“Foreign Investors Face Critical Test Over Chinese Bonds” Peking University Founder Group Part 1

Failure is Most Often Preceded by Failure to Prepare Adequately 

The 9 April edition of the FT had an article about the “critical” test facing foreign holders of USD bonds supported by a “keepwell” from Peking University Founder Group and by extension other similar "Chinese" bonds.

It is indeed a sad story.

So sad that I'll have to discuss it in two posts.

A few quotes to set the stage for my commentary.

A “person” quoted in the article made two comments worthy of note.

Will a Chinese parent recognise its contractual obligations under a keep-well deed, which literally gave the impression to offshore bond holders the deeds are equivalent to a guarantee?

The person added:

The Chinese parent actually took the majority of subscription proceeds back to China for its own use.

And Simmons and Simmons:

The administrator’s decision has cast significant doubts concerning the validity and enforceability of keepwell agreements, at least under [mainland China’s] restructuring process,” the law firm said in a January report

Now to my commentary.

I think the real issue here is that the bondholders failed an earlier “critical thinking test” that got them into this fix.

This is similar to the case of not knowing “insurance” from a “guarantee”. Or a “promise” from a legally binding “obligation”. Or consolidated from legal entity financials. 

The equivalent of running with scissors and wondering why you got hurt.

What in the investment world might be characterized as a “rookie” mistakes, though sadly it’s not just rookies who make this mistake. At least as they are typically defined. 

If they are looking for someone to blame, a mirror would be handy

Background

I found six outstanding bonds issued by subsidiaries of PUFG listed on the HK Exchange.

As you will notice, four of them are guaranteed by PUFG (indicated by “G” in the table below).

Only two have the keepwell and deed of equity interest purchase undertaking (indicated by “K”).

If you had looked at this time last year, most of PUFG’s outstanding bonds were ‘”supported” by keepwells / deeds of equity interest purchase undertaking.

We turn now to AA’s elder wiser brother, expert in many things Asian, for an explanation.

As is often the case, regulatory avoidance “influences” PRC financing and investing structures. There are many regulators in the PRC, but usually avoidance of SAFE (State Administration of Foreign Exchange) requirements is the primary driver. Cross border foreign currency guarantees must be registered with SAFE. A process that can be time consuming, result in requests for disclosure of all sorts of information that one would prefer not to disclose, as well as refusal to register the guarantee. Keepwells do not fall under this regulation

According to press reports, this structure is used with only 16% of outstanding Chinese offshore bonds. But note that represents some US$96 billion. 

The FT article above refers to bondholder concerns about those with keepwell structures.

This is the group of bonds that I focus on this commentary.

It’s a sad but common fact that most investment problems begin prior to the actual purchase of the investment. 

That is, before the “wise” investor plunks down his or her cash.

The first mistake so often made is a failure to read the offering documents.

Here’s a link to the Offering Circular (prospectus) for the Nuoxi Capital US$400 million 5.35% 24 Jan 2023. To which I'll refer in this and a following post. 

I am presuming that the prospectuses for other keepwell issues are similar.

The first thing to notice is that this issue is for “professional” investors.

There’s a reason for that.

The issue contains risks beyond those considered normally acceptable for retail investors.

Even if you are a professional investor (or more likely imagine you are), that should cause you to think very very carefully.

Structure

The Issuer: Nuoxi Capital, is a special purpose company set up for the “special purpose” of borrowing money.

It has no assets of its own. It conducts no operation other than borrowing funds and upstreaming them to its parent.

The Guarantor: HK JHC Company, is an actual company with assets and operations.

According to the prospectus page 17, as of June 2017 the Guarantor had (drum roll) US$28.5 million in equity capital and US$856.2 million in total assets.

You may also have noticed and I certainly hope you did that the Guarantor has some rather “large” gearing (leverage) and some rather “small” equity.

At this point you should be wondering about the capacity of the Guarantor to guarantee some US$600 million in bonds. The Offering Circular is for two bond issues: US$200 million and US$400 million..

And perhaps what it is going to use the $600 million for.

Not to worry we learn on page 55, it is going to use the funds for “general corporate purposes”.

Well actually to worry.

First, this is a rather “large” amount. One might be forgiven for wanting a bit more detail as to what "good works" this money might be put to.

One might also think that the borrower would have concrete plans and be able to supply some details. 

