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Distressed asset investment in Asia

In addition to the more glamorous history of venture capital investments in technology-related enterprises, one of the roots of the private equity industry is in the less flashy but often more profitable area of investment in distressed assets. William Hay of Lovells looks at the opportunities available in Asia.

In the US, substantial pools of organised capital have been devoted to fishing in troubled waters at least since the railway boom in the late 1800s went bust after an orgy of overbuilding. The public utility industry went through the same process in the 1930s, and more recently cheap capital and loose regulation devastated the US savings and loan industry after it poured billions into real estate investments in the 1980s.

After each of these investment booms, prices crashed as quickly as they had risen. As panicked sellers scrambled for the exit, investors with more patience or a longer investment horizon quietly moved in to take advantage of rock-bottom prices. In the evolutionary process celebrated by the economist Joseph Schumpeter as ‘creative destruction', assets migrate into the hands of investors who are better able to put them to productive use.

In the aftermath of an investment bust, public attention is naturally focused on the tragedies of the investors who have been wiped out, or the employees who have lost their jobs. But, like lancing a wound, the faster and deeper the cleaning, the quicker the healing. Once convinced the worst is past, sentiment improves and a willingness to make riskier investments returns. The cycle begins anew.

The aftermath of the bursting of Japan's bubble economy and the Asian crisis of 1997 left distressed assets strewn across Asia. The restructuring of China's planned economy -funded by government-mandated ‘policy loans' -added many more. Although the underlying causes varied from country to country -investor-driven real estate speculation in Thailand and Japan, government-driven industrial expansion in Korea and China -the results were similar: trillions of dollars in uneconomic investments made at premium prices became worth a fraction of their original value.

In the wake of the Asian crisis, investors have purchased all types of distressed assets at deep discounts. Financial investors have found value in purchasing portfolios of loans from failed financial institutions. Traders and hedge funds have purchased discounted bonds and other tradable securities in major local corporates. Real estate investors have acquired prime properties at knockdown prices from mortgage holders. And strategic corporate investors have found new opportunities to purchase failed insurance companies, banks, automobile manufacturers and other viable but distressed operating companies in industries that were formerly closed to foreigners throughout Asia.

For several years, governments across the region have been grappling with the necessity of liquidating these investments in order to restart their economies. Necessity has spawned new policies -policies favouring foreign investment, and restricting the role of the vested interests which benefited from the bubble. After a slow start, more and more assets have been resold -and more are on the way. And more and more investors are participating in these sales.

This article will walk through the steps a potential investor will consider as it evaluates and completes a purchase of non-performing loans and other distressed assets in Asia.

Understanding the environment

For many Asian countries, selling distressed assets to foreigners is a novel way of resolving economic problems in the aftermath of an investment bubble. These problems were customarily resolved through a combination of negotiation and compromise, discreet bailout or other politically - driven means. By contrast, Western investors are accustomed to resolving distressed assets against a backdrop of a strong legal system with clear legal rules.

Westerners new to Asia are often surprised that Asians pay little heed to legal rules when resolving disputes. Asians are just as surprised that Westerners expect legal rules alone to be able to resolve disputes. Distressed debt investment in Asia offers numerous pitfalls for the unprepared, and inevitably challenges the deeply-held expectations of the foreign investor.

The first step in investing in distressed assets, therefore, is to understand the climate of the country in which the investor proposes to invest. Never a sympathetic figure, the distressed debt investor is usually unable to appeal to the informal networks of influence within the country which facilitate the resolution of disputes among locals. Rather, the foreigner's ability to survive a conflict with influential locals will depend on the country's legal system.

In evaluating a legal system, there are three questions to ask:

• Are the legal rules affecting the investment comprehensive?
• If comprehensive, are the rules effective?
• If effective, are the rules enforced?
• One must ask these questions at each stage of the investment process. Going in to an investment, an investor must be confident that he will receive good title to the assets he is purchasing. He must be confident that he can obtain all licences necessary to operate in the country.

