The Evergrande Quantum Kitty Living Its Ninth Life

377 Views, 06 Dec 2021 04:09
  • Evergrande did a "Friday night drop" saying it might not be able to continue to perform its financial obligations. The Guangdong govt called Chairman Hui on the carpet. 
  • The PBOC, CBIRC, and CSRC appear to have thrown Evergrande management under the bus with simultaneous statements that Evergrande's case is an individual one due to "reckless expansion."
  • $82.5mm of coupons are due today at midnight. There is a demand for performance of a a guarantee on a US$260mm bond. Push has come to shove. 

Conclusions are last in this insight.

The NEW News

Late Friday night in what could be called a "Friday night drop" (no serious company looking to inform its shareholders and stakeholders releases a filing on the exchange at 8pm on a Friday night), Evergrande (3333 HK) made an announcement titled "INSIDE INFORMATION."

The important bits are highlighted. 

The sentence before the yellow bit suggesting the company had maintained "ongoing dialogue with offshore creditors" seems new. A month ago, offshore creditor groups signalled they'd had "no meaningful engagement" with the company. 

The YELLOW part is the NEW News. It is blunt, and to the point.

That the announcement is made pursuant to Rule 13.09 of the Listing Rules tells you this is "new news" rather than a continuation of previous warnings made in the H1 results announcement and in "Updates" since. 

The BLUE bit is what tells you is coming - i.e. restructuring. 

The RED bit is the immediate trigger. That is, almost certainly, a demand to perform its obligations under the guarantee of the principal of the Jumbo Fortune Enterprises bond which matured on 3 October. Apparently, Chairman Hui put up collateral at the time of the maturity which allowed a negotiated extension to the bond, at the time reported to be "more than three months", but that extension was contingent on creditors receiving confirmations and documentation from the local government, which according to some media sources has not been forthcoming. 

That bond payment guarantee demand was said to be likely to be exercised last week on Monday. It took until Friday. It is not clear what the time lag is in the terms for such a demand. 

In addition, there are coupons due on 6 December worth US$82.5mm. Those must be paid by midnight 6 December to avoid triggering an Event of Default on all the Notes issued by Evergrande (they were due 6 November and there is a 30-day grace period; so far, the company has made several payments at the end of the grace period after missing the regular payment deadline).

This $260mm + $82.5m is US$342.5mm, which is remarkably close to the US$345mm raised by Chairman Hui just over a week ago when he sold down a 9+% stake in Evergrande at a 20% discount (discussed in Goings On in Evergrande Land). 

The NEW News triggered an immediate reaction (reported by many major news outlets) from the Guangdong government, which was to call Chairman Hui onto the carpet. The Guangdong government had been charged by higher authorities earlier this summer with keeping the parties involved (Evergrande, banks, creditors, regulators) talking, and getting due diligence and restructuring teams to look at all the moving parts. 

The other related event was that (according to the SCMP and other outlets), the Guangdong government said on its website it is “highly concerned about China Evergrande's announcement”.“Per the company’s request … the government has agreed to send a working group to the company to supervise its risk management, strengthen its internal controls and to maintain normal operations.”

It was not immediately clear whether the Evergrande where people would be sent was Evergrande the offshore parent company, or Evergrande Real Estate Group - the onshore company of which Evergrande (3333 HK) owns 60% and which comprises the vast majority of the assets and liabilities of the Evergrande business. 

The People's Bank of China immediately made comment on its website (http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/4406998/index.html) and to news outlets, with the website saying:

That translates roughly to the following:

Question:  Just now, Evergrande disclosed the announcement that it may not be able to fulfill its warranty obligations.

Answer: Evergrande Group's risks are mainly due to its own poor management, blind expansion. The foreign dollar bond market is highly market-oriented, investors are more mature, strong screening ability, for the handling of related issues also have clear legal provisions and procedures. Short-term individual housing enterprises risk, will not affect the normal financing function of the medium- and long-term market. Recently, domestic real estate sales, land purchase, financing and other acts have gradually returned to normal, some Chinese housing enterprises began to buy back foreign bonds, some investors have also begun to buy Chinese housing enterprises dollar bonds.

China has always adhered to the creation of a fair market environment and steadily and orderly promoted the two-way opening of China's financial markets. Relevant departments will continue to maintain communication with relevant regulatory authorities in overseas markets, urge overseas bond-issuing enterprises and their shareholders to strictly abide by market discipline and rules, properly handle their debt problems in accordance with the principles of marketization and rule of law, and actively fulfill their statutory debt-servicing obligations. The relevant departments will provide support and facilities under the existing policy framework for the remitment of funds by enterprises to repay and repurchase foreign bonds.

