This document discusses the opportunity for higher returns in fixed-income investing in China compared to private equity. It notes that Chinese companies and municipalities often pay interest rates double or triple what similar borrowers pay elsewhere due to China's large high-yield debt market. Private equity in China has averaged lower returns of 6-8% annually compared to the 8-10% available on municipal debt or 12-18% on securitized corporate loans. The document argues that on a risk-adjusted basis, debt investing in China may continue to outperform private equity and examines some attributes of the Chinese debt market that support this view.

1. An overlooked opportunity
This proprietary research note is intended exclusively for use of the recipient. It contains confidential information.
All contents are copyright 2015. www.chinafirstcapital.com ceo@chinafirstcapital.com

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Credit vs. Equity in China:
the Strengthening Case
For Debt
Anyone with even the most cursory
knowledge of investing will know about the "equity
risk premium”. Stocks are riskier than bonds and
other fixed-income investments and so must
compensate investors by delivering over time a
higher rate of return. If equities didn’t deliver this
premium then few would bother owning them. So
the theory goes.
China private equity, though, has turned this
theory on its head. It continues to pour money
almost exclusively into equity investing while
achieving cash-distributed returns over the current
seven-year cycle well lower than a portfolio of
collateralized corporate or municipal debt in China.
PE in China has been averaging distributed returns
of 6%-8% a year, while fixed-income can earn
anything between 8-10% on municipal debt
(secured against government tax and fee revenues)
or 12-18% on securitized corporate lending.
Call it China's "equity risk discount". It gets to
the heart of one of the more deep-seated
disequilibria in China alternative investing -- the
money is now allocated almost exclusively towards
higher-risk and lower-return equity PE investing.
This report will examine some of the unique
attributes of China debt investing. Our conclusion:
on a risk-adjusted cash-distributed basis, debt
investing in China may continue to outperform PE
equity investing.
The recent outperformance by fixed-income isn't
just a statistical artifact. It reflects not only the low
distributions to LPs from equity investing, but the
often-overlooked fact that China now has the
world's largest high-yield debt market. Chinese
companies and municipalities are often paying
interest rates double or triple the rates similar
borrowers pay in all other major economies.
INSIDE THIS SPECIAL REPORT:
Credit vs. Equity
The Strong Case for Debt 2
China’s High-Yield Market:
Overtaking the World 4
China’s Loanshark Economy:
The Cost of Borrowing Takes Its Toll 6
China’s Big Banks
Treating Borrowers like Conmen 8
China Debt Mispricing:
Blackrock, Fidelity Get Burned 9
Caijing Magazine:
Chinese Analysis Highlights Policy Fix 11

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The risk-return tradeoff between debt and equity is
unique in China compared to the rest of the
industrialized world. Money should flow to China
fixed-income investing because of its high-yields
and lower risk. Debt is higher up the capital
structure than equity and so offers investors
greater protection against loss, both through
collateralization as well as liquidation preference.
Return data as well as China's legal system both
argue strongly in favor of investing in debt rather
than illiquid shares typically purchased by PE firms
in China. Despite this, there isn't now a single
large specialist international fixed-income debt
fund focusing on China direct corporate lending.
Partly this is because using dollars to lend to
Chinese companies is trickier than investing in
those companies' equity. There is a dense net of
regulations on lending money to domestic firms
that doesn't apply to equity investing. Another
reason, fixed-income investing in China will likely
involve a lot more work than writing a check to
buy company equity. It would require more
meticulous pre-deal diligence, especially tracking
cash flow and receivables, and then more active
and sustained post-investment monitoring.
Seen in a global context, China currently offers
fixed-income investors yields on collateralized
lending that are more attractive than anywhere
else in the developed world. The yields are also
better than what can be earned on debt investing
in underdeveloped places like India and Indonesia.
In the case of both these countries, AA-rated
corporate borrowers are paying around 9% a year
for securitized loans. In China, once fees are
bundled in, the rate is at least 300-500 basis
points higher.
China's corporate and municipal lending market
has undergone an enormous sea change in the last
three years, as China's big banks responded to
regulatory pressures by pushing a huge amount of
lending to the off-balance-sheet "shadow banking"
system dominated by their sister companies in the
stockbroking, trust and asset management areas.
Where borrowing from a bank may cost a borrower
an annual regulated interest rate of 7%-9%,
borrowing from the shadow banking system can be
twice as expensive and is basically unregulated.
Default levels on China shadow banking debt are
officially under 1%. Insiders claim the real rate is
troubled loans is probably higher, around 3%-4%.
That is comparable to bad debt ratios in the
shadow banking systems of the US and Western
Europe, where companies generally borrow for 3%
to 5% a year.
