While the world is obsessing with the fate of Evergrande, and more importantly when, or if, Beijing will bail it out, another just as interesting question is how did the company many call “China’s Lehman” get to the point of no return and become a global systematic risk. For a fascinating look into how we got here, we turn our readers’ attention to a recent article from Caixin titled “How Evergrande Could Turn Into ‘China’s Lehman Brothers‘,” and which provides one of the most comprehensive insights into why Beijing will have to, even if it is kicking and screaming, bail out Evergrande which, at its core, is just one giant shadow-banking black box whose time has finally run out.
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For the past two months, hundreds of people have been gathering at the 43-floor Zhuoyue Houhai Center in Shenzhen, where China Evergrande Group’s headquarters occupy 20 floors. They held banners demanding repayment of overdue loans and financial products. Police with riot shields had to be on site to keep things under control.
As of the end of June, Evergrande had nearly 2 trillion yuan ($309 billion) of debts on its books, plus an unknown amount of off-books debt. The property giant is on the verge of a dramatic debt restructuring or even bankruptcy, many institutions believe.
A bankruptcy would amount to a financial tsunami, or as some analysts put it, “China’s Lehman Brothers.” The venerable American investment bank’s 2008 collapse helped trigger a global financial crisis.
Certainly Evergrande, one of China’s three biggest developers, has a giant footprint in China.
Its liabilities are equivalent to about 2% of China’s GDP. It has more than 200,000 employees, who themselves and many of their families have invested billions of yuan in the company’s WMPs. The company has more than 800 projects under construction, more than half of them halted due to its cash crunch. There are thousands of upstream and downstream companies that rely on Evergrande for business, creating more than 3.8 million jobs every year.
Like many of China’s “too big to fail” conglomerates, Evergrande’s crisis has fueled speculation over whether the government will step in for a rescue. Several state-owned enterprises, including Shenzhen Talents Housing Group Co. Ltd. and Shenzhen Investment Ltd., both controlled by the Shenzhen State-owned Assets Supervision and Administration Commission (SASAC), are in talks with Evergrande on its Shenzhen projects, according to people close to the talks. But so far, no deals have been reached.
In a statement last week, Evergrande denied rumors that it will go bankrupt. While the developer faces unprecedented difficulties, it is fulfilling its responsibilities and is doing everything possible to restore normal operations and protect the legitimate rights and interests of customers, according to a statement on its website.
The company hired financial advisers to explore “all feasible solutions” to ease its cash crunch, warning that there’s no guarantee the company will meet its financial obligations. It has repeatedly signaled that it will sell equity and assets including but not limited to investment properties, hotels and other properties and attract investors to increase the equity of Evergrande and its affiliates.
Growth on borrowed money
Over the years, Evergrande has faced liquidity pressure several times, but every time it dodged the bullet. This time, the crisis of cash flow and trust is unprecedented.
Evergrande shares in Hong Kong plummeted to a 10-year low. Its onshore bonds fell to what investors call defaulted bond level. All three global credit rating companies and one domestic rating company have downgraded Evergrande’s debt.
For many years, Chinese developers were driven by the “three carriages” — high turnover, high gross profit and high leverage. Developers use borrowed money to acquire land, collect presale cash before projects even start, and then borrow more money to invest in new projects.
In 2018, Evergrande reported record profit of 72 billion yuan, more than double the previous year’s net. But behind that, it spent more than 100 billion yuan a year on interest.
Even in good years, the company usually had negative operating cash flow, with not enough cash on hand to cover short-term loans due within a year with and presale revenue not enough to pay suppliers. In addition to borrowing from banks, Evergrande also borrows from executives and employees.
When developers seek funds from banks, lenders often require personal investments from the developers’ executives as a risk-control measure, a former employee at Evergrande’s asset management department told Caixin.
“At times like this, Evergrande would have an internal fund-raising campaign,” the manager said. “Either the executives would pay out of their own pockets, or they would set a goal for each division.”
