Taming the Asian Tiger:Revival of Non-Performing Assetson the Asian Continent

MARIA BOYAZNY

M A R I A BOYAZNY

is A principal .nSigitlL-r C;titV& Co.

Ill NL'W York. NY.

mariab @ sigulerguff.com It seems that fol lowing its financial crisis

of late \')')7 and early 199S. modernAsian society temporarily forgot theimmortal wisdom ot its great philosopher,

(x)ntucius (551-479 u.c.) who proclaimed,"Be honest, honor yoLir ancestors, and respectyour superiors." He might have as well added,"and pay your debts."" The following is an ana-lytical assessment (>!" the non-performing assetproblem facing the Asian economies post-crisisusing the roadmap of Western financial doc-trines and resulting from my observations onthe continent m I99S and 2004.

The burden of non-performing assets ha.saffected many economies at one point oranother in the history ot their economic devel-opment. The Asian financial crisis created alarge number of financially distressed compa-nies, particularly in South Korea, Thailand,Indonesia, Malaysia, and the Philippines, whichto this day continue to weigh down the con-tinent's economies. In post-crisis years,numerous events in specific countries andindustry sectors created an additional steadysupply of troubled situations.

Japan deserves a separate mention in thisarticle, as its economy has been dealing withits own problem of non-performing loans("NPLs") crippling the banking sector fornearly the past two decades. In addition todealing with domestic bad loans, the Japanesebanks became saddled with loans they made toSoutheast Asian companies. Given its own per-sistent economic problenis, instead of defusing

the etlects of the Asian crisis, Japan was forcedto take a defensive approach to maintain con-fidence in its own financial system. And C'hina,which by itself tore down its Wall to becomea major force on the world economic arenaand despite its government's protectionistregime, has for the first time in its history hadto admit and find a solution to its non-per-forming loan problem.

The countries in the Asian region havethe advantage of examining the evolution of therestructuring and bankruptcy systems in theWestern world, and identifying which measuresworked more effectively. Their challenge is tothen apply the findings in their respectivecountries, taking into account the individu-alit\' of each country's economic system, polit-ical intricacies, and cultural differences. Chinanow has the advantage of analyzing how otherAsian countries dealt and continue to deal withthe issue and set its own strategy which, if his-tory is any precedent, they will undoubtedlydo in their own unique way. This article exam-ines the scope of Asia s NPL problem, the land-scape of market participants, and how therestructuring effort is evolving in differentregions.

ASSESSMENT OE THE ASIAN NPLMARKET AND ITS OPPORTUNITY

fhe best way to grasp the scope of theAsian NPL market is to break it down bycountry or region, as each of them is in a dif-

104 TA.MINC TiiE ASIAN Trci.k: REVIVAI or NIIN-PFRFIIRMING ASSETS ON riir. ASIAN CONTINENT 2005

E X H I B I TAsian Non-Performing Loan Market

i

$500 n

$400 -

$300

$200 -

$100

$0

$414

$330

SI 45

$119

China Japan South Korea Thailand Indonesia

$7 S

Taiwan Malaysia Philippines

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fercnt stai c of its restructuring process. Economic dcvt'l-opinem. political systems, cultural and social norms, andother factors play a major rale in shaping the componentsof the restrtictLiring etiort in each individual country, aswell as the balance of power among the parties involvedat all levels.

Japan

Japan has been one ot the region's sickest patients.The prolonged economic recession in that country put alot of strain on the corporate sector. Due to its complexinter-company ownership and fmancial structures, lendingstandards have often been less than prudent. Its well-devel-oped legal system, however, is relatively effective at facil-

itating collateral repossession as well as the repaymentwork-out process. Like most reforms in Japan, the balancesheet clean-up was initially delayed by a number ot years.Foreign investors stood ready to participate in NI'L pur-chases as early as 1993, whereas thejapanese governmentdid not start putting pressure on the banks to dispose ofbad assets until 1997. At that point, the problem escalatedto a level w here the banks had to sell the loans or go bank-rupt. They chose to sell, and foreign investors boughtwith tremendous ferocity.

In the following years, particularly in 1998 and 1999,the banks embarked on a balance sheet clean-iip ofunprecedented magnitude, selling an estimated $600 bil-lion worth of paper. Patience finally paid of} for toreigninvestors, primarily investment banks and private equity

TURNAIUIUNI) MANAdf.MENT ISSUE Tub JOURNAL or I'IUVATT. EQUIIY 1 0 5

and hedge tunds tocusinir on distressed securities, whowere able to acquire assets at significant discounts to theirface value, hi one of tht- transactions. Goldman Sachs andLone Star, a U.S. private equit>' fund, ended up becomingthe biggest owners of golf properties in Japan. Deals com-pleted during those years produced handsonif returns forinvestors who had the patience and optimism to establishthe infrastructure in Japan, and wait for several years forthe government to pull the trigger on sales.