But most important, in realizing the value of a distressed debt or other asset, the investor must be confident that an authority will protect his rights as a creditor. This is true even if the investor expects to negotiate settlements of distressed debts he has acquired, as a debtor will offer more in settlement if he knows a court would otherwise force him to pay the full amount due.

Different answers to these three questions for different Asian countries account in large measure for each country's appeal to distressed debt investors.

Before the Asian crisis of 1997, only a few of the Asian bubble countries could boast strong protection for creditors' rights. These countries -together with the countries which acted quickly to strengthen their systems in the aftermath of the crisis - attracted the bulk of distressed investment in the following years.

Japan, for example, has attracted the bulk of distressed investment not only because of the size and sophistication of its economy, but also because of the perceived comprehensiveness, effectiveness and reliability of its legal system. By contrast, China - also an attractive economy - is just beginning to attract distressed investment, largely due to uncertainty regarding its evolving legal system.

In Thailand, the insolvency process was widely criticized as incomplete and ineffective in the run up to the Asian crisis of 1997. After the crisis, a reform government enacted a new insolvency system and liberalized its foreign investment regime. Although early results of these reforms are inconclusive, the willingness of the government to restructure the system encouraged foreign investment. Similarly, the proactive willingness of the Korean government to amend its laws to remedy perceived weaknesses has encouraged the substantial investments made by foreigners in Korea.

Acquiring distressed assets

In Asia, distressed assets have been resold through a variety of means. The first re-sales in any market are usually done through a public auction by the government. In Thailand, the Financial Reconstruction Agency sold loans taken over on the insolvency of the financial institutions that had made the loans. In Korea, the Korean Asset Management Company auctioned loans from its failed financial institutions. Authorities in Malaysia, China and Indonesia have conducted similar auctions.

Public auctions offer a number of important advantages in the early stages of disposition of distressed assets. Publicity surrounding the auction attracts potential investors who may not otherwise have learned of the opportunity. Disposing of assets in a public process helps ease suspicions that private transactions would benefit insiders. But most importantly, beginning the disposition process by auctioning selected assets helps set a benchmark for pricing for subsequent sales.

Once auctions have set benchmark pricing, other sale techniques emerge to supplement auctions. Often, potential investors with an interest in a particular asset are allowed to negotiate a transaction without competitive bidding. Hybrid transactions are also used, where the authorities retain ownership of a percentage of the assets to be sold. Sometimes, the authorities retain ownership of the asset and auction off the right to service the asset, generally for a service fee plus bonus payments as collections exceed specific levels.

Negotiating the purchase

Whether the purchase is at auction or through a private process, investors must make sure they get what they paid for. Often, simple transfer of title is problematic.

While purchasing one asset is generally straightforward, the purchase of a pool of assets -particularly intangible assets such as 10,000 automobile hire-purchase contracts, or 1,000 commercial loans -can present difficulties never expected under local legal systems. Completion of a transfer in most of these systems usually requires notice to be given to the borrower.

Where ownership of property is registered -as with automobiles and real property -the transfer is not complete until each asset is re-registered. Developing a mechanism to deliver notices to a large number of borrowers and re-register a large number of assets presents a substantial logistical problem, which some countries have addressed through special-purpose bulk transfer legislation.

In addition, transfers of property generally attract value added taxes in most of the countries in Asia. As these taxes can be imposed on the face value of the transfer -in other words, the undiscounted amount of the loan -these taxes can represent a significant percentage of the investment, and must be reflected in determining the purchase price.

Most sale processes for distressed asset portfolios do not allow adequate time for purchasers to complete due diligence on the assets in the portfolio. As a result, sellers must provide assurance to the purchaser that the assets meet certain expected standards - or risk having the purchase price discounted yet further to protect the purchaser against these risks.