PE investors, not only in China, like to promise
their investors outsized returns. In China PE, firms
generally say they "underwrite to a minimum IRR
of +20%". In other words, they only commit
money when they are persuaded they are on an
inside track to earn at least 20% a year. From that
vantage point, the 13%-18% on offer from debt
investing may look dull and unappealing.
But, China PE has not consistently delivered alpha,
not delivered these above-index returns. It has
only promised to do so. Fixed income investing in
China's high yield market, by contrast, has
meaningfully outperformed the S&P index. It is
where the alpha is in China.
The few funds that do focus on lending to Chinese
corporates almost only do convertible lending or
other types of mezzanine structures. Convertible
debt is often illegal under Chinese securities laws.
What’s more, company owners in China tend to
prefer less intrusive, less costly straight lending.
There’s also the huge uncertainty about any non-
quoted Chinese company ever getting permission
to IPO and so make the “equity kicker” liquid and
valuable. Straight securitized senior direct lending
to companies is what the China market most needs
and has shown will pay for. It also could boost
overall PE fund performance in China.
As a fund strategy, direct debt in China seems to
have a lot of positives. Preqin, a leading market
intelligence business for the alternative investment
industry, published a special report in November
2014 called “Private Debt” (click here to
download a copy). It summarized things this way:

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Private equity investing in China, both dollar and
Renminbi, has with too few exceptions delivered in
recent years mediocre distributions to Limited
Partners. All the while, however, fixed-income
investing has clocked consistent high cash returns.
Rules making it tough for dollar-based funds to
direct lend in China are being liberalized. The early
years of PE equity investing in China were similarly
challenging, but the earliest vintage China PE
funds turned in by far the highest performance.
Profit levels in the Chinese PE industry as a whole
never matched the deals done by these early
movers, even as China private equity AUM grew to
+$175 billion, based on commitments to investable
funds, mainly all targeting the same type of
“growth capital” equity deals.
China’s High-Yield Market
Overtakes the World
Despite Polonius’s stern injunction in
Shakespeare’s Hamlet, “neither a borrower nor a
lender be”, now is a very good time to be debt
investor in China. Indeed, for those who can learn
the ropes and avoid the pitfalls, there is perhaps
no better risk-adjusted way to make money
anywhere as a fixed-income investor than lending
to larger Chinese companies. For now, China's
huge high-yield debt market is open mainly to
domestic investors. But a few brave hedge funds,
including it’s said Elliott Advisors, are now getting
into the business of lending onshore in China to
Chinese borrowers. China First Capital is involved
in structuring debt deals for Chinese companies.
Real interest rates on collateralized loans for most
companies, especially in the private sector where
most of the best Chinese companies can be found,
are rarely below 10%. They are usually at least 15%
and are not uncommonly over 20%. In other
words, interest rates on collateralized loans in
China are now generally pegged at the highest
level among major economies.
Borrowing money has always been onerous for
companies in China, with the exception of a few
favored large State-Owned Enterprises. All bank
lending in China is meant to obey orders from on
high, in this case China’s powerful banking
regulator the CBRC. In the last two years, partly to
meet new capital adequacy requirements as well
as damp down somewhat on credit expansion, the
CBRC instructed banks to cut back on new lending
and limit increases in lending to existing private
sector borrowers.
Banks' parent companies responded by vastly
expanding their off-balance sheet lending via the
"shadow banking system" in China. Over the last
two years, a huge proportion of lending both to
private-sector companies and local governments
has been securitized and sold as what are called
“Wealth Management Products”, aka WMPs, in
English, or licai chanpin, （理财产品）in Chinese.
This form of off-balance-sheet lending, usually
arranged and sold by Chinese banks’ sister
companies, their underwriting, asset management
and trust company businesses, has proved
enormously lucrative for everyone involved, except
of course the Chinese borrowers.
The growth in such lending has been little short of
astronomical. There is now $2.5 trillion in shadow
banking debt now outstanding in China, more than
the total amount of outstanding US commercial
“Direct corporate lending as an illiquid debt fund
structure has been the ongoing story within the
growth of alternative credit. Compared to mezzanine
and distressed vehicles which have operated in the
private equity financing segment for decades, direct
lending is more in line with the relatively
conservative risk appetites of the fixed income
investor. Direct lending vehicles have gone from
representing 19% of private debt fund types in 2010
to a considerable 42% in 2014 YTD, marking the
largest increase over four years. Exposure to this
profitable and evolving asset class may continue to be
attractive to institutional investors in a low-yield
environment.
The private debt asset class is offering a genuine
alternative to private equity funds with its reduced
risk profile and strong return offering.”