Question:  The Guangdong Provincial People's Government has agreed to send a working group to Evergrande Real Estate Group.

Answer: At the request of Evergrande Real Estate Group Co., Ltd., the Guangdong Provincial People's Government has agreed to send a working group to Evergrande Real Estate Group Co., Ltd., which is a powerful measure to promote enterprise risk management, urge the effective strengthening of internal control management and maintain normal operation. We will continue to cooperate with the Guangdong Provincial Government, relevant departments and local governments to do a good job in risk resolution, maintain the stable and healthy development of the real estate market, and safeguard the legitimate rights and interests of housing consumers.

There are several important bits here. 

  1. The PBOC is throwing Evergrande management under the bus. This is not at all surprising. About 7 weeks ago the PBOC had a rare press conference talking about Evergrande and the property market but quite specifically about Evergrande. The speaker was Zou Lan, director general of the Financial Market Department, and a Bloomberg article was blunt. He said, “In recent years, the company failed to manage its business well and to operate prudently amid changing market conditions... Instead it blindly expanded and diversified.” That whole article is worth re-reading as a framework for how the PBOC and State Council will frame everything they do from here on out. In that same presser, Zou said (with my framing in italics)...
    • China’s government has insisted property not be used as a short-term stimulus for the economy (the government will not use blanket stimulus of the sector to push up prices)
    • Cities have seen an excessive surge in property prices, which mortgage restrictions helped to curtail (property prices should not go up)
    • Property investment has slumped recently after some developers faced credit problems, but this is a normal market phenomenon (over-levered tycoons will likely not survive and that is their problem)
    • Some banks have misunderstood macro-prudential policies regarding the property sector (banks thought they were supposed to curtail lending but that is not the case (retrospectively)).
  2. The PBOC is signalling that overseas bonds issued by Evergrande will be dealt cleanly, but that means no bailout.“The overseas US dollar bond market is highly market-oriented, with relatively mature investors and strong screening capabilities, and there are clear legal regulations and procedures for handling related issues.”
    • "mature investors and strong screening capabilities" means overseas investors are big boys and they could have avoided this if they wanted. They took the risk. They will reap a "market-oriented" result.
  3. The PBOC is signalling that the housing market is recovering. It may not be given the statistics I have seen (though China Vanke (000002 CH)'s November sales numbers look better than many expected), but the PBOC is going to be telling people it is recovering.
  4. The PBOC is confirming that it is well-known within government circles that the LOCAL government is now in charge at Evergrande as of Monday morning. This has multiple aspects of import.
    • The PBOC is making it clear this is the problem of the Guangdong government. The central government is watching, but if someone takes the heat for people losing money, it will first be the Guangdong government. This is not that problematic. 
    • The PBOC is making it clear that this problem is non-systemic. It is a regional problem which can be dealt with by a regional government. It does not extend one with national repercussions. 
    • This is going the way of every major government restructuring takeover of a heavily over-indebted conglomerate in the past few years. That includes Anbang, Baoshang Bank, Tomorrow Group, and most notedly HNA Group. 

In fact, the PBOC, the CBIRC, and the CSRC all issued statements on Friday - practically simultaneously - to say that the Evergrande situation is an individual case and will not cause risks to spill over into the capital markets and housing markets. 

According to the Global Times, the CBIRC said that Evergrande's failure to fulfill its guarantee obligations remains an individual case, which "will not have any negative impact on the normal operation of China's banking and insurance industry" and "the CSRC said that the spillover effects of the Evergrande incident on the capital market are under control."

So What Next?

If there is no payment of either of the Scenery Journey bond coupons on 6 December, then we move to a situation where there has been an Event of Default triggered on practically the entire known offshore indebtedness of Evergrande (3333 HK)

From that point onward the bankruptcy petitions can start, and sources tell me the lawyers have been lined up and agents funded for months. 

I expect the trading of Evergrande (3333 HK) shares may be halted Monday. They do not have to be halted - that was the reason for the Rule 13.09 announcement on Friday. It pre-empts questions about significant downward movement in the shares Monday. However if the shares fall far enough on Monday, I would expect them to be halted. 

Next, there would likely be a standstill on the offshore debt. The bankruptcy petition docs are surely ready to go, but the value of the Evergrande (3333 HK) assets are "unknown" in that there are a few major listed assets which trade at volatile prices, a few other 'large' assets such as Fangchebao, and there are unknown debts. Until a few months ago very few knew of the guarantee on Jumbo Fortune Enterprises. It was a contingent liability which could have been assessed as unlikely to require support of the guarantee. There may be others of which creditors and the public are unaware. Separately, there is the issue of Evergrande's buyback guarantees to buyers of the $2.1bn in shares in Fangchebao sold in March. And there is cash and inter-company lending between Evergrande and some of its subsidiaries which would have to be "cleaned up" before they were sold (it seemed clear that was what stopped the Evergrande Property Services (6666 HK) sale to Hopson earlier this autumn. 