After all, if you borrow money, you generally borrow only as much as you need. So before you borrow, you need to know the amount so you don't wind up with too little or too much money.  

Unless of course your borrowing is motivated by negative cashflow in your business.  

Second, if you know your PRC company behaviour, you know there is classic PRC MO: borrow money outside the PRC (HK is a favorite) and funnel it to China.

If you’re a serious international investor, you should know this.

If you don’t, you probably should stay in your home marker where you could buy today's Carillon, Thomas Cook, Tesla or Gamestock.

The Parent Company: PUFG, a PRC company, was founded in 1986. Its consolidated financials as of 30 September 2017 are prepared according to Chinese GAAP. 

If you’re not familiar with Chinese GAAP, you might want to pause to ask yourself if you should proceed with this investment. Can you evaluate PUFG's financial position?

The financials shows some CNY 56.7 billion in shareholders equity composed of NCI of CNY 35.8 billion (!) and CNY 20.8 billion to shareholders of PUFG.

If you’re wondering, the fine banks that prepared the prospectus had a very high opinion of readers’ ability to convert CNY to USD. 

Or perhaps thought we should all getting used to thinking in terms of CNY. 

So they didn’t provide conversion to USD.

As per my calculation using IMF data as of the financial statement date, those numbers are in sequence US$8.5 billion, US$5.4 billion, and US$3.1 billion.

Usually in consolidated financials the NCI have a smaller share of total equity than the shareholders of the Group.  That's why they are typically called "minority interests".

That might be another sign to take a deep breath and close the prospectus unless of course you are already sleep walking your way to a “wise” investment.

What the financial position of the three above parties indicates is that the “credit” rests on PUFG, assuming of course that we assess that PUFG is sufficient credit support. 

Otherwise, you should find another “prime” asset to invest in.

What’s key then is the ability to go after PUFG in their jurisdiction with a reasonable chance of prevailing in court.

That’s a matter of structure and the law. PRC law.

So let’s look at how the transaction has been designed to “achieve” that.

Governing Law and Jurisdiction: Laws of England and Hong Kong Courts.

Hmm. But we want to go after a PRC entity in the PRC unless of course PUFG has many cash rich subsidiaries in jurisdictions where we can get a HK court judgement enforced.

This structure is probably going to work as "well" as that in Golden Belt Sukuk did.

The Parent Company Undertakings

The Keepwell Deed (Page 78) tells us that

The Keepwell Deed is not, and nothing therein contained and nothing done pursuant thereto by the Company shall be deemed to constitute, or shall be construed as, or shall be deemed an evidence of, a guarantee by or any legal binding obligation of the Company of the payment of any obligation, responsibilities, indebtedness or liability, of any kind or character whatsoever, of the Issuer or the Guarantor under the laws of any jurisdiction, including the PRC.

And

The parties to the Keepwell Deed will acknowledge that in order for the Company to comply with its obligations under the Keepwell Deed, the Company may require approvals, registrations, filings, clearance or other authorisation of PRC government authorities. The Company will undertake to use its best efforts to obtain such approvals, registrations, filings, clearance or other authorisation. The Keepwell Deed and any non-contractual obligations arising out of or in connection with it will be governed by and construed in accordance with English law.

In “little words” not a guarantee. 

May require PRC government approvals which Company will use its “best efforts” to obtain. 

Oh, and they will do that at perhaps the least convenient time to learn whether there is an obligation--after payment default occurs.

A keepwell is best written on soft paper, either Charmin tough and soft or Kleenex soft, so that one will be able to obtain the maximum benefit from it. Because it’s likely to be a limited use in getting your money.

The Deed of Equity Interest Purchase Undertaking (Page 82) also repeats that same bit of information

The Deed of Equity Interest Purchase Undertaking is not, and nothing therein contained and nothing done pursuant thereto by the Company shall be deemed to constitute, or shall be construed as, or shall be deemed an evidence of, a guarantee by or any legal binding obligation of the Company of the payment of any obligation, responsibilities, indebtedness or liability, of any kind or character whatsoever, of the Issuer or the Guarantor under the laws of any jurisdiction, including the PRC.

This disclosure appears several times in the prospectus as early as page 6.

If as the unnamed person above says you got the “impression” you had a guarantee, I suppose you can similarly conjure up the “impression” that you were repaid. 

One delusion is as good as the other.

But wait there’s more!

See Post 2.