(Emphasis ours.)

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paper. It's been a great business for the bank
holding companies packaging and selling such
loans. They earn sales commissions and other fees,
as do domestic lawyers, accountants and domestic
rating agencies. These add 2-3% to the cost of
borrowing. Chinese savers who buy the securitized
debt are earning interest rates of 10%-14% on
corporate debt, and 6-10% on municipal lending.
Bank deposits in China offer investors government-
regulated interest of 1% or lower.
The shadow bank lending is mainly meant to be
fully-collateralized and in many cases, there’s a
third party default guarantee in place as well.
Shadow bank loans are almost all one-year term,
and can't be automatically rolled-over, so principal
needs to be paid back at the end of the term. For
borrowers, this means they pay interest for twelve
months but generally have use of the money for
eight to nine. During the time it takes to renew a
shadow bank loan, which is often one month or
more, companies generally have recourse only to
informal "bridge lending" in China, priced at 2% to
3% a month.
There is no organized secondary market for this
securitized lending, and it's been very lightly
regulated compared to bank loans which are
subject to various caps on interest rates and term.
In the last six months, however, the Chinese
government has signaled it wants to more actively
control the growth of shadow banking, particularly
securitized debt being sold to small retail investors.
The likely result is that it will become even more
expensive for Chinese companies to borrow. With
China's growth rate slowing and wage and energy
costs still rising, the high cost of borrowing is
having a more and more pronounced negative
impact on cash flow and net margins across
China's corporate sector.
The official default rate on such collateralized
lending is running at 1%, well below the rate in the
US, where companies above junk grade are
borrowing at as low as 3-4%, uncollateralized. It
seems likely that default rates will rise on shadow
bank loans in China. But, some factors should keep
default rates in check. For one, when a local
company gets into trouble, local governments will
often step in with new sources of capital to pay off
existing loans. Also, when Chinese companies
borrow, they generally need not only to pledge
most or all of the company's own assets but often
those owned personally by the company's main
shareholders. There is no real equivalent to
America's Chapter 11 law, no "debtor in
possession" process. So default can and usually
does reduce a company and its equity owners to
pauperdom. Hence, it’s to be avoided at all costs.
Note, some lucky Chinese companies own a
holding company outside China, often in Hong
Kong, BVI or Cayman Islands. These companies
can borrow or issue bonds in Hong Kong and so
generally pay interest rates of 4%-6%. But, the
Chinese government made this kind of offshore
structuring illegal in 2009.
Kaisa Group, a troubled real estate developer that
issued $2.5 billion in bonds in Hong Kong is now
threatening to default and has asked offshore
bond-holders to accept much lower interest
payments spread over much longer period. Kaisa's
domestic Chinese creditors it seems will not have
to accept such steep write-downs. This preferred
treatment for domestic lenders may not have been
fully understood by the institutions that bought
Kaisa's Hong Kong bonds.
So, how might international fixed-income investors
get into the domestic high-yield game in China?
There are ways for dollar-based investors to get
their capital in and out for this purpose. But, it's
far from straight-forward. Once that's sorted out, a
good strategy would be to cherry-pick the most
credit-worthy borrowers from among the hundreds
of thousands now relying on shadow bank loans,
and then negotiate a private loan directly with the
company's chairman and board.
The shadow banking system basically treats all
Chinese corporate borrowers the same. Most carry
the same AA credit rating and so pay the same
amount to borrow. The one-size-fits-all approach
also applies to maturities, types of pledged
collateral. Convertible or mezzanine structures are
mainly forbidden under Chinese securities law.
The yawning gap between the cost of collateralized
borrowing in China compared to the US, Europe
and much of the rest of Asia will really only narrow
when the Chinese government removes the
remaining restrictions and loosens regulations that

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make it difficult for foreign investors to swap
dollars into and out of Renminbi to lend to Chinese
companies. Until this happens, China's companies
will find more and more of their available cash flow
going to service debts. At the same time, China’s
new mass rentier class of institutions and
individuals will continue to live the high life,
earning interest payments beyond the dreams of
avarice for fixed-income investors elsewhere.
China’s Loanshark
Economy
What’s ailing China? Explanations aren’t
hard to come by: slowing growth, bloated and
inefficient state-owned enterprises, and a ferocious
anti-corruption campaign that seems to take
precedence over needed economic reforms.
Yet for all that, there is probably no bigger, more
detrimental, disruptive or overlooked problem in
China’s economy than the high cost of borrowing
money. Real interest rates on collateralized loans
for most companies, especially in the private
sector where most of the best Chinese companies
can be found, are rarely below 10%. They are
usually at least 15% and are not uncommonly over
20%. Nowhere else are so many good companies
diced up for chum and fed to the loan sharks.
