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Michel Lowy co-founded the Hong Kong-based firm SC Lowy in 2009, having spent the earlier part of his career at Deutsche Bank. He is the chief executive officer at a firm that invests in so-called ‘distressed debt’ — bonds issued by companies that have fallen into severe financial difficulty. The company also provides other forms of lending, known as “alternative credit,” to mid-sized companies, primarily in Asia and Europe. In this lightly edited interview, we began by discussing the problems of China’s highly-indebted real estate developers: SC Lowy has been an investor in dollar-denominated bonds by such companies issued “offshore,” i.e. in international markets. 

Q: Let’s start with the troubles at Evergrande, China’s largest real estate developer. Did you anticipate the problems there that we’ve seen in the last few months, or was there an assumption in the market all along that the Chinese government would step in to bail out the company at some stage?

A: We expected serious problems with the group, starting in the last few months. What made us really concerned about the situation — and I said this publicly on a couple of occasions, in June and July — was the fact that to get around the regulator’s “three red lines,” Evergrande had started to accumulate a huge amount of payables in a way that made it seem that it was deleveraging. In reality, it was still increasing its liabilities. And that, to me, was an indicator that there was no source of liquidity, or no traditional source of liquidity — and at some point, the music was going to stop.

The company seemed to have carried on as if it was “too big to fail.” Do you think they were taking the attitude that if things got really bad, the government would step in; but until that happened, they should just carry on in their merry way?

Yeah, I think they were probably surprised, otherwise they would have started acting earlier. And they assumed that either channels of liquidity would remain available to them, or that the government would not act as drastically as it has to stop the price increases and the speculation that has been rampant for a number of years in the Chinese property market.

How widespread do you think the problems are in China’s real estate sector now?

The problems are widespread, in the sense that overall land sales [to property developers] by provincial governments have collapsed. The amount of new home sales has collapsed, and most developers are showing double-digit sales declines compared to previous periods. So you have a real liquidity problem across the sector.

Do you think others, though, have as serious a problem as Evergrande?

No, because not every developer is as leveraged, and most have better land banks or more developed assets. Evergrande has got the problem of too much leverage, and assets that are much more speculative on average than many of its peers.

Have you seen the fall in Evergrande’s bond prices, and for property developers in China generally, as a buying opportunity? And are you mainly investing in the offshore bonds of these property developers?

At the moment, our Chinese exposure is primarily through public bonds. But we are also looking at onshore private debt at the project level, which is not something we were looking at until recently, when there was just too much liquidity. We have now started to discuss that type of investment opportunity as well.

Can you explain that a little further. What’s changed in the market conditions that has made you more interested in buying bonds onshore?

Stepping back, we had not been significant investors in the offshore bond market until last summer. And we weren’t investors — neither onshore nor offshore — because our view was that there was too much liquidity, and we would not be rewarded for the risk that we were taking. The first opportunity set, as always in all markets, came in the public bond market and with the price collapse, now you are being rewarded for the risk that you take.

Now that the public bond market is shut as a means of financing for developers, there are more opportunities onshore. You can become a private lender, not at a holding company level, and not offshore, but directly at the project level. Those opportunities are very complex to analyze, and to negotiate due diligence and structure, but it is something that we are actively working on. And we expect to do deals of that nature very soon.

Have you been making money in the last few months in this market? 

No we have not. 

Are you expecting that to turn around? Is this a long term position that you’re taking?

It’s a long term view on restructurings that will take place. We were a late entrant into that market, so our losses are rather limited compared to others, because we had no exposure to the sector entering into the summer. But we’ve built our exposure in the last two or three months and on a mark-to-market basis we would be down. We are reasonably confident that our positioning is right going into next year and that there is no other option than having restructurings done that will create some value in some instances, but it could be a long term process 

In your line of business that’s typical, right? It can take months, or years even sometimes. 

Absolutely. 

Are you investing just your own money? Or are you investing clients’ money as well? And what sort of return are you typically aiming for? 

We run investment funds and obviously in those investment funds, you have third party capital, from institutional investors like pension funds and sovereign wealth funds that we are managing like a traditional asset manager does. 

[The return we aim for] really depends on the type of deals. If you’re in the private debt world we’ll target [an internal rate of return] of 10 percent to 15 percent. When we are lending money to a company that needs alternative capital, and when the situation is more stressed or distressed and we are a secondary investor, then you’d want to generate at least 15 percent to 20 percent return.

