The ‘smart money’ says yes

Today he is Britain’s biggest foreign investor, but most people won’t recall Li Ka-shing’s first major acquisition in the UK. It occurred in 1986 when Li spent $80 million for a 5% stake in Pearson – the company that publishes the Financial Times. Thus began a wave of overseas investments by the canny Hong Kong tycoon. But while Li has come to be regarded as a masterly asset trader, not all of his dealmaking paid off, like the 1990 attempt to buy a $3 billion junk bond portfolio from the Columbia Savings and Loan Association, a California lender liquidated by the Resolution Trust Corporation (RTC).

What was the attraction to Li? The portfolio would have given him access to the credit profiles of 300 large American firms. “The big factor in the deal is that it would give us a periscope into corporate America,” Simon Murray, then managing director for Li’s conglomerate Hutchison, explained to the New York Times at the time.

Ultimately Li’s interest in the souring US credits was to go unfulfilled, as the American authorities didn’t approve the sale.

Today another ‘periscope’ opportunity is open to investors – although this time it brings a glimpse into corporate China. And while Li is nowhere to be seen on this occasion, a lot of other ‘smart money’ has been plunging in. That’s turned Cinda’s $2.5 billion initial public offering into Hong Kong’s largest listing of the year. It’s also generated many questions about what exactly investors see in it. Evidently, they have discerned a great deal of value – how else to explain why some of the world’s best hedge funds have bought $1.1 billion of the stock?

And they were immediately vindicated. When Cinda began trading yesterday it opened almost 25% above its listing price.

Why buy into a bad bank?

It’s not immediately clear why Cinda should be so attractive to investors. It is one of four ‘bad banks’ (along with Huarong, Great Wall and Orient) set up in 1999 to bail out an ailing financial sector. In the wake of the 1998 Asian financial crisis, these four asset management firms (AMCs) were set up as a means of absorbing the country’s most toxic credits. Each was paired with one of the ‘big four’ state banks. Cinda got the dirtiest job of all: absorbing the bad loans regurgitated by China Construction Bank (CCB) and China Development Bank, the most prolific purveyors of policy-driven loans to unprofitable state firms.

Cinda was officially incorporated in April 1999 with the Ministry of Finance (MoF) injecting Rmb10 billion ($1.6 billion) in registered capital. It then received about Rmb250 billion of CCB’s zombie loans – all of them at face value. Some financial sleight of hand followed: Cinda only needed to pay Rmb3 billion in cash for the dud porfolio while issuing Rmb247 billion in 10-year bonds (with a friendly 2.25% interest rate) back to CCB.

Similar arrangements applied for the mopping up work at the three other AMCs too.

The exercise helped to shore up CCB’s books, allowing the bank to list in 2005 largely free of bad debt. But Cinda still had the thankless task of collecting the original monies owed by some of China’s most hopeless state firms. It was grimly difficult work and investors in CCB’s share offering were concerned about the bank’s Rmb247 billion exposure to the very Cinda bonds that had cleaned up CCB’s balance sheet in the first place.

So in a further financial waltz, the MoF issued a notice guaranteeing Cinda’s debts. (In 2009, the MoF issued another notice extending the bonds’ maturity by 10 years.) All this looked to the Hong Kong Economic Journal like a bit of a charade. “Bad assets were just being moved around the balance sheet of corporate China without being properly resolved,” it commented. A South China Morning Post columnist made a similar point, describing Cinda as China’s “insolvent toxic-waste dump”.

So who’d be interested in buying into Cinda then?

Prior to the deal, Forbes magazine ran an article headlined “Is this China’s worst IPO ever?” warning that investors “will not know what they are buying when Cinda goes public”. But an impressive group of investors including Oaktree Capital, Farallon Capital Management and Och-Ziff Capital doesn’t seem to have needed much persuading. They were among the 10 cornerstone investors which bought 45% of the shares offered in the IPO. The presence of such big-name specialists generated confidence among other fund managers and with retail investors too. Bloomberg reports that institutional orders for Cinda’s offering topped $45 billion while the retail tranche – just 5% of the 5.3 billion-share total – was 160 times oversubscribed, making it Hong Kong’s most popular IPO since American insurer AIA listed in 2010.