At present, an estimated $330 billion of non-per-forming assets remain in japan {sec Exhibit). However, asthe country's economy is beginning to recover, localplayers have also shown interest in this space. (Competi-tion for deals has intensified, which only means one thingtor returns—they have been filling. However, barriers toentry in this market are high—many auctions are invita-tion-only and it takes years ot building relationships toget on the auction invitation list of Japanese financial insti-tutions. Judging by the substantial remaining supply ofloans and the still relatively limited competition, com-pared to the more developed markets, the opportunitycannot be over yet, and skillful investors who know howto shitt strateg\' in the face of changing market winds cancontinue to deliver returns.

Southeast Asia

Since the 1997-199H crisis, Thailand, Indonesia,Taiwan, and Malaysia have made a lot of progress addressingthe problem. Many situations in these countries have beensuccessfully restructured, the iiquidit)' in the fmancial mar-kets has greatly improved, and the economies have recov-ered to pre-crisis levels, thereby reducing the amount ofavailable NPLs. Progress varies by country. Indonesia hasmade a considerable push over tlie past five years. Its cen-tral bank. Bank Indonesia, estimates that at December 31,2003, the Indonesian banks' tot;d NPL ratio was 8.2%, whichfurther fell to 7.8% by the end of March 2004. It should benoted that this compares widi a staggering ratio of 32.8% in1999. As a frame of reference, most Western banks aim tokeep their NPL-to-total-assets ratios below 5%.

South Korea still has another $60 billion of loans toclean up, even as the amount has been reduced from $145billion in 1999. In Korea, one in every ten consumers wasin default on a credit card or personal loan. It is no surprisethat a large portion of NPL sellers have been credit cardcompanies, forced to clean up their balance sheets to meetthe government's mandated non-performing loan require-ment of 10%. According to PrieewaterhouseCoopers,

appRjximately $7.0 billion of non-performing credit cardand personal loans were sold in 2003 alone, with Lone Staremerging as the largest buyer, accumulating $2.7 billionof that amount.

Overall, the Southeast Asian countries have decreasedthe amount of their NPLs from over $428 billion in 1999to $151 billion in 2004, nearly a 65% reduction. Theprogress is significant but the restructuring effort continues.

China

As the NPL markets in Southeast Asia and Japan getmore mature and returns start to deteriorate, investors turntheir eyes to a new land of opportunity, and it is not hardto notice it. It has the largest population iti the world, andis the fourth largest trade country in the world. Foreigncapital, drawn to the potential of its 1.3 billion consumerbase, IS increasingly being intrigued by China's future. Forseveral decades, the country's fmancial institutions havebeen run as part of one enormous state-controlled eco-nomic machine. Years of government support of unprof-itable and outright dying state-owned enterprises have leftthe country's banks saddled with defuilted loans, by mostestimates, of S414 billion which represent 40% of all loansoutstanding, according to data by Standard &: Poor's.

The issue of NPLs has become one of the biggestthreats to China's economic prosperity and its cautiousgovernment has finally come to recognize this tact. As thegovernment attempts to reform the banking seetor and setsits sights on overseas public listings for some of its fman-cial institutions, it is faced with the necessity to bring thebanks' capital ratios and reserve requirements in line withinternational standards. Ciiina initiated the process in 1999by trausterring $164 billion of NPLs from the four largeststate banks to four a.sset-management companies {"AMCs"),which received a mandate to dispose of the loans by 2009.This deadline has recently been accelerated, to the delightof eager domestic and foreign buyers. In addition to theAMC's, potential NPL sellers include state-owned com-mercial banks, domestic private and local banks, some for-eign banks, as well as provincial and municipal governments.

The loan disposition process so far has been slow,logistically convoluted and tied up in various bureaucraticgovernment bodies who approve the sales. The non-per-torming paper consists primarily of senior secured andunsecured loans, denominated in local currency, wheredebtors are mostly state-owned enterprises. Sales havebeen conducted via auctions and bilaterally-negotiatedtransactions to local and, to a lesser extent, foreign buyers.

106 TAMIN<; THE ASIAN TH:LR: KHVIVAL i>r- NciN-l'r.RroRMiN!"; ASSETS ON TIIF. ASIAN CONTINENT SPRINC 20

The latter group consists primarily ot U.S. and Europeaninvestment banks, mostly investing their own proprietarycapital, and distressed investment funds with capital frominstitutional and high-net-worth individual investors.

