Evergrande debt restructuring is almost unavoidable

China's Evergrande Group is in deep trouble. A debt restructuring is almost unavoidable at the real estate developer as it struggles to repay even its suppliers. Those wishing for an “orderly wind down” will end up disappointed and empty-handed. Those who come away with any semblance of their investment will have played politics to get to the front of the line. It’ll be like the Hunger Games.

What does an “orderly” endgame really mean? The vantage point is important. If you’re concerned that Evergrande will create financial contagion, you don’t have to worry too much. China has an incentive to ensure the stability of its banking system. Any unwinding of Evergrande, while inevitably involving haircuts, will be gradual and slow. 

It’s different if you are a bond holder asking how much claim you have on Evergrande’s dwindling assets. You may have structural seniority — that is, first claim to assets in the event of a bankruptcy or liquidation — but it’s not going to matter. As long as Evergrande’s bonds are not in actual default, billionaire founder Hui Ka Yan can choose who he wants to redeem first. Those loudest on social media, or who cite China’s “common prosperity” drive, or even threaten street protests, will likely be paid off first. 

Evergrande’s dollar bond holders need only look at how investors in China have responded to the developer’s latest crisis. Over the years, it sold wealth management products to its suppliers, apartment buyers and even its own employees. For instance, when Evergrande settled construction project costs, it often asked suppliers to buy products sold by Evergrande Financial Wealth Management (Shenzhen) Co., a wholly-owned subsidiary, to the tune of about 10% of total construction bills, according to Caixin, the influential financial media outlet. These products, typically promised 5%-to-10% yield, reduced the developer’s immediate cash outflows. 

Evergrande also raised money this way from its own staff. In 2017, the company convinced some mid-level managers to become equity tranche investors of a 40-billion yuan trust product, which in turn bought into projects targeted by Evergrande, according to WeNews, Caixin’s premium service. Maturity of this trust, which promised 25% annual yield, had already been extended twice; some are now overdue. 

All these off-balance-sheet obligations bubbled up after Evergrande Wealth suspended repayments on September 8. According to Debtwire, some investors in the unit’s products said they had reported Evergrande’s “fraudulent fundraising” to the Shenzhen police and were preparing to file a petition to local governments. On Sunday night, hundreds of small investors went to Evergrande’s Shenzhen headquarter to demand to talk with management. “The situation appears to be very chaotic,” reported Debtwire.

Hui clearly felt pressured. On Friday, while presiding over a so-called Evergrande Wealth Conference, he promised to fully redeem his investors as early as possible. “I can have nothing, but Evergrande Wealth’s investors can’t be left with nothing too,” he said, according to Caixin. 

Social pressure, instead of structural seniority, seems to be the trump card now. Instead of propping up its bond prices, or cutting down payables to its suppliers, Evergrande is appeasing buyers of its wealth products, which do not even appear as liabilities on its balance sheet. Late last week, it promised to repay small investors with less than 100,000 yuan of holdings in full. On Monday, it went a step further, offering to redeem all investors with physical assets it owns, such as unsold apartments, store fronts or even parking lots, at as much as 52% discount to market price, reported Caixin. 

It is unclear how many products Evergrande Wealth has sold over the years. It has about 40-billion yuan due now, reported Caixin. As of June, the group held 86.8-billion yuan in cash. By the time a creditor committee is formed, how many real assets will Evergrande have left? 

Perhaps this is the lesson going forward: to get decent recovery rate, Evergrande’s bond holders need to discard corporate finance textbooks and play politics instead. Evergrande Wealth’s investors have shown them how. So let the games begin.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.

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