China's Looming Bad Loans Are Good News For Distressed Debt Investors

Hey, investors: Would you like acquiring private equity level returns for senior secured loan risks?

That sounds pretty sweet, doesn't it? That's what Guangzhou-based Chinese distressed debt investment firm Shoreline Capital strives to offer.

In the words of its co-founder Benjamin Fanger, his firm has achieved private equity returns for taking secured lender risks investing in China's bad loans during the past ten years.

In essence, unlike distressed debt investors in developed markets who most likely would go through a complicated and time-consuming reorganization process, Fanger's firm does more plain vanilla stuff of buying non-performing loans from Chinese banks, then trying to receive recovery or settlements that are much higher than the prices paid.

Of course, if something sounds too good to be true, it probably is.

The important caveat of Fanger's proposition lies with "taking senior secured loan risks," which when transferred to China's legal environment could be completely lost in translation.

Putting aside China's rarely-tested bankruptcy law — which does not have much relevance to Shoreline's business of investing in non-performing loans — enforcing creditor rights in Chinese courts can be daunting to any outside investors.

"Let's say if you could do ten things in courts in London or New York to enforce your rights as a creditor, you could probably do four or five in China today," Fanger told me during an interview in Hong Kong.

As such, Fanger says he would price those things that he cannot do with predictability in Chinese courts to zero, and then try to create value on the few things that can be done in Chinese courts.

These include doing searches for titles of a borrower's assets, putting liens on those assets, taking the borrower to court, and auctioning off certain assets. Increasingly, investors can also pursue fraudulent conveyance in China's courts, meaning being able to sue a borrower if it transfers its assets to another entity.

Now, with China's economy decelerating and more non-performing loans emerging, Fanger is seeing this as the next great opportunity for his firm.

"In the early 2000s, it was estimated that there were half a trillion U.S. dollars of non-performing loans. Today, non-performing loan estimates in China are around two to six times that number," he says.

That may explain why investors have been hot on the idea of distressed debt investing in China. Shoreline is currently raising a third fund with a target US$500 million, a much larger fund than its previous two funds at US$303 million and US$178.2 million.

Having held a first closing of US$150 million last month, the firm is expecting a swift final closing this fall, a rare feat in today's sluggish private equity fundraising environment.

But for Fanger, this is not the time to gorge on Chinese bad loans. He senses China's bad loans problem is only starting. Asset quality will continue to decline, and liquidity will increasingly become a problem.