BX Blackstone Inc

SUZHOU--Near a murky river in this eastern Chinese city, a freshly renovated apartment building touts dozens of furnished rooms in move-in condition.

Nine months ago it was an abandoned hotel, littered with dirty clothes and empty food containers. Its former owner had disappeared several years earlier, leaving behind unpaid bank loans, according to documents reviewed by the Journal.

In 2017 a fund managed by Bain Capital Credit stepped in. It bought the defaulted debt, navigated China's bankruptcy-court system to resolve the loan--and profited when the building was auctioned last spring for 15.2 million yuan ($2.2 million) on Taobao, Alibaba Group's eBay-like marketplace.

A flock of vulture investors is circling China: large money managers including Blackstone Group, Lone Star Funds and Oaktree Capital as well as Bain Capital. In the past few years global investment firms have invested more than $3 billion in nonperforming Chinese commercial loans, estimates PricewaterhouseCoopers.

These investors are sifting through mounds of distressed debt for corporate loans they can buy at deep discounts to their face value--often 30 to 60 cents on the dollar. Annualized returns across bad-loan portfolios can top 20% after the debt is resolved or resold, some investors say.

Corporate defaults and failures are on the rise in China. A surge in corporate borrowing fueled a decade of rapid economic expansion, but with growth now slowing, credit has tightened, making it harder for companies to refinance. And the prolonged trade war has squeezed businesses, notably manufacturers.

"China's bad-debt problem is growing, and U.S. investors are trying to cash in," said Andrew Brown, a senior advising partner at ShoreVest Partners, which buys and resolves defaulted Chinese loans. Its investors include sovereign-wealth funds, pension funds and other institutions around the world.

Foreign investors represent only a small part of the market for China's nonperforming loans, but authorities are encouraging them. Getting deep-pocketed investors to take over the bad debt clogging banks' balance sheets is a crucial element of Beijing's plan to rejuvenate the economy and free up capital for banks to make new loans.

As of last September, Chinese banks were sitting on at least 6.18 trillion yuan ($899 billion) in shaky debt--nonperforming or at risk of default--and some analysts think that official figure is a major underestimate.

China has dealt with waves of debt defaults in the past, but "what's different about this cycle is that the amount is very, very large," said Zhang Xiaolin, chief investment officer at Lakeshore Capital, a private-equity firm that has been an active investor in nonperforming loans. "You have to discharge the flood somewhere."

To clear out bad debts, Chinese commercial banks sell portfolios of defaulted loans to asset-management companies, mostly state-owned, that were set up to resolve troubled assets--whether by working them out with creditors or reselling them to domestic and foreign investors. Under the recent U.S.-China trade pact, American financial firms will be able to apply for licenses to run asset-management companies that can buy nonperforming loans directly from banks.

Last year, China's four largest asset-management companies resolved roughly $70 billion in nonperforming loans, according to James Dilley, a Hong Kong-based PwC partner.

Investing in defaulted Chinese loans is largely a property play. A lot of the bad debt is secured by hotels, warehouses and other commercial or residential buildings. Investors buy loans at deep discounts to the properties' market value, then profit by selling the real estate.

Foreign investors can also make money by reselling defaulted loans to other investors, or working out a deal with borrowers, forgiving a portion of the debt in exchange for reduced payouts.

The vultures are betting that China's economy won't go completely off the rails, and real-estate values will hold up even as growth continues to slow. They are also counting on Chinese banks not to flood the market with defaulted loans.

"Because China has a long way to work out all its bad debt, authorities can't just rip off the Band-Aid," said Kei Chua, a managing director at Bain Capital Credit. "There's just not enough investors (in the country) to deal with it."

Boston-headquartered Bain's private-equity business started investing in companies in China more than a decade ago. Bain Capital Credit began purchasing Chinese nonperforming loans in 2017; it also has other types of investments in the country.

So far, Bain's special situations funds have spent about $500 million acquiring hundreds of loans, many secured by commercial real estate in second-tier cities that have larger populations and relatively robust economies. It plans to invest more and remain very selective, said Barnaby Lyons, head of Asia for Bain Capital Credit.

To resolve bad loans, Bain works through a master servicer it owns in Guangzhou. The staff--which includes lawyers, accountants and appraisers--scouts for loans, assesses the properties and works with local loan-servicing firms and courts to liquidate assets or resell loans to other investors. Properties Bain has taken control of and sold include office buildings, land and shopfronts.

Roughly 40 miles north of the refurbished apartment building in Suzhou sits a four-story commercial building that used to be a food and beverage establishment. It was owned by an individual who had a manufacturing business and pledged it as collateral for a bank loan. After the loan went bad, it became part of a portfolio of more than 100 defaulted loans that Bain bought from a state-owned asset-management firm in 2017.

After Bain took over the property, it broke the building's leases, sourced potential buyers and sold it on Taobao early last year for 14.6 million yuan. That exceeded the loan's unpaid principal balance and interest claims, which totaled 13.8 million yuan.

The building has since been gutted, but has sat empty for months without any construction activity, according to nearby residents.

Zhou Wei

and Serena Ng

Write to Serena Ng at serena.ng@wsj.com

(END) Dow Jones Newswires

January 21, 2020 05:44 ET (10:44 GMT)

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