John O’Donnovan was invited by The Banker to discuss the due diligence lessons banks can learn from the Evergrande crisis. What should they be aware of when contracting with developers?

As the debt-laden Chinese developer teeters on the brink, and fears about contagion increase, banks should consider several things with developer clients.

The phrase ‘too big to fail’ still sends shivers down the spine of anyone working in, or connected to, the financial sector after the failure of Lehman Brothers in 2008. For those of us who lived through the global financial crisis and witnessed the speed with which financial panic spreads, the thought of history repeating itself is not particularly pleasant.

The developing Evergrande crisis in China is, therefore, being monitored closely in light of its similarities. Add in the limited information being made available and the unpredictable nature of the Chinese economy, and it is not a stretch to see a set of circumstances arising that cause global stock markets to plummet.

The Evergrande crisis in China raises a few issues that banks elsewhere in the world should pause and reflect on.

Where are we
Evergrande, the privately owned Chinese property developer with approximately $300bn of debt, was unable to make an $83.5m interest payment in September on some of its bonds. The company claims the issue has now been resolved, but whether this was done with cash or other assets remains unclear. Over the summer, the company was reportedly paying suppliers with unfinished apartments instead of money. In addition, further debt payment deadlines loom on the horizon.

It goes without saying that a default of such scale would have seismic repercussions in China and across the world. The Beijing government has so far been reluctant to step in and provide a bailout. Meanwhile, a recent deal to sell 50% of the property services division of the company for around $2.6bn fell through, fuelling further uncertainty.

A banking perspective

The Evergrande debt stack dwarfs most exposures banks have to a single property developer client. But as contagion risk increases, it provides a reminder of several considerations banks should always have in mind when dealing with developer clients.

• Ambition: naturally we all want to see upward trajectories and positive projections on a property developer’s financials and prospectus. However, it is always prudent to ask whether such ambitions are realistic or overly aggressive. As a caveat, borrowing aggressively to fund rapid expansion can sometimes prove a very successful strategy for developers and lenders. But if the strategy is totally reliant on debt, with little or no capital alongside it, then it can often become precarious. The slightest economic or political headwind could have a significant impact on the company’s fortunes and leave it teetering.
• Due diligence: carrying out due diligence on a property developer is not an exact science, but the importance of building a full picture of a group’s obligations and liabilities cannot be emphasised enough. This is an imperative — both prior to providing a loan facility, as well as during it. All lenders will have financial covenants included in the loan documentation, but other covenants and conditions may need to be included, and these need to be robust, relevant and effectively monitored. Evergrande used every method possible to increase the availability of leverage, loans, bonds, notes and even tailored products to investors, in order to navigate borrowing limits.
• Remedies: even when all parties adhere to best practices, things can still go wrong and developers can run into difficulty. It is, therefore, important to have adequate security and rights in place. This means having security that is appropriate and can be enforced effectively, or it could become a costly and protracted process. From a bank’s perspective, the question is whether they can step in, rely on their insurance or have recourse to various contractors to ensure that the loan is eventually repaid.
• Clients: as always, client relationships are a vital consideration. The better the relationship, the less likely the client is to run into difficulty. Investing in the relationship should ensure that banks better understand the developer’s business and commercial drivers, and help ensure they have the necessary experience and expertise to transact with the client.

It remains to be seen how the Evergrande crisis will play out, but in light of the ripples it has already caused across global markets, it has the potential to cause many more. The Beijing government’s iron grip over the banking sector in China makes a financial crash unlikely. However, banks are advised to watch this space and apply some of the considerations above to prepare for any further financial panic, should it come around.

For more information please contact John O’Donovan, Partner and Head of Banking and Finance, at john.odonovan@haroldbenjamin.com or +44 20 3096 0823