SVA Assessment – China’s Property Debt Crisis – What Practical Steps Can Foreign Investors Take to Mitigate Risk and What Can Be Done to Recover Assets Offshore
The liquidity challenges facing real estate developer Evergrande Group (恒大集团) and many other comparable businesses have underlined how far political and commercial risks in China have risen.
Those foreign firms that have invested in offshore bonds, shares and other instruments must now prepare for significant fallout, and may struggle to reclaim funds.
SVA has been advising clients around the world as to practical measures to recover what is practicable under such circumstances. Litigation alone is unlikely to be useful, meaning investors must look to more creative solutions.
Evergrande Group has already defaulted on offshore bonds, and must meet significant interest payments in the coming year – which seems increasingly unlikely to be achieved.
Worse, Evergrande is far from alone. Other property companies have effectively been “locked out” of the debt market, leaving businesses struggling with crushing liquidity shortfalls. Fantasia, Tahoe Group, China Fortune and Sinic have all missed payment deadlines.
Even more worrying, property’s strategic importance, comprising perhaps 28% of China’s GDP, means that this liquidity crunch will have implications that go far beyond the real estate market. Financial institutions may rein in credit, and suppliers to the property and construction industries will suffer. GDP will certainly slow.
One, not so obvious, outcome may be an increase in levels of fraud in other areas, as senior executives come under pressure to prop up ailing businesses, particularly if collateral drops in value. Key concerns to watch for will include companies inflating receivables, overstating asset values, or using deception to secure access to funds from offshore or as collateral.
In this context, foreign investors may find themselves seeking to reclaim funds – but recouping money in China will not be straightforward. For one thing, investments in Chinese companies often rely on shaky structures that provide foreigners with few legal protections.
Take Evergrande’s bonds. One such bond, issued in November 2018 by Scenery Journey, a British Virgin Islands company controlled by Evergrande, had payment confirmed through a “keepwell” deed.
These “keepwell” deeds amount merely to undertakings that the onshore company will ensure the offshore vehicle has sufficient liquidity to settle liabilities – but explicitly do not amount to a guarantee.
Other “bonds” rely on guarantees, offering better protection, but these can also prove hard to collect on, particularly if politically-connected domestic creditors are competing for the same funds.
US and other foreign firms appear to have been blindsided to the risk involved in such investments, or badly advised, and are heavily exposed. The upshot is that foreign bond investors may find that the paper they hold is of little current value.
Similar concerns relate to equity investments, particularly in sectors (such as technology) that rely on the variable interest entity (“VIE”) structure. This mechanism circumvents restrictions on foreign investments, by establishing a contract for payment between a subsidiary in China of an offshore company and another entity that earns the revenues.
VIE structured deals, though, offer few protections for foreign investors in the event of financial shortfall. After all, the structure operates in a “gray area”, meaning that enforceability depends on the goodwill of the Chinese authorities – goodwill that may well be in short supply.
Capital controls in China
A further risk stems from capital controls; payments to offshore investors still require formal permission from the relevant authorities, most notably from the State Administration for Foreign Exchange (“SAFE”), as well as from other regulatory bodies.
Permission may not be readily forthcoming, though, given current tensions, and the tilt towards autarchy and “common prosperity” at home. Accordingly, such investors may find that approvals take considerable time, or even are denied, leaving them exposed. After all, such restrictions support a shift towards “dual circulation” – a policy goal of the Chinese government, of clearly defined internal and external spheres.
The impact of tighter capital controls on business will be real, as is made clear by the challenges facing Macau’s casinos, for whom restrictions on movements of funds have crimped growth of late. Other sectors may find themselves also struggling to secure access to funds.
A final concern is growing skepticism towards foreign business in regulatory and judicial circles, which China’s relative isolation owing to its internal political dynamics and “zero-COVID” stance will only amplify. The authorities will seek to prioritise domestic demands over those of foreign business, perhaps leaving many western institutions empty handed.
What should foreign businesses do?
The outlook is challenging. Sudden liquidity shortfalls will not only damage the value of investments, but also create a much more testing environment for recovery of funds. In this context, litigation may prove less effective a means to collect funds than in the past.
Companies can take steps to protect their interests, however. SVA has been advising businesses to think more creatively about how best to recover some funds, through measures such as:
- By avoiding the problem; companies, especially foreign investment banks and others, must adhere to robust due diligence standards, even when under pressure to contain costs. These processes should scrutinise the structure of investments and take account of the regulatory pressures that may make recouping funds harder.
- Boards should mandate independent and rigorous investigations of IPOs, investments or partnerships, and ensure that oversight measures are in the hands of the general counsel, or of another relatively “neutral” party, rather than a local deal team, particularly as attitudes towards foreign business are hardening.
- Senior management must amend appraisals, to take account of the rising political and regulatory risks. These appraisals should include close monitoring of the regulatory and legal authorities’ statements and actions, so as to capture any shift in political attitude at the earliest opportunity. Monitoring for new measures in the property sector, and ensuring compliance, are of particular importance at present.
- Management must urgently conduct forward looking analysis, so as to establish what other sectors may come under pressure. At particular risk will be those in which foreign investment is substantial, and those considered sensitive, such as energy, resources, telecommunications, technology and finance. Companies must also take account of how a further deterioration in relations between the US (and its allies) and China might affect efforts to reclaim funds.
- Investors should re-examine the structure of holdings in debt and shares, given that many instruments often rely on shaky, “work-around” structures, which offer little actual legal protection. They should amend these structures, if possible. Such appraisals should also take into account the use of opaque company structures, or proxies, to disguise ownership of assets.
- SVA has experience in such stressed circumstances and recommend that in the event of a default, companies must not purely rely on litigation, but should also examine much more robust means to recover funds. Key measures might include but are not limited to:
- Asset searches outside China, in jurisdictions linked to key principals in any business with a view to freezing actions.
- Investigations of clear proxies, as they may often hold assets on behalf of principals.
- Actions against key directors or other senior personnel off shore.
- Efforts to put legitimate pressure on other commercial interests, as part of a broader “bargaining process”.
The collection of other useful information for use in securing a settlement or supporting a leveraged discussion.
SVA stands ready to assist in these, and other, measures aimed at locating funds and recovering or attaching assets.
SVA (www.stevevickersassociates.com) is a specialist risk mitigation, corporate intelligence and risk consulting company. The firm serves financial institutions, private equity funds, corporations, high net-worth individuals and insurance companies and underwriters around the world. SVA are specialists in asset-tracing and recovery actions.
SVA also has a dedicated crisis management team which, for our retained clients, stands ready to assist companies during crisis situations. Retained clients pay an annual fee for a 24-hour response capability.
SVA is based in Hong Kong and is the only firm with the local and senior expertise drawn from Intelligence, Operations and research functions of the former Royal Hong Kong Police Force.