Oaktree Sees Bad Loans as Good Way Into China

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After years of waiting for the right opportunity, Oaktree Capital Group has made its first major move into China.

The downtown L.A. investment group specializing in distressed assets last week announced a joint venture with China’s Cinda Asset Management Co., one of that country’s largest managers of bad loans. Each company will initially contribute up to $500 million toward a fund to invest in distressed assets in China, primarily in real estate. The move comes as the slowing economy in China and the overhang from its boom years in real estate construction indicate that bad loans will soon be big business there.

Oaktree is also investing $53 million in Cinda’s $2.4 billion initial public offering, When Cinda does go public, Oaktree will have an equity stake in the company, which is majority owned by the Chinese Ministry of Finance.

Oaktree bills itself as the world’s premier distressed asset investor and ranks 11th on the Business Journal’s list of largest public companies in Los Angeles. These are the firm’s first significant steps to enter the huge China market. Oaktree has invested extensively in Japan, South Korea, Taiwan and has maintained an office in Hong Kong. But the rest of mainland China, with its complex rules and extensive government role in the economy, had been an elusive goal – until now.

John Frank, Oaktree’s managing principal, said timing was a factor as China’s distressed market seems ready for action.

“For us, this represents a learning experience and way to jump-start our investing business in China,” Frank said. “Our hope is that we will be much more active in the world’s second biggest economy.”

The initial $500 million investment is modest for a company Oaktree’s size; after all, the firm manages more than $20 billion in distressed assets worldwide. But it’s a first step in a much grander plan for deals in China.

Oaktree’s stock rose slightly in the days after the announcement, closing Nov. 27 at $54.87.


Bad loans

Oaktree is moving into China as the communist nation’s economy slows after a prolonged period of rapid growth fueled by massive government stimulus.

“Since 2008, Chinese banks made huge volumes of loans based on the government policy to stimulate growth,” said Baizhu Chen, professor of business and economics at USC who specializes in China. “Now, with the slowdown in growth, there’s a huge overcapacity of buildings, of factories and production, and of roads and bridges.”

Chen said China’s banks are only now just beginning to start writing off some of the bad loans they have accumulated. These are the distressed assets that Cinda and Oaktree will pursue through their joint venture.

This isn’t the first time American companies have moved in to buy bad loans. Roughly 15 years ago, China’s economy was going through a similar slowdown and the government created four asset management companies – including Cinda in 1999 – to manage bad loans. Many of Cinda’s top executives came from China’s largest construction bank. Also at that time, American companies such as Morgan Stanley also came in and snapped up packages of bad loans, sometimes for only 10 cents on the dollar.

“The American companies made a killing back then as the economy recovered and the assets began to regain their value,” Chen said.


Joint venture

Many of those American companies remain in China, poised to snatch new batches of bad loans. By partnering with Cinda, Oaktree could gain an advantage: Cinda has hundreds of people already on the ground who can find the bad loans and negotiate to get them packaged at discount.

Oaktree’s Frank said Cinda initially would be sourcing most of the loan deals and bringing them to the joint venture for investment consideration. Eventually, Oaktree will gain the expertise and have enough local staff that it will be able to do its own searching for distressed assets to bring to the joint venture or even buy independent of Cinda.

Frank said Oaktree has about two dozen people at its Hong Kong office. Some of those people will move to Shanghai and possibly Beijing. Also, one executive from the firm’s L.A. headquarters will be assigned to Beijing.

As for the $500 million Oaktree is bringing to the table, he said that amount could grow if the first rounds of investment achieve significant returns.

“We expect we will want to do more,” he said.

The principal focus of the joint venture, Frank said, will be on distressed real estate assets. It will not be buying loans for the problematic “ghost cities” of empty office and residential towers that sprouted in China during the boom, however. The joint venture will be purchasing loans on property in cities that have significant economy activity, such as Shanghai.

“We’re much more likely to be interested in piece of real property in an established city,” he said. “In that way, it is more like traditional investing.”

But even this carries risk, especially if the Chinese economy enters a deeper and more prolonged downturn than is widely expected. In the past few years, the growth rate has slowed from double digits to about 7 percent as the central government has halted much of the fiscal stimulus set up after the economic crisis of 2008.

USC’s Chen said that as long as the Chinese government does a competent job of managing this slowdown and the transition from an export economy to a more mature consumer and innovation economy, overall economic growth will continue. In that case, assets purchased by Cinda and Oaktree will recover their value over time.

But if the growth rate plunges to near zero or the Chinese economy actually contracts, then real estate values could fall further, making it more difficult for Oaktree to realize gains on its investments in bad loans.

The other major risk is that the loans on all those empty towers in the ghost towns could be dumped on the market in a very short time period, depressing all real estate prices. But Chen said this scenario is unlikely; he believes the economic daage would remain contained to the regions around the ghost towns.

“The real estate market in China is very segmented,” he said.