China Offshore Bonds: Restructuring and Defaults
While 2021 has been an incredibly quiet year in the world of restructuring - as was to largely be expected given how much deal activity was pulled forward in 2020 - there have been pockets of distress bubbling to the surface.
Chances are you've already heard of the mounting distress among notable Chinese property developers. While Evergrande has been the primary focus of the media because of its incredibly large outstanding liabilities, they are just one example of a distressed property developer among many (some others are further along in their attempted restructuring processes, such as China Fortune Land Development).
Note: To give you a sense of scale, in just 2022 there will be over $92b in offshore dollar-denominated bonds coming due that have been issued by mainland China property developers.
Given the dearth of distressed assets out there, many notable distressed funds such as Redwood and Silver Point have recently got in on the action by buying up non-trivial amounts of distressed offshore bonds. This buying activity ramped up beginning in early 2021 as the three red lines policy began to have negative ramifications across the mainland China property development sector.
In years past, the idealized trade of any distressed fund would be to go buy up the notes or loans of a debtor that the fund had some underlying conviction of the market being too pessimistic on. A distressed analyst would have to pour over the credit docs, try to model out recoveries, and think strategically about how you could achieve a higher level of return than what the market was pricing into these securities (potentially by trying to push the debtor toward their favored restructuring solution pre- or post-filing Chapter 11).
While this is admittedly somewhat of an idyllic portrait of how distressed investments are made, one thing that most in the industry would not have believed even a few years ago is that funds would be jumping headlong into offshore bonds because there was so little else to do.
This is because offshore bonds exist in a murky ecosystem. In a case like Serta's non-pro rata uptier - which I wrote a little case study on - a strict reading of the credit docs allowed for a quasi-novel restructuring transaction to occur. Apollo, et al. sued over this, and the Court ultimately rejected their arguments based on a strict interpretation of the credit docs. In other words, the credit docs of Serta meant something and had the force of law behind them.
The offshore bonds that distressed debt funds are currently buying most certainly have extensive credit docs. Many even have verbiage surrounding how a holder will have some level of recourse in a restructuring or default scenario.
However, these bonds reside in an entirely foreign legal construct. One in which precedence is hard to come by, and where past precedence is in no way indicative of future actions.
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In keeping with these theme of all my posts, I'm going to try to break down what these offshore bonds are, why anyone would buy them to begin with, and briefly touch on the restructuring and default process (insofar as you can really say much definitively here).
Simply put, China offshore bonds are dollar-denominated bonds that are issued by a HoldCo that is usually established in the Cayman Islands or the British Virgin Islands. These HoldCos own nothing beyond shares (common equity) in operating companies that will be domiciled in mainland China. It's these OpCos that actually hold the assets of the company and engage in business activity.
Therefore, the holders of the HoldCo bonds are structurally subordinate to any debt issued at the OpCo level. And, as you'd expect, OpCos do issue debt themselves. The debt they issue comes in the form of onshore bonds, secured loans, and all the others forms of unsecured claims any business will rack up as a consequence of their normal business operations (all of this onshore debt is obviously RMB-denominated, not dollar-denominated).
Note: If you're a bit iffy on the HoldCo / OpCo distinction, reading this post on structural subordination should help clear things up.
To give you an idea of where onshore vs. offshore debt resides, I've drawn up a little diagram:
Note: The cash needed to repay the coupons due to HoldCo holders comes via dividends that OpCos issue that then flow through to the HoldCo. Alternatively, sometimes the relationship between the HoldCo and OpCo - by which the HoldCo passes on the proceeds from bond issuance and the OpCo passes back up proceeds for the coupon payments - comes via an intracompany loan as opposed to an equity investment by HoldCo into OpCo.
Remember that all else being equal, as a creditor you want to reside closer to where the assets are. But with offshore debt you're about as separate from the actual assets of the OpCo as you can get because you're at a HoldCo domiciled in a different country with an inability to have true upstream guarantees as they're conventionally understood and practically applied.
If you've read through the Restructuring Guides, you may be wondering to yourself what exactly precludes the offshore bonds from being primed (having lots of onshore debt being issued, which will have a higher priority than the HoldCo debt).
It's a good question! To which there's a bit of a hand-wavy answer of, "The credit docs say there will be some form of limitation on the amount of onshore debt that will be raised".
While I'm trying to be relatively concise and high level in this post, if you're dealing with a restructuring in the United States you'll think a lot about "basket capacity". All this means basically is how much more money can be placed at a certain level of priority per the existing credit docs.