How do you go about assessing investment opportunities in China right now, whether it’s the offshore bonds, or these onshore project-based investments that you’re talking about?

I will start with onshore investment, because it’s simpler. You need to understand the actual project, its value and liquidity — and the worst case scenario in terms of recovery. You need to assess the profile of who you’re dealing with. And most importantly, you need to have the right structure in place that allows you to enforce and have ways to bring money out of China once the transaction is completed, and the project developer has exited the project. 

In terms of the evaluation of offshore opportunities, those tend to be focused more on distressed opportunities, rather than those that are performing well. The first set of data that you need to try to understand is the extent of the company’s total liabilities, which is very difficult, because there’s various types of guarantees and joint ventures and contingent liabilities that it may be exposed to. Once you’ve done that, you need to try to assess the quality of the assets. And there you’re going to be focused mainly on whether the developer has got an exposure into Tier One and Tier Two cities, that tend to have more liquidity, or Tier Three and Tier Four cities where investments are a lot more speculative.

Finally, you will look at whether the developer has offshore assets: Some of those developers have got assets in the U.K. or Australia or Canada. Obviously, if you go through an enforcement scenario, you have a lot more leverage if there are significant offshore assets. And so those are the main areas that we would look at in the first due diligence. 

Is China’s system transparent enough for you to be able to get the data that you need in order to make those assessments?

There is a lack of transparency, which is not necessarily unusual for developers. This is not necessarily a China problem. Large developers may have hundreds of thousands of projects under their belts, they may have some joint venture partners, meaning they don’t control the entirety of the development, or they may operate through hundreds of different legal entities. Those structures are very difficult to assess, to understand and to analyze as a fixed income investor. This is something that we face with developers in other jurisdictions as well. 

Where China may differ from other markets is that the importance of state-owned enterprises, instead of banks, is very significant. And with the importance of the central government and the regulations in place, the central government has a much larger impact on liquidity than in other jurisdictions. 

The problem with China is that [property developers] are a very significant portion of the high yield market. In other markets there aren’t many developers that have high-yield bonds. But when they do their structure tends to be extremely complex and close to impossible to analyze as well. Where China may differ from other markets is that the importance of state-owned enterprises, instead of banks, is very significant. And with the importance of the central government and the regulations in place, the central government has a much larger impact on liquidity than in other jurisdictions. That’s adding a little bit of complexity to how you can try to predict future outcomes.

Do you mean reading the government’s intentions and the central bank’s intentions is particularly important in China, and particularly difficult?

It’s both difficult, as well as particularly important. 

Can we talk a little bit more about the sources of information you use. What other sources of information can you look at, say with a company like Evergrande or Kaisa to assess their credit worthiness, financial position, and so on?

Besides the publicly available data, one of the things we do is have one person stationed in Shenzhen, and we’ll try to have him meet real estate brokers to understand whether their clients are still prepared to buy any of the properties that are for sale from particular developers. They go and visit some of the sites, and they see whether construction is ongoing, or construction has totally stopped. That’s the limited sort of things that one can do.

So you have on the ground researchers doing practical research: It’s not just spreadsheets and financial information, correct? 

We have people that are based in Hong Kong, that are Chinese, that we’ve sent across the border to be able to do that additional work for us.

Do you find any blocks to doing that kind of direct research inside China itself? 

We are totally free to do that kind of research, meeting local real estate brokers that are selling homes, or trying to get financing for home buyers; standing outside of a project and seeing whether trucks and people are coming in and out, or whether things have totally stopped, you can easily do that. Each of those developers have hundreds of developments, though, so you’d only ever be able to do this on a sample basis.

Typically, how much coverage would you try to achieve from that sample size?

It’s more that it’s almost anecdotal evidence, it gives you a sense of whether the company is operating and still able to enter into contracts to sell assets, or whether everything’s come to a halt, buyers aren’t ready, they are not constructing anything anymore…

Do you have contact with the companies themselves? 

We try to have contact with companies. In the past, they were reasonably open. In recent times, it’s been much harder to be able to have conversations and access to too much information. The contact is through the investor relations department. 

And that access has noticeably changed, has it?

There’s noticeable change. I have to believe that those people are getting contacted by a lot more people than they may be used to. Also, I suppose that whatever they say is probably a lot more sensitive than it may have been in the past. The change has come in the last few months as those companies have entered into trouble.

