Debt guarantee chains in China, where companies guarantee loans to other unrelated companies, are not as strong as they are meant to be.  Everything appears rosy in good times, when such arrangements are made.  The real risk is the same economic headwinds driving the original debtor into default, often also negatively affects the debt guarantor's ability to pay.  This is especially true for small or mid-sized companies in a concentrated geographic area.  Given most banking relationships are local, this risk is always present.

This risk is magnified in China because such guarantee chains have played large role in driving it's rapid massive debt expansion since the 2008 financial crisis.   About 25% of US$13trn in total outstanding loans as of end of October 2014 was backed by promises from other companies and individuals to pay up if borrower defaults. 

Lenders outside traditional banking system, aka shadow bankers, have also relied heavily on guarantees to assure investors their funds were secure and to circumvent government restrictions on lending to certain types of businesses.

As typically happens when things start to slow down or go bad, what was once considered isolated, separate, and secure, turns out to really be closely linked and threatens broader/deeper risk.

Guarantees were traditionally used by state firms to back loans to undercapitalized units, Recently, they have been directed to unrelated companies.  US$20.6bn of guarantees have been extended by companies listed in Shenzhen and Shanghai to firms other than their own units over the last 2 years (+76% increase),  according to data provider Wind Information.

Guarantees play a key role in many countries where governments leverage their own balance sheets to encourage lending to small firms or to support home ownership. In US, Fannie Mae andFreddie Mac guarantee trillions of dollars’ worth of mortgages. Credit default swaps are used by private-sector lenders to insure themselves against risk of borrower defaulting.

China is, as always, different.  In China, individual companies are the guarantor.

Such guarantees gave banks false sense of security and they did not scrutinize borrowers’ ability to pay, some analysts and banking executives say.

Customers of companies forced into liquidation can also have their business negatively impacted as the debtor's assets, including machines and inventory are locked up awaiting liquidation.  Production scheduled, becomes unscheduled.

Source: http://online.wsj.com/articles/loan-guarantee-chains-in-china-prove-flimsy-1416775097

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

Tesco is in news a lot lately for all the wrong reasons: financial shenanigans from early recognition of commercial income and delayed recognition of related expenses.  What is also coming out now is how much Tesco in the past used off-balance sheet financing (special purpose vehicles (SPVs) and sale and leaseback arrangements) to artificially reduce its debt - i.e. hide its true debt picture from investors - even though it was either required to make guaranteed lease payments or buy properties back.

Background

Between 2009 and 2013, Goldman Sachs helped Tesco execute a sale and leaseback plan which used 6 SPVs to issue around £4bn worth of property bonds. Analysts think the effect of this off-balance sheet financing has been to artificially reduce Tesco’s net debt by around £2bn.

Between 2009 and 2013, 6 SPVs — Tesco Property Finance 1 through 6 — issued around £3.6bn of 30 year bonds to investors. These SPVs are not Tesco subsidiaries, although Tesco is contractually obliged to cover interest and principal payments.

Structure

For each transaction, Tesco established limited partnership to which it sold package of properties, which it leased back for 30 years with annual rent increases linked to the retail price index (RPI). 

Purchase was financed by issue of 30-year bonds by SPV, which loaned proceeds to partnership. 

Bonds and partnership loan have identical, back- to-back terms, with same fixed interest rate and repayment schedules. 

To solve cashflow mismatch between RPI-linked rents paid by Tesco to partnership, and fixed payments due on bonds, partnership and SPV, and SPV and Tesco entered into back-to-back swap arrangements. Netting off various swap and other payments, Tesco receives amounts equal to rental income and pays to SPV amounts equal to interest and principal repayments on bonds. 

Rent payments are completely circular: Tesco pays rent out of one pocket to partnership and receives it back (via SPV) in another. In simple terms, Tesco receives bond proceeds and repays interest and principal; bond investors look to Tesco as source of all bond payments, while underlying property leases are, in effect, irrelevant.

These bonds don’t appear on Tesco’s balance sheet, being treated as regular operating leases instead. But even here, disclosure is limited. While leases have 30-year term, Tesco has break option after 10 years if it buys back the properties – so it only has to disclose minimum future lease payments up until that point. And because Tesco only has option to buy back properties — and is not required to do so — cost of buying back properties is not treated as an obligation either. 