One of the higher-profile early deals was an actionby Huarong, of the AMCs, for over $1.5 billion of NPLs.It was won by a constirtiuni of financial institutions ledby Morgan Stanley and Goldman Sachs that also includedLehman Brothers, Salomon Smith Barney, and the Inter-national Finance Corporation, according to data byPricewaterhouseCoopers. The transaction took two yearsto complete, held up by multiple regulatory approvalbodies. Although frustrating, market sources say the dealwas a home run for the buyers (by some estimates theconsortium paid as little as SC">5 million), most ot whomcontinue to participate in the limited number ot auctionsthat have taken place since.

There are two polar camps among the Chinese NPLmarket observers—those who believe this is an unprece-dented opportunity bound to produce unprecedentedreturns in exchange for the risk, and those who have losttheir patience and packed their bags. Skeptics say that themarket is not goiiii^ to tree itself ot political and bureaucraticobstacles in the foreseeable future and that NPL sales willnot reach the scope of those in Japan in 1998-1999. Opti-mists agree that obstacles are abundant, but only inefficientmarkets create opportunities for outsized returns, and theyare willing to place bets. Proponents at investing in (]hinasay that problems in the early deals were inevitable, giventhat such a vast market was just taking its tirst steps iii theright direction. Both buyers and sellers have learned a lotin the process, and many issues have been smoothed out.C'liina is working on its new BankrLiptcy Law which isexpected tt) go into effect sometime this year. The Chinesegovernment is putting etiort into streamlining the processand is reducing the number of regulatory bodies requiredto approve the sales to probably three government agencies.

SOURCES OF SUPPLY AND DEMANDFOR NON-PEREORMING LOANS

Access to the supply of NPLs is one of the key com-ponents of success in the Asian markets. Sellers of dis-tressed loans can be classitled into the following categories:

* Banks and other financial institutions that originatedthe loans;

• Asset management companies set up by the gov-ernments to acquire the loans from the banks and

then dispose ot tliem in the market;• Local governments that acquired the loans via

nationalizations and closings of bankrupt banks; and• Foreign banks.

Many of these parties are non-economic sellers ofloans and have little regard for the intrinsic value or upsidepotential of the paper. Saddled with tremendous amountsof non-performing assets following the Asian economiccollapse, banks were forced to dispose of the paper toimprove the strength of their balance sheets and bringthem into line with capital guidelines. The motivationsof the AMC's and governnients are primarily driven bypolitical pressures and the need to facilitate the restruc-turing process to enhance econoniic growth.

The demand side of the equation consists primarilyof distressed securities tlinds and investment banks investingmostly their proprietary capital. Multilaterals such as theInternational Finance C'orporation play a role particu-larly in helping the governments develop strategy andplan for asset dispositions. Experts estimate that totaldemand for distressed assets in Asia is in the range of $25billion, most of which has already been invested. It shouldbe noted, however, that the investment banks could be asubstantial swing factor, as they have the ability to tap intotheir balance sheets and allocate substantial pools ot cap-ital opportunistically.

In Southeast Asia, where many defaulted enterprisesare family-controlled, families often step in to purchasetheir own iion-pertbrming debt for fear ot losing controlover their holdings. Social differences are also interestingto point out here—the Southeast Asian families are verymuch focused on preserving their ownership of the enter-prise, with little regard to the destiny ot the workers ortlie impact on the community. Ou the other hand, inChina, social issues are a much more important consid-eration in a restructuring—job preservation and local taxrevenues take center stage in the process.

Proactive sourcing ot paper is a key component ofsuccess in Asian investing, where only the largest issuersenjoy a liquid market. Direct access to the sellers of paper,without relying on brokers, is the way to achieve the mostattractive pricing. The investment banks, who in Westernmarkets act more as brokers of securities than purchasers,are competition as buyers for their own account. Clearly,relationships with banks, AMCs, and local governmentsare what separates those who have done successful dealsfrom those who complain about the illiquidity of themarket.

Si'IClAI TURNAIiOUND M\NA(;!'MF.N'l ISSUE TMhJoUKNAI oe I'RIVATK EcjUlTY 1 0 7

ADAPTING STRATEGY IN THE EACE OECHANGING MARKET DYNAMICS IS KEY

It IS no secret that the ability to quickly adjust todynamic market conditions is critical in any environment.It is particularly relevant in situations where the avail-ability ot supply is non-market driven and political andsocial considerations take precedence. Asia is such an envi-ronment. Single corporate loan purchases based on fun-damental credit analysis in late-stage or post-restructuringsituations have been an etlective way to generate mid-20% returns in the Southeast Asian market. However, thesupply of NPLs in that market, consisting of many family-owned companies, C(>ntinues to shrink following manybank dispositions since 1998 and a favorable economicclimate. Within the next 18 months, the remaining supplyis likely to be significandy diminished, and returns will notbe sufVicient on a risk-adjusted basis.

