Part I. What is Evergrande?
So this one is a colossal clusterf*ck.
Shenzhen-based The Evergrande Group ($EGRNF) is China’s second largest property developer by sales and the 122nd largest developer in the world by revenue according to the 2021 Fortune Global 500 List.* While its core business is buying land and developing it into residential real estate, it is really an investment holding company that, in addition to property development, dabbles (or dabbled, as the case may be) in hotel operations, finance, internet businesses (for real estate and automobile sales), professional sports, theme parks, mineral water and health industry businesses. This sucker has had its tentacles in a lot of pots over the years, leveraging billionaire founder Xu Jiayin’s charisma and close contacts to the government to chase whatever the “it” thing of the moment was in Chinese spheres (i.e., electric cars).**
It also happens to be levered to the tits.
It also happens to be generally indebted to the tits.
It also happens to be delinquent AF on a lot of those debts and deeply in trouble.
And it is very much at the mercy of the Chinese government which, as of about a year ago, has been on a very public crusade to tamp down on over-leveraged private companies (implemented via “three red lines”*** meant to forestall a systemic crisis). Evergrande may very well be the poster child of the very type of company the Chinese government had in mind.
Pundits are dubbing Evergrande’s emergent financial crisis China’s “Lehman” and the markets are flustered (the Dow closed down over 600 points after taking a 900+ point tumble yesterday afternoon after The Hang Seng got napalmed in afternoon trading with real estate giants like Henderson Land Development Co. ($HLDCY) getting hammered).
All eyes are on the Chinese government to see whether they’ll ultimately conclude that Evergrande is too big to fail. 😬
Part II. The Extent of the Problem.
Evergrande is a behemoth; it owes a smorgasbord of creditors including (i) banks, (ii) contractors doing the work, (iii) foreign bondholders, (iv) local investors (who often times also double as employees), and (v) homebuyers who paid in advance for (reportedly 1.6mm) new properties that Evergrande is apparently struggling to complete. At this point the question really ought to be ‘who doesn’t this company owe money to?’ The company has raised billions in debt from foreign investors (some of which trades as low as 20-30 cents on the dollar now) in addition to funds raised from over 80k retail investors to fund its construction projects across greater China. $7.4b in bond payments are due in 2022 alone and that’s after the company deals with $669mm in coupon payments through the end of ‘21 (including $615mm of that on the company’s dollar bonds).
If that sounds like a lot, well, wait until you get a load of the amount owed to other creditors and suppliers. We’re talking approximately $300b. That’s right: $300b.**** This is what happens when residential real estate constitutes approximately 17% of GDP and real estate generally equates to approximately 30% of GDP. Evergrande alone represents approximately 2% of GDP. Per Fortune:
That [$300b] is 2.4X the $123.8 bln cost of the bailout of the savings and loan industry to the U.S. government in 1998-99 and twice the $169 bln direct cost of the 2000-2001 Chinese bank bailout, both of which had enormous consequences for their respective economies.
Hence all of the sudden attention to this issue.
With amounts that staggering, the last thing creditors need to hear is some sort of inkling that the company may not be able to make near-term interest payments and otherwise appear creditworthy or, alternatively, that the Chinese government won’t bail the company out because it wants to teach over-levered corporates a lesson in financial responsibility.
⚡️Spoiler alert: they’re hearing both of those things.⚡️
Indeed, interest payments due this week on certain of the company’s bank loans are not going to be made. This obviously calls into question whether the company will satisfy coupon payments of $83.5mm on September 23 and $45.17mm on September 29 on certain of its dollar-denominated notes.
Given all of this, unsurprisingly, the company’s Hong Kong-traded shares have nosedived 90% in the past year and continued the rapid descent on Sunday going into Monday.
