2012-04-19

Hundreds of billions in private placements are just covert loan sharking; high interest loans masquerade as equity stakes

Are hundreds of billions in private placement loans from private equity funds (hedge funds) the next bomb to detonate in the real estate crisis? Are these funds just covert loan-sharking and will they follow in the footsteps of the Wenzhou crisis? According to one industry insider, only about 5% of loans follow regulations, the rest are high-interest loans where investors are promised 25% returns.

In 2009 a developer named Shen Ming (name changed) invested 800 million yuan to buy land: 400 million of his own capital and 400 million from a private placement. Due to real estate controls, they never broke ground and the private placement loan was due to be repaid in February 2012. Shen Ming transferred the land rights for 600 million yuan. The fund took 400 million plus 100 million interest, while the developer received 100 million and took a 300 million yuan loss. In the crazy days of 2009, Shen Ming agreed to 30% percent annual interest rates.

Shen Ming is not an isolated case. A developer in Changsha (Hunan) said most developers have taken out high interest loans through private placement loans. In second and third tier cities, small and medium developers have used the capital for bridge loans. Although they are called private placements, 95% come from investment advisory firms said an investment manager with WINS Investment (金地集团的稳盛投资管理有限公司). Some people want to borrow, some people want to lend, the loan sharks exist in the middle. Originally, most customers wanted to invest in shares, but they didn't need equity when the loans were offering 10% interest.

A lot of private placement and private equity is called equity investment, the firm receives stock rights, but all they've done is assumed credit risk. In the current monetary and policy environment, many funds believed the credit risk was comparatively less and the returns higher. Most of these loans, however, were bridge loans. The way it works is the firm would loan the money to the developer and receive an equity stake in land, shares or future sales. After the developer received the bank loan or started selling the properties, they would buy back the equity stake for a pre-determined price. In this way, high-interest loans masqueraded as equity investment. Most of these loans returned 15-25%, with some over 30%. A lawyer in Beijing said he saw one deliver a 40% return.

The more common agreements also have equity or land as collateral; if the developer cannot meet the 25% return, they transfer land or face other punitive measures. Most of the time, however, investors are deceived. If the developer cannot meet the payment, the private placement firms do not inform investors that anything has happened. If the developer cannot pay, the private placement firms take collateral and as long as investors don't lose money, they don't complain. There is no risk control in this market, only the shared risk in the project. Some developers are selling their properties for 50% off, but they cannot find buyers because these aren't existing homes, it's just land or a half-built building. The article cites this story to illustrate the point: Soho China Plans To Buy Shanghai Property Project For CNY2.1 Billion. The reporter says that since 2009, Greentown has used the aforementioned type of financing with interest rates exceeding 20%. (Greentown has been an aggressive seller of property over the past six months.)

Greentown stands out as a large developer using this type of financing. Most loans went to medium and small firms that have much less leeway and far greater risk. Since the second half of last year, there have been more than 5 cases of small developers hitting the road in Xiamen, Changsha, Zhuhai and other cities (similar to the stories from Wenzhou), all of whom used private placement high-interest loans.

A former Merrill Lynch executive said there will be a lot of disputes between investment managers and investors over the next 3 to 5 years. There's a legal framework, but no regulations or guidelines for the private equity industry. Some developers have also invested in funds, opening the door to all manner of problems. For example, a developer would want a cost of capital to be 6%, but a private equity firm wants 30% returns. The example is given where two developers have a vote and pressure the private equity firm to reduce their interest rate.

Nevertheless, some are upbeat. Capital remains scarce and there will be many mergers and acquisitions in Chinese real estate, driving the demand for fresh capital. Private capital is more concerned with the viability of projects than banks, for example they more closely examine cash flows and can pull funding in an instant. Regulation can help the industry increase transparency and educate investors.

Above summarized from this article: 千亿地产私募起底:“大部分是变相高利贷”

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