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Distress funds eye more direct loans to Chinese companies

Investors spot opening as yields rise and businesses try to recover from virus

A pedestrian in the Lujiazui financial district in Shanghai in March. Firms usually known as distressed debt investors are now stepping up lending in China.   © Reuters

HONG KONG -- When Heneng Group, a Chinese property developer, needed a $46 million loan to develop some residential land recently it did not turn to a bank -- but to a fund manager.

InfraRedNF Investment Advisers, which lent money to Heneng, is one of a number of money managers and distressed debt investors that see opportunities from the coronavirus pandemic, beyond the chance to snap up some of China's $1.5 trillion in bad debt.

The firms expanded their presence in China over the past few years as the nation warmed up to foreign capital to address a mounting bad debt pile. They are now looking to fund companies that are currently hungry for cash but likely to emerge stronger in the post-virus environment.

"Heneng is a client we know well, and understand their business," said Grant Chien, head of special situations financing at Infrared NF in Hong Kong. "In the first quarter, property sales have declined but that has not deterred developers from buying land again in March and April. Every week, we receive multiple new opportunities."

Heneng could not be reached for comment.

Fund houses, distressed debt investors, hedge funds and pension funds have a combined $25 billion to lend directly to companies in the second-largest economy, interviews with five money managers and two deal arrangers suggest.

Burgeoning demand has boosted yields on such loans to as much as 18% from about 12% at the end of last year, investors said.

One advantage of striking lending deals over buying up portfolios of bad debt is that it is usually far quicker to arrange -- perhaps taking one-third of the time that would be needed for a portfolio deal.

And investors -- such as distressed debt investors, including Bain Capital Credit and Shorevest Partners -- typically lend only one-third of the underlying collateral's value, thereby limiting their risk. On the upside, they have a chance to work with the company to turn around the operations and "boost their returns," said Benjamin Fanger, founder of ShoreVest Partners.

Fanger has bought Chinese distressed debt for 15 years. "We have looked at far more direct lending deals in the last few months than we have looked at in all of last year," he said.

For some Chinese companies, these types of deals are among the few open avenues for funds. Offshore bond markets have grown cool toward Chinese paper. Authorities maintain tight controls over shadow banking. And other lenders, already restricted from funding land purchases, are inundated with applications from stretched companies.

Scores of smaller businesses across leasing, tourism, aviation services, retail and hospitality have lost more than two months of revenue from the lockdown and need cash to restart operations.

"There are those businesses that are in the eye of the storm, so to speak," said Barnaby Lyons, head of Asia at Bain Capital Credit. "Where there are very substantial revenue declines over the last few months, and they are now having to deal with the liquidity and cash flow problems that come out of that. So we're looking at solutions to provide capital to some of the better businesses that we believe will survive and will have a very healthy story on the other end of the pandemic."

Bain Capital Credit manages $40.8 billion in assets and invests in leveraged loans, high-yield bonds, distressed debt and special situations, direct lending, structured products and equities.

"There continues to be a huge demand from corporates and from small businesses for liquidity," James Dilley, a deals advisory partner at PwC in Hong Kong said. "Whilst banks are rolling out forbearance to existing clients, lending to perceived higher risk customers is not at the top of the agenda right now. Private credit investors currently have an opportunity to fill that gap."

Shadow banking, which includes off-balance-sheet lending by banks and credit extended by onshore asset managers, has been the primary lifeline for small businesses but is expected to shrink further this year. Fitch estimates shadow banking assets to decline to 41% of China's gross domestic product from 43% last year as authorities step up scrutiny.

As a result -- and in contrast to the loosening in overall credit conditions -- Fitch expects private-sector companies that rely heavily on shadow-banking activities for funding to face increased liquidity pressure in 2020.

Offshore bond issuance by Chinese companies, another source of funding for larger companies, has "virtually frozen" in the past month after a strong start to the year, said Alicia Garcia Herrero, Asia Pacific Chief Economist at Natixis.

PwC's Dilley, who has helped clients raise loans from funds, said distressed funds should make the best use of the "market dislocation" and put money to play in direct loans.

"If you are a large pan-Asian distressed fund and trying to put a billion U.S. dollars to work, today, it's challenging to do solely via a single credit strategy," he said. "You should be willing to look at non-performing loans portfolios, other distressed credit, high yield bonds, special situations and direct lending."

Unlike a distressed loan portfolio, a direct lending transaction is to a single borrower and so carries greater concentration risk. That can slash returns in the event of default, while a distressed portfolio comprising 50 or more loans has a bigger chance of meeting return expectations.

In both situations, investors still need to comb through the assets to test performance, returns and enforceability in a Chinese court in the event of a default, Shorevest's Fanger said. While it may take a far shorter time to conclude a direct lending deal compared to an NPL, the opportunity window can close fairly quickly if liquidity is flush and shadow banking clampdowns are eased, investors said.

But for now, the opportunity is there and it brings with it better terms for investors.

"With the demand, investors can get higher yields or more collateral," said Ron Thompson, who leads the restructuring practice at turnaround firm Alvarez & Marsal Asia. "If not, they have the choice of working with companies with a better credit profile for the same yield that they would have got with a lower rated firm a few months ago. Ultimately, I think it's a very good opportunity for special-situation investors."

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