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"A Reverse Rollup From Hell": China's "Boldest Dealmaker" Faces Margin Call Disintegration

One month ago, when describing the bizarre, not to mention systemically dangerous practice of dozens of small and mid-cap Chinese companies and executives offering to backstop losses on their employees' purchases of company shares, we couldn't quite explain it, although it seemed to revolve around a simple, and fraudulent, ponzi scheme: the same executives who were making the "make whole guarantee" had themselves taken out substantial loans collateralized by a pledge on their own stock. Naturally, the lower the stock dropped, the closer the moment when the dreaded margin call would come in demanding loan repayment, and since the value of the stock used as collateral was below the value of the loan, defaults would inevitably follow. As such, the "offer" to backstop losses was nothing more than a last ditch effort to find the greatest fool of all: an employee who believed that the sinking ship known as his or her employer would bail them out, when in reality it was the other way round. Oh, and good luck, trying to collect on your "guarantee", when both the company and the executive were in bankruptcy court, or worse.

We bring it up because in a report overnight, Bloomberg has uncovered that while the practice of backstopping corporate stock purchases may - for now - be limited to a subset of potentially fraudulent companies (our advice is to create a short basket of all the companies that engaged in this practice listed here and watch them sink), pledging shares is not. In fact quite the opposite: as it turns out, one of China's most acquisitive companies, HNA Group which Bloomberg dubbed "China's boldest dealmaker" which "supercharged its transformation from an obscure Chinese airline operator to a juggernaut capable of amassing multibillion-dollar stakes in globally recognized brands, including Hilton Worldwide Holdings Inc. and Deutsche Bank " had pledged billions of its own shares as a source of funding for these purchases.

And herein lies the rub: as we said one month ago, "fundamentally a ponzi scheme, this works without a glitch during rising markets but falling prices especially among small and mid-cap companies, have eroded the value of that collateral, raising the specter of forced liquidation - where lenders, often Chinese brokerages, make borrowers sell the pledged shares. Selling the stock adds more pressures on share prices, triggering a downward spiral."

But wait, there's more: while most Chinese companies pledged "only" their own shares to get loans, a handful of companies also used shares of the acquired companies as pledged collateral.

This is precisely what HNA Group did, which now faces not only growing regulatory scrutiny from Beijing that threatens to spook bond investors and raise HNA’s financing costs, but also send its shares plunging as holders are forced to liquidate even as most of the shares pledged to fund its buying spree are already declining, accelerating its demise. And, in an scenario that can only be dubbed as a "reverse rollup from hell" - on steroids and margin - one that would make even Valeant blush and snicker, if the value of its collateral, i.e. stock price, falls enough, HNA will soon be forced to sell its holdings to repay debt, thereby resulting in the disintegration of the company.

While HNA is privately held and a detailed breakdown of its share pledges is not available, Bloomberg has compiled the following unprecedented look at the company’s exposure:

Here's the bottom line:

HNA and its units have pledged at least $24 billion of shares across 15 publicly traded firms, including the Hilton and Deutsche Bank stakes, filings show. HNA-related entities also have pledged billions more of unlisted assets that include shares of holding companies, land-use rights, planes, a golf resort and $289,000 of corporate vehicles. Shareholders pledged a 17 percent stake in the group’s closely held parent, according to government filings obtained by Bloomberg that document the pledges.

Again, while this process works great during rising, when prices start declining it's a recipe for disaster.  To be sure, there’s nothing wrong with share pledges or collateralized borrowing. Both are common forms of financing, both in the US but particularly in China, where according to BofA's David Cui about 10% of the country’s stock-market value has been pledged for loans.

"Whenever your share pledges increase, especially with respect to ratcheting up debt, I would say it increases risk," said David Yu, an adjunct finance professor at New York University Shanghai. "The question really becomes, ‘At what point is it too much?’”

According to the company at least, it hasn't hit that level... yet:

HNA, founded in 1993 and chaired by Chinese aviation tycoon Chen Feng, said by email that the pledging of shares isn’t its only financing source. The company said its business operations, asset quality and cash flows allow it to pursue a range of financing options, including bond and fund issuance and securitization.

The problem emerges when there is a run on the bank, er, collateral as may well happen here.

To this too, the company had a canned response: "While price swings may prompt lenders to ask for additional cash or stock to supplement guarantees, the collateral can be returned to HNA when prices rebound, the company said in its response to questions from Bloomberg."

HNA said that on most of its pledged shares, it hasn’t had to put up additional collateral or face margin calls. That may very soon change, especially now that creditors are aware they are all in the same boat, launching one margin call after another, which in turn prompts a firesale of the underlying "asset", the company's stock, thereby accelerating the liquidation of the underlying value and prompting even more margin calls.

