JPMorgan Checks Fine Print as Kaisa Default Alerts S&P on China

By Lianting Tu & Christopher Langner

May 18, 2015 — 12:00 AM SGT Updated on May 18, 2015 — 10:08 AM SGT

Investors are scrutinizing Chinese developers’ books after Kaisa Group Holdings Ltd.’s default, as rating companies highlight accounting red flags.

A doubling of Kaisa’s debt only came to light after a potential buyer reviewed its accounts and customers sought refunds on deposits for buying properties without presale clearance. Advance payments, bookkeeping for joint ventures and perpetual bonds are among areas needing attention to assess risks, Standard & Poor’s and Moody’s Investors Service said.

“Investors are taking a closer look at the small print because they have begun to think Kaisa may not be the only one,” said Ben Sy, head of fixed income, foreign exchange and commodities for Asia at JPMorgan Chase & Co.’s private banking division. “The accounting issues surrounding Chinese developers have always been there, but the Kaisa default has increased worries about the contingent and unreported debt.”

The accurate assessment of China’s corporate debt, which S&P says was the highest in the world at $14.2 trillion at the end of 2013, has taken on new urgency as Premier Li Keqiang allows more delinquencies while trying to prevent contagion. The use of off-balance sheet vehicles and structured finance tools has prompted billionaire investor George Soros to note “eerie resemblances” between China and the U.S. in the run-up to the 2008 global financial crisis.

Borrowing Curbs

Debt at China’s developers has ballooned since 2008, when the crisis prompted the government to unveil 4 trillion yuan ($645 billion) of stimulus that sparked a wave of building. During the boom, speculators using less-transparent shadow financing built an excess of housing in some places. Researcher SouFun Holdings Ltd. says the nation has more than 10 “ghost cities” haunted by empty apartment blocks.

Seeking to rein in the excesses, policy makers began enacting curbs on real estate financing from 2010, including limits on onshore loans, bonds and funding from shadow banks. While authorities have since eased some of the rules, homebuilders still face higher hurdles to access credit.

“With the tightening in credit, financial ratios such as debt to equity and interest cover have become crucial to obtain financing,” said Liu Xuong, a Shanghai-based managing director at the transaction advisory group of Alvarez & Marsal. “So if there is a way to improve the ratios, they would do that.”

Joint Ventures

One method property companies have used that complies with the country’s accounting rules involves joint ventures, which they needn’t always consolidate onto their balance sheets.

“Many developers are using JVs to build out their portfolio without inflating their debt,” said Chris Yip, director, corporate ratings at S&P. “So we adjust for debt guaranteed by Chinese developers’ from joint ventures.”

Moody’s also makes such adjustments, said Franco Leung, a senior analyst in Hong Kong. Sunac China Holdings Ltd. is a prime example of the joint-venture trend, according to Leung and S&P’s Yip. Moody’s estimates Sunac’s adjusted debt-to-capitalization ratio after factoring in joint-venture debt was 67 percent as at the end of 2014, compared with 59 percent without such obligations added.

Liu Qiang, an investor relations official at Sunac, confirmed the adjusted figure by phone on May 13. He declined to comment further on the joint-venture accounting.

Sunac’s 12.5 percent bonds due 2017 are little changed in the past year at about 107 cents, according to prices compiled by Bloomberg. Its shares have jumped 142 percent.

Perpetual Bonds

“The presence of a significant number of joint ventures could be at times opaque from a disclosure standpoint,” said Swee Ching Lim, a credit analyst at Western Asset Management Co., which managed $455 billion of assets as of March 31. “This certainly adds another layer of complexity.”

Perpetual securities also help companies cut debt ratios, as international standards allow the proceeds to be counted as equity. While the notes have no set maturity, their coupons can rise if the company doesn’t pay them off by defined dates.

Evergrande Real Estate Group Ltd., the third-largest Chinese developer by assets, has the most perpetuals among rated developers with 52.85 billion yuan at the end of 2014, according to Moody’s Leung. Its revenue-to-debt ratio was 53.3 percent after treating perpetual securities as debt, compared with 71.4 percent before the adjustment, he said.

Kaisa Footnotes

John Peng, assistant chief financial officer at Evergrande, said its perpetuals accounting complies with standards in Hong Kong, where it is listed.

Evergrande’s 8.75 percent notes due 2018 have advanced 1 cent in the past year to 91 cents. Its shares leapt 101 percent.

Perpetuals often carry rules saying any nonpayment on other obligations would force the issuer to repay the securities, according to Andrew Lam, a Hong Kong-based director at BDO Ltd.

“Although it sits nicely as equity during normal times, it can hurt as a double whammy by reducing equity and increasing debt if a company defaults,” Lam said.

Kaisa’s debt more than doubled to 65 billion yuan at the end of 2014 from six months earlier, which it explained in statements as related to requests from independent third parties for a “refund of their deposits with interest.” It said trust financing and other borrowings also contributed.

BDO and Lucror Analytics analysts said the advance deposits had characteristics of interest-bearing debt and booking them under current liabilities may have hidden credit risks.

Calls to the mobile phone of Frank Chen, a Kaisa investor relations official, went unanswered Friday. There was no immediate reply to an e-mail seeking comment.

Current liabilities at China’s 100 biggest listed developers have ballooned to the equivalent of $497 billion from $107 billion at the end of 2009, Bloomberg-compiled data show. Debt jumped to 169 percent of equity from 96 percent.

“Chinese property developers might have been short-sighted and tried to increase their valuation by using some creative accounting methods,” said Emir Hrnjic, director of education at the National University of Singapore Business School’s Centre for Asset Management Research and Investments. “In the long-run, the debt problem will surface.”