Two Chinese real estate giants face default—but only one is positioned to pull off a comeback

December 8, 2021, 12:25 PM UTC

China’s property sector slid deeper into financial distress this week as two of the nation’s largest housing developers appeared to miss key payment deadlines for millions of dollars owed to global bondholders. Both companies—China Evergrande Group and Kaisa Group Holdings—are near the brink of default, but the latter looks as if it has the better shot at a possible turnaround.

On Monday, Evergrande, China’s most indebted property developer with bills totaling more than $300 billion, reached the end of a 30-day grace period for $82.5 million in interest it failed to pay to overseas bondholders last month. The day came and went without an announcement from Evergrande, which, in a statement Friday, acknowledged that it might not be able to cover the interest payments—and disclosed a further $260 million in overdue debts. Evergrande’s investors said Tuesday they had not received the interest payments.

Meanwhile, Kaisa, China’s largest offshore debtor among developers after Evergrande, was due to repay a $400 million bond maturing Tuesday. Kaisa acknowledged in a filing last week that it had failed to win bondholder approval for a proposal to exchange the maturing bonds for new notes that wouldn’t have to be repaid until June 2023. “There is no guarantee that the company will be able to meet the repayment obligations under the existing notes at maturity,” Kaisa said.

As of late Wednesday, Kaisa had no update to that statement, although a source from a coalition representing holders of more than 50% of the company’s $11.9 billion in dollar-denominated bonds said Kaisa executives were actively reviewing terms of a proposal that would grant the Chinese firm a “forbearance” period of up to three months.

Kaisa requested a suspension in trading of its shares in Hong Kong early Wednesday morning pending “an announcement containing inside information.” Kaisa stock has surrendered three-quarters of its value since the beginning of the year.

Evergrande and Kaisa are the most visible victims of Beijing’s effort to squeeze speculative excess from China’s frenzied housing market and force developers to kick their addiction to high-risk debt. In 2020, Beijing imposed “three red lines”—strict limits on developers’ ratios of assets to liabilities, debt to equity, and cash to short-term borrowing—to choke off property companies’ access to credit.

The policy seems to have worked—perhaps too well. Sales of the nation’s largest developers, which have fallen for the past five consecutive months, plunged 40% in November compared with the same month a year ago, according to China Real Estate Information Corp., a property consultancy. Evergrande’s travails have shaken Chinese savers’ hitherto unshakable faith in residential property as an investment; residential transactions have fallen, and analysts say home prices in many major cities have dropped as much as 15%.

That has left many highly leveraged Chinese property companies reeling. Several developers, including China Properties Group and Fantasia Holdings Group, have defaulted on dollar debt in recent months, while others, such as Yango Group and Xinyuan Real Estate, have managed to stave off default by negotiating debt swaps. China Aoyuan said last week that its creditors have demanded that the company repay about $651 million in principal after recent credit rating downgrades.

The plight of Evergrande and, to a lesser extent, Kaisa poses a wrenching dilemma for China’s leaders. The collapse of either firm could trigger a downward spiral of property declines and corporate defaults, destabilizing China’s financial system. But if Beijing rushes in to bail the developers out, it risks creating a “moral hazard”—sending the message that the state will rescue any developer no matter how foolish or greedy.

In recent days, Beijing has sought to take a calibrated approach to problems in the property sector that protects the financial system without rewarding rash developers.

On Friday, as Evergrande telegraphed that it was unlikely to meet its payment deadline, the People’s Bank of China excoriated the company, saying Evergrande’s problems were the result of its “own poor management” and “reckless expansion.” Meanwhile, the Guangdong provincial government summoned Evergrande chairman Xu Jiayin for a meeting and dispatched a team of financial overseers from large state-owned companies to establish a risk-management committee at the company, tasked with “strengthening” its internal controls.

On Monday, the central bank said it would inject nearly $200 billion of additional liquidity into the broader financial system by cutting the share of deposits it requires financial institutions to hold in reserve by 50 basis points. The move was widely perceived as an effort to reassure markets ahead of a possible Evergrande default—though it may take several months for the fresh capital to make its way to other embattled property companies.

The Communist Party’s Politburo also weighed in to say the government will take measures to help support the property market.

