It’s always the minority that ruins it for the majority. After a handful of companies dented the sector’s reputation, few Hong Kong mid-cap companies were able to access the syndicated loan market last year.
The problems started when Tack Fat, a Hong Kong clothing firm, became the first corporate borrower in Asia to default on a syndicated loan in August 2008. But rather than turning out to be an isolated case, the number of Hong Kong borrowers threatening to miss loan payments grew. Within three months, Tack Fat had been joined by U-Right, 3D-Gold (formerly Hang Fung Jewellery) and Peace Mark.
Tack Fat had total debt of HK$992m ($127m) at the end of March 2008 and since then had borrowed a further HK$99m. By September 2008, U-Right had received written demands from banks for around HK$850m ($109m) of debt, while 3D-Gold had sold high yield bonds worth $170m.
Coupled with the Asian loan market being at a standstill after Lehman Brothers’ collapse and only top-tier borrowers being able to secure funding, the Hong Kong mid-caps stood absolutely no chance of sourcing any debt last year.
Lenders tend to paint the entire sector with the same large brush stroke of suspicion, but the defaulters can be split into two groups — one where lenders showed a glaring lack of understanding of the entities they were funding, and another where allegations of fraud were involved.
Governance concerns
Work-out situations are never easy to resolve but accounting irregularities complicated the insolvencies of 3D-Gold and Peace Mark.
In both cases, allegations of fraud were added to the list of misdemeanors, and senior staff were charged with running away with the companies’ assets.
For 3D-Gold, which had also reopened the Asian high yield bond market in 2007, the fall from grace was extremely public. On October 14, 2008, the company declared that trade receivables in its wholesale business "may be difficult to recover" and warned that its inventory might be "substantially less than previously reported". Two days later, the police arrested five employees on suspicion of stealing gold bars worth HK$179m.
Accounting irregularities also hit luxury watch retailer Peace Mark, which had borrowed heavily to fund expansion.
"Two reasons why Peace Mark defaulted were, first, because it had bought the Sincere Watch business in Singapore and in doing so incurred an unserviceable level of bank debt," says Neil McDonald, partner at Lovells, a law firm. "Second, there were irregularities with its wholesale distribution business in China and Japan."
Bankers were quick to link Peace Mark’s problems to an endemic problem for the sector.
"Many of these Hong Kong mid-caps have grown from family companies, and some of the management may continue to see them as such," said Nick Gall, partner at Gall & Lane. "Because of this, the companies tend to suffer from a lack of transparency and management may struggle to maintain independence when conflicts of interest arise between related public and private companies"
The extent of the problems, of course, only becomes clear when it is already too late. No bank could have ever predicted that management would even be accused of theft, but the spate of cases raises concerns that due diligence standards are not sufficient.
Structural subordination
Poor credit checks may have also contributed to the insolvencies of Tack Fat and garment manufacturer U-Right.
"In other recent defaults, such as Tack Fat, the lenders lent to entities within a group which did not own or control assets with any realisable value," says McDonald. "This has been a common problem in default situations in Hong Kong and Singapore where lenders have often loaned money to offshore holding companies, which money is on-loaned by the offshore company to onshore operating subsidiaries (for example in China or Indonesia). The lender has usually not taken (or been able to take) appropriate security over on-shore assets where the real value lies."
In both cases, banks were lending to a company set up and listed in Hong Kong. But the borrowing entities were just intermediate holding companies, meaning the offshore lenders were not able to monitor the company’s cashflows clearly and instead had to rely on dividends that were being passed on from the operating company.
"The structure was fine and good when things were going well," says one U-Right creditor. "But when debts started getting triggered, things started to fall apart quickly."
The problem was that the holdco lenders soon discovered that their security was worth nothing, because employees and onshore lenders always rank before offshore lenders in a work-out situation under Chinese law. That structural subordination is a feature of most deals for Chinese borrowers, meaning the defaults have much wider implications.
"Because of these issues, many banks may start lending through a PRC branch or lending to an entity where cashflow is generated," says the same banker.
In marked contrast to the Hong Kong mid-caps, blue chip borrowers have had a much easier time accessing the loan market. Property company Henderson Land Development attracted commitments worth HK$12bn ($1.5bn) from banks for its HK$5bn facility in June and Hutchison Telecommunications closed a HK$5bn loan in December.
The search for yield, however, is gathering pace in the Asian market, and most bankers expect loans to the sector to start picking up soon.
"There will be a move down the credit curve and we will see an increase in mid-cap and second-tier names in 2010," says Phil Lipton, head of loan syndications for Asia at HSBC.
Given the pace of the defaults and the turmoil in the broader markets, the cautious approach that lenders adopted to the sector in 2009 came as no surprise. As risk appetite continues to improve, however, banks would be well advised to keep some of their stricter due diligence standards in place.