December 25, 2015 – January 7, 2016

Sovereign-backed corporate debt. Chinese Real Estate Developers in America. Hanergy shares unloaded at a 95% discount. RCAP files for Chapter 11 bankruptcy.

The S&P 500 is down nearly 5% through Thursday, the circuit breakers in China have been triggered twice this week (market is closed for the day after a fall of 7% – the rule was just implemented at the start of 2016 and China is already suspending it), one gigabit/second WiFi kiosks are being rolled out in New York City, North Korea has detonated a nuclear bomb as a test (apparently not a hydrogen bomb, doesn’t make me feel all that better), Crude Oil dropped below $33 a barrel (good for consumers, bad for producers) Venezuela is quickly heading to hyperflation (monthly inflation greater than 50%), Sunni – Shia tensions have spiked in the middle east after Saudi Arabia executed a high profile Shia cleric… basically welcome to 2016. Hope you had a restful holiday.

I recognize that these topics are getting a lot play in the press, so I won’t go into detail. For those who haven’t been following: for more on the Chinese stock market and the knock on effect to the rest of world markets see “Why China Is Rattling the World” by Karl Russell and K.K. Rebecca Lai in the New York Times. Note that China’s foreign exchange reserves fell $108bn in December to $3.33tn according to central bank figures (see graphic below from “China’s Shortest Day Will Prolong the Pain” in The Wall Street Journal).

For context on the history between Sunni and Shia Muslims see “Sunni and Shia: explaining the divide” by Heba Saleh in the Financial Times.

And it’s worth showing the following graphic that was in the Financial Times that highlights the company valuations of the FANGs (Facebook, Amazon, Netflix, and Google Alphabet). Irrational exuberance for some (note the PE multiples)…

Sorry, I digress. Since it has been two weeks since the last post, there are many articles in the “Other Interesting Articles” category worth reading, but I’m only going to focus on 1) Elaine Moore and Jonathan Wheatley’s “Fears mount over rise of sovereign-backed corporate debt” in the Financial Times, 2) Eliot Brown and Esther Fung’s “Chinese Developers Build In America, but Look for Buyers at Home” in The Wall Street Journal, 3) Ben Bland’s “Hanergy Thin Film founder sells 6% stake” in the Financial Times, and 4) just because RCAP filed for bankruptcy this week, I’ll cover a little of the rise and fall of this once star of public non-traded REITs.

*Note: bold emphasis is mine, italic sections are from the articles.

Fears mount over rise of sovereign-backed corporate debt. Elaine Moore and Jonathan Wheatley. Financial Times. 5 Jan. 2016.

One way for a sovereign country to keep its debt levels down is to hide it in companies that are effectively (either explicitly or implicitly, but preferably implicitly) controlled by the government.

“More than $800bn of emerging market sovereign debt is being camouflaged by the growing use of bonds that offer implicit state backing without always appearing on government balance sheets, according to new research.”

Why not, especially considering the buyers of this debt have been willing to oblige.

“The growing use of such bonds suggests developing countries are increasingly transferring debt obligations to third parties that have taken advantage of historically low interest rates to load up with cheap debt.”

“Although official debt-to-GDP levels of countries such as India, Russia and China remain low by global standards, the growth of less visible debt which they might still have to guarantee in a crisis underlines the potential scale of their liabilities.”

“New figures from JPMorgan and Bond Radar show that issuance of quasi-sovereign bonds outpaced that of sovereign bonds in emerging markets last year, raising the stock of such debt from $710bn in 2014 to a record $839bn by the end of 2015.

By comparison, the stock of all external emerging market sovereign debt stood at $750bn at the end of last year, according to JPMorgan.”

For example,

“Quasi-sovereign borrowers include 100% state-owned entities such as Mexico’s Pemex, local governments in countries such as China and entities in which the government owns more than 50% of the equity or has more than 50% of the voting rights – a description that encompasses Brazil’s Petrobas.

However, the treatment of such debt is not uniform. Bonds issued by Pemex are included in debt-to-GDP calculations for Mexico, but this is unusual and only 19 of the 181 quasi-sovereign bonds tracked by JPMorgan carry an explicit sovereign gurantee.”

Therefore, it is of no surprise that the big ratings agencies have been down grading the sovereign debt of countries with large amounts of corporate debt tied up in semi-sovereign companies.

“What can really break the dam is the quasi-sovereign element in EM external debt,” says Gary Kleiman of Kleiman International, an emerging market investment consultant. “People have always assumed there is an implicit backing, but that capacity has not been called into question explicitly.”

“Analysts say the problem extends beyond that of dollar-denominated debt. Emerging market companies have issued an estimated $23.7tn including dollar and local currency debt, up from about $5tn a decade earlier. Many such issuers are quasi-sovereigns. About $16.7tn had been issued by companies in China, according to the BIS, almost all of which carry an implicit or explicit state backing.”

Chinese Developers Build in America, but Look for Buyers at Home. Eliot Brown and Esther Fung. The Wall Street Journal. 29 Dec 2015.

As real estate developing opportunities are becoming scarce (or more financially risky) in China, the large Chinese developers are expanding into various unrelated business lines and more naturally, have expanded into new markets abroad. Interestingly, they tend to bring their buyers with them.