A revival of investor sentiment in Hong Kong’s primary market helped too. Up to 30 new listings were approved last month, including less marketable stories from Everbright Bank (now in its third listing attempt) and funeral home operator Fu Shou Yuan (hoping it’ll be second time lucky).

Is Cinda the best “bad bank”?

Many investors like Cinda as they expect it to have the strongest state backing if things turn sour. The moneyman in this respect is the MoF, which remains – even after the IPO – Cinda’s biggest shareholder with a 70% stake. But Cinda has been emphasising that it is more than financially capable of standing on its own two feet. Absorbing vast amounts of awful assets at toppish prices was a “historical mission” in the “policy phase” of its early development, it claims. But China’s distressed asset business has moved into the “commercial phase” since 2010, Cinda now suggests, which allows it to “operate as a profit-seeking entity”.

That sounds grand, but what does it actually mean? Since 2004 each of the four AMCs have been allowed to compete for NPL packages from state banks by bidding at market prices (Cinda is the ‘market’ leader with a 35.5% share). Cinda has also been permitted to diversify into other businesses. In fact, it has turned into a mini financial conglomerate, offering a brokerage, an insurance arm and leasing operations.

But what about the core: all those rotten loans? Cinda said its recovery of bad assets has picked up in recent years. Between 1999 and 2012, it acquired Rmb1.1 trillion in distressed banking assets (it doesn’t disclose how much it paid for them – all we know is that it paid full whack for the first Rmb250 billion of bad debt from CCB ). From these loans Cinda has recovered Rmb276 billion in cash, a figure that translates roughly into a 25% cash recovery rate. Performance of the four AMCs as a whole stands at 23%.

What else is in the trash bag?

Cinda has actually got back more than 25 cents on the dollar on its debt portfolio – although valuing precisely how much more is difficult. That’s because much of the potential gain has been taken in the form of equity stakes that Cinda has swapped for earlier debt.

The equity portfolio consists of shares in 400 or so state firms, with 62% of those holdings in the coalmining sector. It also includes a 7.3% stake in Qinghai Salt Lake, China’s largest listed potash producer, and a 5.9% stake in Chalco, the biggest aluminum firm.

The unlisted holdings include substantial stakes in state coalminers, such as a 42% share of a key unit of Shenhua, the country’s leadingcoal producer.

These equity stakes carry a book value of Rmb27.6 billion. But American Appraisal China, an independent valuer hired by Cinda as part of its IPO preparations, estimates that all these shares are worth Rmb62.3 billion. According to the Financial Times, the hope that these shareholdings are worth this figure or more is a key reason why investors are keen on buying into Cinda’s offering.

So in a sense, when investors buy into Cinda they are buying into a China-focused private equity fund. The 21CN Business Herald expects that Cinda will “unlock the true value of its equity holdings” in the next few years, especially as it becomes a key player in the consolidation drive in the coalmining sector (a policy priority flagged by the government in its latest Five-Year Plan).

How else will Cinda make money?

Contrary to popular belief, Cinda is more than just a repository for loans that bankers wished they’d never made. Near the top of Cinda’s income statement is an item listed as “income from distressed debt assets classified as receivables”. This segmental revenue climbed 3.9 times year-on-year to Rmb4.2 billion for the six months ending in June and it contributed 22% of Cinda’s income (it contributed zero in 2010). During the same period the volume of receivables expanded from nothing to Rmb80 billion.