The "problem" facing Evergrande creditors is that the two main listed non-property development units are their own entities. Evergrande may be the owner of the majority of shares, but they will likely not be able to act to the detriment of the stakeholders in those businesses. Separately, Evergrande is also the owner of 60% of Evergrande Real Estate Group onshore which, even if Evergrande (3333 HK) defaults, will not - to my knowledge - have defaulted. 

Negotiations on how the debt could be restructured could include packages which would deliver ownership of the listed assets (such as Evergrande (3333 HK)'s stakes in Evergrande Auto (708 HK) and Evergrande Property Services (6666 HK)) to creditors in return for extending maturities and lowering principal.  

It will take time to sort these things out. 

And the big question, unanswered over the weekend, is whether the Guangdong "work group" will go in and take over at Evergrande (3333 HK), or at the onshore real estate developer of the same name, or both.

The HNA Model

After years of "reckless expansion" (much like the words the PBOC used to talk about Evergrande Friday), followed by a couple of years of "self-help" aimed at overcoming its resulting financial woes, at the end of February 2020, the local Hainan government sent in a government and regulatory agency "work group" to HNA to "help the company resolve its liquidity problems."

The intention could have been good but the work group sought to simultaneously avoid bankruptcy, work to serve all stakeholders, including the ongoing involvement of then-current management, while avoiding missteps. It made some anyway.

The company wanted to extend debt repayment maturities in April 2020 and asked bondholders to provide their input within a relatively short time frame. It gave them 90 minutes to do so. The company had to apologise for that but existing bonds went lower in price when that happened and good will which might have been created towards a government takeover and clean workout was lost. 

It took nearly a year to untangle a bunch of the issues amongst 2000+ companies and cross-funding arrangements. 11 months after the Work Group went in, the Work Group presented a "disposal plan" and the company filed for bankruptcy in Hainan Court after creditors had asked for the process to start. 

When the news came out about some of the details the Work Group found, there was considerable consternation. Among other issues, HNA had three major listed affiliates in China - Hainan Airlines, Ccoop Group (a department store operator), and HNA Infrastructure Investment Group. It turned out that HNA had borrowed up to RMB 60 billion from the three units, using their ability to raise money from the capital markets. Those companies lent money to the HNA parent, and paid off receivables to the parent (separately, the three companies said that their assets had been used to guarantee the debts of HNA and its related entities, which seems worse). The accusations made were that these inter-company loans were "misappropriations" because the funds raised were not used for the subsidiaries themselves. That suggests that even dividends up the chain by indebted companies could be considered "misappropriation." The asset guarantees seem somehow worse.

Right now, Evergrande is in the position of being a debtor to its own subsidiary - Evergrande Property Services. If the HNA 'misappropriations' see similar labels transferred to Evergrande, those loans, the sale of subsidiary stakes accompanied by off-balance-sheet buyback guarantees, and even the high level of dividends paid out over the years by Evergrande could all come under considerable scrutiny. The chairman of HNA was eventually taken into custody for various "misdeeds" which included related party transactions at higher-than-market prices, etc. One might imagine Chairman Hui could face risk as he has always been known for being somewhat flamboyantly wealthy, and an enormous recipient of dividends over the years which constitute what is now a material portion of the net worth of the company now in danger.

Once the Hainan Court accepted the bankruptcy petition in late January 2021, it took 8+ months to come up with a restructuring plan. 

  • The company arranged for certain parties to bid, but probably did not act widely enough, and almost certainly did not give a strong enough indication of how "complete" it wanted the bids to be. Apparently several attempts made no effort at dealing with the WMP holders. 
  • The company had more than 60,000 WMP holders of whom about 35-40% were employees. The plan which was put forth gave a baseline repayment to employees which was more than six times higher than the baseline repaid to non-employees. 
  • Eventually, despite starting "in the black" in terms of assets vs liabilities with an excess of RMB 200bn+, as of 10 February this year, the company and its 321 remaining subsidiaries had RMB 253bn in assets and RMB 1.04 trillion in liabilities, with the group's 69,000+ creditors claiming liabilities of RMB 1.46trln or more but the working group had only confirmed RMB 746.7bn by the time the restructuring plan for 4,900+ creditors was passed in September this year. 

It's still a mess and will likely be a mess for a long time to come. 

The Box Is Starting To Shimmer

In old movies when something was coming in and out of view, it would "shimmer" on the screen until the 

The box holding the quantum kitty is starting to shimmer.

