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Turning Distress into Gold

The ramifications of the Asian financial crisis were many, but high on the list was the creation of an unprecedented volume of bad debt.

Although specific estimates vary, it is largely accepted that almost US$2 trillion worth of non-performing assets (NPAs) sat on balance sheets – which at the time represented almost a third of Asia’s GDP.

Economic growth was impeded by the weight of this bad debt – since the capital badly needed to help rebuild economies was tied up with defaulted borrowers.

As always, adversity promotes opportunity. Distressed debt workout specialists, primarily the larger international investment banks – such as Citigroup, Deutsche Bank, Goldman Sachs and Morgan Stanley – became successful at turning the region’s bad debt into a lucrative business.

“The Asian financial crisis of 1997 caused widespread corporate distress and bankruptcies across the region,” says Michel Lowy, Deutsche Bank’s head of Asia-Pacific strategic investment group. “Even robust companies saw their foreign debt burden explode as their currency devalued sharply against the dollar. This widespread distress brought numerous opportunities to businesses that had the patience, local knowledge, experience and information to understand the special complexities of investing in Asian distressed debt.”

Indeed, the early years of Asia’s distressed debt business was a very lucrative time for both bankers and hedge fund managers able to understand the special complexities of this asset class. Billions of dollars were made as institutions would vacuum up huge amounts of NPAs at a fraction of their nominal worth and recover as much of the debt as possible.

By 2002, four years after the Asian crisis an estimated US$300 billion of the bad debt had been acquired. Of that over US$125 billion of that had already been recovered.

However, given that Asia has enjoyed a remarkable recovery in the intervening years, the heady days of distressed debt have long since passed by. In 2000, distressed debt was a consequence of a wider systemic failure. Today’s opportunities have become more limited.

Instead, the business has become much more event-driven with default rates in Asia enjoying near historical lows.

As one Hong Kong-based distressed debt specialist says, “Generally, what we look to employ is an event-driven strategy whereby we purchase debt at deep discounts, between 20 and 80 cents on the dollar, and either hold it passively throughout or, more commonly, becoming actively involved in restructurings or other events that bring significant recovery in its credit standing.”

However, many believe that Asia’s current credit cycle is near its liquidity peak and that a severe tightening of the credit belt is coming. As a result of less credit and liquidity, a potential wave of defaults may follow. Most distressed debt players are expecting the distressed debt cycle to return in the next 12 to 24 months and along with it increased opportunities.

“We are reasonably late in the day in our current credit cycle which began in 1997-98, and although data is relatively insufficient, defaults in Asia are at very low levels,” says one hedge fund specialist. “I would expect to see more systemic problems in the credit markets in the next one or two years.”

Even so, there are still numerous opportunities to be found at companies that have yet to restructure their debt or have recently gone into some form of rehabilitation.

The Name’s Bond, Bad Bond

The region’s investment banks predominantly focus on three areas of the distressed debt world. These are distressed debt trading, non-performing portfolios and open-ended special situations.

Distressed debt trading is the most well known product. It typically involves a situation where a large syndicated loan goes into default and needs to be restructured. Enter the loan-workout arm of an investment bank, which negotiates with the commercial banks that hold the distressed assets, and will normally provide a market for those commercial banks to exit – after, of course, taking a haircut (which is jargon for a loss on the loan’s principal).

“This is the kind of trade that hedge funds are typically keen to get into,” says Lowy. “It is a debt instrument but has equity risk and equity type of return. However, it also has equity type downside which is why commercial banks are willing to participate in the trade.”

The recent failure of Ocean Grand is the most recent example of this kind of trade – albeit this involves a bond default, rather than a loan. However, the principles do not differ.

The second business line is non-performing loan portfolios. This involves the purchase of a large portfolio, which will include anywhere between 100 and 5,000 NPLs – sourced from local banks. Usually these are local currency loans to smaller corporates with the debt ranging from the US dollar equivalent of between $5 million to $100 million.

The banks work through the portfolio over an extended period individually addressing each of the loans – by either working with the creditor to restructure the debt or helping to liquidate the entities.

The final and most recent addition to the business is “special situations”. This arm of the business has a fairly wide mandate. Indeed, it takes into account any type of financial transaction where the bank’s valuation and restructuring expertise can be used.

Essentially it means looking at any corporate entity that is under stress – though not necessarily (yet) distressed. The company instead might face a financial situation where it is no longer able to get funds from commercial bank loans or the public bond markets.  In these cases, the investment bank will provide rescue or turnaround financing. This might be arranged through loans, preferred shares, unlisted shares or other instruments.

These products typically boom in periods of financial trouble. And with Asia currently doing so well, there are many who probably assume the distressed debt market must be shrinking. However, certain countries provide the region’s distressed debt bankers with hope.

Indian Summer

India, in particular, has seen its distressed debt market gather momentum over the past 12 months and analysts are expecting this trend to continue. This is mainly due to the establishment of new guidelines issued by the Reserve Bank of India (RBI) last July, which makes it easier for banks to sell off NPAs.