Talk about a falling knife:
Which only stands to reason. Last week Fitch — always late to the party — declared that default “appears probable” and Moody’s indicated that both cash and time are on short supply for Evergrande. S&P Global Ratings piled on (per Bankruptcy Data):
The liquidity and funding access of China Evergrande Group are shrinking severely, as demonstrated by an announced material drop in sales, a fall in the cash balance and the continued use of physical properties to settle payments, according to S&P Global Ratings. The Company is negotiating repayment terms and two of its subsidiaries have failed to meet guarantee obligations on wealth management products to retail investors. The ratings agency believes the Company may not be able to service debt in time, which will lead to a default scenario including the possibility of debt restructuring. Therefore, on September 15, 2021, S&P Global downgraded Evergrande and its subsidiaries Hengda Real Estate Group Co. Ltd. and Tianji Holding Ltd. to CC from CCC and its long-term issue rating on the U.S. dollar notes issued by Evergrande and guaranteed by Tianji to C from CCC-.
Such worsening parameters, coupled with the appointment of financial advisors to evaluate the Company's liquidity and explore solutions to ease the situation, imply that Evergrande's default scenario, which could include debt restructuring, is a virtual certainty, the ratings agency states.
AllianceBernstein is saying Evergrande is in crisis, the effects of which might spillover into wider parts of the Chinese economy, creating a systemic problem. The markets on Monday appeared to buy into this thinking, relying on Evergrande to spark a long overdue market correction.
All of this has a lot of people understandably afraid and extremely pissed off.
III. Who Might Get F*cked?
Among them Evergrande’s customers.
It’s hard to say exactly but it looks like Evergrande is pretty darn close to a straight-up Ponzi scheme. They collect pre-sale deposits for apartments and then use those deposits to accelerate construction on other homes that they then put up for sale and rinse, wash and repeat. This works, we suppose, when there’s demand. Lately demand has come crashing down in China thanks in large part to the government’s effort to wean the economy off of the corrupt real estate teat, significantly weakening a primary revenue stream.
And potentially weakening the Chinese middle class. As indicated by those insane GDP figures above, real estate in China is like religion. Lots of those depositors hanging in the wind are people who put down deposits thinking their new apartments constituted a sound investment. As this writer notes:
“All over China, salesclerks and factory workers are sitting on empty Evergrande apartments and dreaming of selling them at a big mark-up to fund their children’s study abroad or their own retirement.”
Apparently it’s pretty common in China for owners and employees of highly levered Chinese companies to buy “wealth management products” from said companies to help finance them when they’re in dire need. Indeed, Evergrande reportedly tapped into approximately 70 to 80 percent of its workforce back in April for large sums of money, threatening to withhold bonuses of employees who declined to provide Evergrande short-term loans. What happened next is unconscionable. Per the NYT:
Some workers tapped their friends and family for money to lend to the company. Others borrowed from the bank. Then, this month, Evergrande suddenly stopped paying back the loans, which had been packaged as high-interest investments.
Now, hundreds of employees have joined panicked home buyers in demanding their money back from Evergrande, gathering outside the company’s offices across China to protest last week.
Of course, each of these creditors should, in a fair world, be treated similarly but, of course, you have the extra bonus here of a bunch (six, actually) of scumbag senior Evergrande executives who, seeing the writing on the wall, secured redemptions of their investments. They got busted, however, and the company indicated that the funds would be returned and that those executives would be on the receiving end of some good ol’ fashioned Chinese retribution. Thoughts and prayers to those fools.
A different kind of punishment may extend far and wide. If Evergrande fails, reverberations will be extensive. Per the NYT:
Panic from investors and home buyers could spill over into the property market and hit prices, affecting household wealth and confidence. It could also shake global financial markets and make it harder for other Chinese companies to continue to finance their businesses with foreign investment. Writing in The Financial Times last week, the billionaire investor George Soros warned that an Evergrande default could cause China’s economy to crash.
Xi Jinping, China’s leader, has collided with economic reality. His crackdown on private enterprise has been a significant drag on the economy. The most vulnerable sector is real estate, particularly housing. China has enjoyed an extended property boom over the past two decades, but that is now coming to an end. Evergrande, the largest real estate company, is over-indebted and in danger of default. This could cause a crash.
The signals are there. Chinese high yield is getting crushed. Construction operators are getting annihilated across the board. And the stress is spreading to banks and financials. Even some Chinese investment grade issuance is beginning to look shaky.
