Foreign investor participation in China’s distressed debt market has always been hindered by inefficient pricing due to an absence of losses from selling – an exception that remained true until this year.
Mainland Chinese asset managers historically sat on non-performing loans (NPL) bought from banks that did not attract to end-investors, often due to unsatisfactory returns from overpaying, rather than sell at a loss, according to a recent PwC report. This ineffective pricing behavior has long acted as a hurdle for foreign investors wishing to enter the $1.5 trillion market.
The exceptional case of a loss-making NPL sale aside, the report underlined a trend of increased selling which could make the market ripe for new investors. This is due to potential forced selling of existing NPLs, assuming continued state expectation to absorb new NPLs and the absence of new capital. Asset management companies have also, on average, paid lower prices for new NPLs which means that «reaching agreement on pricing should become easier, particularly for investors who have already built credibility through closing deals».
13-15 Percent Returns
Investors in Chinese bad debt are seeking annualized returns of 13-15 percent before leverage, according to PwC, and an estimated $1.1 billion from international buyers was poured into the market in 2019. Most of the transactions during the cycle were made in China’s wealthiest provinces including Jiangsu, Zhejiang and Guangdong.
PwC also highlighted a notable concern about returns due to a disappointing experience between 2015 and 2017 when returns were hit due to foreign investors’ underestimation of the time required to recover loans and a shrinking secondary market from tightening liquidity in mid-2018.
Trade Deal Surprise
The inclusion of foreign access to mainland China’s NPL market in the latest phase one trade deal was called a surprise due to the niche nature of the asset class – a move the PwC report suspects was made after «serious lobbying from one or more distressed investor groups».
«This was a surprise as China NPL investing is a niche business that we, at least, would have thought had the heft to be even considered an issue,» the report exclaimed.
Nonetheless, PwC urges against overoptimism as no timeline has been provided for NPL access nor have there been any signals about how many participants will be approved for licenses. Even on pricing where selling pressures have improved efficiency, PwC underlined potentially competitive NPL bidding against local rivals with more access to information and experience to cope with shorter due diligence timetables. Despite cutting out the wholesaler to become one, foreign investors could still end up overpaying for bad debt.