Do you use outside sources at all, such as risk analysis firms? 

Not really, no. We do it ourselves. Ultimately those firms are very good when it comes to investigations. If you have security in a project and the shareholders have disappeared, and you’re looking for them, or you’re looking for some of their assets, you could [use such firms]. But I don’t necessarily see how they would be helpful in this particular situation, for very large corporates.

Have you been surprised by Beijing’s response to the property sector’s problems so far? I know we had a reserve requirement ratio cut earlier this month, but in general, did you expect that they would have done more by now to ease liquidity and broader market conditions?

Yes, I have been surprised. I have not been surprised at the fact that they’ve been cracking down on leverage in the industry, because clearly, the policies that have gradually been put in place in the last two years indicated that they want to rein in leverage in the industry. So that has not surprised me. What I’m surprised with is that there’s not been more relaxation on liquidity for homebuyers or developers, and certainly for those that are not in breach of those ‘three red lines. 

I have not been surprised at the fact that they’ve been cracking down on leverage in the industry… What I’m surprised with is that there’s not been more relaxation on liquidity for homebuyers or developers, and certainly for those that are not in breach of those ‘three red lines’. 

I’m not surprised by the fact that there’s been a major crackdown on developers that are very leveraged. That was very clearly the government’s game plan for the last two years, because it’s been measure after measure. What I’m surprised with is that after seeing in the last two or three months that sales have been collapsing, that they’ve not been faster in relaxing access to leverage for homebuyers, or for developers that are not in breach and that are not a risk for a system with too much leverage.

Do you think Beijing knows what it’s doing then, and has got a sense of the unintended consequences here? Or is there a danger that this spins out of control, and there are broader economic and market impacts that they don’t really have a handle on?

I think they know what they are trying to achieve. Ultimately it’s difficult to assess the amount of pain the market is going to incur. But I think that we will end up with more sturdy developers and with a less fragmented market: fewer but stronger developers. I think they will achieve their goal. Whether they could do that with less pain for market participants — yeah, maybe. But I certainly think that there is a game plan and they know what they want to achieve and they will achieve it. 

Does the fact that the likes of Evergrande have become these sprawling conglomerates, with interests in businesses like electric vehicles or soccer teams, make it harder to assess the overall value of the company and how a restructuring might work?

Yes, it certainly adds to the complexity. They are very complex conglomerates. And with a level of disclosure that’s not as much as we would have liked.

There seems to have been some frustration with the lack of communication from Evergrande about what its intentions are. Is that par for the course in these kinds of situations?

I think it is par for the course. At the end of the day, there’s a lot of uncertainty. And there are a lot of different types of stakeholders that are involved. And you’re talking about a situation that is extremely complex. So I’m not really sure there is much for them to communicate. 

Are you expecting a grand restructuring plan to emerge from Evergrande? And where do you see bondholders, the offshore bondholders in particular, ranking in terms of priority here for the company?

So in terms of priorities, it’s obvious that bondholders are last in line. That’s the easy part. 

In terms of the process going forward, you have different scenarios. You have a scenario where there’s some form of debt rescheduling extension that allows the company to operate as a going concern and liquidate some assets, and where they remain in control. There’s a scenario where they are forced to sell mature assets, and you get a little bit more cash up front. Although in a scenario like that, because you [as an offshore bondholder] are at the end of the queue, you may not see anything. And there’s a scenario where the company is broken up between good assets and bad assets — like the good bank-bad bank type of scenario that we’ve seen in Europe. And I think the outcome will be dictated, first of all, by the quality of the underlying asset, by due diligence, and by discussions between the various stakeholders, which will surely include the government.

Can we talk about Kaisa — another serious situation at the moment. How do you see that differing from the Evergrande situation? And are you investing there? 

We are involved in Kaisa. First of all, Kaisa has much better assets, more focused on Tier One and Tier Two cities as opposed to Evergrande’s portfolio. The business is much less complex, because it’s a developer and it’s not moved into all sorts of different directions. Its capital structure is also simpler, because more than half of its debt is offshore, as opposed to Evergrande. That means that in a Kaisa situation, the offshore creditors have much more importance at the table. 

The other difference is that there was no alternative but a default in the restructuring for Evergrande. I think Kaisa has other options. It’s now at a point where they have to decide whether they want a soft restructuring with offshore creditors on terms that they may not really like, or go to a full blown restructuring. And they need to decide what they think is in their interest. 