Which is precisely why Ed Yardeni thinks that, ultimately, the Chinese government will be resigned to step in. There are signs that Beijing regulators are playing some ball: they’ve agreed to permit Evergrande to renegotiate payment deadlines with banks and other creditors in an attempt to sort through this hot mess. Some banks are accommodating. Per Bloomberg:
China Minsheng Banking Corp., China Zheshang Bank Co. and Shanghai Pudong Development Bank Co. had agreed to give Evergrande extensions on some project loans. Citic Trust, one of the developer’s biggest non-bank lenders, has given preliminary approval to a three-month extension on loans that were due in August, a person familiar with the matter said.
And there are additional signs that the government is growing concerned: late last week it infused $14b of short-term cash into its banking system.
But what if, beyond this small level of initial latitude, the Chinese government doesn’t intervene? Bondholders are reportedly scrambling to hedge their positions but failing to do so; they’re apparently beginning to realize that this whole situation may turn into the Hunger Games. Also per Bloomberg:
Banks’ trading desks are reluctant to offer hedging tools after some of them suffered losses earlier in the year, and due to the sparse trading of Evergrande’s CDS, according to people familiar with the matter who were not authorized to speak publicly about the matter.
Owners of Evergrande’s $19 billion in dollar bonds are currently watching their investment shrivel as they wait to find out if Beijing will step in to halt its downward spiral. For money managers used to relying on the $10 trillion swaps market to hedge downside risks, it’s an extraordinary situation.
China Evergrande Group may undergo one of the country’s biggest-ever debt restructurings, if the developer’s distressed-level bond prices are any indication.
It’s “almost unavoidable,” said Nomura International Hong Kong Ltd. credit analyst Iris Chen. Her base case is a government-supervised deal that ensures Evergrande delivers homes and pays suppliers, where dollar debt investors would get 25% of their money back. Luther Chai, a senior research analyst at CreditSights Singapore LLC, also predicts Evergrande may default and enter restructuring. That risk is being priced in, with many of Evergrande’s dollar bonds trading near 30 cents.
Evergrande restructures its debt and bondholders recover a portion of their funds. This would be an “orderly wind down,” says Omotunde Lawal, head of Barings LLC’s emerging-market corporate debt group. There may be some contagion across China’s property issuers at first, according to Nomura’s Chen, though sentiment would improve as a key overhang would be removed. She expects only a 5% recovery rate for investors in Evergrande unit Scenery Journey Ltd.
Annnnd others are evaluating the doomsday scenario:
Liquidation is a scenario where bondholders may get close to nothing. This is unlikely, says CreditSights’s Chai, because it would “wreak havoc across China’s property and banking sectors, as well as related companies such as Evergrande’s suppliers.” Morgan Stanley analysts say “all parties are incentivized to avoid a liquidation scenario” in the restructuring of any Chinese property developer. Chairman Hui Ka Yan, who controls more than 70% of Evergrande’s equity -- would lose a significant portion of his wealth.
Another negative scenario would involve Evergrande bringing some of its off-balance sheet debt -- which may include pledged assets -- back into the books, according to Nomura’s Chen. These assets could have priority over the dollar bonds in a recovery and if the off-balance sheet debt is higher than expected, bondholders could get less than 15% of their money back.
And still others are trying to be sanguine:
A complete or partial takeover by a state-owned enterprise is another possibility, though Nomura’s Chen assigns a low probability to this scenario. Evergrande could also sell its listed assets at better prices if market conditions improve, says Chen, which she predicts would give bondholders a recovery rate of 30% or more.
Evergrande could buy some time to improve its liquidity over the next year, according to Chai at CreditSights. In this scenario, Evergrande would repay some of its nearest-term dollar bonds upon maturity. The developer has two sizeable dollar bonds due over the next 12 months, or a combined $3.5 billion to pay.
Whatever. Any which way you slice it…
That’s right. The company’s most active dollar-denominated bonds — the 8.75% notes due in June 2025 — have freefalled from 84 cents at the end of May to 31 cents late last week. Similarly, the shortest-maturity bonds — due in March ‘22 — are down to 35 cents on the dollar from 99.6 cents at the end of May. The company has hired restructuring advisors: Houlihan Lokey Inc. ($HLI) and Admiralty Harbour Capital. In turn, certain bondholders have reportedly hired Kirkland & Ellis LLP and Moelis & Co. ($MC). No doubt other firms will be getting calls. Per Bloomberg:
With 13 outstanding dollar bonds, including one note touted as one of the most widely traded in the world, and a diverse group of bondholders globally, getting organized is going to be tricky.