This is a bright-line rule. If there's only the ability for the debtor to raise $100m more of secured debt, then a series of amendments to existing credit docs (that creditors will likely not be keen to consent to) would be needed to raise more secured funding.
The point I'm trying to illustrate with offshore bonds is that while they have somewhat analogous verbiage to traditional credit docs, their practical ability to be enforceable is rather dubious. Both because it can be hard to know exactly how much debt OpCos actually have to begin with (e.g., private construction loans or small unsecured debt issuances) and because there's no obvious time-tested venue at which offshore holders can try to stop OpCos from raising onshore funding.
While there are potential legal ways to prevent being primed or otherwise having no influence in a restructuring - in particular if the company has assets in the United States, the U.K., Canada, etc. - the main way is through a kind of quasi-political influence. Basically by trying to convince the debtor that if they treat offshore holders unfairly, then the offshore funding market will be entirely cut off to the debtor forever.
This may seem like a poor hand to play in a restructuring negotiation, but it's not terrible because of how reliant most prominent Chinese property developers are on the offshore bond market as we will get into below.
What may surprise you is that the capital structure of most prominent mainland China property developers will be comprised of mostly offshore bonds. Usually offshore bonds will make up between 50-80% of the total capital structure.
For example, below is Greenland Holdings, which had been actively trying to raise debt to avoid a serious restructuring:
The cap table above is analogous to the cap table of every major Chinese property developer, and there a few things you should note.
First, all the secured debt that the debtor has issued is onshore debt. Second, while there are both onshore and offshore bonds, the onshore bonds have a substantially lower coupon.
The second point should be entirely logical and expected. As was discussed in the structural subordination post, all else being equal you want to reside closest to where the assets are (even if classic upstream guarantees are in place, which are not in play here). Whenever you reside further from where the assets reside you should be demanding a higher coupon to compensate for that risk.
An obvious question you may be asking yourself after reading all of this is why would anyone even touch these offshore bonds? They operate in a weird legal limbo, have minimal practical protections relative to traditional HoldCo bonds, etc.
The answer is yield. Credit markets - with the brief aberration brought on by pandemic - have been incredibly tight in the United States and Europe for the past decade.
For years mainland China property developers looked relatively sound, and so even though buyers of offshore bonds understood the downside risk was severe they were enticed by the eye-watering coupons that were 500+ basis points over what you could get in the United States.
Further, there's a form of self fulfilling logic at play here. Even though these offshore bonds operate in a weird legal limbo, offshore bonds are not an afterthought for prominent mainland China property developers. Rather, the offshore bonds are an absolutely essential form of funding.
So, the logic is that offshore bond holders can't just be left with nothing in a restructuring, as that would close off the offshore funding market for years, which would impair the ability for even healthy mainland China companies to raise offshore debt. Thus, creating a credit crunch cycle that, if nothing else, the Chinese government would not like to see occur.
So, in other words, the mindset of many offshore bond holders has historically been that they can't be entirely cast aside in a restructuring - even if they technically can be - as it would have devastating consequences for how one of China's most important sectors funds itself.
It's relatively easy to look at the offshore bond market and say that it doesn't make much sense. However, there is an underlying rationality to how it began and there's still an underlying rationality to why it will persist in the decades to come (even with the major restructurings that will need to take place over the next year or two).
For offshore bond holders, the tools in the toolbox that exist after a debtor actually defaults are severely limited relative to if an analogous situation took place in the United States under Chapter 11.
This is not only due to these holders being structurally subordinate (although that doesn't help!), but is rather also a reflection of how arbitrary the mainland legal process can be and the lack of clear precedence that exists when it comes to the handling of offshore creditors.
So, what we've seen a lot of in 2021 are classic out-of-court style restructurings with the exception that there aren't (obviously) debt-for-equity swaps occurring whereby offshore creditors are taking chunks of mainland China OpCo equity.
What we've seen primarily are various forms of debt swaps. The structure of these debt swaps will usually involve some level of cash pay down to entice existing holders to take new bonds that have a longer dated maturity. Alternatively, they could involve debt being exchanged at a haircut, but with new debt having a much higher coupon rate.
Further, if the debtor believes they need to spice up the offer even more to get above a certain consent threshold (usually 85%) then they can mix in new guarantees (some of which have dubious value).
These guarantees can take a few different forms.
First, they can be cross guarantees with other offshore bonds (which are very common, and essentially mean that a default of one offshore bond will also make another be considered in default even if a coupon payment hasn't yet been missed).
Second, you can have personal guarantees from the founders of the debtor. This is increasingly common and something the government has not so quietly been supportive of debtors doing because so many of the founders of mainland China property developers are billionaires.
