Investors have been pouring more money into China’s bad loan market as the supply of these assets continues to rise, but some experienced debt investors are less bullish.

Senior executives at alternative fund managers KKR and CLSA Capital Partners argue that mainland Chinese non-performing loans are likely to fall short of the returns being sought.

Investors, including US firms Oaktree Capital and Lone Star Funds, poured $1.5 billion into Chinese NPLs in the 18 months to September 2018 after investing $500 million between 2015 and mid-2017, a November report by PwC estimated.

And six in 10 are targeting internal rates of return (IRR) from such assets of 16% to 20% or more according to a survey released earlier this month by law firm Ashurst (see figure 1 below). Almost seven in 10 expect IRRs for China NPL investment to rise over the next two years, and it is the most sought after new NPL market globally (see figure 2).

FIGURE 1: INVESTORS EXPECT HIGHER RETURNS ON CHINA NPLS
(Source: Ashurst; Click for full view)

As a consequence,Texas-based Lone Star is believed to be building up its team in Hong Kong with a focus on China NPLs. Steve Bernstein transferred to the city from Tokyo as managing director of portfolio management and operations last year.

Lone Star declined to comment for this article.

UNATTRACTIVE PRICING

However, Chinese NPLs are not so well priced at present, said Brian Dillard, head of Asia credit at KKR in Hong Kong.

“The challenge is that these assets are trading at implied valuations that are not much lower than where you could monetise the underlying real estate,” he told AsianInvestor.

Most China NPL deals are currently priced to provide 1.2 to 1.3 times multiple on invested capital, according to one Hong Kong-based fund executive.

Other industry sources indicate that the average selling price of China NPL portfolios has climbed from between 30 cents and 40 cents to the dollar in 2016 to between 50 and 70-plus cents to the dollar at the end of 2018. Though they point out that pricing is not the central factor in likely returns; at least as important are the level of investment and length of time required to execute such trades.

FIGURE 2: CHINESE NPLS ARE HIGHLY SOUGHT-AFTER
(Source: Ashurst; Click for full view)

"It's a market our credit and real estate teams watch very closely, so we have a pretty good view on activity levels and what’s happening," Dillard said. "We feel like we will be able to get involved when the supply-demand dynamics improve and the trade becomes attractive."

David Lee, head of the special situations group at Hong Kong-based CLSA Capital Partners, takes a similar view to Dillard.

“Most people, when they think of [debt] opportunities in China they think about NPLs,” he said. “But our view is that the net returns to investors are still not as attractive as is required for the risk.

Other firms are buying portfolios and making the required onshore investment in capabilities in this area because the number of NPLs are quite large, he said. “However, we are not sure if our view on required returns [in the 15-20% range] will be achieved.”

Indeed, foreign buyers are likely to be more demanding in terms of returns than local investors, said the Asia head of investments at one US pension fund.

There is a greater supply of Chinese NPLs now, meaning pricing should be getting more attractive, he told AsianInvestor. “But I understand that China NPLs still have a relatively lower return profile than other special situations or distressed investments given huge appetite from local buyers, which have a lower return requirement, despite the risks involved.”

CONVICTION NEEDED

Dillard detailed the challenges of investing in China NPLs.

Brian Dillard, KKR

The basic construct of an NPL trade is: buy a portfolio of NPLs, mostly secured against real estate; turn the loans into ownership of the asset through the courts, a lot of which is often already in process when you buy the portfolio; and then monetise the underlying assets.

But the time that takes can vary.

“In some cases, there’s decent visibility in terms of how long it will take to complete these processes,” Dillard said, “while in other cases it is more opaque.”

“To get excited about this trade at current price levels, you need a strong view on where Chinese real estate prices are going in the next 12-18 months, as well as whether the liquidity environment will remain where it is or improve for the downstream buyer.”

Those seem like difficult bets to make with conviction across broad swathes of the Chinese real estate market, he believes. “And there’s not a lot of room for error.”

Ultimately, investing in China NPLs is a big opportunity but is “not for the faint of heart”, said Jamie Tadelis, co-head of sales at SC Lowy, Hong Kong-based boutique investment bank. It takes “an abundance of manpower and patience”.

“Potential investors need excellent teams on the ground to value the assets and price them appropriately in terms of recovery probabilities and amounts,” he told AsianInvestor.

“A considerable amount of due diligence for each portfolio is required and you will likely be in heated competition with other potential investors,” he added. “And even if you are chosen as the winner, you then have to work very closely with third-party service providers to enable adequate collections on the NPLs throughout the life of the portfolio.”