Evergrande's Final Collapse to Set Important Precedent

The collapse of China Evergrande (HK:3333)  EGRNY , which has finally been pushed into liquidation, has been an awfully long time coming. With both the stock and the high-yield bonds trading close to zero, the immediate market impact is limited.

But what happens next will determine how much faith investors can place in mainland markets, and the Beijing government's commitment to reform. Evergrande, as the world's most-indebted developer, was the poster child for problems in China's property industry. Would-be homeowners as well as creditors await the outcome as its empire is dismantled.

Evergrande, staggering under a debt burden estimated at US$371 billion, has finally and fully collapsed. The Hong Kong High Court on Monday issued a winding-up order for the company. Judge Linda Chan dismissed yet another request, this time for a 3-month extension, to delay proceedings since the company has not proposed any concrete restructuring proposal, or even really negotiated on concrete details with creditors.

Despite 19 months of proceedings during which Evergrande was supposed to be working on some kind of bailout, "there is no restructuring proposal, let alone a viable proposal which has the support of the requisite majorities of the creditors," Chan finds. On the contrary, Chan decides, it's better to put independent liquidators in charge "to secure and preserve its assets and review and formulate a restructuring proposal if they consider that such a course is appropriate."

What's more, the judge adds, "this has the additional advantage of putting the Company out of the control of Mr. Hui," referring to founder and figurehead Hui Ka-yan. Hui, once the richest person in China, founded the company in the southern megacity of Guangzhou in 1996, just across the border from Hong Kong. He expanded it across the country into a developer that, until its collapse, sold more homes in China each year than any other. Hui was detained last fall "due to suspicion of illegal crimes," as I explained in September, proceedings that have yet to yield an outcome.

Evergrande issued a company statement requested trading in its stock, at a paltry HK$0.16, to be suspended. The workout specialists at Alvarez & Marsal Asia, which handled the Lehman Brothers collapse, have been appointed liquidators to dissolve the Evergrande network.

That will not be easy to do. The Hong Kong court ruling covers Evergrande's offshore entities, but it's yet to be seen how enforceable the winding-up order is, if the Hong Kong-based liquidators want to seize and sell assets in mainland China. Capitalist Hong Kong, with a common-law system founded on the one used in Britain, and Communist mainland China maintain separate legal systems that will now be at odds. Over 90% of Evergrande's US$242 billion in assets lie inside China. To top it off, it has a complex series of cross-holdings.

The Beijing government has recently been courting international investors, who in large part have abandoned mainland markets, resulting in three years of decline. Hong Kong stocks have suffered four falling years, and sit at half the level set in a February 2021 Covid rebound. How Evergrande's international creditors are handled will set a precedent, indicating how much trust non-Chinese investors can have in their mainland holdings.

Yet the interests of equity investors, bondholders and of homeowners, some who have put down deposits on apartments that risk never being built, are also at odds. The Communist government has frequently demonstrated that it is most concerned with preventing social instability. It will want to head off any outcry about unbuilt homes, abandoned high-rise towers and unpaid labor bills, certainly more than it worries whether overseas capitalists will get fewer cents back on their dollar.

Evergrande says it is also focused on completing projects. "The company has made all efforts possible and is sorry about the winding-up order," CEO Shawn Siu said in a statement. "The company will ensure home deliveries and steadily promote normal operation of the group," while dealing with the liquidators.

Any unwinding will be incredibly complicated. Evergrande has sister listed companies in the form of real-estate management entity Evergrande Property Services Group HK:6666 as well China Evergrande New Energy Vehicle Group HK:0708, which is struggling to bring its EVs to market. Its mainland business operates under the company's original name, Hengda Real Estate. What's more, most individual property developments are structured as separate legal entities. And, fueled by Hong Kong's capital markets, the Evergrande group expanded into theme parks, bottled water, pig farms, even a highly successful Chinese soccer team, essentially according to the founder's whim.

In terms of market response, there's been follow-through selling in Hong Kong, Shanghai and Shenzhen on Tuesday, with the Hang Seng Index sinking 1.9% and the CSI 300 Index down 1.1%. That's even though the Hang Seng held up well yesterday, ending with a 0.8% gain for Monday, in contrast to the 0.9% fall for mainland markets. But any fallout will be contained.

Evergrande's shares have been trading below the equivalent of US$1 since mid-2021, while the company's high-yield bonds were valued around 1.5 cents on the dollar. Its market capitalization, as high as HK$50.6 billion (US$6.5 billion) in 2017, has sunk to HK$2.1 billion (US$270 million) before trading was stopped.

But there was still hope that a developer that's built the equivalent of multiple cities many times over in China could still survive.

Troubled developers can reach a deal with creditors, given the right amount of will, and goodwill. Sunac China Holdings HK:1918 did exactly that, as I explained in October, with a Hong Kong court approving its proposed deal with investors to restructure US$9 billion in offshore debt. There's the hope Sunac, which delisted its pink-sheets U.S. shares last May, could form a template for other companies to follow.

Country Garden (HK:2007)  CTRYY , Sino-Ocean Group (HK:3377)  SIOLY and CIFI Holdings (HK:0884) are likely on the shortlist of 50 or so developers that have defaulted on debt payments but that the Beijing government has identified as worthy of financial support.

The Chinese property industry has been hurtling toward debt defaults and company collapses ever since Beijing introduced the "three red lines" in August 2020, setting limits on credit for property developers. That essentially put an end to the industry's modus operandi of taking deposits on "off-plan" unbuilt homes, selling projects as fast as possible, buying up expensive land, then using the credit generated to fund the next project.

Evergrande became the first major developer to miss debt payments in October 2021, entering technical default that December. As a result, homebuyers across China are now reluctant to put down money on properties, and home sales are down roughly 50% from pre-Covid 2019 levels.

It may be that Evergrande, which ran up more debt than anyone else and appears to have done little to negotiate meaningfully with creditors, is a particularly egregious case. Savvy private developers and in particular government-backed state-owned enterprises will survive. How the Evergrande empire is dismantled, whether any parts of it survive, and how investors are treated can now begin to play out.

At the time of publication, Alex Frew McMillan had no position in the securities mentioned.