Stranded in Evergrande’s web of debt

The overseas bondholders who poured money into China’s real estate boom have discovered to their cost that they have little recourse in the Chinese system when boom turns to bust.

By Thomas Hale, Kaye Wiggins and Wang Xuexiao · 1 July 2024

What was going through the mind of Filipino geologist Michael de Guzman as he boarded a helicopter to Busang in Indonesian Borneo in the spring of 1997? His destination was the site of what was said to be the largest gold discovery in history. Twenty minutes after take-off, the pilot heard a popping sound and felt a whoosh of air. When he turned around, one of the rear doors was open and de Guzman’s seat was empty.

Did he jump, was he pushed or is there another explanation? These are the questions underpinning The Six Billion Dollar Gold Scam, a podcast produced by the BBC World Service and CBC and hosted by Canadian journalist Suzanne Wilton, who has been reporting on the case on and off for 25 years.

The bare bones of the story are as follows: in the early 1990s, a Canadian mining company called Bre-X

Minerals, where de Guzman was chief geologist, claimed to have found “the mother lode” in the Indonesian jungle. This prompted thousands of investors, from first-timers to millionaire financiers, to empty their wallets; share prices soared.

The site was hard to access, meaning outsiders needed the services of the indigenous Dayak people as guides. Its remoteness both added to its allure and made it susceptible to corruption; as news of the gold travelled round the world, mining companies wanted a piece of the pie, prompting them to embark on a charm offensive with Indonesia’s president, the military dictator Suharto.

Given the podcast’s title, it is no spoiler to reveal that claims of a golden jackpot in Busang were absolute nonsense, ultimately leading to the loss of livelihoods and life savings. Despite this, no one was successfully prosecuted. As for de Guzman, a hard drinker whose downtime was spent in strip clubs, many held him responsible for tampering with samples that tricked the world into believing there was $6bn worth of gold on the site.

You can see why this remarkable tale of greed, intrigue and epic deceit has been catnip for storytellers: it is already the subject of a book and inspired the 2016 Hollywood movie Gold, starring Matthew McConaughey. Wilton does a decent job of making old material feel fresh, though nine episodes feels like too many. The Six Billion Dollar Gold Scam suffers not so much from of a stretching of material as a desire to include every detail and test every piece of evidence; I can’t be the only listener to have fitfully lost track of the protracted negotiations and expanding cast of men in suits.

Despite this, it is worth pressing on for the final three episodes that yield new information and a suitably mindblowing theory about de Guzman’s final hours. If you thought the scam story was good, the murder mystery is pure gold.

bbc.co.uk

In Changsha, the capital of Hunan province, Yang has just finished his morning flute practice by the lake next to his apartment. Over his seven decades he has lived in five different housing compounds, but says this one, with its greenery and nearby high-speed rail link, is the best.

Yang, who declined to provide his full name, bought into the Changsha Evergrande Oasis, one of many developments in the region, for Rmb615,000 ($85,000) in 2009. A year later, he and his son’s family moved in.

Although the name has since become synonymous with the rise and fall of Chinese real estate, back then he knew “nothing about Evergrande” or “where its money came from”.

At the time, it was expanding rapidly. The year Yang moved in, Changsha Oasis brought in Rmb1.7bn ($230mn) in sales. In 2011, when Evergrande issued over $1bn of bonds settled in dollars to overseas investors, its offer document mentioned the project nine times.

The document, which offers the most comprehensive insights into Evergrande’s funding mechanisms, bore the logos of western investment banks such as Bank of America, Deutsche Bank and Citi alongside that of state-owned Bank of China International. More pertinently, they promised coupons of up to 9.25 per cent — a highly attractive return in a world of near-zero interest rates.

It was part of a wave of bond issuance that funnelled tens of billions of dollars from western financial institutions, and the savers ultimately behind them, into China’s real estate boom.

Endorsed by Wall Street’s finest and often issued via Hong Kong, with its westernised legal system and investor protections, they represented a financial bridge between China and the wider world. But they offered none of the security usually associated with debt instruments when boom turned to bust.

The 2011 bonds fully matured in 2016, but many more recent issues with similar characteristics are close to worthless. They are being fought over by restructuring experts, and picked over by speculators hoping to salvage some returns in a Hong Kong insolvency process.

Almost three years after Evergrande first missed payments to offshore investors, China’s real estate industry is still struggling. Beijing has refused an overt bailout but has permitted local authorities to buy unsold housing. Many of the projects launched developers are unfinished, and in some cases under the control of provincial bureaucrats rather than the overseas investors who helped to fund them. In Hunan, local government late last year identified 45 unfinished Evergrande projects alone.

