As China opens bad debt market, private equity firms step in

[HONG KONG] Foreign distressed debt managers are building a presence in China, undeterred by an opaque legal system but equally encouraged by government steps to open up to specialised players and reduce a mountain of corporate bad debt.

New measures that include a pilot programme to securitise bad loans may only act to dent an estimated 4 trillion yuan (S$842 billion) of distressed debt, but big foreign firms believe the economy's slowing growth is pressuring Beijing to allow alternative ways to reduce debt.

KKR & Co LP and Oaktree Capital Group LP, as well as niche players such as Clearwater Capital Partners and Shoreline Capital Management, have all staked out plans in China's distressed debt market.

"The government seems willing to allow large, well capitalised alternative credit managers into China," said Robert Petty, who co-founded Clearwater Capital in 2001. The China businesses that Clearwater has invested in have conducted US$5.7 billion in onshore senior secured loans. "When people are nervous, there's less capital in the credit markets, which in turn drives improved deal terms for others that are willing to invest."

KKR, the world's No.2 private equity firm, said in January it had formed a partnership with state-owned bad-debt manager China Orient Asset Management, to seek deals particularly in the property sector.

Howard Marks, co-founder and chairman of Oaktree Capital, the world's largest distressed debt investor, said late last year his company was actively looking for opportunities in China, where it has a joint venture with China Cinda Asset Management.

Clearwater Capital last April bought onshore asset management and loan servicing company Fan Ya Tai.

Shoreline Capital is raising money for a new fund in 2016 that aims to surpass a previous US$700 million fund, building a warchest to invest in a new wave of bad debt expected to come to markets this year.

These players expect to pick up distressed assets from sectors burdened by overcapacity, such as steel, coal and cement, as well as real estate. "We do have enough dry powder to participate in the opportunities that we're seeing right now. That said, I do expect to raise the next fund this year," said Benjamin Fanger, co-founder of Shoreline Capital.

China's troubled loans, including non-performing loans and ones that are categorised as at risk of turning sour, totalled 4.16 trillion yuan in 2015, the China Banking Regulatory Commission said on Feb 15. Analysts say the total is more like US$3 trillion.

Global names like KKR are not the only investors running a slide rule over China's bad debts. A range of players are also wading in, including Chinese asset managers, trust companies and even ex-regulators.

One of them, Denis Zhang, said he has launched four hedge fund products since October. He said they are the first distressed debt hedge funds in China and invest in bad loans from smaller firms to avoid competing with bigger players.

"Chinese banks are under increasing pressure to dispose of distressed assets," the former financial engineer at Credit Lyonnais said.

In the past, banks would sell soured loans every quarter, he said. In 2013, it became every month and now it is a "rolling business".

Still, entering China's bad debt market is not for the faint hearted. Financial transparency is often poor and China's legal system can be difficult to navigate.

Shoreline has been involved in more than 1,000 lawsuits to enforce its claims on loans. On one occasion, it found that a building that served as collateral had been torn down.

"When you buy a pool of 1,000 corporate loans across an entire province that are already in default, you're going to have to sue a few businesses to create some leverage to get paid back," Mr Fanger said.

REUTERS