When it comes to China, you’re investing through dollar-denominated bonds that the companies have issued offshore [i.e. in international markets outside China]. Do you think that’s a market that the authorities in China are happy to see develop? Are they happy to see foreign investors piling into the debt of some of their major companies? 

Well, this is nothing new. The size of the Chinese offshore bond market has been exploding in the last few years. And I suppose that the authorities are just happy to see one extra channel of financing for its corporates. 

Do you think the offshore dollar bond market is a source of financing that Chinese companies are going to still look to use, or do you see that market drying up?

Well, it’s certainly going to dry up in the next few months. But long-term, I believe that market will continue to grow, and that it’s a market that’s important to the Chinese corporate world as an alternative source of financing. It’s also an alternative investment category for global investors in search of diversification. So that’s not going to be the end of it. 

And they’re going to continue to want to attract foreign capital in this way?

I believe so. It’s a tough point in the cycle. And maybe that’s something that’s needed for this market to mature.

What are we learning about China’s bond market from the distress that we’re seeing at the real estate developers? 

So far, things are not playing differently to what you would expect in a time of low liquidity and stress in that industry. If you look back 20 or 25 years ago, when a number of local state-owned investment trusts were restructured, we were faced with a similar type of situation. So we are not terribly surprised. But that doesn’t mean that there are not a lot of questions that are unanswered. The next few months, finding out the number of developers that need to be restructured and understanding how quickly liquidity is going to come back into the onshore real estate market, are going to be very interesting to witness. 

There does seem to have been a general assumption in the past, particularly in the onshore Chinese bond market, that ultimately the government stands behind all this debt that’s being issued by companies. Are those perceptions changing?

Quite frankly, I did not have that perception. I think that perception is wrong. I think that ultimately, it’s a capitalistic market, a capitalistic economy, and the government doesn’t see a need to bailout fund managers.

I think that perception [that the government stands behind companies’ debt] is wrong. I think that ultimately, it’s a capitalistic market, a capitalistic economy, and the government doesn’t see a need to bailout fund managers.

Do you think that that has been a perception that others have had, though, and which is changing? 

Possibly. 

How sophisticated is the Chinese bond market these days?

From an insolvency regime standpoint, it’s not as tested, or as well-oiled, as some of the most robust jurisdictions globally, from the U.K. to Australia to Korea. But it’s also not as totally untested or totally unreliable as some of the frontier emerging markets. So it’s half way — you wish it was faster, you wish it was more predictable, but there is a process.

What further reforms would you like to see in China?

I think more centralization, so that the courts that are dealing with large insolvencies are centralized and more focused on bankruptcies or restructuring, so that they can get a lot more expertise in these issues — that would certainly be preferable, because that would help with the predictability and speed of outcomes. 

I know you operate across Asia, and you have businesses in Europe as well. Proportionately, how much time and how much of your business is associated with China? And how do you see China as an opportunity relative to those other markets, both within Asia and versus Europe?

So as a percentage of our business globally, China is a small but growing part. A year ago, it was a much smaller part than it is today. We recently added a head of China; we are looking into opening offices in mainland China in the next few months. So we are investing resources to develop that opportunity set. Markets like Korea, India, Australia, Hong Kong, Singapore, even Indonesia are much bigger still for our platform. And the same with some of the European opportunities like Italy, for example, which is a very large portion of our business globally.

And you expect China to grow in importance because maybe we’ll see more situations like Evergrande emerging?

Yes, and also because there’s a lack of liquidity onshore, and we can provide alternative capital when needed.

How has the pandemic affected your business? Hong Kong has been quite difficult to get in and out of: Has that been problematic? 

Yes, it’s been problematic, because for us, as a global operation with many offices outside of Hong Kong, it’s prevented me from meeting shareholders, investors, and most importantly our teammates. And that’s preventing us from growing the firm the way we would hope for.

How important do you see Hong Kong as being as a financial centre in future? How important is it to you for your business in terms of the advantages that people often talk about, such as the city’s legal system?

Well, for us it’s been a great place from which to operate with a strong legal system, the ability to attract talent, very efficient administration and regulators. So, until two years ago, it was a perfect place to operate from. In the future, if restrictions on travel continue to be as drastic as they are, it will become increasingly difficult for us to drive the business from here. No question about it.

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