Logic would suggest that the high rates price in
some of the world’s highest loan default rates. This
is not the case. The official percentage of bad loans
in the Chinese banking sector is 1%, less than half
the rate in the U.S., Japan or Germany, all
countries incidentally where companies can borrow
money for 2-4% a year.
You could be forgiven for thinking that China is a
place where lenders are drowning in a sea of bad
credit. After all, major English-language business
publications are replete with articles suggesting
that the banking system in China is in the early
days of a bad-loan crisis of earth-shattering
proportions. A few Chinese companies borrowing
money overseas, including Hong Kong-listed
property developer Kaisa Group, have defaulted or
restructured their debts. But overall, Chinese
borrowers pay back loans in full and on time.
Combine sky-high real interest rates with near-
zero defaults and what you get in China is now
probably the single most profitable place on a risk-
adjusted basis to lend money in the world. Also
one of the most exclusive: the lending and the
sometimes obscene profits earned from it all pretty
much stay on the mainland. Foreign investors are
mainly being shut out.
The big-time pools of investment capital —
American university endowments, insurance
companies, and pension and sovereign wealth
funds — must salivate at the interest rates being
paid in China by credit-worthy borrowers. They
would consider it a triumph to put some of their
billions to work lending to earn a 7% return. They
are kept out of China’s more lucrative lending
market through a web of regulations, including
controls on exchanging dollars for Renminbi, as
well as licensing procedures.
This is starting to change. But it takes clever
structuring to get around a thicket of regulations
originally put in place to protect the interests of
China’s state-owned banking system. As
investment bankers in China with a niche in this
area, we are spending more of our time on debt
deals than just about anything else. The aim is to
give Chinese borrowers lower rates and better
terms while giving lenders outside China access to
the high yields best found there.
China’s high-yield debt market is enormous. The
country’s big banks, trust companies and securities
houses have packaged over $2.5 trillion in
corporate and municipal debt, securitized it, and
sold it to institutional and retail investors in China.
These shadow-banking loans have become perhaps
the favorite low-risk and high fixed-return
investment vehicle in China.

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Overpriced loans waste capital in epic proportions.
Total loans outstanding in China, both from banks
and the shadow-banking sector, are now in excess
of Rmb 100 trillion ($15.9 trillion) or about double
total outstanding commercial loans in the U.S. The
high price of much of that lending amounts to a
colossal tax on Chinese business, reducing
profitability and distorting investment and rational
long-term planning.
A Chinese company with its assets in China but a
parent company based in Hong Kong, BVI or the
Cayman Islands can borrow for 5% or less, as
Alibaba Group Holding recently has done. The
same company with the same assets, but without
that offshore shell at the top, may pay triple that
rate. So why don’t all Chinese companies set up an
offshore parent? Because this was made illegal by
Chinese regulators in 2009.
Chinese loans are not only expensive, they are just
about all short-term in duration — one year or less
in the overwhelming majority of cases. Banks and
the shadow-lending system won’t lend for longer.
The loans get called every year, meaning
borrowers really only have the use of the money
for eight to nine months. The remainder is spent
hoarding money to pay back principal. The
remarkable thing is that China still has such a
dynamic, fast-growing economy, shackled as it is
to one of the world’s most overpriced and rigid
credit systems.
It is now taking longer and longer to renew the
one-year loans. It used to take a few days to
process the paperwork. Now, two months or more
is not uncommon. As a result, many Chinese
companies have nowhere else to turn except illegal
underground money-lenders to tide them over
after repaying last year’s loan while waiting for this
year’s to be dispersed. The cost for this so-called
“bridge lending” in China? Anywhere from 3% a
month and up.
Again, we’re talking here not only about small,
poorly capitalized and struggling borrowers, but
also some of the titans of Chinese business,
private-sector companies with revenues well in
excess of RMB 1 billion, with solid cash flows and
net income. Chinese policymakers are now
beginning to wake up to the problem that you can’t
build long-term prosperity where long-term lending
is unavailable.
Same goes for a banking system that wants to
lend only against fixed assets, not cash flow or
receivables. China says it wants to build a sleek
new economy based on services, but nobody
seems to have told the banks. They won’t go near
services companies unless of course they own and
can pledge as collateral a large tract of land and a
few thousand square feet of factory space.
Chinese companies used to find it easier to absorb
the cost of their high-yield debt. No longer.
Companies, along with the overall Chinese
economy, are no longer growing at such a furious
pace. Margins are squeezed. Interest costs are
now swallowing up a dangerously high percentage
of profits at many companies.
