27/06/22, Oaktree and Evergrande
Pissed off distressed investor versus broken real estate developer
Hello everybody, and welcome to week four of this newsletter. As of writing, we’re at 497 subscribers. So close! I promised my parents I’d take them out to dinner if I hit 500 - so any recommendations, feel free to message me on LinkedIn lol. And no vegan or similarly calorie-light restaurants - I’d rather not spend £30 on a bowl of air.
With that being said, let’s dive in!
Outline
What do you get if you mix a load of debt with Chinese real estate and the same distressed debt fund that obliterated PE fund Apollo in the Caesars Entertainment Bankruptcy?
If you said ‘the plot of a really boring Billions spin-off’, you’d be wrong (but I’d laugh).
What actually happens is that the second-largest Chinese real estate developer gets loads of its developments seized by LA-based Oaktree Capital Management.
Today I will show you how the political and economic climate in China led to Evergrande taking on $300b in liabilities, and ultimately defaulting on their debt.
However, nifty distressed investor Oaktree was able to claim $1b of Evergrande property as security on their debt.
Timeline
1995: Howard Marks and Bruce Karsh set up Oaktree Capital Management. Marks came from the junk bond trading bonanza of the 1980s, whilst Karsh was an ex-corporate lawyer. Together, they would figure out how to lend money to poorly-performing companies and ensure - whether the company went bankrupt or not - that they would always get paid (this style is called distressed debt investing).
1996: Evergrande is founded - at this point, it was named the Hengda Group.
2019: Oaktree begins relocating senior portfolio managers to Hong Kong and mainland China, being one of the first distressed debt funds to do so. Simultaneously, Brookfield acquire a controlling stake in Oaktree at a valuation of circa $7b.
September 2021: Evergrande begins missing payments on its foreign bonds.
December 2021: Evergrande is placed in default by ratings agency Fitch.
January 2022: In response to Evergrande defaulting on $600m loan, Oaktree seizes ‘The Castle’, a 2.2 million sqft plot currently being constructed by Evergrande. This project was supposed to be a Palace of Versailles for Evergrande chair Xu Jiayin. So much for that.
February 2022: In response to Evergrande defaulting on a $400m loan, Oaktree seizes ‘The Venice Project’, a 294 apartment development currently being developed by Evergrande. Look at the end of the timeline to see just how sprawling this property development was.
Present day: Evergrande’s stock has fallen 90% from its peak, with creditors owed around $300b. Nice financial management there, guys! Oaktree stand to gain a 20% windfall on their $1b, which is a pretty nice return on a few years of lawyering and financial modelling (and probably a good bit of praying).
Analysis
What caused this collapse?
At its peak, Evergrande had $300b of liabilities. A milieu of policy schemes by the CCP, low interest rates, and unparalleled consumer demand for property (to the point where Chinese families were routinely buying apartments before construction had even begun) all combined to create super-leveraged developers like Evergrande.
And this problem extends to other multi-billion dollar developers like Kaisa Group, Sunac, and Sinic Holdings, who have all struggled with liquidity in recent months.
Whilst the CCP strongly regulates some areas, such as banning for-profit tutoring, they pay little attention to the developers that have now become widely distressed. For example, Evergrande (and many other developers) sold wealth management products to retail investors, only for these funds to be invested in fake companies or to pay off existing shortfalls in Evergrande’s operations.
So, with all these negative factors surrounding Evergrande, it seems like their downfall was inevitable. The catalyst was ultimately a statement in August 2021 that they were about to default. Of course, global markets went haywire and total chaos ensued. This table from Bloomberg Intelligence shows just how much had to go wrong for Evergrande’s credit ratings to tank. What a cock-up.
Why don’t more people take advantage of this?
So, if this crisis seemed relatively predictable, why didn’t more funds do what Oaktree did and benefit?
Well, China is still a communist nation, and with that comes restrictions on the free-market and alienability of property that dissuade foreign investment. Overt or implicit control of Chinese companies by the CCP is common, one only has to look to Jack Ma’s Ant Group or the education sector as examples.
Ultimately, it is hard for someone without strong legal support, financial modelling prowess and a lot of balls to invest in China.
However, more than $800b of Chinese assets are owned by foreigners. There is a lot of risk, but with risk comes significant reward.
Here’s what Howard Marks, founder of Oaktree had to say on the matter:
‘When everybody else says China is uninvestable, that means the competition for Oaktree to make investments declines. We get better opportunities and more of them.’
Key takeaway: investing in China is hard, and their financial and political fabric is very different to that of the West. However, with enough capital and know-how, betting on Chinese companies can be a very lucrative endeavour.
Thank you for reading!
Hope that was a nice read, I think the Evergrande crisis is a fascinating mix of company mismanagement with macro chaos.
Anyway, I’m starting an internship on Monday for a month, so I’m not sure how I’ll continue pumping deal analysis out thrice a week. Then again, I am more machine than human so who knows. I’ll try.
Love you all,
Alex
Further readings
BBC, ‘Evergrande: China property giant misses debt deadline’
FT, ‘How Oaktree captured Evergrande’s castle’
FT, ‘Evergrande used retail financial investments to plug funding gap’
Investopedia, ‘Investing in China’
The Washington Post, ‘China’s Evergrande is in trouble. But so is China’s top-down political economy.’