Note: Should a debtor default within mainland China the insolvency process undertaken is somewhat similar (theoretically) to a Chapter 11 proceeding. The rule of absolute priority will be followed and there will be a restructuring plan. In this plan impaired creditors will be listed along with their recovery values. The form of recovery that creditors will receive can come via cash, reinstated debt, or equity in the reorganized debtor. However, the devil is always in the details and there's much greater opacity, a lack of precedence, and a level of arbitrariness as to how the practicalities are all worked out relative to the Chapter 11 process (especially around what exactly the recovery values will be, and how one can argue for higher recovery values).
While there are many potential restructurings to talk about, let's briefly cover what occured with Yango (a modestly sized property developer).
In mid-November of 2021, Yango came to an exchange agreement with the vast majority of the creditors that held Yango's January 2022, March 2022, and February 2023 offshore notes. These notes represent just shy of $750m in face value. Creditors holding $669.9m worth of notes agreed to tender their notes, which represents a consent level of just over 89%.
In exchange for tendering (swapping) these creditors will receive new notes that pay a 10.25% coupon, along with an immediate cash payout of $25 for every $1,000 tendered.
Further, to sweeten the deal and get above the 85% consent threshold that Yango sought, the founder personally guaranteed these newly issued bonds. You can read the full revised offer to creditors here.
This is a classic example of a distressed exchange; buying the debtor sometime to hopefully turn things around by avoiding an otherwise imminent default (which is why Fitch downgraded Yango after the exchange). Currently Yango's offshore notes due 2024 are being quoted in the high 20s so the market is quite pesimistic on them turning things around.
So, let's say you're a distressed Chinese property developer. You don't have imminent maturities, but you also don't have much liquidity.
Of course, you could try to raise money onshore. Either through issuing secured debt backed by existing assets, or through doing an onshore bond offering. Both of these options will have lower yields than anything raised offshore - as we've already discussed - but the issue for property developers is that raising too much onshore may make them run afoul of the three red lines policy.
What many developers in the situation have done is try to offer quite short dated bonds that have embedded put options.
For example, Greenland (one of the largest mainland China property developers) attempted earlier this year to do a $200m+ offshore bond issuance. The bond they pitched would have had a two maturity with a put option at the end of the first year.
What the put option gives a note holder is the right, but not the obligation, after the first year to demand the debtor repurchase their note for cash at face value.
What embedding a put option in a bond does for the issuer is lower the coupon rate that the market will demand. Because the put option - like all other options - has value unto itself. So, market participants will take a lower coupon for the optionality that the put option represents (e.g., a buyer can think to themselves, "Instead of being locked in for two years by buying this bond, I can get a good yield for a year and reassess the situation at the end of one year and get cash back if the company is beginning to look a bit riskier").
So, one of the most popular ways for Chinese property developers to raise cash over the past year has been to do these slightly funky offerings with embedded put options. Yuzhou has done several of these types of transactions in 2021 to raise cash to repay older offshore bonds coming due.
Obviously the biggest name to follow in the space is Evergrande, which had a technical default on December 9th. Houlihan Lokey is advising Evergrande, while a sizeable group of creditors hired Moelis.
Another big name is Kaisa, which also technically defaulted on December 9th as well. A sizeable group of creditors hired Lazard.
Other names worth following include: Greenland, China Fortune Land Development (which was among the first large developers to default), Yuzhou, and Yango.
Given the dearth of restructuring activity lately, almost every major RX shop has some kind of creditor-side mandate dealing with offshore bonds. So, for interview purposes, it's worth having a rough idea of what we mean when we're talking about offshore vs. onshore bonds.
What we've gone over here will be more than sufficient to thoroughly impress your interviewer. If I can find the time over the next few months, I may put together a slightly longer guide on all this like I did for Serta for those that are interested.
However, one big takeaway from everything we've covered here should be that while companies domiciled in the United States (or the U.K., Canada, etc.) follow very formal processes, when it comes to these property developers everything will get quite a bit messier and lots of odd things will no doubt occur.
But, in the end, despite all the opacity that will occur in the post-default processes, the rule of absolute priority will (more or less) be followed, there will be a restructuring plan brought forward, and there will be arguments about how much various creditors should receive and in what form they should receive it (cash, new debt in the reorganized debtor, or equity in the reorganized debtor).
We've covered a lot here, but hopefully it's somewhat helpful. I've also put together a longer list of typical restructuring interview questions and an overview of restructuring investment banking if you're gearing up for interviews and haven't read those posts yet.