One crowdfunding product issued to executives was called “Chaoshoubao,” which means “super return treasure.” In 2017, Evergrande tried to obtain project financing from state-owned China Citic Bank in Shenzhen, which required personal investment from Evergrande’s executives. The company then issued Chaoshoubao to employees, promising 25% annual interest and redemption of principal and interest within two years. The minimum investment was 3 million yuan. China Citic Bank eventually agreed to provide 40 billion yuan of acquisition funds to Evergrande.
In 2020, Chen Xuying, former vice president of China Citic Bank and head of the bank’s Shenzhen branch from 2012 to 2018, was sentenced to 12 years in prison for accepting bribes after issuing loans.
A senior executive at Evergrande said he personally invested 1.5 million yuan and mobilized his subordinates to invest 1.5 million yuan into Chaoshoubao. Some employees would even borrow money to invest in the product because the 25% return was much higher than loan rates.
When the Chaoshoubao was due for redemption in 2019, the company asked employees who bought the product to agree to a one-year extension for repayment. Then in 2020, the company asked for another one-year extension. One investor said buyers received an annualized return of 4% to 5% in the last four years, far below the 25% promised return.
When Evergrande’s cash flow crisis was exposed, the company chose to repay principal only to current executives. From late August to early September, the company repaid current executives and employees about 2 billion yuan but still owed 200 million yuan to former employees, including Ren Zeping, former chief economist of Evergrande who joined Soochow Securities Co. in March.
Evergrande’s wealth division also sells WMPs to the public. Most of these WMPs offer a return of 5% to 10%, with a minimum investment of 100,000 yuan, the former employee at Evergrande’s asset management department said. As the return is higher than WMPs typically sold at banks, many of Evergrande’s employees bought them and persuaded their families and friends to invest, an employee said. Usually, a 20 million yuan WMP could be sold out within five days, the employee said.
The company also sells WMPs to construction partners. Evergrande would require construction companies to buy WMPs whenever it needed to pay them, a former employee at Evergrande’s construction division told Caixin.
“If the construction companies are owed 1 million or 2 million yuan, we would ask them to buy 100,000–200,000 yuan of WMPs, or about 10% of their receivables,” the former employee said. Although it was not mandatory for construction companies to buy WMPs, they often would do so for the sake of maintaining a good relationship with Evergrande, the former employee said. In addition, Evergrande property owners were also buyers of the company’s WMPs.
About 40 billion yuan of the WMPs are now due. “It is difficult for Evergrande to make all of the repayments at once at this moment,” said Du Liang, general manager of Evergrande’s wealth division.
Evergrande initially proposed to impose lengthy repayment delays, with investments of 100,000 yuan and above to be repaid in five years. After heated protests by investors, the company tweaked its plan last week, offering three options. Investors can accept cash installments, purchase Evergrande’s properties in any city at a discount, or waive investors’ payables on residential units they have purchased.
Some investors opposed the “property for debt” option, as many projects of Evergrande have been halted and there is a risk of unfinished projects in the future.
“The proposals are insincere,” a petition signed by some Guangdong investors said. “It’s like buying nonperforming assets with a premium.” The petition urged the government to freeze Evergrande’s accounts and assets and demanded cash repayment of all principal and interest.
Some investors chose to accept the payment scheme proposed by Evergrande. They selected Evergrande projects located in hot cities in the hope of making up for losses by resale in the future.
As Evergrande owed large amounts to construction companies, more than 500 of Evergrande’s 800-plus projects across the country are now halted. The company has at least several hundred thousand units that have been presold and not delivered. It needs at least 100 billion yuan to complete construction and deliver the units, Caixin learned.
Whether and how to repay WMP investors or deliver housing is Evergrande’s dilemma.
Debt to construction partners and suppliers
In August, the construction company that was contracted to build Evergrande’s Taicang cultural tourism city in Nantong, Jiangsu province, announced the halt of the project due to bills unpaid by Evergrande. The company, Jiangsu Nantong Sanjian Construction Group Co. Ltd., said it put 500 million yuan of its own funds into the project and Evergrande paid it less than 290 million yuan.