Not surprisingly, in China there is probably no
better business to be in than banking. Chinese
banks, almost all of which are state-owned, earned
one-third of all profits of the entire global banking
industry, amounting to $292 billion in 2013. The
government is trying to force a little more
competition into the market, and has licensed
several new private banks. Tencent Holdings and
Alibaba, China’s two Internet giants, both own
pieces of new private banks.
Lending in China is a market structured to transfer
an ever-larger chunk of corporate profits to a
domestic rentier class. High interest rates sap
China’s economy of dynamism and make
entrepreneurial risk-taking far less attractive.
Those running China’s economy are said to be
reassessing every aspect of the country’s growth
model. Those looking for signs China’s economy is
moving more in the direction of the market should
look to a single touchstone: is foreign capital being
more warmly welcomed in China as a way to help
lower the usurious cost of borrowing?
(Originally published in The Nikkei Asian Review, March 2015.)

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China's Big Banks: They
Misprice and Misallocate
Credit While Treating
Borrowers Like Conmen
Do you have the financial acumen to
run the lending department of one of China’s giant
state-owned banks? Let’s see if you qualify. Price
the following loan to a private sector Chinese
company. Your bank is paying depositors 0.5%
interest so that’s your cost of capital. The company
has been a bank customer for six years and now
needs a loan of Rmb 50mn (USD$8 mn). The
audit shows it’s earning Rmb 60mn a year in net
profits, and has cash flow of Rmb 85mn.
You ask the company to provide you with a first
lien on collateral appraised at Rmb 75mn and
require them to keep 20% or more of the loan in
an account at your bank as a compensating
deposit. Next up, you ask the owner to pledge all
his personal assets worth Rmb 25mn, and on top,
you insist on a guarantee from a loan-assurance
company your bank regularly does business. The
guarantee covers any failure to repay principal or
interest. What annual interest rate would you
charge for this loan?
If you answered 5% or lower, you are thinking like
a foreigner. American, Japanese or German maybe.
If you said 13% a year, then you are ready to start
your new career pricing and allocating credit in
China. At 10% and up, inflation-adjusted loan
spreads to private sector borrowers in China are
among the highest in the world, particularly when
you factor in the over-collateralization, that third-
party guarantee and fact the loan is one-year term
and can’t be rolled over.
As a result, the company will actually only have
use of the money for about nine months but will
pay interest for twelve. Little wonder Chinese
banks have some of the fattest operating margins
in the industry.
Chinese private businessmen are paying too much
to borrow. It’s a deadweight further slowing
China’s economy. Debt investing and direct lending
in China could represent excellent fund strategies.
The high cost of borrowing negatively impacts
corporate growth and so overall gdp growth. It is
also among the more obvious manifestations of an
even more significant, though often well-hidden,
problem in China’s economy: the fact that nobody
trusts anybody. This lack of trust acts like an
enormous tax on business and consumers in China,
making everything, not just bank credit, far more
expensive than it should be.
Online payment systems, business contracts, visits
to the doctor, buying luxury products or electronics
like mobile phones or computers: all are made
more costly, inefficient and frustrating for all in
China because one side of a transaction doesn’t
trust the other. One example: Alibaba’s online
shopping site, Taobao, will facilitate well over
USD$200bn in transactions this year. Most are paid
for through Alipay, an escrow system part-owned
and administered by Alibaba. Chinese shoppers are
loath to buy anything directly from an online
merchant. They generally take it as a given that
the seller will cheat them.
Most of the world’s computers and mobile phones
are made in China. But, Chinese walk a minefield
when buying these products in their own country.
It’s routine for sellers to swap out the original
high-quality parts, including processors, and
replace them with low-grade counterfeits, then sell
products as new.
Chinese, when possible, will travel outside China,
particularly to Hong Kong, to buy these electronics,
as well as luxury goods like Gucci shoes and
Chanel perfume. This is the most certain way to
guarantee you are getting the genuine article.
In the banking sector, loans need to have multiple,
seemingly excessive layers of collateral, as well as
guarantees. Banks simply do not believe the
borrower, the auditors, their own in-house credit
analysts, or the capacity of the guarantee firms to
pay up in the event of a problem.

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Disbelief gets priced in. This is one main reason for
the huge loan spreads in China. Banks regard their
own loan documentation as a work of fiction. It
stands to reason that if a company’s collateral
were solid and the third-party guarantee
enforceable then the cost to borrow money should
be at most a few points above the bank’s real cost
of capital. Instead, Chinese companies get the
worst of all worlds: they have to tie up all their
collateral to secure overpriced loans, while also
paying an additional 2%-3% a year of loan value
to the third-party credit guarantee company for a
guarantee the bank requires but treats as basically
worthless.
