From 2003-2007, over US$100 billion poured into China via offshore structures in tax havens like the Cayman Islands. Much came from global institutional investors who tasked alternative investment managers with allocating a percentage of their portfolios to high-yield opportunity funds, emerging markets and real estate.
Everyone wanted a piece of the “China Dream,” but in recent months they have woken up to deteriorating economic conditions. Institutional investors are forcing redemptions of their investments from high-yield, high-risk markets.
Summarized from Mr. Rodman’s article for China Economic Review, May 2009.
Given China’s resilience to the financial crisis, it seemed a good place to meet redemptions and liquidity needs by selling positions. However, it was much easier to get money into China than to get it out.
Beijing has long been wary of foreign investors, imposing strict controls on FDI and offshore loans. Unable to resist GDP growth, renminbi appreciation and real estate expansion, investors wanted in – keen to avoid regulatory processes and wanting exit strategies. Offshore structuring appeared as a solution, but this was conceived against the bubbling real estate market – where much of the foreign money was headed.
I warned investors that 1 billion square feet of residential and commercial projects were underway in Beijing alone. But local banks and foreign funds provided cash; developers continued to build. The government tried to rein in a runaway market. The lending spigot at local banks ended, interest rates and down payment requirements increased and anti-speculation taxes were imposed. The bubble began to burst, with markets in south China suffering first. Developers, undeterred, bought more land and continued building. Their ambitions finally caught up with them last year.
China’s listed real estate developers have seen their share prices fall by 80% from November 2007. Despite government efforts to revive the residential market, buyers are only responding to price cuts. Many of these developers are hemorrhaging cash, turning to non-banks and gray market lenders.
The unlisted firms have caused the most trouble. An IPO promised riches and so these developers expanded aggressively. They needed capital; foreign investors acquiesced. Investments were structured offshore and the money came onshore via preferred equities and convertible bonds issued by offshore companies with real estate holding companies in China.
Many large developers missed IPO deadlines, facing disgruntled investors. Alternative investment managers now face redemptions from investors and busted covenants and debt defaults from Chinese developers.
It seems, from the offer¬ing circulars, that few of the investors or developers knew what they were getting into. The developers gave guarantees, pledged unlisted shares, issued “no-IPO put options”. They agreed to pay punitive escalating internal rates of return, going from 30% to 70%, if the IPO was delayed by 18- 30 months.
The alternative investment managers who relied on “contractual” guarantees to protect their interests overlooked the clause in the circulars which states that offshore creditor rights are not enforceable in Chinese courts. Neither are judgments in foreign courts binding on Chinese corporations or citizens.
Many of the international law firms that developed these structures are now advising clients not to enter Chinese litigation. Yet they recognize that by the time the offshore judicial process concludes, Chinese developers would have transferred assets with any unencumbered value, or allowed onshore creditors to slap asset preservation orders on any remaining assets.
The international law firms are too pessimistic. Foreign investors can use the Chinese legal system to enforce their offshore creditor rights, seize collateral, freeze assets to keep them from disappearing, enforce guarantees and bring Chinese entrepreneurs to negotiate.
Most Chinese real estate developers sleep soundly yet foreigners remain engrossed in inconclusive meetings trying to answer their investors’ questions:
• What is the status of my investment in China and what is the condition of the Chinese partner?
• Is the original investment strategy still viable in the present climate?
• Should I continue to hold, sell or invest additional capital and if so is there a realistic business plan I can evaluate?
• If I continue to hold or invest is there a way to get closer to the company and its assets onshore to remedy some defects inherent in offshore structures?
• How do I limit my liability and is there a plan to get my capital out of China?
• Are my interests and those of the alternative investment manager still aligned?
My advice to foreign investors is: act now. Chinese business partners will inevitably satisfy local creditors first, unhesitatingly encumbering a foreign investor’s secured assets. Investors must rectify the defects in their offshore structures so they can use local courts and rely on Chinese litigation to settle with local partners.
The end game is to develop a capital preservation and exit strategy, leading to an informed decision to invest, sell or stay the course.