Dozens of investors in Evergrande bonds, the structure of which is rarely discussed outside specialist circles, declined to comment to the FT, as did the banks.

Their rise and fall sheds light on the profound differences between mainland China’s financial, legal and political systems and those of the wider world, and raises questions over how capital will flow between the two in future.

“The international investing community wanted to be part of the great real estate boom in China, and the Chinese real estate companies recognised this was an avenue to generate liquidity . . . in some senses it was a match made in heaven,” says one restructuring specialist. “Everything was premised on the assumption that the real estate market would continue to rise.”

Before Evergrande listed its shares in Hong Kong in 2009, it was already drawing in money from outside China. One former investor, who spoke on condition of anonymity, participated in a private placement that raised over $500mn in the mid-2000s.

At a creditors’ meeting, he recalls discussing one of the projects that had been earmarked for the funds. It was supposed to be completed in three to five years, but someone had visited the construction sites and found there was “nothing going on”. Money, however, “was flowing out of the account”.

The investors’ money was released from a mainland bank account after the company provided invoices stamped with an official seal. But “you couldn’t find who had signed it off”, the investor says. “They might say, you know, five tons of steel, but five tons of steel for what? It doesn’t matter.”

“What became evident was [the money] was raised against certain projects, but wasn’t necessarily spent on those projects,” he concludes.

In Hong Kong, the perils of trying to account for mainland assets and liabilities were well known after a wave of often speculative state-owned companies listed there in the 1990s.

“They were effectively towns,” says one person involved in some of the earliest listings, referring to the range of municipal assets such entities often controlled. “As much as possible, we tried to get them into the international model.”

A private property market had been recreated in the same decade in China, and by the 2000s it was a leading driver of economic growth. But, wary of the risks of an overheating property sector, Beijing was already starting to rein it in.

A 2007 circular issued by the People’s Bank of China prohibited commercial banks from lending to any developers “found to be hoarding land”, Evergrande said in its bond documents. In the same year, Safe, part of a regulatory apparatus set up to control capital flows, said it would no longer process foreign debt registration for real estate.

As a result, Evergrande relied on a structure whereby bonds were sold to international investors by a specially created vehicle outside of China, often in the British Virgin Islands. That entity sent the money it raised into China mostly in the form of equity investments in subsidiaries — and relied on the dividends from them to meet its own obligations.

Lawrence Lu, a director at S&P in Hong Kong, says the rating agency has referred to this phenomenon as “structural subordination”, a term also used in developed markets when holding companies issue debt that may have limited claims on the assets of its subsidiaries.

“Once they raise the money, they use [it] as equity to project companies,” he says. “Where the money goes, it’s outside of our expertise.”

Offshore instruments of this kind helped to fund companies such as Changsha Tianxi Real Estate Property Co, the developer of Changsha Evergrande Oasis. A chart in Evergrande’s documents shows dozens of such subsidiaries, both in China and outside.

The foreign flows were not Evergrande’s only source of financing, but they helped to kick-start presales payments from homebuyers like Yang, which could then be invested elsewhere. On its opening day, the Changsha Evergrande Oasis brought in over half a billion renminbi in downpayments. Across 62 Evergrande projects in total in that year, a total of Rmb50bn was brought in.

The investor in the private placement says that such transactions were typically arranged ahead of equity IPOs, which in turn were priced based on the value of the developer’s land holdings. That gave banks “an incentive to encourage developers who wanted to list to grow their land bank and show they could sell projects”.

It was a “fee machine”, the investor adds: from the pre-IPO bonds, the IPO itself, and then high-yield bond issues after that. The developer’s presence in Hong Kong, meanwhile, “gave it the veneer of ‘you’re covered by Hong Kong law and it looks like a normal bond’.” But in his view, that was “an illusion”. He adds: “They were always going to be the part that didn’t get paid.”

When Evergrande stopped making interest payments to overseas investors in late 2021, it was the first clear sign that something was seriously awry with China’s property model. But since then, the fate of its bonds has faded from public discussion.

A two-year restructuring negotiation, led by lawyers at Kirkland & Ellis and investment bank Moelis in Hong Kong and largely focused on its listed subsidiaries outside China, produced no deal. Moelis declined to comment. Kirkland & Ellis did not respond to a request for comment.

A court in the city issued a winding up order for Evergrande’s Hong Kong entity but it has limited legal significance unless it is recognised by courts in mainland China. Even then, the investors’ ultimate claims are equity stakes in projects in China owned through a web of subsidiaries. Evergrande also did not respond to a request for comment.

