Greater China’s rapid economic growth over recent years has primarily been driven by abundant cheap liquidity, with a significant proportion provided by retail investors. Within this context, real estate has played a disproportionately significant role in asset financings across both mainland China and Hong Kong.
Government policy in mainland China drives real estate credit crunch
In mainland China, government initiatives designed to curb rampant speculation in the property market have led to a credit crunch. A number of mainland Chinese property developers – who have substantial investments both onshore (financed by mainland Chinese creditors) and offshore (financed via the international capital markets and Hong Kong banks) – have defaulted on their debt.
The majority are listed in Hong Kong, which has historically enabled them to raise significant levels of now-defaulted offshore bond and bank debt. As a result there has been a wave of holistic offshore restructurings aimed at balance sheet deleveraging that have used schemes of arrangement to impose haircuts alongside alternative solutions such as debt-to-equity swaps.
Offshore processes coupled with ‘closed door’ onshore liability management exercises
Parallel to these offshore efforts we have seen largely “closed door” liability management exercises to handle onshore indebtedness, with the Chinese government focused on ensuring the completion and delivery of domestic residential projects and on maintaining social stability.
Hong Kong’s property sector remains generally bearish, despite measures to make residential property more affordable, such as a gradual lowering of interest rates, the abolition of demand-side stamp duties and an increase in the maximum loan-to-value rate for mortgages to 70%.
While these developments have helped improve market sentiment and initially led to an uptick in transactions, demand has slowed once again in recent months.
The office rental market continues to suffer as a result of oversupply, the trend towards “decentralization” (i.e., businesses shifting away from central business district locations), and generally soft demand. Rents have dropped by 40% since 2019, and as of October 2024, the Grade A office vacancy rate stood at 13.3%.
Hotel sector remains under pressure
Investment and occupancy rates in the hotel sector remain down despite a dramatic rise in visitor arrivals year-on-year. A notable trend is the conversion of hotels into student accommodation, driven by demand from the Hong Kong education sector, primarily from Mainland China.
Market attention is now shifting towards the need to deleverage both lender and borrower balance sheets in the Hong Kong real estate sector.
PRC property developers will continue to use statutory processes to deleverage
Looking ahead, PRC property developers will continue to use statutory restructuring processes such as schemes of arrangement to de-leverage their balance sheets. These schemes offer debtors the ability to consolidate creditors by class rather than by individual debt instruments, allowing them to cram down significant dissenting creditor minorities. This has led to the emergence of holistic restructurings, which are becoming increasingly contentious as debtors aggressively control information flows and push for deep debt discounts.
In response we are seeing creditor constituencies – broadly divided into classes of bond debt and bank debt and represented by bondholder ad hoc groups and lender coordinating committees – looking to maximize their returns at the expense of each other. Restructuring processes are often lengthy, with different stakeholder groups driven by divergent commercial objectives finding it hard to reach a consensus.
Traditionally, restructuring schemes involve parallel processes in Hong Kong (where the debtor is listed, operates, and raises funds) and, most commonly, the Cayman Islands (where the debtor is incorporated).
Where the compromise involves U.S. law-governed debt, the process is coupled with applications for recognition under Chapter 15 of the U.S. Bankruptcy Code.
Debtors explore cross-class cramdown procedure of U.K. restructuring plans
However, with the rise of debtor-on-creditor and creditor-on-creditor violence, where the debt to be compromised includes English law-governed facilities, the desire to avoid delay as a result of intercreditor issues has prompted debtors to explore the cross-class cramdown procedure available under a U.K. restructuring plan (e.g., in the restructurings of Hong Kong Airlines and the ongoing proceeding involving Sino-Ocean Group).
As is the case in the English market, the use of multiple processes in an attempt to implement a cross-class cramdown has led to dissenting creditor groups threatening or making class composition and fairness challenges to disrupt or derail the restructuring and leverage better returns from the debtor, or at the expense of other creditors.
While it is not ideal for creditors to go down this path, the risk of potential challenges from dissenting creditors has had some positive impacts on debtor behavior.
For example, debtors and their advisors are now more focused on developing restructuring plans designed to produce fair outcomes across classes. They are also more willing to share and disclose information to avoid accusations of withholding information and to enable creditors to make informed decisions.
Hong Kong court increasingly critical of debtors’ delaying tactics
The Hong Kong court has also adopted a more proactive approach to supervising restructuring processes and is increasingly critical of debtors and their advisers using delaying tactics to prolong scheme processes by withholding information or claiming unsubstantiated levels of creditor or external “white knight” support for a restructuring.
The court is also willing to wind-up debtors in the absence of tangible and timely progress. Looking ahead, this stance should help foster a “win-win” environment that results in more responsible behavior from debtors and better, fairer returns for creditors.
PRC banks now focusing on their exposures to Hong Kong conglomerates
As the models for PRC property developer schemes become more established, so PRC banks are shifting their focus to their similarly significant exposures to Hong Kong conglomerates.
Those for whom Hong Kong real estate has been a primary source of collateral and cash flow are particularly vulnerable. This includes not only real estate developers, but also prime commercial and residential landlords, as well as the hospitality and leisure industries.
Here, debt restructurings will follow a different path than for PRC property developers, with a preference for consensual processes.
Many of the banks’ exposures to distressed debt in this market are based on long-term relationships with conglomerates, which are often family-run dynasties or part of the establishment.
Hong Kong has a well-developed non-statutory rescue culture based on common interest and supported by the Hong Kong Monetary Authority and the Hong Kong Approach to Corporate Difficulties guidelines, which are endorsed by the Hong Kong Association of Banks.
Common interest among market participants to minimize disruption
Additionally, the lower levels of bond debt in the relevant capital structures means there is a common interest in the market to minimize disruption and maintain stability, with any resulting enforcements likely to be discrete and any restructurings, where possible, likely to be consensual and similarly low-key. In these situations, we expect parties will prefer to term out the debt to the maximum extent possible, and to avoid schemes of arrangement, debt discounts, or equity solutions.
At the same time, capital adequacy constraints are impacting banks' ability to lend, offer borrowers amend and extend refinancings, and to finance new money asset acquisitions.
To overcome these constraints we expect them to package non-performing loans (NPL) but to do so conservatively to minimize market disruption, and to execute discrete property asset enforcements against single assets and projects. The restructuring environment presents opportunities for private capital firms looking to invest.