These receivables are mainly acquired from non-financial firms. Cinda borrows from state banks, capitalising on its MoF backing to access short term funding at rates ranging from 4.75% to 6.15%. Then it buys up short-term loans between companies for a small discount. Often, as the new creditor, Cinda helps debtor firms – facing a liquidity crunch – to buy time. But that breathing space doesn’t come cheap. Reuters reports that Cinda’s loans carry an interest rate of 14%.

What Cinda is doing here is basically subprime lending – and it views it as a growth engine. After subtracting expenses including provisions for bad debt, Cinda could easily come away with a 6% spread.

Up to 60% of these receivables came from the real estate sector – which in the past two years has been starved of loans by the formal banking system.

The Cinderella of shadow banking?

Whisper it quietly, but Cinda’s stock offering represents the first opportunity for overseas investors to buy into China’s shadow banking system. Funded by the major banks, Cinda has become something of a shadow lender itself. Ergo, bank loans to Cinda have grown from Rmb7.8 billion in 2010 to Rmb104 billion as of June. More than half of these loans will mature in two years but the enthusiasm which the IPO has generated among fund managers suggests that they think Cinda’s prospects as a subprime banker are good.m

There is also another benefit we haven’t mentioned yet. In order to make Cinda more appealing, the MoF couldn’t resist another wave of its financial wand.

When it turned Cinda into a joint stock company in 2010 it also transferred Rmb247 billion of Cinda’s liabilities (the original bonds issued to buy CCB’s bad loans) to an off-balance sheet fund. Cinda’s corporate tax bill (till 2019) is supposed to be used to repay the principal on these loans, while the MoF will cover the interest. In case Cinda defaults, the MoF promises to settle outstanding amounts or further extend their term.

The result? Cinda’s investors have been left with a lot of potential upside (its equity holdings in 400 firms) but much of it purchased with debt that’s no longer there.

That too might explain why the 10 cornerstone investors were ready to commit so much capital to the Cinda story.

But for them there is an additional motivation. The distressed debt business is still in its infancy in China but there is widespread expectation that a wave of bad debt restructuring is on the way. So these cornerstones see partnering with Cinda as their best means of participating in the coming clean up. Oaktree, one of the world’s biggest distressed debt investors (with $80 billion in assets under management), has already agreed on a joint venture with Cinda to co-invest $1 billion in distressed assets in China.

“We have known a number of foreign players who really wanted to get into China’s NPL market, but faced a lot of difficulty in getting the good deals. Most of those went to the four AMCs, of which Cinda is the biggest,” an industry executive confided to Asian Investor.

Now Cinda needs to prove itself?

Reworking bad debt into profitable assets could be lucrative work, but success will depend on the Cinda management and its ability to implement its relatively diverse business model.

Eight of the 11 senior managers that feature in Cinda’s listing prospectus are former CCB staff. But the bigger unknown for purchasers of Cinda’s shares is the calibre of its middle management team. “A punt on Cinda’s management remains a shot in the dark,” the Financial Times warns.

A further concern – aired in the Chinese media – is over Cinda’s rapid push into shadow banking. The worry? Will it soon be generating non-performing loans of its own rather than buying them from others. “Cinda may look good as a bad bank. But the problem is that it is rapidly become a bank itself,” Chinese magazine Moneyweek concluded.

But if the market verdict is anything to go by, Cinda looks like a sure thing. At its close yesterday, the stock settled 26% above its listing price meaning that the company now enjoys a market capitalisation of $20.5 billion.

---

© ChinTell Ltd. All rights reserved.

Sponsored by HSBC.

The Week in China website and the weekly magazine publications are owned and maintained by ChinTell Limited, Hong Kong. Neither HSBC nor any member of the HSBC group of companies ("HSBC") endorses the contents and/or is involved in selecting, creating or editing the contents of the Week in China website or the Week in China magazine. The views expressed in these publications are solely the views of ChinTell Limited and do not necessarily reflect the views or investment ideas of HSBC. No responsibility will therefore be assumed by HSBC for the contents of these publications or for the errors or omissions therein.