Sanjian has other construction contracts with Evergrande and its subsidiaries. As of September, Evergrande owes the Nantong company about 20 billion yuan.
As of August 2020, Evergrande had 8,441 upstream and downstream companies it was working with. If the flow of Evergrande cash stops, the normal operation of these companies will be disrupted, and some would even face the risk of bankruptcy.
In Ezhou, Hubei province, five of Evergrande’s projects have been halted for more than a month, and it owes contractors about 500 million yuan.
“Housing delivery involves not only hundreds of thousands of families, but also local social stability,” a banker said. The housing authorities in Guangdong province are coordinating with Evergrande and its construction partners, trying to resume construction, the banker said.
Evergrande relies heavily on commercial paper to pay construction partners and suppliers. Among payments it made to Sanjian, only 8% was in cash and the rest in commercial paper.
Initially, the commercial paper borrowings were mostly six-month notes with annualized interest rates of 15%–16%. Now most carry interest rates of more than 20%. Holders of such commercial paper can sell the notes at a discount to raise cash. In 2017–18, the discount rate on Evergrande paper could reach 15%–20%. Since May 2021, the few Evergrande notes that could still be sold have been discounted as much as 55%, according to a person familiar with such transactions.
For small and medium-sized suppliers, holding a large amount of overdue Evergrande notes is a burden too heavy to bear. In recent months, a number of suppliers sued Evergrande for breach of contract but often settled the cases. A lawyer who represented Evergrande in related cases told Caixin that many plaintiffs chose to negotiate with Evergrande while fighting in court.
Evergrande also offered a “property for debt” option to its commercial paper holders. The company said it’s in talks with suppliers and construction contractors to delay payment or offset debt with properties. From July 1 to Aug. 27, Evergrande sold properties to suppliers and contractors to offset a total of 25 billion yuan of debt.
Selling assets, but not land
Meanwhile, Evergrande has been offloading its assets to raise cash. Its biggest assets are its land reserves. As of June 30, it had 778 land reserve projects with a total planned floor area of 214 million square meters and an original value of 456.8 billion yuan. Additionally, it has 146 urban redevelopment projects.
In the past three months, Evergrande has been in talks with China Overseas Land and Investment Ltd., China Vanke Co. Ltd. and China Jinmao Holdings Group Ltd. for possible asset sales. Shenzhen and Guangzhou SASACs have arranged for several state-owned enterprises to conduct due diligence on Evergrande’s urban redevelopment projects, a person close to the matter said. Evergrande has approached every possible buyer in the market, the person said.
However, no deals have been reached. Several real estate developers that have been in contact with Evergrande told Caixin that while some of Evergrande’s projects look good on the surface, there are complex creditors’ rights that make them difficult to dispose of.
Some potential buyers have said they could consider a debt-assumption acquisition, but Evergrande was reluctant to sell at a loss, Caixin learned.
At an emergency staff meeting Sept. 10, the wealth management general manager Du said in a speech that most of Evergrande’s land reserve is not for sale, reflecting the position of his boss, founder and Chairman Xu Jiayin.
“In China, land reserves are the most valuable assets,” Du said. “This is Evergrande’s biggest asset and last resort.
“For example, for a land parcel, Evergrande’s acquisition cost is 1 billion yuan, and the land itself is worth 2 billion yuan, but the buyer may only offer 300 million yuan,” Du said. “If we sold at a loss, we would have no capital to revive.”
For his part, Xu maintained that Evergrande could repay all its debts and recover as long as it turns land into houses and sells them.
But even if Evergrande can quickly sell its houses, the revenue would be far from enough to pay down debt. The chance that Evergrande won’t be able to pay interest due in the third quarter is 99.99%, estimated by a banker whose employer has billions of yuan of exposure to the company.
As of the end of June, Evergrande had total assets of 2.38 trillion yuan and total liabilities of 1.97 trillion yuan. Of the nearly 2 trillion yuan of debt, interest-bearing debt was 571.7 billion yuan, down about 145 billion yuan from the end of 2020. The decrease in interest-bearing debt was mostly achieved by deferred payables to suppliers.