In the event a loan does go sour, the bank will
often choose to sell it to a third party at discount
to face value, rather than go to court to seize the
collateral or get the guarantee company to pay up.
The buyer is usually one of the state-owned asset
recovery companies formed to take bad debts off
bank balance sheets. Why, you ask, does the bank
require the guarantee then fail to enforce it? One
reason is that Chinese private loan-assurance
companies, which usually work hand-in-glove with
the banks, are usually too undercapitalized to
actually pay up if the borrower defaults. Going
after them will force them into bankruptcy. That
would cause more systemic problems in China’s
banking system.
Instead, the bank unloads the loan and the asset
recovery companies seize and sell the only
collateral they believe has any value, the
borrower’s real estate. The business may be left to
rot. The asset management companies usually
come out ahead, as do the loan guarantee
companies, which collect an annual fee equal to 2%
to 3% of the loan value, but rarely, if ever, need to
indemnify a lender.
Don’t feel too sorry for the bank that made the
loan. Assuming the borrower stayed current for a
while on the high interest payments, the bank
should get its money back, or even turn a profit on
the deal. Everyone wins, except private sector
borrowers, of course. Good and bad like, they
are stuck paying some of the highest risk-adjusted
interest costs in the world.
When foreign analysts look at Chinese banks, they
spend most of their time trying to divine the real,
as opposed to reported, level of bad debts,
devising ratios and totting up unrealized losses.
They don’t seem to know how the credit game is
really played in China.
Most of the so-called bad debts, it should be said,
come from loans made to SOEs and other organs
of the state. Trust is not much of an issue. SOEs
and local governments generally don’t need to
pledge as much collateral or get third-party
guarantees to borrow. A call from a local Party
bigwig is often enough. The government has
shown it will find ways to keep banks from losing
money on loans to SOEs. The system protects its
own.
Chinese banks should be understood as engaged in
two unrelated lines of business: one is as part of a
revolving credit system that channels money to
and through different often cash-rich arms of the
state. The other is to take in deposits and make
loans to private customers. In one, trust is
absolute. In the other, it is wholly absent.
Many Chinese private companies do still thrive
despite a banking system that treats them like con
artists, rather than legitimate businesses with a
legitimate need for credit. The end result: the
Chinese economy, though often the envy of the
world, grows slower and is more frail than it
otherwise would be.
Everyone in China is paying a steep price for the
lack of trust, and the mispricing of credit.
Blackstone, Fidelity and
Other Pros Get Burned by
Chinese Debt Pricing
For all the media ink spilled recently, you’d
think the ongoing fight in Hong Kong between
severely-troubled Hong Kong-listed Chinese real

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estate developer Kaisa Group and its creditors was
the biggest, nastiest, most portentous blood feud
the capital markets have ever seen. It’s none of
that. It’s a reasonably small deal ($2.5 billion in
total Hong Kong bond debt that may prove
worthless) involving a Chinese company of no
great significance and a group of unnamed bond-
holders who are screaming bloody murder about
being asked to take a 50% haircut on the face
value of the bonds. The creditors have brought in
high-priced legal talent to argue their case, both in
court and in the media.
Nothing wrong with creditors fighting to get back
all the money they loaned and interest they were
promised. But, what goes unspoken in this whole
dispute is the core question of what in heaven’s
name were bond investors thinking when they
bought these bonds to begin with. Kaisa was if not
a train wreck waiting to happen then clearly the
kind of borrower that should be made to pay
interest rates sufficiently high to compensate
investors for the manifold risks. Instead, just the
opposite occurred.
The six different Kaisa bond issues were sold
without problem by Hong Kong-based global
securities houses including Citigroup, Credit Suisse
and UBS to some of the world’s most sophisticated
investors including Fidelity and Blackrock by
offering average interest rates of around 8%. If
Kaisa were trying to raise loans on its home
territory in China, rather than Hong Kong, there is
likely no way anyone would have loaned such sums
to them, with the conditions attached, for anything
less than 12%-15% a year, perhaps even higher.
Kaisa’s Hong Kong bonds were mispriced at their
offering.
It may strain mercy, therefore, to feel much
sympathy for investors who lose money on this
deal. Start with the fact Kaisa, headquartered like
China First Capital in Shenzhen, is a PRC company
that sought a stock market listing and issued debt
in Hong Kong rather than at home. Not always but
often this is itself a big red flag. Hong Kong’s stock
exchange had laxer listing rules than those on the
mainland. As a result, a significant number of PRC
companies that would never get approval to IPO in
China because of dodgy finances and laughable
corporate governance managed to go public in
Hong Kong. Kaisa looks like one of these. It has a
corporate structure, which since 2009 has been
basically illegal, that used to allow PRC companies
to slip an offshore holding company at the top of
its capital structure.
