Commentary

What investors and market observers can learn from Evergrande situation

Evergrande has made global headlines in recent weeks and remains an evolving situation.

Investors are still anxiously waiting for more information on whether the company will make good on interest payments of US$83.5 million (S$113 million) due on one of its offshore bonds.

When all is done and dusted, there would be much more to be learnt from this episode.

From what is known so far, there are several key takeaways from Evergrande.

1 WHAT YOU SEE MAY NOT BE WHAT IT IS

While total liabilities of around two trillion yuan (S$420 billion) have been widely publicised, this is based off Evergrande's latest available unaudited consolidated balance sheet as at June 30.

However, various media had surfaced that Evergrande had financed certain parts of its business through wealth management products (WMPs) mainly sold to retail investors including employees and where 40 billion yuan has reportedly come due.

It is still unclear to us what the exact terms of such WMPs are and whether these are outright guaranteed by subsidiaries.

The company also has various other obligations that may still materialise, if certain conditions are unfulfilled.

This means we cannot discount the possibility that the actual level of liabilities could exceed US$304 billion.

2 TOO MANY LIABILITIES COMING DUE

Assuming all the on-balance sheet liabilities were all there is, this is still undoubtedly a large amount relative to the reported total assets of 2.4 trillion yuan, where 54 per cent consist of uncompleted properties. Large liabilities themselves were unlikely insurmountable in benign market conditions where financing was freely available and where assets have a liquid market.

This is especially more so if assets can fetch more in the open market than what was recorded on the balance sheet.

However, it is no secret that liquidity has been tightening for the China property sector, with oversupply in certain regions, and that investors could no longer take for granted that refinancing would happen at a reasonable cost.

In the case of Evergrande, the company had been trying to sell non-land assets for months to generate cash but there was little notable progress.

Short-term liabilities at Evergrande due within a one-year period represented 80 per cent of total liabilities as at June 30 this year. It would require a gargantuan effort to find that much financing in a condensed amount of time.

3 WHEN CASH REALLY NEEDS TO BE USED FOR SOMETHING ELSE

In certain industries, it is a common practice for companies to receive cash upfront before goods and services are rendered and so is the case for Chinese property developers.

This cash appears on balance sheets. Subject to local regulations, the cash is allowed to be used by developers for other purposes such as paying lenders and shareholders, buying new land for expansion or even buying a football club.

However, the question then becomes: If the cash is used elsewhere, where would the cash to build houses come from? After all, there is a contractual liability to deliver houses to the buyers who had paid good money for them.

Historically, when property markets and financing markers were robust, the answer was simpler. Sell more unbuilt houses and raise money from banks and investors.

However, with an overriding policy direction in China that housing is meant to be for living, not for speculation, and the imposition of limitation over additional debt to be taken by developers, these mean that the previously robust markets may no longer be so.

As at June 30 this year, contract liabilities which would be where such obligations are likely to sit were reported as 216 billion yuan.

4 WHEN EQUITY MAY NOT BE EQUITY

Company assets can be funded in many ways, commonly through funds provided by lenders and shareholders who invest in a company's equity.

All things being equal, before companies pay shareholders, lenders (such as bondholders) would need to be paid first and this is most stark in a liquidation scenario where lenders have rights to recoup losses before others. This partly explains why bond-holders require a much lower investment return, which is typically also a fixed contractual payment, whereas shareholders want to be rewarded when a company prospers.

These "rules" also mean that in practice, lenders are better protected if a company funds itself more by equity rather than debt.

In the case of Evergrande, minority interest amounted to 220 billion yuan as at June 30 this year. Selling stakes in subsidiaries and welcoming new minority investors is a common business practice.

Often, this is a smart way to mitigate business risk which may be fraught in a property development project.

Having other equity investors means a parent company can share the pain should a project be unsuccessful.

However, it is worth noting that minority interest makes up 54 per cent of Evergrande's already thin total book value of equity, begging the question of why a company as prominent as Evergrande needed so much money from business partners and what the specific nature of such minority interest is.

While we do not have the full answers, minority investors in its onshore subsidiary Hengda Real Estate Group had terms which were "debt-like" as these investors had rights to redeem their stake in Hengda, or obtain more shares in Hengda for no consideration.

These were subsequently waived, averting potential liquidity stress last year, though it is yet unknown what the company offered in lieu of the waiver.

5 LENDERS WHO SIT TOO FAR FROM ASSETS

All lenders are not necessarily equal and how much each group of lenders can get back in a negotiated debt restructuring significantly depends on their bargaining power.

Much depends on the specific entity that lenders have lent their money to and the corporate structure of the whole group.

Evergrande's US dollar-denominated bonds are issued out of offshore entities (of which, US$14 billion is issued out of the Cayman Island incorporated listed entity).

In contrast, Evergrande's main assets are located in China.

This is not an unusual arrangement and par for course for investors who are active in bond markets.

However, it does mean that in an adverse situation, being far from assets would mean lower bargaining power versus other lenders, especially against other lenders who have direct claims over assets.

Compounding this is the fact that total offshore bonds of US$19 billion represent only 6 per cent of reported total liabilities and likely even smaller when off-balance sheet liabilities are properly accounted for.

While Evergrande is providing an invaluable experience for investors and market observers, the same could be said for past restructurings big and small.

Evergrande's scale, though, means that effects would ripple and the unfolding situation would be closely watched.


• The writer is a credit research analyst at OCBC Bank's global treasury research and strategy team.

A version of this article appeared in the print edition of The Straits Times on September 28, 2021, with the headline 'What investors and market observers can learn from Evergrande situation'. Subscribe