“Big Chinese development companies, including Greenland, Dalian Wanda Group and Oceanwide Holdings, are collectively planning billions of dollars of U.S. development, including Chicago’s third-tallest tower and a $5 billion apartment project in Brooklyn. Most of the large developers have ambitions one day to collect as much as 20% of their income from international markets such as the U.S. and England.”

“Buyers out of China thus far account for about 40% of Greenland’s Los Angeles project… Wanda is expecting foreign buyers – the bulk of which are Chinese – to buy about 30% of its 94-story, 406-unit condo and hotel project in Chicago.”

“Chinese purchases of commercial property grew to about $5 billion through the third quarter of 2015, already a record that is up from $2.5 billion in all of 2014 and $1 billion in 2010, according to real-estate services firm JLL.”

“Nowhere has the interest been more concentrated than in Los Angeles, where at least 10 Chinese developers have purchased large development sites, all within the last two years, according to JLL.”

Of course, savvy to Chinese demand for real estate in the U.S., several domestic developers of higher priced condo projects in the U.S. have set up sales offices in or agreements with listing agents in China as well.

Hanergy Thin Film founder sells 6% stake. Ben Bland. Financial Times. 29 Dec. 2015.

“Li Hejun offloaded the shares at a 95% discount to their last traded price in May, before they were suspended from the Hong Kong exchange after plunging 47% in one day.”

“This week’s share sale values HTF at $1.16bn, far below the $21bn market capitalization recorded in May.”

So here’s the skinny. Hanergy Thin Film Power, once one of the most highly valued solar companies in the world utilized shell companies and accounting methods in an investment environment that was desperately looking for renewable-high tech investments particularly with a China tie. The company’s leader, Li Hejun, in the process briefly became China’s richest person.

There is a good amount of coverage on the subject, but two articles that will help you get your head around it pretty quickly are Abheek Bhattacharya’s “Hanergy’s High Demands for Rehabilitation” in The Wall Street Journal (8/17) and Miles Johnson and Lucy Hornby’s “FT Investigation: The strange tale of ticker ‘566’” in The Financial Times (7/20).

Basically, Hanergy maintained the highest profit margins (near 50%) in the industry (despite continual sales price pressure in the industry) by selling almost all of its product to its unlisted parent company at above market pricing. But no worry, the parent company didn’t actually pay for most of the product. Rather Accounts Payable and Accounts Receivables increased on both ends. The “listed Hanergy racked up receivables equal to 101% of annual revenue.” Still, to the investment community, the stock looked to be a winner and as a result several high profile emerging market funds added the stock and helped push the valuation to about 80 times trailing earnings. Then of course the façade began to fade (particularly after the China stock market collapse in the summer). The stock was suspended and now several months later…

“The founder and chairman of Hanergy Thin Film (Li Hejun), who was once briefly crowned China’s richest man, has sold a 6% stake in his solar power group for just US$70m – valuing the company at 1/40th of the $40bn it was worth at its peak.”

RCAP files for bankruptcy; Cetera to emerge as independent company. Bruce Kelly. Investment News – Crain Communications Inc. 4 Jan. 2016.

RSC Capital Corp (RCAP) said on Monday, January 4, that it is planning on filing for Chapter 11 bankruptcy protection by the end of the month. The debt holders (Fortress Investment Group, Carlyle Investment Management, and others) will infuse $150 million of new capital and take Cetera Financial Group from the carcass and the equity holders will be wiped out. At its peak RCAP reached $39.50 a share on April 1, 2014 (assuming the current number of shares outstanding that would have implied a market cap over $3.5bn). As of January 7 the shares are trading in the OTC market at $0.0335 a share for a $3m market cap.

For a great synopsis on the rise and fall of RCAP and particularly its founder, Nick Schorsch, Bruce Kelly’s “How Nick Schorsch lost his mojo” in Investment News is a great read. In a matter of two years, Schorsch’s American Realty Capital Properties’ (ARCP) real estate portfolio went from $100 million to $21 billion (largely assisted by the related financing vehicle of RCAP). Imagine the effort of buying that much property that quickly and the prices that would have to be paid to “win” that many properties. Of course, the timing was perfect (with bottomed out pricing after the 2009 crash which subsequently rebounded meaningfully) until it wasn’t.

Other Interesting Articles

Bloomberg Businessweek

The Economist

Bloomberg – Manhattan Luxury-Home Prices in a Slide, Defying Broader Market 12/24

Bloomberg – The Return of the Affordable Starter Home 12/29

Bloomberg – Landlords Face Slowing Price Gains After U.S. Records Shattered 12/30

Bloomberg – U.S. Real Estate to Draw More Foreigners in 2016, Survey Says 1/3

Contra Corner – The Next Big Short: Jeff Bezos’ Brobdingnagian Bubble 12/31/15

FT – China orders SOEs to hire former soldiers 12/28

FT – Sydney property: pride or a fall 12/28

FT – Tokyo property: bargain basement 12/28

FT – Oil’s prologue likely to be a harbinger of worse things to come 1/3