The bigger issue, though, was that bond buyers
clearly didn’t understand or price in the now-
obvious-to-all fact that offshore creditors (meaning
anyone holding the Hong Kong issued debt of a
PRC domestic company) would get treated less
generously in a default situation than creditors in
the PRC itself. The collateral is basically all in China.
Hong Kong debt holders are effectively junior to
Chinese secured creditors. True to form, in the
Kaisa case, the domestic creditors, including
Chinese banks, are likely to get a better deal in
Kaisa’s restructuring than the Hong Kong creditors.
This fact alone should have mandated Kaisa would
need to promise much sweeter returns and more
protections to Hong Kong investors in order to get
the $2.5 billion. Investors piled in all the same,
and are now enraged to discover that the IOUs and
collateral aren’t worth nearly as much as they
expected. Kaisa bonds were, in effect, junk sold
successfully as something close to investment
grade. As long as the company didn’t pull a fast
one with its disclosure – an issue still in dispute –
it’s fair to conclude that bond-buyers really have
no one to blame but themselves.
At this point, it’s probable many of the original
owners of the Kaisa bonds, including Fidelity and
Blackrock, have sold their Kaisa bonds at a loss.
Kaisa’s bonds are trading now at about half their
face value, suggesting that for all the creditors’
grousing, they will end up swallowing the
restructuring terms put forward by Kaisa.
If the creditors don’t agree, well then the whole
thing will head to court in Hong Kong. If that
happens, Kaisa has threatened to default, which
would probably leave these Hong Kong
bondholders with little or nothing. Indeed, Deloitte
Touche Tohmatsu has calculated that offshore
creditors in a liquidation would receive just 2.4%

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of what they are owed. The collateral Kaisa
pledged in Hong Kong may be worth more than the
paper it was printed on, but not much.
The real story here is the systematic mispricing of
PRC company debt issued in Hong Kong. It’s still
possible, believe it or not, for other Chinese
property developers with similar structure and
offering similar protections as Kaisa to sell bonds
bearing interest rates of under 9%. Meantime, as
discussed here, Chinese property companies in
some trouble but not lucky enough to have a
holding company outside China are now forced to
borrow from Chinese investors, both individuals
and institutions, at 2%-3% a month. This is from
widely-practiced though theoretically illegal loan
sharking in China. It’s a common way for Chinese
with spare savings to juice their returns, allocating
a portion to these direct “bridge loans”.
It’s a situation rarely seen – investors in a foreign
domain provide money much more cheaply against
shakier collateral than the locals will. Kaisa’s
current woes are part-and-parcel of at least some
of the real estate development industry in China.
Kaisa seems to have engaged in corrupt practices
to acquire land at concessionary prices. It got
punished by the Shenzhen government. It was
blocked from selling its newly-built apartment units
in Shenzhen. No sales means no cash flow which
means no money to pay debt-holders.
Kaisa is far from the first Chinese real estate
developer to run into problems like this. And yet,
again, none of this, the “politico-existential” risk
many real estate development companies face in
China, seems to have made much of an imprint on
the minds of international investors who lined up
to buy the 8% bonds originally. After all, the
interest rate on offer from Kaisa was a few points
higher than for bonds issued by Hong Kong’s own
property developers.
Global institutional investors like Blackrock and
Fidelity might control more capital and have far
more experience pricing debt than Chinese ones.
But, in this case at least, they showed they are
more willing to be taken for a ride than those on
the mainland.
Curing the Cancer of
High Interest Rates in
China -- Caijing
Magazine
While China’s recent performance as an
innovator may be a disappointment, averaged
The cost of borrowing money is a huge
and growing burden for most companies and
municipal governments in China. But, it is also the
most attractive untapped large investment
opportunity in China for foreign institutional
investors. This is the broad outline of the Chinese-
language essay published in March 2015 in Caijing
Magazine, among China’s most well-read business
publications. The authors are China First Capital’s
chairman Peter Fuhrman together with Chief
Operating Officer Dr. Yansong Wang.
Foreign investors and asset managers have mainly
been kept out of China's lucrative lending market,
one reason why interest rates are so high here.
But, the foreign capital is now trying hard to find
ways to lend directly to Chinese companies and
municipalities, offering Chinese borrowers lower
interest rates, longer-terms and less onerous

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collateral than in the Rmb 15 trillion (USD $2.5
trillion) shadow banking market. Foreign debt
investment should be welcomed rather than
shunned, our Caijing commentary argues.