When it defaulted, Evergrande had over $20bn of offshore bond debt in issue, held by investors such as BlackRock, HSBC and emerging market specialist Ashmore. Those that still had some exposure this year, according to Bloomberg terminal data, included UK insurer Legal & General and US hedge fund Saba. All declined to comment.

Some investors spoke on condition of anonymity, including one investor at a major international firm. “It will be a very, very low price, like 0.0 something, depending on the market price of that day,” the investor says of the firm’s “legacy exposure” to Evergrande. “Over the past two years we have de-risked the sector significantly, but of course we cannot 100 per cent exit.”

She adds that the investor community was “fully aware of the structure” and that there had been “long discussions” about the bonds in the past. But there was never “clarity” on exactly how cash moved from individual projects in China to the offshore vehicles that paid bondholders and the matter of legal obligations was “overlooked”.

No full list of bondholders is publicly available. But Evergrande “was in the portfolios of ‘tourist investors’,” says one person involved in the fallout, referring to those who would not normally invest in the region but made an exception for Evergrande because it was a wellknown name.

Some hedge funds “decided, without knowing much, to pile in” when signs of distress emerged, expecting to negotiate a profitable restructuring through a US-style approach, the person adds.

Those investors have now “discovered what the lawyers already knew, that . . . it wasn’t going to be easy to enforce and it would be time-consuming and expensive, with a limited prospect of recovery.”

Claims against those who underwrote the bonds are complicated by international norms, which see fixed-income instruments as much safer than equity.

Guiping Lu, a lawyer at Mayer Brown specialising in capital markets, says investors in the US seeking redress need to prove that private bond underwriters ignored clear red flags rather than simply provided inaccurate information. That is a higher burden of proof than in more regulated equity issuance. “If you want to sue the [debt] underwriters, you need a legal basis,” he says. “What is the legal basis?”

“We have been holding the view [that] it’s not worthwhile to get involved in the recovery process,” says another investor. “The [real estate] market, in the form of what we had in the past almost twenty years . . . it’s gone.”

Online searches suggest that all 76 of the real estate projects mentioned i n Evergrande’s 2011 bond documents have been completed. But at a former Evergrande scheme a few miles away from Yang’s morning flute recital, construction has been suspended for three or four years and a crane is about to be removed. “The money has not arrived,” says one employee of a state-owned company that has taken over.

At another development, a member of staff has just completed sales of all of the apartments in the block. He used to work for Evergrande, attracted by its prestige and the staff discounts, but now his wages are paid by the government.

At a third, closer to the city centre, a woman holding a baby is anxiously checking in on an unfinished project launched by Evergrande but since taken over by a state-owned developer.

For Beijing, householders like these who have not yet received their properties are the priority. Their claims are part of a wider social contract.

Evergrande’s accounting for its revenues inflated them during 2019-2020, according to China’s financial regulator, which has imposed a Rmb4.2bn fine on the group’s mainland entity. Its auditor, PwC, has also come under scrutiny.

But individual projects were often audited at a local level: the subsidiary behind Changsha Evergrande Oasis was audited by the Hunan Yuancheng United Certified Public Accountants Office, and 2011 documents list dozens of other similar local accountants.

Compared to the 2011 bonds, future debt issues leading up to Evergrande’s collapse provided less detail as to where a growing pool of money sourced from outside China was going.

Meanwhile, dozens of Chinese developers listed i n Hong Kong have defaulted on their debts, though some have shown signs of being able to restructure outside of China.

“I don’t think any of us thought it would be a Chapter 11-style process,” says one investor in the bonds of several mainland property developers, referring to the established US insolvency mechanism. “But we thought there was a capital structure in China.” He describes his holdings as “subordinated equity”, a far more junior entity than a bond secured on real assets.

Evergrande’s financial instruments were shaped by a system that retained strict capital controls but which was at the same time hosting the biggest property boom in history.

Future foreign investment into China, whatever its structure, will have to assess the unfolding realities of a property bust that has, according to Goldman Sachs estimates, left China with Rmb30tn of unsold housing.

On the edge of Changsha, in the ruins of an unfinished theme park that was once part of Evergrande’s empire, there is only one person on site. He is taking a break from a separate project nearby to fish in what remains of a boating lake.

“There are enough houses for four billion people in China nowadays . . . I read that number online,” he says with a grin, as he throws a fish into a nearby bucket. But, like many of those left holding Evergrande’s bonds, “we’re not really all that clear”.