In addition to the 571.7 billion yuan of interest-bearing debt on its books, it’s not a secret that developers like Evergrande have huge off-balance sheet debt. But the amount at Evergrande is not known.
In the early stage of projects, developers need to invest a lot of money, which could significantly increase the debt on the balance sheet. Companies often place these debts off their balance sheet through a variety of means. After the pre-sale of the project, or even after the cash flow of the project turns positive, these debts would be consolidated into the balance sheet in the form of equity transfer, according to a property industry insider.
For example, 40 billion yuan of acquisition funds Evergrande obtained from China Citic Bank were invested in multiple projects. Among them, 10.7 billion yuan was used by Shenzhen Liangyang Industrial Co. Ltd. to acquire Shenzhen Duoji Investment Co. Ltd. As Evergrande doesn’t have an equity relationship with the two companies, this item was not required to be consolidated into Evergrande’s financial statement. Evergrande used leveraged funds to acquire equities in 10 projects, and none of them were included in its financial statement, the prospectus of its Chaoshoubao shows.
Evergrande has sold equity in subsidiaries to strategic investors and promised to buy back the stakes if certain milestones can’t be reached in the future. Such equity sales are actually a form of borrowing, too. In March, Evergrande sold a stake in its online home and car sales platform Fangchebao for HK$16.4 billion ($2.1 billion) in advance of a planned U.S. share sale by the unit. If the online sales unit doesn’t complete an initial public offering on Nasdaq or any other stock exchange within 12 months after the completion of the stake sale, the unit is required to repurchase the shares at a 15% premium.
Evergrande’s hidden debts also include unpaid payments to acquire equities. Dozens of small property companies have sued Evergrande demanding cancellation of their equity sales agreements with the company because Evergrande failed to pay them. They are Evergrande’s partners in local development projects. Evergrande usually paid them 30% down for equities but declined to pay the rest even after the project was completed, according to the lawsuits. A plaintiff’s lawyer told Caixin that Evergrande’s project subsidiaries don’t want to go sour with local partners, but they have no money to pay as sales from the projects have been transferred to the parent company.
A total of 49 of Evergrande’s wholly owned local subsidiaries have been sued since April, according to Tianyancha, a database of publicly available corporate information.
Evergrande also owes land transfer fees to some local governments. Some 20 Evergrande affiliates have not yet made payments to the city government of Lanzhou, the capital of Northwest China’s Gansu province, according to a list of 41 such firms issued in July by the city’s natural resources department.
A potential default by Evergrande could spread to markets outside China as it has huge, high-interest offshore bonds. Some of its offshore bonds carry interest rates as high as 15%, a person close to the Hong Kong capital market said. UBS estimates that $19 billion of Evergrande’s liabilities are made up of outstanding offshore bonds.
Evergrande has been frantically selling properties at discounts this year. In late May, it offered certain homebuyers 30% to 40% off if they paid entirely in cash. In the first half, the company reported 356 billion yuan of contracted sales, slightly higher than 349 billion yuan for the same period last year. Average selling prices in the first six months declined 11.2%. Meanwhile, payables increased 14.7% to 951 billion yuan, and sales and marketing expenses increased 30% to 17.8 billion yuan. In response to the market environment, the company increased sales commissions and marketing expenses, the company said.
Compared with its competitors, Evergrande has higher capital and human costs but lower selling prices, an industry participant said. “How can it make money?” the person said.
The developer reported a 29% slide in profit for the first half. Its 10.5 billion yuan of profit mainly reflected an 18.5 billion yuan gain from the sale of some shares and marked-to-market holding in internet unit Henten Networks. It reported a loss in its core property business of 4 billion yuan.
Evergrande’s extremely high debt ratio, high financing cost and repeated delays in payments to suppliers, partners and local government show that its liquidity has always been tight, but on the other hand, the fact that it has survived years under this model indicates that it has always been able to generate money, a veteran investor said.
Now everyone is watching whether it can dodge the bullet once again.