Tesco has choice between 2 obligations: (1) Buying back properties or (2) paying rent.  Yet Tesco's off-balance sheet financing allowed it to avoid recording either obligation by saying both are options.  There is only one true option, to recognize the lower of the 2 values at your liability exposure.  Tesco failed this test.

From 2010, Tesco had regular wording buried in its annual report setting out the above — until this year, when it added:  "
Current market value of these properties is £5.4bn (2013: £5.2bn) and total lease rentals, if they were to be incurred following option exercise date, would be £4.2bn (2013: £4.1bn) using current rent values.  

Discounting £4.2bn back to present value increases Tesco’s total debt by £2bn.

How many times until leaders learn off-balance sheet financing is a paper allocation exercise which simply serves to mask the true transparent situation of the company.  Rarely is it really off-balance in the send the liability does not belong to the company itself in the end.

Ultimately, when leadership of a company becomes more focused on managing numbers, they lose focus on managing to take care of customers.  Result is a company in double whammy trouble:  The business suffers as it loses touch with satisfying customer's needs who defect to competitors and the financial situation turns out to be worse than everyone saw on paper.

Sources:
http://ftalphaville.ft.com/2014/09/22/1979462/tescos-off-balance-sheet-wheeze-courtesy-of-goldman-sachs/
http://discount-investing.com/2014/08/26/tescos-hidden-debt/

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

The real work begins AFTER you find the real estate property you want to invest in - because disclosure laws have important loopholes.  Since real estate agent only gets paid commission when transaction closes, they are incentivized to close the deal at all costs - even at client's expense.

Massive oversight. You’ve just bought a residence right next door to soon-to-be constructed 20,000-seater stadium. So how on earth did you and your lawyer miss this?  Well, sadly, because there’s no obligation for this sort of info to be disclosed in buying process.

In UK, searches don’t have to reveal any information on nearby properties or planned private developments at all.  Only pertain only to generic public work such as road or urban renewal, or commercial centre developments. Unless you know to ask seller or estate agent specifically about private developments, they’re not obliged to offer info at all. 

Until recently, estate agents were not obliged to disclose information about any external factors that may affect property being marketed, such as train lines, flood plains or flight paths. At least, not unless they were specifically asked about such matters.  This changed in 2014 with repeal of Property Misdescriptions Act, which shifted industry to oversight of Consumer Protection from Unfair Trading Act in October 2013. From now on agents obliged to provide all price-sensitive info they have on property to prospective buyers.

Unfortunately, there’s still blurry line on what constitutes price-sensitive information. Typically understood to mean factors that materially alter residential experience.   

Every real estate agent would happily publicise a respected author, politician or playwright once having lived in property they are marketing. It makes sense because there’s value to be exploited. But what about the opposite?  Grey area is discovering property’s murky or spooky history.  Has a murder taken place in the property?  Were previous owners running brothel or drug lab on premises?   What if previous owners convinced house was haunted?  Unfortunately, no clear system to help prospective buyer acquire this info.

Real estate agent’s best strategy would be to obscure this info or market property to foreign buyer unfamiliar with local concerns.

If it's too good to be true, it is.  Better to lose a good deal, then win a bad one.  Caveat emptor, especially when no one has your best interests in mind because they are incentivzed against it.

Source: http://www.ft.com/intl/cms/s/2/08ea7f5a-601a-11e4-98e6-00144feabdc0.html#axzz3IddbN0g4 


CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

Background

• Suntech Power Holdings was forced to put its Chinese solar unit into bankruptcy in March 2013
• The slide into insolvency began in 2009 when customers linked to the company's founder were not paying their bills and yet the company booked the sales as revenue anyway
• Suntech suffered a €60m (US$720m) fraud resulting in a US$541m bond default

Missed Red Flags

• Suntech was booking revenue from sales to related companies with unbuilt projects in a fledgling industry - solar.
• Suntech guaranteed loans to those related companies. 
• Suntech relied on a former sales agent to secure one guarantee with bonds it never saw or verified actually existed.
  
• Suntech had uncollected bills from related-company projects exceeding sales from those companies by a widening margin. Receivables were US$44.7m in Q1 2011, against US$33.6m in revenue booked from the companies. Sales dried up in later quarters and uncollected bills remained.
  
