China's Non-Performing Loans: Why do some investors turn to this special asset class?

One person's asset is another person's liability - this is a fundamental concept underscoring the credit-based economy we live in today.

As China's property market faces one of its biggest crises in recent years, some investors are finding unexpected opportunities in Non-Performing Loans (NPLs) arising from rising default rates.

As a special asset class, NPLs are not as well-known as traditional asset classes and can often be the subject of misunderstandings. Here are some key facts about NPLs and the NPL market in China.

NPLs offer the opportunity to buy assets at a low price

NPLs involve loans which a borrower has defaulted on, and are also known as non-performing assets or distressed assets tied to defaulted loans.

These terms, however, can be misleading as they appear to incorrectly suggest that the underlying assets are in disrepair or critical condition. In reality, the terms "nonperforming" or "distressed" refer to the loan status due to the default, not the underlying assets pledged as collateral against the loans.

NPLs enable investors to take advantage of distressed loans to obtain exposure to special assets at a low price.

The NPL's investment value is unlocked by first acquiring the NPL from the lender, usually at below-market price. In doing so, the investor takes on the role of creditor and has the right to dispose of the collateral in order to recover the debt by selling it at a profit.

NPLs are private class assets offering an alternative to traditional asset classes

NPLs are an alternative asset falling under the sub-category of private class assets, making them suitable for investors looking for alternatives to traditional asset classes.

The scope of NPL investment opportunities rises in tandem with default rates, which are in turn negatively correlated to the general economy. Markets undergoing challenging economic conditions, such as China's, can therefore yield good NPL investment opportunities.

This also implies that NPLs are negatively correlated to the mainstream asset class of public equities. Investors whose portfolios have a strong focus on traditional asset classes can thus consider turning to NPLs for diversification.

The workings of China NPL markets are similar to those in the US and Europe

NPL investment strategies, being little-known, can appear opaque and risky to the uninitiated. But when investing in an NPL market like China's, investors can actually enjoy multiple layers of safety margins.

Investors in China's NPL market enjoy an intrinsic discount, known prior to acquisition of the NPL, which is derived from the difference between the NPL value and the underlying asset's market value. This is due to strict Loan-To-Value (LTV) ratios, defined by Chinese banking regulations and typically ranging from 30 to 70 per cent.

In a typical China NPL investment, the investor has first claim on proceeds obtained in the sale of the property collateral. The equity, or the difference between the money owed by the debtor and the value of the collateral, acts as a buffer from potential property price corrections. These processes and safeguards are similar to what happens in developed markets like the US and Europe.

"China has a transparent regulatory and legal process for buying and working out NPLs. The government has been forthcoming in its implementation of judicial and banking regulations, allowing a proper legal framework for restructuring of these NPLs," says Aurous Capital chief executive Kenneth Yeo.

"Having said that, there are nuances in China's laws that warrant a highly experienced onshore team for investing in NPLs," he adds.

A lack of understanding of China's residential property market

NPL opportunities can be found all over the world in loans involving a wide variety of collateral. Mr Yeo understands investors' concerns about China's residential property market.

Chinese enterprises and property developers are currently under intense pressure from deleveraging reform, resulting from a litany of new regulations designed to reduce debt in the property sector. At the same time, China is grappling with a tapering in economic growth caused by the pandemic, which has caused the supply of NPLs to rise and created an abundance of opportunities for NPL investors.

According to Mr Yeo, the Chinese government is likely to prioritise keeping the residential market afloat in the face of external challenges.

"As China strives to stabilise the real estate market with its common prosperity ethos and an integral premise of every Chinese household having a roof over their head, we do not foresee a sharp correction in the real estate market as 70 per cent of Chinese household wealth is held in real estate," he says.

"We have seen China relax the strict debt ratio policy in January 2022 to encourage property mergers and acquisitions as developers currently contribute more than 30 per cent of the GDP, thus supporting its restructuring will avoid major systemic risks."

Disposing of NPLs quickly can lower risk

Rapidly disposing of acquired assets can protect investors from volatility, while at the same time freeing up cash for more acquisitions.

"The legal system for enforcing credit rights in China has improved by leaps and bounds in the last decade, and PwC has reported that NPL workout times take 12 to 30 months on average while Aurous Capital takes an average of six to nine months from acquisition to disposal of the NPL (assets)," Mr Yeo says.

This compares favourably to the NPL recovery timeframe in other major markets, where the typical workouts can range between three and seven years.

The Singapore-based fund management company's chairman and founder Divya Doshi adds, "Aurous Capital's strategy heavily focuses on improving communities, the environment and stakeholder relations by helping to clear debts and improving bank's balance sheets."