Like HNA, Evergrande also has offshore and onshore assets - some bought expensively (it is to note that the HK headquarters of Evergrande is actually owned by an SPV which is owned by the onshore real estate company now, though it was owned by offshore Evergrande when originally purchased), a very large number of subsidiaries which exercised what appears to have been somewhat flexible accounting, and in many cases a lack of strict adherence to regulated escrow account  funding. And as contract sales drop and suppliers and contractors stop working, the mark value of some of the assets would be in danger, which would possibly start to trigger contingent liabilities. 

Given the experience of HNA (not to mention CEFC, Anbang, Dalian Wanda, Baoshang Bank, Tomorrow Group, etc), there is a very real possibility that the onshore real estate business of Evergrande is seen to have negative shareholder equity when all is said and done. 

If the goal of restructuring it is to make the businesses - the employees, the networks, the relationships, and dare I say the customers - profitable on an ongoing basis, then the ownership transfer will need to be profitable for the new owners. Nobody is going to throw billions of dollars at this without even the prospect of making some money.

For that, the various "stakeholders" (homebuyers, lenders, employees, contractors, etc) all need to be paid in a way that makes them willing to engage with the new entity and its new controllers/management. Hengda equity holders are all the way down the list of onshore priorities. And if Evergrande debt is restructured in default, it is highly likely Evergrande debtholders "own" that Hengda equity option, which may be worth zero. 

That means the Evergrande equity holders are not likely to get anything back unless the entire process stretches a VERY long time. 

Conclusions Last

  • The announcement Friday by Evergrande puts the company in virtual limbo.
  • It is now firmly a question of when and how the debt gets restructured, not if (it has been the case for many, many months) and the box containing the quantum kitty that is Evergrande's current existence is shimmering. 
  • The PBOC, the CBIRC, and the CSRC have thrown management under the bus in order to present the case that the rest of the industry is OK as long as it has behaved and behaves responsibly. Those that have incurred too much debt and which look like they are goners are probably goners. Those with "reasonable" projects will get financing.
  • The Guangdong government has decided that Evergrande would invite it to send a "work group" so Evergrande invited them to do so, and the government will send the group in to work alongside Evergrande management in order to resolve insolvency issues. 
  • This is, as Caixin put it in an article behind a paywall, "the proven playbook" of many government takeovers of soon-to-be-bankrupt companies which ran too hot. 
  • The other part of the "proven playbook" is usually a debt standstill, discovery of a bezzle, then a later restructuring where creditors get minimal cash and/or liquid assets and a capped payout in return for not getting completely stuffed. 
  • The priority list of who gets what ONSHORE has been known for some time. In the insight nearly four months ago introducing the quantum kitty, Evergrande as a Study of Quantum Mechanics Theory, I wrote that for the central government, the ranking of stakeholders in this process regarding Evergrande is likely to be, from top to bottom:
  • The US$82.5mm of coupons due Monday 6 December are a trigger. 
  • The US$260mm bond repayment is another, and we don't know what the deadline is in the repayment demand. 
  • We may know later today or tomorrow that an Event of Default has been triggered (I had expected this to get into January after paying the coupons last month, but the Jumbo Fortune Enterprises bond repayment demand may be the straw that broke the camel's back). 

The Trade

  • I am not sure there is much of one.  The equity is still likely to go to zero. 
  • The offshore bonds may get less than people think they will get. I do not think they will get zeroed but it will take time and a lot of goodwill at the two main listed subs and an effort to make FCB work for the bonds to get paid well. I think it will end up being a very long process. Perhaps not as long as Lehman but long. The actual bankruptcy petition might come early, and restructuring at the offshore unit could be "quick" because it is less complicated than the onshore unit sub, but resolving the value of the onshore real estate developer could take years. 
  • The onshore bonds may be a better bet, because that is the business which everyone wants to save, but generically speaking, the unsecured debt is a LONG ways behind some other creditors. That said, the project equity would have to be worth very little, and the land bank less, for the unsecured creditors to get zeroed. I also expect that those higher in the list will get haircut in the interest of "fairness." I expect a bunch of the land bank can be put back to local governments, but that might mean assets are marked down as they are returned. 
  • The biggest risk for the unsecured creditors is that they are joined by lots of other unsecured creditors as contingent liabilities are realised as actual liabilities, and that too will take time.

For the moment, the best place to be may be on the sidelines. 

This insight is labelled Bearish.

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Travis Lundy
Pan-Asia Catalysts/Events
Quiddity Advisors
Japan & Hong KongEquitiesEvent-DrivenQuantitative Analysis

HK Type 4 license through Ballingal Investment Advisors Ltd. ("BIA" or "BIAL") BACKGROUND I have 20+yrs experience in A...