Evergrande Crisis Explained
From a Fortune 500 company to now owning debt amounting to over $305bn, the Chinese firm Evergrande (HKG: 3333) is in a liquidity crisis that is deepening by the day. The struggle for the company to pay its debt obligations has been causing seismic waves of concern across global markets, with analysts comparing the situation to that of the Lehman Brothers.
But what is the cause of this financial wreck? And what will be the effect of this terrible unravelling?
Who Is Evergrande?
The Evergrande Group is a real-estate developer with headquarters in China. The company was founded by Hui Ka Yan in 1996 and it primarily used debt to grow its business. Evergrande is a home-building business at its core, and the company website states that it owns more than 1,300 building projects in over 280 cities across China. In 2020 it had sales of more than $100bn and adjusted core profits of c$5bn, making it the second biggest property developer in China.
Unconventionally, the group ventured beyond homebuilding by expanding into different sectors. The company invested in electric vehicles (Evergrande New Energy Auto), an internet and media production unit (HengTen Networks), a theme park (Evergrande Fairyland), a soccer club (Guangzhou F.C.) and a mineral water and food company (Evergrande Spring), among others. Some believe that this wayward spending by senior management may have contributed to the crisis we are seeing today.
How Did the Crisis Start?
To better understand the crisis, one must understand the nature of the real estate industry. The real-estate industry is notorious for having terrible (i.e., long) cash conversion cycles, a metric that expresses the time it takes for a company to convert its investments in inventory into cash flows from sales. Property development is capital-intensive, and many payments are either made on credit or not received until a piece of land is turned into something marketable. This increases accounts payable but does not affect the cash flows of a business. Remember, cash is king, so Evergrande’s decision to borrow extortionately came as a response to not producing sufficient cash flows from operations. Further, Evergrande took advantage of its position in power by bidding land at prices significantly higher than market price. At the time, the premium paid for the land was of no concern to the company as the risk of using debt for transactions was transferred to whoever financed the purchase. In most instances, this would be either the flat buyers or the banks.
However, as the debt burden grew so did the interest payments on that debt. By 2020, Evergrande had erased 75% of all operating income compared to 2018 and gross margins had also dropped from 36% in 2018 to 24% in 2020. The company then had its first major liquidity scare. Evergrande sent a letter declaring its concerns over not being able to pay an upcoming interest payment, and this letter was leaked to the media. Fortuitously, the company was bailed out by a big investor group waiving their right to force a $13bn repayment. The short-term crisis was temporarily avoided.
As per Bank of America, Evergrande’s high yield offering makes up 16% of outstanding notes in China. The fear of default sent Evergrande’s bond price tumbling, causing the market yields to rise to an all-time high. Evergrande’s stock was also affected, with it plummeting by 80%.
Earlier this month, the troubled company missed a deadline on interest payments of $83.5 million to offshore bondholders and $35.8m to onshore bondholders. The default will hit a crop of financial institutions that own its bonds such as BlackRock, UBS, and HSBC. It has been reported that Evergrande are selling properties at a fire-sale discount, and the company has been selling shares in its EV unit, internet and media unit, and a regional bank. Evergrande was forcing its employees to give loans to the company if they wanted to receive their end-of-year bonuses, and there have been protests from people who have paid their deposits on houses but are now left in a devastating limbo. With over $7.4bn bond payments due in 2022, it is hard to imagine the situation easing anytime soon.
What Happens Next?
Real estate is estimated to contribute roughly 29% to China’s annual output. If there is a serious pullback in the Chinese property sector, then there will be less demand for commodities such as steel and copper. The effect will not only impact the Chinese economy but potentially reach markets beyond.
China wants to condone reckless borrowing and so is willing to make an example out of Evergrande. But in the short term, the risk of international contagion is ever-present. Some analysts believe it would be devastating for the Chinese economy if the government let Evergrande crumble, claiming that the firm is ‘too big to fail’. This is further supported by reports that regulators have already signed off on allowing Evergrande to renegotiate payment deadlines with banks and other creditors. For Evergrande’s sake, it is imperative that Chinese authorities step in to manage the restructuring of the company’s liabilities. But whether this happens, we will have to wait and see.