New opportunities in the China NPL market

The amount of debt shouldered by private enterprises and state-owned entities have risen in recent years, causing an increasing number of domestic and international investors to shift their attention to the non-performing loan ("NPL") market in the PRC (the "PRC NPL Market"). Given the economic downturn caused by the Covid-19 pandemic, how foreign investors could enter the PRC NPL Market has again garnered significant interest. At the same time, the PRC government is taking steps to welcome international market players by attempting to promulgate new rules at both the national and local level.

Overview of the PRC NPL transactions

The transactions in the PRC NPL Market can generally be classified into two categories; primary transactions and secondary transactions. Primary transactions refer to banks or other financial institutions selling the NPLs on a bulk basis to the national or local assets management companies (referred to as the "AMC", which is a special licence holding company). Secondary transactions refer to the transactions where the AMCs transfer the NPLs, which they have obtained from banks previously, to the retail investors.

Historically, non-PRC investors including global financial institutions and overseas funds may only engage in secondary transactions through a number of limited channels, such as purchasing NPL portfolios from AMCs through a public bidding process, utilising the Shenzhen Qianhai pilot program to purchase NPLs that are listed on the Qianhai Financial Assets Exchange, investing in NPL ABS products through the (R)QFII, CIBM Direct and Bond Connect schemes etc.

New opportunities arising

• Investment through the QFLP fund

In April of this year, through a public announcement made by Shanghai Financial Services Office (SFO), Shanghai has broadened the investment scope of its QFLP pilot program to include NPLs and convertible bonds.

As background, at present, the pilot areas that have launched the Qualified Foreign Limited Partners ("QFLP") program include Shanghai, Tianjin, Beijing, Shenzhen, and Chongqing etc. The local governments which introduced the QFLP pilot programs aimed to provide a channel for foreign investors to access the private equity market in the PRC. Therefore, as a general principle, access to non-private equity related investments such as the provision of loan had not been permitted (until the new policies issued in Shanghai in April), and any attempted access would be met with resistance from SAFE (the foreign currency control authority) and banks at the foreign exchange settlement stage. While we note that some foreign managers hve in the past successfully invested in the PRC NPL Market through the QFLP program, those managers had to adopt a complicated structure in order to package the transaction as an equity investment.

Although the expanded investment scope of Shanghai's QFLP program as introduced has not been codified or set down as black letter law, it clearly demonstrates the Shanghai government's acceptance of investments made by QFLP fund into the PRC NPL Market. Such apparent acceptance by the Shanghai government acts as strong reassurance for SAFE and banks to give QFLP funds the green light for releasing capital in NPLs. We expect to see more investors entering into the PRC NPL market via QFLP funds. For detailed information on the launch of a QFLP fund, please click here.

Typically, foreign asset managers would first apply for a fund management license from the Asset Management Association of China ("AMAC"), the de facto regulatory authority of the private fund industry, in order to raise and/or manage a fund in China. However,  where both the General Partner ("GP") and Limited Partner ("LP") of the fund are established overseas, and all the investment decisions are made outside of China, the establishment of a foreign-owned limited partnership in China and the subsequent investment activities associated with the foreign-owned limited partnership may not fall within the "fundraising and management" category which would otherwise trigger the requirement to apply for a fund management license. As the fund management license requirement is omitted for the foreign GP, the ability to invest in the PRC NPL Market is much easier.

In addition, we understand Tianjing also offers quite similar policies to allow for a QFLP to invest into NPLs without the need to file such QFLP product as a private credit fund with AMAC.

• Establishing an AMC WFOE/JV

AMCs have been playing a dominant role in the PRC NPL Market as only they can purchase NPLs in bulk directly from commercial banks. Currently there are only five national AMCs which are controlled by state-owned banks and around 60 local AMCs. National AMCs have a broader access to the PRC NPL Market in terms of the types of NPL portfolios they can purchase. For example, a local AMC mainly purchases those NPL portfolios that only reside in that province.  In the past, wholly foreign owned entities ("WFOE") and sino-foreign joint venture ("JV") were not permitted to obtain the AMC license either at the national level or the provincial level, and were only permitted to participate in the secondary transactions.

Since January of this year, the AMC market is open to foreign financial institutions as well, beginning with the provincial level.  This was also documented in the China-US Trade Deal reached in January.

Key Issues to look out for

• Due diligence of onshore loans

Due diligence of the NPLs remains the most important step which decides the value of NPLs. It includes the status of the borrowers, security providers or guarantors, security and guarantee packages, and any legal proceedings in relation to NPLs if any.

AMCs, when purchases NPLs from banks, have been given some regulatory and judicial advantages/exemptions with respect to consent to transfer by security providers (if there is such a requirement in the security documents), taxes and participating in legal proceedings. Investors purchasing from AMC (including those through QFLP) should look at these protections/exemptions on case by case basis to see whether it is possible for them to inherit these protections/exemptions as assignees.  

Recent local rules show that some cities may have pilot policies and detailed rules allowing foreign investors acquire directly from commercial banks individual NPLs provided that certain requirements are met. In that case, detailed due diligence for each NPL should be conducted for evaluation. 

• Relevant foreign exchange issues

Offshore investors' purchasing of onshore NPLs will convert onshore debt to cross border foreign debt as far as borrowers are concerned, therefore relevant filings with National Development Reform Committee and registrations with foreign exchange authorities will be required to be carried out by relevant obligors. These filings/registrations have become purely operational recently and relatively easier to be completed. As a result, the original security arrangements will become cross-border security arrangements and relevant cross-border security rules should also be observed.

In the meantime, offshore investors can open accounts onshore to pay into purchase price, collect recoveries or proceeds of further sales.  

• Financing of acquisition of NPL through an offshore SPV

When investors wish to gain exposure by financing acquisition of NPLs, using a structure of multiple layers of SPVs will help to give the flexibility for disposal and make enforcement more easily. Cross border accounts arrangements need to be looked into carefully to ensure smooth transfer of funds to serve the ultimate financing payments.

As said, national and local authorities in the PRC have introduced new opportunities to invest in the NPLs through the QFLP program and obtaining the AMC licence, and we believe these new opportunities would provide easier and quicker access to the NPLs in China and make the PRC NPL market more attractive.