Worse, the more stock HNA pledges, the less cushion it has when the share price falls. HNA’s holdings in companies that trade on China and Hong Kong exchanges have lost almost $2 billion in value this year. Losses accelerated since last month, when China’s government was said to scrutinize overseas investments by HNA and other dealmakers to assess risks to the nation’s lenders. Regulators had already made it harder for would-be acquirers to move money overseas, part of an effort to stem capital outflows and prop up the yuan.

As we said, a "reverse roll up from hell", on margin.

it’s the degree to which HNA has relied on pledged assets to fund its acquisition spree that concerns credit-rating agencies and analysts, including at Aberdeen Asset Management Asia Ltd. In at least 11 of the 15 cases in which HNA disclosed a pledge of publicly traded shares, more than 90 percent of its stake was exposed to creditors, according to data from public filings compiled by Bloomberg.

That's just the tip of the known unknowns: "The scale and complexity of HNA’s approach to equity-backed borrowing raises questions about how the firm will manage its leverage across so many businesses, according to Carol Yuan, an Aberdeen credit research analyst in Sydney who studied HNA bonds. “It’s a bit concerning," she said, adding that Aberdeen hasn’t bought the parent company’s bonds. "That’s why we’ve never touched this group."

There are many reasons to be concerned: the shares of Tianjin Tianhai Investment Co. have dropped 25% this year through July 11, the worst performance among the pledged shares linked to the conglomerate (see chart above). CCOOP Group Co., an HNA-linked retailer with about $1.5 billion worth of shares pledged, has tumbled 23%. Still, not every investment has been a loser for HNA in 2017. Its two listed overseas holdings with known pledged shares, Hilton and Deutsche Bank, have posted gains.

Then there is a question on the permitted LTV for these loans. Bloomberg notes that according to data from Chinese stock exchanges, companies typically can borrow about 40 cents for every dollar of shares pledged, although this is China, where brand name is all that matters, and it is not unlikely that the LTV for HNA stock was much higher.

Another potential risk: the counterparties themselves are a motley collection who may or may not be able to survive a direct hit in case of loan default. HNA entities pledged shares to Chinese state-owned banks, securities firms, trusts and foreign banks, according to an analysis of filings. UBS Group AG, the pledgee in the Deutsche Bank transaction and one of four foreign lenders in the Hilton deal, declined to comment. In one case, an HNA subsidiary pledged shares in Bohai Financial Investment Holding Co. to 19 entities. Among the pledges was a $300 million stake pledged to yet another HNA subsidiary.

* * *

While the practice of stock pledging was very popular during China's M&A boom times in 2014-2016, it has ended now ended with some very public thuds.

Some Chinese tycoons have faced financial struggles that underscore the risks of such arrangements. Jia Yueting, founder of internet media giant LeEco, had part of his stake in a publicly traded unit frozen by a Shanghai court this month after his businesses faced a cash squeeze. The stock dropped to a two-year low in April, when trading was halted in Shenzhen. Jia, who had pledged almost all of his stake in the unit as of March 31, didn’t respond to a request for comment sent through a spokeswoman.

The best description of this lunacy comes from Alex Wong, a Hong Kong-based money manager at Leverage Partners Absolute Return Fund:

“It’s mainland Chinese culture; they’re much more adventurous with pledging of shares. The market isn’t too picky when everything looks fine, even though there’s actually a huge inherent risk."

Funny, because that is precisely what we said one month ago.

Meanwhile, HNA finds itself an increasingly more troubled position, and the fate of its executives may soon mirror what happened to Wu Xiaohui, chairman of China's other mega-merger behemoth, Anbang (which as we described one month ago has quietly become a "systemic risk" for China's market). HNA’s use of leverage to fund its acquisition spree has raised red flags at credit-rating companies. Moody’s Investors Service and S&P Global Ratings have downgraded a total of six companies in the past 15 months across Asia, Europe and the U.S. and changed the outlook on a seventh after HNA bought the companies or increased its stakes. Deutsche Bank, upgraded in March on a German law change, is an exception.

In the most recent credit action, a Moody’s outlook change on Swissport Group Sarl in May, the aviation services provider technically breached loan covenants after an HNA holding pledged its shares in Swissport entities to secure a debt facility. S&P put Swissport on CreditWatch negative the following day. HNA said it took immediate action to ensure a stable financial structure after insufficient communication between different project teams caused the technical default. HNA has so far declined to comment on the six downgrades.