Typically, the seller will provide the purchaser of a portfolio of distressed assets assurance that:

• the portfolio consists of all the assets set out on a list provided the purchaser;
• the assets on the list are correctly described in all material respects, including identity of borrower,
• description of loan terms and outstanding principal amount and nature of collateral;
• the assets on the list are all properly documented through enforceable legal agreements;
• none of the assets on the list is more than a certain number of days in default of payment; and
• the borrower under each of the assets does not have any defence to payment of his loan.

The seller generally gives the purchaser a specified period of time to force the seller to repurchase loans that fail to meet these criteria. Often, this ‘put-back' right is limited to loans comprising a certain percentage of the portfolio. The right also expires after a certain period of time.

Put-back rights are generally the most heavily negotiated aspect of a distressed debt purchase, and failure to agree on their terms has killed more transactions than any other cause.

Getting permission to own and operate

Since the Second World War, most Asian countries have sharply restricted the ability of foreigners to make investments and operate businesses. In some cases, foreigners are prevented from holding a majority interest in any local company. In strategic industries, foreigners are often not allowed to own any interest. To sell distressed assets to foreigners, therefore, governments have had to remove many traditional barriers to foreign investment. Through this process, opening a country to distressed debt investors has resulted in wholesale changes to investment policy, reversing decades of investment protectionism.

Distressed asset investors generally need assurance that they will be able to do a number of activities:

• they must be able to own the distressed assets;
• they must be able to service the distressed assets, by hiring staff to manage outstanding accounts, by hiring lawyers to collect payments, and so forth; and
• they must be able to repatriate the proceeds of their investment in foreign exchange.

Before the Asian crisis, many countries in the region imposed tight restrictions on all three of these rights, in part to control the creation of credit in the country, in part to protect the balance of payments, and in part to protect incumbent financial institutions. Successful distressed debt sales required restructuring these restrictions.

Each government that has successfully attracted foreign investment has found ways to extend these rights to investors. Once extended to distressed debt investors, however, governments found other foreign investors clamouring for equal treatment.

Many governments turned these rules to their advantage, offering to open the market to offshore companies who first purchased distressed assets. In particular, the inducement of market entry attracted sophisticated international companies to Japan and Korea. In Japan, for example, GE Capital has invested more than $20bn since 1997 to create a profitable financial services business through distressed debt acquisitions.

Structuring the investment

In the absence of a pre-existing network of companies in the target country, most distressed asset investors will establish a new structure to invest in Asian distressed assets. These structures must balance two goals -they must allow the investor to conduct the activities that it must conduct in the country, while minimizing the overall tax burden on the investment.

Like most other international private equity investments, distressed asset investments are commonly funded by pools of equity capital funneled through offshore holding companies in Bermuda, the Cayman Islands or other tax-friendly jurisdictions. Where multiple investors are involved, a number of these companies can be used, each with different classes of security to reflect the relative priority or status of each investor.

In addition to these offshore entities -which are customary for most international direct investments - the investor in distressed assets will usually need to form or acquire an onshore company to hold the assets it purchases. An onshore entity is required for a number of essential activities, including obtaining licences to own and service financial assets, suing in local courts and registering as a value added tax taxpayer (often a prerequisite for collecting payments from any local person).

But use of a local entity also subjects the foreign investor to the full panoply of local regulation. Any disputes between the government and the entity will be resolved in local courts under local laws. The cooperation of local bureaucrats will be important for the success of the investment. Leveraging the investment through offshore loans to the local entity will often require layers of approval from numerous authorities.

Minimising the tax burden on investment in distressed assets necessitates careful structuring. Generally, investors face numerous taxes on their investments:

• value added or similar taxes on gross receipts, against which the investor may not be able to offset his investment;
• income taxes on interest and service income from the investment portfolio;
• capital gains tax on settlement of distressed debts;
• withholding taxes on dividends and interest paid offshore;
• offshore taxes on dividend and interest income and capital gains; and
• home country tax on dividend and interest income and capital gains.
• A detailed discussion of strategies for minimizing taxes is beyond the scope of this article.