The opportunity in Japan is still abundant, but itsnature is changing. Large pools ot small loans have his-torically dominated the distressed loan auction sales byJapanese banks. A handful of players, including GoldmanSachs, Morgan Stanley, Lone Star, and Cerberus C .apital,have been the dominant participants in many invitation-only auctions. A typical NPL pool consists of several hun-dred small business and personal loans, which in the pastcould be bought for as little as 10 cents on the dollar. Thekey to making these transactions work is to have a stib-stantial servicing capacity that could consider each creditseparately and either negotiate a discounted payoff witbthe borrower or repossess and sell the underlying asset. Itis a very labor-intensive process which can only be effec-tively completed by hiring and training locals. One suc-cessful investor in Japan has a servicing arm employing asmany as 75 people.

As the supply of NPL pools in Japan continues todiminish, the opportunity set has shifted towards more pri-vate-equity style transactions. They involve buying singlelarge and medium-size corporate loans and convfrting thedebt into equity of the underlying enterprises. That is onlythe first component of the transaction, and a more chal-lenging part lies ahead. The purchaser needs to get involvedwith operational and managerial issues of the debtor, andfigure out ways to improve pertbrniance of the companyas a single entit>', or break it up in pieces if the sum of partsis worth more. This has to be accomplished in a complexsocial environment ot Japan, with its long-standing tradi-tions and business culture. There are examples of successwith this strategy—Ripplewood Holdings' home run

restructuring ot Shinsei Bank which is now a public com-pany and Cx'rberus C .apital's progress with its Aozora Bank.tt)rmerly Nippon Credit Bank, which is still private.

It remains to be seen how the Chinese NPL marketwill unfold, when it tmally Lnifolds—whether via sales ofpools ot loans or through larger single credit purchasesand their restructuring. Prior experience in other Asiancountries could certainly serve as a source of wisdom.

EXIT STRATEGIES

A variety' ot exit strategies could be employed inthe Asian NPL markets, and their effectiveness variescountry by country. Let us examine them individually:

Negotiated Discounted Payoffs. This strategy hasworked effectively in Japan where some ot the problemswere a result of the banks' ineffective collection etTorts,as opposed to the borrowers' complete unwillingness topay. L^isccnmted payoffs have also been the most coinmoiimethod used so far in China.

Asset Value Strategy. Repossession of the under-lying assets works best in countries with strong legal sys-tems and relative easiness of law enforceability. Japan andSouth Korea have the strongest bankruptcy systems inAsia. While judgments are obtainable in China and thePhilippines, their enforcement is challenging due io manypolitical and social issues. In Indonesia and Thailand, bothjudgment and enforcement are a challenge.

Financial Restructurings. Financial restructuringswhereby the debtor and the creditor agree on new termsfor interest and principal repayment have been a verycommon strategy in Indonesia, Thailand, and the Philip-pines. Investors in China have so far focused on assetvalues, as opposed to cash flows. The country also lacksmechanisms to ensure that debtors will abide by therestrticturing agreement.

Sales in the Secondary Market. There is an activesecondary market for post-restructuring paper in South-east Asia and Japan, once the underlying enterprise sta-bilizes its operations and cash flow. China's secondarymarket is in its embryonic stages of development. If thecountry makes further progress with bankruptcy reformand accelerates sales of NPLs, it is logical to assume thata more active trading market would follow.

Debt-jor-Eqmty Swaps. As mentioned earlier in thearticle, the Southeast Asian families do everything in theirpower not to give up ownership and control of their com-panies, making this approach very ditficult to implementin those countries. The Japanese model is evolving towards

108 TAMINC I HI- ASIAN TK,LK: NoN-l'fiti-oRMiNt; ASSETS ON THE ASIAN C^ONIINKNT Si'kING 2

this resolution and could become an etfective way to acquirecontrol ofjapanese enterprises. In C'hiiia, this approach hasnot yet been tested but I believe it could grow into a methodto cheaply acquire control of companies.

A EINAL THOUGHT

Historically, the best returns have been achieved byinvestors who had the courage to invest during times otmajtir structural market changes as well as external shocks.The Asian crisis of late 1997 and early 1998 created suchan environment in Southeast Asian countries, and earlyinvestors in those markets are still enjoying rewards. Japantook longer to realize the need for a major banking sectorclean-up, and investors who have been patient can nowbenefit from the oligopc^listic nature of that marketplaceand its high barriers to entry.

C~hina is the new frontier, with many risks, questionmarks, and unknowns. In its banking sector restructuring.China has now reached the point where the rest ot Asiancountries were in 1998, Investment history makes onethiiii^ clear—particularly in asset classes wkh limited supply,pioneers who establish a traiichise betortf a marketplacegains wide acceptance have the greatest potential torrew'ard.

'/(' order reprints of this artidc. please contact Ajani Malik at

iUiudik@iijournaL<AOiii or 212-224-M05.

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