“It is notable that Evergrande’s announcements have coincided with statements from Chinese regulators and with the PBOC cutting the reserve ratio,” said Paul Lukaszewski, head of corporate debt for Asia-Pacific at abrdn. “This suggests that there is substantial coordination happening, which is a positive signal for the market in that it suggests regulators are aware of the severity of the crisis and the risks they pose on the broader economy.”

S&P Global Ratings, a credit rating agency, said Evergrande’s failure to meet the Monday interest payment “will not likely constitute a default event yet.” But the agency added that “we believe a default looks inevitable for Evergrande” given that it must also repay $3.5 billion on bonds that will reach maturity in March and April of 2022.

Analysts interpreted the creation of the new risk-management committee at Evergrande as a sign that Xu, also known by his Cantonese name of Hui Ka Yan, has been stripped of control over the company. Though the founder was appointed chair, four of the committee’s seven seats are held by representatives from state-owned enterprises controlled by China’s central government or local governments in Guangdong province.

China has used similar arrangements to essentially nationalize other highly leveraged companies in past years, most notably in the cases of HNA Group, an aviation, logistics, and tourism conglomerate based in southern Hainan Island, and Anbang Insurance Group, a financial conglomerate that rang up huge debts to fund an overseas shopping spree that included New York’s Waldorf Astoria Hotel. State-appointed administrators oversaw long restructurings that dismantled those companies without triggering a financial crisis. Founders of both firms now languish in prison.

And yet neither HNA nor Anbang was as big or as deeply entangled in China’s economy as Evergrande, the nation’s second-largest developer with nearly 900 completed commercial, residential, and infrastructure projects and proprietor of a string of loss-making subsidiaries in electric vehicles, bottled water, and professional soccer.

Chinese media generally has played down the travails of the nation’s giant property developers—even as global investors dumped stock of the companies and raised their borrowing costs to record highs. But on Monday, China Central Television, the state-owned broadcaster, reported that Kaisa hasn’t paid workers for months and is struggling to complete the construction of a luxury residential complex in Guangzhou.

Evergrande and Kaisa have much in common. Both companies are based in Shenzhen, the manufacturing and tech boomtown across the border from Hong Kong, and are run by brash, first-generation founders who became multibillionaires by borrowing huge sums from banks to build houses for China’s burgeoning middle class. In recent years, both companies have sought to leverage their success on China’s mainland to muscle into Hong Kong, the world’s most lucrative property market.

But the comparison can be misleading. Investors say Kaisa’s prospects for a successful turnaround are far greater than those of its larger rival.

That’s partly because Kaisa’s debts—$19 billion in total—are a fraction of Evergrande’s. Another crucial difference: Unlike Evergrande, which holds a far-flung property portfolio heavily tilted toward projects in third- and fourth-tier cities where residential property sales have slumped, Kaisa’s property portfolio is concentrated in Shenzhen, the mainland’s most buoyant property market, and a handful of other first-tier cities in Guangdong where demand for housing has remained robust.

Bruce Pang, head of macro research at China Renaissance Securities, argues that Kaisa has a lower market profile and poses less risk to China’s financial system than Evergrande, but boasts a much better asset portfolio. “This will make the negotiation and restructuring process far easier for Kaisa than Evergrande,” Pang said.

Members of the New Money Coalition, the group representing a majority of Kaisa’s offshore bondholders, agree. That’s why the group has adopted a strategy of constructive engagement with Kaisa founder Guo Yingcheng rather than trying to claw back assets in a messy court-led restructuring process.

“It’s all about assets, assets, assets,” says an executive from one large investor in Kaisa’s U.S.-dollar bonds. “We have very little fear of underwriting them again.”

The coalition includes some of Kaisa’s largest offshore bondholders—among them investment management giants Amundi, Ashmore Group, Farallon Capital, and Pimco—and has enlisted Lazard, a global financial advisory firm, to help craft a recovery plan. The group has proposed seven different options for refinancing Kaisa’s debt, according to people familiar with communications with the developer.

One alternative offers $2 billion in bridge lending for a third-party buyer of Kaisa assets. Another proposes selling convertible bonds that could be exchanged for shares in Sing Tao News Corp., owner of Hong Kong’s oldest Chinese language newspaper, which is controlled by Guo’s 27-year-old daughter.

