Shoreline Capital Management Ltd, a longtime investor in distressed Chinese debt, raised over $300 million for a new fund at the end of 2012. DAC Management LLC, a hedge-fund firm and another experienced investor in Chinese bad loans, is seeking to raise $300 million for a new China-focused fund. And Fortress Investment Group, a New York private-equity fund that invests in distressed property globally, is looking at buying a small Guangzhou-based company that manages distressed loans on behalf of investors, said people with knowledge of the deal.
Distressed-debt investors buy bad loans from banks at a fraction of the amount the banks originally lent. The investor can make a return when the borrower repays at least a portion of the loan, or by taking ownership of the borrower’s collateral.
The approach is risky in China, where bankruptcy rules give creditors little scope to wind a company down. Instead, investors holding distressed debt can swap their loans into equity, negotiate with the company to repay at least a portion of the loan or go after a third party for repayment. In some cases, they can use the courts to apply pressure by freezing a company’s assets or the assets of its executives.
Some bad loans already are becoming available through China’s trust companies, a part of the country’s informal lending system that has made hundreds of billions of dollars worth of loans to property developers, mining companies and local governments in recent years.
Children play with military equipment at Minsk World Theme Park, created from an old Soviet aircraft carrier.
GETTY IMAGES
Craig Blomquist, chief executive of Fan Ya Tai Asset Management Co., the firm in talks with Fortress, estimates that local buyers had bought about 150 billion yuan ($24 billion) worth of loans from the trusts by the end of September. Trust executives and industry consultants say trusts—a type of asset-management company that raises money from wealthy individuals and firms to make corporate loans—also have been approaching foreign investors to take over loans to distressed property developers.
Morgan Stanley and Goldman Sachs, which were major players during the last selloff of Chinese bad debt ending in 2008, are taking the temperature of the market but haven’t gotten involved, said people familiar with the companies’ thinking.
Distressed-debt funds piled into China more than a decade ago as Beijing moved to clean up the balance sheets of its major banks, which had amassed hundreds of billions of dollars worth of nonperforming loans. But years of negotiations to dispose of assets ranging from office buildings to an old Soviet aircraft carrier repurposed as the Minsk World Theme Park left only moderate returns for most of the funds. By 2008, the cleanup was over and most of those funds had departed after taking far longer than anticipated to dispose of the loans, resulting in a significantly lower annual return.
This time around, it isn’t clear how many of the loans on the balance sheets of banks, trust companies and other institutions have gone bad. But investors believe they piled up in the wake of the 2008 global financial crisis.
Starting in late 2008, Beijing instructed the country’s banks to massively increase lending to developers, local governments and large industrial firms, and analysts expect significant portions of those loans could go bad. Moreover, credit has continued to expand through the informal—or shadow—banking system, a development that could end up creating more bad debt.
“We believe that nonperforming loans within the banking and larger financial system are rising in absolute levels already,” said David Madden, a member of the investment committee of DAC, which has offices in Chicago and Hong Kong and has invested $425 million over the last decade, primarily in China. “The key factors will be when and how the government decides to instruct the banking system to dispose of them.”
According to China’s banking regulator, nonperforming loans account for less than 1% of total loans in the banking system. But banks are required to go easy on local government development projects that are behind on their loan payments and not classify the loans as nonperforming.
Credit-ratings firm Standard & Poor’s says that nonperforming loans accounted for 3% of total loans at the country’s top 50 banks at the end of June.
Shoreline co-founder Benjamin Fanger said his firm already has invested $100 million of the fund it is raising, part of which went toward buying a portfolio of 400 corporate loans from China’s southeastern Jiangxi province. The loans were to state-owned companies involved in manufacturing, furniture, cement and printing as well as some property developers and technology firms. He said Shoreline bought the loans for less than 10% of their original face value from an asset-management corporation.
Still, the experience of last time might give some investors pause. Local government politics, an opaque legal system and often patchy paperwork frustrated many investors. Given the market has been dormant for more than four years, many of the people with experience of negotiating China’s bad-debt bureaucracy have moved on. “A lot of the institutional knowledge is gone,” said Mr. Blomquist. “People will make the same mistakes as last time.”
Write to Dinny McMahon at Dinny.mcmahon@wsj.com and Lingling Wei at Lingling.wei@wsj.com