If Chinese rules are one day liberalized, a waterfall
of foreign capital will likely pour into China,
attracted by the fact that interest rates on
securitized loans here are often 2-3 times higher
than on loans to similar-size and credit-worthy
companies and municipalities in US, Europe, Japan,
Korea and other major economies. The likely long-
term result: lower interest rates for corporate and
municipal borrowers in China and more profitable
fixed-income returns for investors worldwide.
China First Capital has written in English on the
problem of stubbornly high borrowing costs in
China, including here and here. But, this is the first
time we evaluated the problem and proposed
solutions for a Chinese audience -- in this case, for
one of the more influential readerships (political
and business leaders) in the country.
The Chinese article can be downloaded by clicking
here.
For those who prefer English, here’s a summary:
high lending rates exist in China in large part
because the country is closed to the free flow of
international capital. The two pillars are a non-
exchangeable currency and a case-by-case
government approval system managed by the
State Administration of Foreign Exchange (SAFE)
to let financial investment enter, convert to
Renminbi and then convert back out again.
This makes the 1,000 basis point interest rate
differential between China domestic corporate
borrowers and, for example, similar Chinese
companies borrowing in Hong Kong effectively
impossible to arbitrage. Foreign financial
investment in China is 180-degrees different than
in other major economies. In China, almost all
foreign investment is equity finance, either through
buying quoted shares or through giving money to
any of the hundreds of private equity and venture
capital firms active in China. Outside China, most
of the world's institutional investment – the capital
invested by pension funds, sovereign wealth funds,
insurance companies, charities, university
endowments -- is invested in fixed-income debt.
The total size of institutional investment assets
outside China is estimated to be about $50 trillion.
There is a simple reason why institutional investors
prefer to invest more in debt rather than equity.
Debt offers a fixed annual return and equities do
not. Institutional investors, especially the two
largest types, insurance companies and pension
funds, need to match their future liabilities by
owning assets with a known future income stream.
Debt is also higher up the capital structure,
providing more risk protection.
Direct loans -- where an asset manager lends
money directly to a company rather than buying
bonds on the secondary market -- is a large
business outside China, but still a small business in
China. Direct lending is among the fastest-growing
areas for institutional and PE investors now
worldwide. Outside China, most securitized direct
lending to good credit-rated companies earns
investors annual interest of 5%-7%.
For now, direct lending to Chinese companies is
being done mainly by a few large US hedge funds.
They operate in a gray area legally in China, and
have so far mainly kept the deals secret. The
hedge fund lending deals have mainly been lending
to Chinese property developers, at monthly
interest rates of 2%-3%.
China First Capital can see no benefit to China
from such deals. Instead they show desperation on
the part of the borrower. A good rule in all debt
investing is whenever interest rates go above 20%
a year, the lender is taking on "equity risk". In
other words, there are no borrowers anywhere that
can easily afford to pay such high interest rates.
The higher the interest rate the greater the chance
of default At 20% and above, the investor is
basically gambling that the borrower will not run
out of cash while the loan is still outstanding.
Interest rates are only one component of the total
cost of borrowing for companies and municipalities
in China's shadow banking system. Fees paid to

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lawyers, accountants, credit-rating agencies,
brokerage firms can easily add another 2% to the
cost of borrowing. But, the biggest hidden cost, as
well as inefficiency of China's shadow banking loan
market is that most loans from this channel are
one-year term, without an automatic rollover.
Though they pay interest for 12 months, borrowers
only have use of the money for eight or nine
months. Spend then hoard, this is China’s business
cycle.
China is the only major economy in the world
where such a small percentage of company
borrowing is of over one-year maturity. This
imbalance in corporate and municipal lending –
long-term investment attracts only short-term
money – is a problem of ever greater magnitude in
China.
If more global institutional capital is allowed into
China for lending, these investors will likely want
to hire local teams, source and structure their
deals in China by negotiating directly with the
borrower. These credit investors would want to do
their own due diligence, and also tailor each deal in
a way that China’s domestic shadow banking
system cannot, so that the maturity, terms,
covenants, collateral are all set in ways that
directly relate to each borrowers' cash flow and
assets.
China does not need one more dollar of "hot
money" in its economy. It does need more stable
long-term investment capital as direct lending to
companies, priced more closely to levels outside
China. Foreign institutional capital and large global
investment funds could perform a useful long-term
role. They are knocking on the door.
© CHINA FIRST CAPITAL
Global outlook, China-focused investment banking for companies, financial sponsors
Tel: +86 755 86590540 Email: ceo@chinafirstcapital.com http://www.chinafirstcapital.com