However, most strategies generally combine several basic techniques:

• using pass through entities to reduce the number of layers of tax on investments;
• creating deductions to reduce the amount of income subject to tax;
• characterising profit as capital gain or another form of income which attracts tax at lower rates;
• realising income in a jurisdiction with low tax rates;
• using favourable tax treaties between the host country and other countries; and
• keeping profits offshore or otherwise free of home-country taxes.

Staff

While many distressed asset investors make passive investments in a limited number of assets, most become actively involved in administering and collecting the assets they purchase. In some cases involving portfolios of consumer loans, the investor must hire thousands of clerks, collectors, adjusters and other professionals -creating a full-sized bank virtually overnight which must often be dismantled just as quickly when the portfolio runs off. In other cases, the investor acquires an existing bank with the goal of reselling or continuing to operate it after it is made more profitable. Both cases require the investor to understand labour laws and practices affecting employer-employee relations.

In some cases, the problem is clear: in Korea, for instance, most staff belong to militant labour unions with a tradition of using strikes, lock-ins and other confrontational tactics to resist restructuring. Even in countries with little experience with unions, however, employee expectations limit the new owner's flexibility to restructure operations, as one foreign bank found out to its dismay in Indonesia when its local employees refused to work with their new foreign managers, forcing the foreign bank to walk away from its investment.

In most Asian countries, the bond between employer and employee is not merely economic, but part of a broader social contract in which an employee's loyalty to the employer is reciprocated by the employer's loyalty to the employee, in both good times and bad. Foreigners who fail to heed this reality often find expected profits disappearing in acrimony.

In the end, most employer-employee problems boil down to questions of money. The foreign investor whose business plan depends on radical restructuring of an existing operation, or the creation of a temporary bank for the duration of an investment, must carefully budget for sufficient severance pay and incentive compensation to compensate employees for the risk of working under western-style employment practices.

Realisation and exit strategies

Distressed asset investors generally share one of two investment strategies. One group - the turnaround operators - aims to turn around a troubled institution over a several year period. These investors value the institution based on its ability to serve as a platform for growth; their goal will be to spend as little time as possible collecting existing loans as that would distract from building the institution. These investors generally value an investment on the basis of the income they will generate from continuing operations.

The other group -the asset liquidators - looks to realise value from a fixed pool of distressed assets over a short period of time, with minimal commitment of management time and attention. These investors are usually not interested in long drawn-out litigation to collect outstanding loans; rather, they will sit down with the borrowers to negotiate the best deal they can get quickly. These investors will value an investment based on a discount from the amount they expect each borrower to pay to settle its loan.

Each of these strategies naturally leads to a different exit strategy. Like traditional venture capitalists, the turnaround operators will exit their investments through a stock exchange listing or a trade sale to an established operator. The asset liquidators will recoup their investment through liquidation of the portfolio -or, as markets develop, through advanced financial techniques imported from the West, such as securitisation of the portfolio.

The future

Although more than $500bn in distressed assets have been sold by Asian governments in the last four years, Ernst & Young recently estimated that more than $2000bn of additional distressed assets remain on the books of regional financial institutions, with more accumulating daily. Mirroring the size of its economy, the bulk of these assets are in Japan. China comes in second as it attempts to commercialise its banking system to meet the challenge of joining the WTO.

Although Asia is not moving as quickly as many economists and policymakers would like, Asian governments are increasingly recognising that the weight of distressed assets is crippling their banks and with them, their nations' growth prospects. At the same time, new WTO rules are opening Asia to competition from far more efficient international banks. Under these circumstances, the only way forward for Asia is to continue seeking international investors who are willing - for a price - to purchase distressed assets so banks can resume their core function of creating credit.

Lovells, 23/F., Cheung Kong Centre, 2 Queen's Road Central Hong Kong, 852 2219 0888, www.lovells.com

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