• Suntech’s vehicle for investing in new solar projects in the credit crisis was Luxembourg-registered Global Solar Fund, run by Javier Romero, who was once Suntech’s external sales agent in Spain. Romero persuaded Shi to commit 258 million euros to Global Solar Fund beginning in 2008, eventually giving Suntech an 86% equity stake.  Shi himself committed €32m for almost 11% of the fund. Suntech wound up with 79% of the fund after giving part of its stake to Romero as an incentive payment.  Global Solar Fund invested in 7 solar projects, mostly in southern Italy. They became the Suntech customers that had difficulty paying their bills. One of them, Solar Puglia II S.ar.L, required the guarantee of a €554.2m bank loan from China Development Bank.  Suntech told the SEC that Global Solar Fund backstopped the guarantee with €560m of German government bonds.  Romero assured Suntech that the bonds could be sold at any time to pay China Development Bank if the project defaulted on its debt, Suntech wrote to the regulator. Trouble was: The German bonds Romero promised as a backstop never existed, Suntech said in December after looking for them for four months.
  
  

How did people miss this?  They did not check the SEC files and correspondences available online.  

The SEC’s first letter to Suntech was in November 2005, and its latest was April 2011. All of its letters were available to the public by mid-June 2011. There were about 38 equity analysts covering Suntech as of July 1, 2011, of whom 31 recommended either holding or buying the stock, data compiled by Bloomberg show.

Source:
"Suntech Unit Bankruptcy Had Roots in Deadbeat Customers", Bloomberg, April 4, 2013
http://www.bloomberg.com/news/2013-04-02/suntech-unit-bankruptcy-had-roots-in-deadbeat-customers.html

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

In July 2012, Intrepid lost control of its 80% stake in Indonesia’s Tujuh Bukit deposit.  The deposit may contain 25 million ounces of gold and 15 billion pounds of copper, in July.

Australia’s Intrepid Mines Ltd. entered into an agreement with Indonesia’s Indo Multi Niaga in 2008 for stake in the Tujuh Bukit deposit in East Java.  Indo Multi was sold to a new owner and the new holder of the project license,  Bumi Sukses Indo controlled by Indonesian businessman Edwin Soeryadjaya, in 2012.  The mining license was transferred to a separate entity, dishonoring the agreement between Indo Multi Niaga and Intrepid.  Intrepid claims it had already spent A$95 million to develop the project.  

Hong Kong-based private equity investor Quantum Pacific Investment Ltd., which represents a group holding 5.4% of Australia’s Intrepid Mines Ltd., thinks it can negotiate a new deal with Bumi Sukses Indo better than Intrepid itself.  Unlikely  to happen without any leverage on the operations.

Quantum Pacific claims the current Intrepid board has pursued a strategy that has not gone over well with the new title holders.   Instead of going in as a bull in a china shop, Quantum Pacific has gone in and tried to sit down with the new local title holders and that has gone over well, and we have gotten confidence that there is a negotiated deal to be done.  

Quantum Pacific is seeking to remove five Intrepid directors, including Gordon, at a shareholder meeting on June 20 and thinks a new leadership could recover a stake in the Indonesian asset in six to nine months.

This is exactly what Edwin Soeryadjaya wants - the foreign investors fighting each other while he moves forward with his own plans without them.

Like China before it, Indonesia plays by its own rules.  If you are a foreigner expect to get fleeced unless they have continuous control and leverage over the operations.  This means controlling the money and the licenses.  Anything less is amateur hour at the comedy club.

Source: 
"Quantum Says Can Recover Intrepid Indonesia Stake With New Team", The Jakarta Globe, May 20, 2013
http://www.thejakartaglobe.com/business/quantum-says-can-recover-intrepid-indonesia-stake-with-new-team/

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

S&P estimates China will need more than $8 trillion for refinancing during the five years ending 2017, accounting for half of such needs in the Asia-Pacific region.  

Bloomberg data shows borrowers from Hong Kong and China have sold 7x more bonds to repay existing debt this year than in the first five months of 2012. 

Bright Food Group Co., which has operations from dairy to wine, issued US$500 million of securities maturing May 2018, according to data compiled by Bloomberg. The company will use the funds to repay financing for its acquisition of British cereal maker Weetabix Ltd., Moody’s Investors Service said in a report on May 7.