The transfer of NPAs to India’s Asset Reconstruction Companies (ARCs) was permitted under previous guidelines issued in 2003. But at that point Indian banks could only transfer NPAs from their balance sheet to foreign buyers with the prior approval of the RBI on a case-by-case basis. The more recent regulations have helped to increase the number of potential buyers of Indian NPAs.

The success of these new regulations has been quite clear. Earlier this year, India saw the closure of its largest NPL auction, when ICICI Bank sold off 300 loans worth US$300 million. It is estimated that India has seen upwards of US$1 billion of NPL auctions since the instigation of the new guidelines.

Moreover, with the anticipated acceptance of the Basel 2 in 2007, there is an expectation that the NPL market will become even more important as banks look to improve asset quality and consequently seek to increase their capital adequacies.

With these banks looking to improve their balance sheets, the Indian market has seen a rise in consensual workouts via the corporate debt restructuring (CDR) system. Indeed there has been no shortage of foreign capital interested in entering the distressed debt space. Already the likes of Deutsche Bank, JPMorgan and Citigroup have entered the Indian market.

“We are hopeful of closing 3-4 deals annually with an average deal size between US$15-50 million,” says Varun Batra, Citigroup’s head of special situations in India. “We’re bullish on the product in the long term.”

Chinese Wall

China has proven something of a dilemma for distressed debt investors. Since the establishment of the first asset management companies (AMC’s) in 1999, the Chinese market has seen little in terms of actual disposal of NPAs. It has been a particularly difficult business for foreign investors, who have been patiently waiting for what is potentially a very lucrative market to take off.

But it now seems that after six years of stagnation, China now seems poised to reach its potential. The government, which has been critical of the pace of NPL disposal, has now issued a deadline to the AMCs – NPLs that the AMCs picked up in 1999 must be transferred by the end of 2006.

Since then, not surprisingly, a number of those NPL transactions have been announced. Of particular note, many of them involve the foreign players. At present there is an estimated RMB520 billion (US$65 billion) in 1999 originated NPLs sitting on the balance sheets of the Chinese AMCs that need to be offloaded by year’s end. (That estimate refers to their face value.)

Another trend that will increase the activity in China is the emergence of joint ventures between the foreign investors and the ARCs. At the end of 2005, foreign investors only accounted for about US$12 billion (4%) of overall disposals, and while some investors are maintaining their own platforms, others, such a Deutsche Bank, have set up JVs to help expedite the process.

Last year Deutsche Bank set up a JV with Huarong, one of China’s largest ARCs. This approach should go a long way to getting quicker governmental approval for the transactions and should help to alleviate some of the overall costs with preferential tax benefits. 

Indeed, having already disposed of almost RMB90 billion (US$12 billion) since September of last year, the ARCs, such as Huarong, China Orient, Cinda and Great Wall, have set combined year end disposal targets estimated at RMB100 billion to 150 billion (US$13 billion to US$19 billion).

Philippines Flip

The Philippines provides an interesting contrast to both China and India, in that it seems to be an old hand in the disposal of bad assets from banks balance sheets.

In 2002, the Philippine Congress enacted the Special Purpose Vehicle Act, in order to perpetuate the disposal of Ps500 billion (US$10 billion) worth of NPAs in the country’s banking system. Since its implementation the Bangko Sentral (the Philippine central bank) has issued almost 350 eligibility certificates for 48 financial institutions. Although that law expired last year, its extension was signed into law in April.

By the end of 2005, the Bangko Sentral estimates that almost Ps100 billion of these assets had been dealt with. This has led to a marked improvement in the banking system’s aggregate NPL ratio. As of 31 December 2005, banks had a total NPL ratio of 9.5%, down from 14% in 2004. Additionally the country’s NPA ratio fell from 12.5% to 9% over that same period.

The extension of the SPV law will further encourage banks and other financial institutions in negotiating sales of their NPL portfolios – especially as they are now more familiar with its requirements.

Thailand Adds Spice

Thailand is another market that is expected to increase its NPL activity over the next year as it moves toward the full implementation of the Basel 2 accord.

In preparation, the Bank of Thailand (BoT) is compelling its local banks to improve their respective balance sheets. One of the more aggressive provisions requires the country’s commercial banking industry to bring its collective NPL ratio down to 2% from 5% by the end of the year.

To facilitate this, the BoT has put the Bangkok Commercial Asset Management Company in charge of the auctions for transferring the non-performing assets from the domestic banking sector. Currently the sector has around Bt450 billion (US$12 billion) in non-performing assets.

Looking forward, enormous opportunities still exist in Asian distressed debt. That is especially true given that governments throughout the region are putting pressure on banks to release NPLs from their balance sheets ahead of the 2007 implementation of Basel 2. And with a fresh round of NPLs expected in the next couple of years, the opportunities can only increase.

This article first appeared in FinanceAsia, September 2006.