Coalition members say that, after some initial stonewalling, Guo and his team are actively reviewing bondholder proposals. “This isn’t a one-size-fits-all, force-it-down-their-throat kind of thing,” said an executive from one of the bondholders in the coalition.

If the two sides can reach a deal, it would be an extraordinary second comeback for Guo, 57, who founded Kaisa in 1999, the year after China formally legalized property ownership.

Evergrande’s Xu is known for his flamboyance—Chinese internet users mocked him as “Belt Brother” for wearing a gold-buckled Hermès belt to a high-profile gathering for top leaders of China’s Communist Party in 2012. But Guo, often referred to by his Cantonese name, Kwok Ying Shing, has kept a comparatively low profile. Investors describe him as extraordinarily well-connected in Shenzhen. In the Chinese financial press, he’s known as the “King of Urban Renewal,” reflecting Kaisa’s penchant for taking on complicated urban redevelopment projects that involve long conversion times, many stakeholders, and enormous political risk.

Guo’s political connections became a liability in 2014, when Shenzhen authorities arrested Jiang Zunyu, one of the most senior Communist officials in the city, on bribery charges. The government froze Kaisa’s property sales and withheld approval for new projects, cutting off the company’s cash flow. Courts froze Kaisa’s assets, forcing Kaisa into default.

Guo resigned as chairman in late 2014, citing health reasons. He offered to sell his family’s entire 49% stake in Kaisa to a rival developer, Sunac China, and dropped from public view. But a few months later, Guo resurfaced unexpectedly, reclaimed the chairmanship, and scuttled the proposed sale. Shenzhen authorities subsequently lifted sales restrictions on Kaisa, and the company won a financial lifeline from Sino-Life Insurance, one of its biggest shareholders.

In 2015 and 2016, Kaisa defaulted on six offshore bonds totaling $2.5 billion, according to data compiled by Bloomberg. But in the years that followed, the company seemed to flourish, expanding into Hong Kong and Macau as well on the mainland.

In 2020, Kaisa purchased four sites in Hong Kong for $1.1 billion, according to an exchange filing, including a 50% stake in a residential land plot in the rapidly developing Kai Tak neighborhood on the Kowloon side of Victoria Harbor. Bloomberg touted Guo as being in the vanguard of mainland property developers poised to elbow aside Hong Kong’s homegrown property tycoons as Beijing asserted greater control over the former British colony.

In February 2021, Guo’s daughter Kwok Hiu Ting paid $48 million to secure a controlling 28% stake in Sing Tao, the Hong Kong media company. A month later, two of Guo’s daughters shelled out an additional $29 million to purchase two apartments in Hong Kong’s tony Bel-Air residential complex. Kaisa said sales in the first six months of this year surged 77% over the same period last year.

But by the end of 2021, the company was again pleading financial distress. In November, Kaisa confirmed that it had failed to pay $88 million in interest due on offshore bonds—and revealed that it had issued wealth management products to mainland investors it couldn’t afford to pay. The company unloaded three of its four Hong Kong properties at a steep discount and put 18 properties in Shenzhen on the auction block.

S&P slashed Kaisa’s credit rating to CCC-, then withdrew its rating altogether at Kaisa’s request.

For Kaisa’s overseas bondholders, one key question is whether the company faces a liquidity problem—meaning that it has a solid underlying business but is temporarily short of cash—or a solvency problem, genuinely lacking the assets required to ever repay its debts. The Lazard-led coalition seems confident that, for Kaisa, liquidity is the issue.

If Kaisa’s foreign bondholders can come to terms with Guo on a forbearance agreement, they likely face weeks, if not months, of high-stakes negotiations. They know they have only limited ability to influence the outcome of a crisis that ultimately will be shaped by Chinese politics, public perception, and personal relationships.

Chinese authorities may yet subject Guo’s empire to the same harsh restructuring conditions they seem to be imposing on Evergrande.

But if regulators’ firm handling of Evergrande is enough to reassure Chinese homebuyers that China has dodged its Lehman moment, it’s also possible that Guo—and his worried creditors—will get a second shot at redemption, and reemerge to absorb the remnants of their less fortunate competitors.

Subscribe to Fortune Daily to get essential business stories delivered straight to your inbox each morning.