Especially as funds trade in and out of the paper. Per Bloomberg:
Saba Capital Management, Redwood Capital Management, Contrarian Capital Management and Silver Point Capital are among funds that have built positions in offshore bonds of China Evergrande Group’s ahead of a likely default of the real estate giant.
The four investors are among the credit funds that took a position in Evergrande’s $19 billion dollar-denominated notes in recent weeks, as prices fell to about 25% of face value amid uncertainties over the future of China’s second largest developer, according to people with knowledge of the matter who asked not to be identified because the transactions are private.
You know the old saying: one company’s crisis is a lot of vulture funds’ opportunity.
Anyway, there very well may be quite a bit of asymmetric upside when you’re buying in at 25 cents on the dollar but Johnny seems to remember a time when buyside shops were VERY skittish about political risk enveloping foreign credits. But what’s a little political risk when you’ve got money to deploy and not many other distressed opportunities to play in? YOLO b*tches! 🤷♀️
Take a look at prices for steel and copper, among other things, and it’s ugly AF. There was the largest drop in steel output ever in August. Take a look at these charts:
E. The Chinese Consumer & American Companies Catering Thereto
Evergrande directly and indirectly contributes approximately 3.8mm jobs. It’s employees and suppliers are now potential victims of Evergrande’s predicament. As the government cracks down on various industries and Evergrande wavers, the consumer is getting a bit flustered. Retail sales recently dropped 11% off trend and all indicators reflect sluggish consumer confidence. This could end up affecting large US companies with China dependency. Maybe this is the reason why Apple Inc. ($AAPL) is 10% off its recently set ATH — a reason that doesn’t entirely have to do with an underwhelming product launch or misunderstood injunction.
Part IV. How Does this End?
It’s unclear. The state will likely extract enough flesh to make sure Chinese bank loans are safe. Contractors likely have security by way of mechanic’s liens and the like. But then there are the bondholders, investors and employees. Things could get ugly for them.
In the meantime, Evergrande will likely flood the market with existing property assets, and look to engage in a tremendous amount of liability management across double-digit debt issuances. It could explore selling more equity (LOL…ain’t gonna happen — especially after recent equity issuances have tanked). Or declare bankruptcy. Or…OR…get a bail out.
“It’s a confus[ing] world when equity markets are generally within a couple percent or so of their record highs whilst we’re seeing the biggest dollar-Asian-high-yield company, Evergrande, with $300 billion of liabilities, on the brink, with no-one really aware of how the work-out will be managed and whether [there will] be contagion,” writes Jim Reid, Head of Global Fundamental Credit Strategy at Deutsche Bank, this morning in a markets note.
This happened in July:
Perhaps everyone was distracted by a deadly pandemic.
This is a situation that we — along with the rest of the market — will be watching very closely.
Is there a crypto component to all of this? This thread ⬇️ suggests there very well may be. This is something we’ll also be keeping an eye out for.
*In 2018, Evergrande’s stock price made the company the world’s most valuable real estate company.
**Notably, as part of it a deleveraging sparked by a Chinese government crackdown on over leverage, the company has been divesting of non-core businesses of late. Mr. Jiayin recently stepped down as chairman of the property group; he was, before all of this transpired, roughly the 53rd richest person in the world.
***The three red lines include: (i) Liability-to-asset ratio (excluding advance receipts) of less than 70%, (ii) Net gearing ratio of less than 100%, and (iii) Cash-to-short-term debt ratio of more than 1x.
If the developers fail to meet one, two, or all of the ‘three red lines’, regulators would then place limits on the extent to which they can grow debt.
****And there’s a lot of questions as to whether this is even the right number given JV partnerships that Evergrande is part of that may carry debt off balance sheet.
⚡️Tweets of the (Early) Week: Evergrande Edition⚡️
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