has got involved. This means that, despite the high technical default rate identified by Standard & Poor’s, companies are not generally ending up in bankruptcy or even being forced into firesales. “Deals that otherwise should be defaulting are getting refinanced,” says Holland. “For example, many small to medium Chinese property developer deals should have been restructured but have been able to get refinanced from the domestic market.”

Still, it’s all on its way: bad loans, troubled assets, flagging companies. Morse says there is about $100 billion of distressed demand, in terms of investors, which is likely to be a lot less than the situations that need capital. “So,” he says, “there’s still an excess of supply over demand and that should make things very interesting.”