This is how the beginning of the end begins.  Companies and governments issue new debt to pay off old debt as the cash flows of the underlying asset/investment do not generate sufficient returns to pay off the original debt.  And they never will.  Kicking the can down the road works for a time, that is until the road ends either because runaway inflation prevents governments from continuing to print money or investors balk at rolling over the debt again forcing a bankruptcy restructuring.

Source:
"China Corporate Debt to Overtake U.S. Within Two Years, S&P Says", Bloomberg, May 15m 2013
http://www.bloomberg.com/news/2013-05-15/china-corporate-debt-to-overtake-u-s-within-two-years-s-p-says.html

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

A recent settlement between the U.S. SEC and a husband-and-wife team that ran a Chinese maker of pollution control equipment provides another shining example of how due diligence was not "do" diligence.

In this case, CEO Zou Dejun and his wife, the chairwoman, Qiu Jianping, ran Rino International, at one time worth about US$500 million on Nasdaq.  It collapsed after short seller Muddy Waters accused it of claiming revenue from nonexistent contracts. More than three years ago, the company raised $100 million from American investors in a stock offering.

The S.E.C. complaint said the company kept two sets of books. The Chinese books, which the S.E.C. said were correct, showed total revenue of $31 million from the first quarter of 2008 through the third quarter of 2010. The United States books, which were used in financial statements, showed revenue of $491 million, or about 15 times as much.

Shocking!  A Chinese company with more than one set of books?  This surely has never happened before in China or anywhere else.  Nod, nod, wink, wink.

The S.E.C. said that days after the 2009 public offering, the couple, who together controlled 65 percent of the company’s stock, used $3.5 million of the money raised to buy a home for their use in Orange County, Calif., then gave conflicting accounts to auditors regarding how the money was used. They eventually signed notes indicating that they had borrowed the money from the company.  So they got caught with their hand in the company cookie jar, and the auditors did not think maybe something else is going on and just took everything else at face value?  Well done to the due diligence team.

The fraud fell apart in November 2010 after the Muddy Waters research Web site, which seeks out stocks to sell short and has exposed a number of Chinese frauds, released a report saying some of the company’s reported revenue came from fraudulent contracts with purchasers.   A few days later the company’s auditors, Frazer Frost, reported that Mr. Zou had admitted that some of the contracts did not exist. The auditors withdrew their previous certifications of the financial results.

Again, well done to the Frazer Frost auditors for the level of rigorousness on this one.  They were clearly more concerned with getting paid than fulfilling their responsibility for investors.

On Nov. 30, the company sent a letter to the S.E.C. saying it intended “to file restated audited financial statements” for 2008 and 2009 “as soon as practicable.” It has made no such filings since, and the company’s Web site is no longer available.

Source:
"Couple Settle Fraud Case Involving Chinese Company", New York Times, May 15, 2013
http://dealbook.nytimes.com/2013/05/15/chinese-couple-settle-s-e-c-fraud-case/

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

Article in SCMP about shadow banking practices includes telling examples of how business is really done in China.

Conflict of interests are rife in China.  When there is the opportunity for employees to use their company positions for personal gain, assume they are doing so.  Even if they have to put personal interests and enrichment at the expense of company interests.  Chalk this up to the lack of a moral compass in Chinese culture as the result of the communist government stamping out religion.  Everything is acceptable unless caught.  Company policies are not compliance in China.

• With an average loan size of 133,000 yuan, loans of 20 million yuan loan to a fish farm and a 5 million yuan loan to a furniture store. Within a year, both defaulted.
• Undeterred by the defaults, made another 20 million yuan loan at cut-price rates and over an unusually long maturity to a small local air-conditioner company that boasted it was in line for a stock exchange listing.  Discovered,  the managers had accepted stock options from the company in the hope that a loan would translate into a handsome profit for themselves personally when the borrower finally listed.
• Private equity investor who used his connections with a big state bank to obtain cheap funds, which he proposed investing in local government infrastructure projects. Only his "equity" stakes would come complete with a buy-back clause, which effectively meant they were loans, disguised to allow the bank's executives to exceed both their loan quotas and their lending rate cap to pocket a handsome 25 per cent return."

Source:
"Illuminating confessions from a shadow banker", South China Morning Post, May 15, 2013.
http://www.scmp.com/business/article/1237823/illuminating-confessions-shadow-banker

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.