Are the Conglomerates the Black Swan in China?

by Wolf Richter • Jul 20, 2017

Bank of America suddenly pulled back from doing business with HNA Group, a privately held Chinese conglomerate that has been on the forefront of highly leveraged, opaque Chinese conglomerates out on a mind-boggling debt-funded acquisition binge around the world.

“We simply don’t know what we don’t know, and are not prepared to take the risk,” Bank of America president for Asia Pacific, Matthew Koder, wrote in an internal email, dated June 28 that was leaked to The New York Times. “Given the importance of maintaining rigorous client selection standards, we have decided not to be involved with transactions with the HNA Group at this point in time.”

So Bank of America is getting scared and won’t do business with HNA. It’s walking away from a lucrative customer that has been generating piles of fees and interest income for the banks. The Times:

On one side of business, banks have helped HNA buy companies by arranging what is called collateralized financing. That has entailed allowing HNA to borrow money against the shares of the company that it is acquiring.

Big banks have also received large paydays for advising on HNA’s acquisitions. HNA and its affiliates overseas have paid an estimated $100 million in fees to banks advising on mergers and acquisitions since 2016….

HNA’s most recent mega deal in the US was its $2.2-billion purchase in May of the 45-story office tower at 245 Park Avenue, the sixth largest transaction ever in Manhattan. At $1,282 per square foot, the price was also among the highest ever paid for this type of asset.

Most of HNA’s funding for this deal came from loans by state-owned banks in China that have extended HNA a $60 billion line of credit for those kinds of deals. But it also borrowed $508 million from JPMorgan Chase, Natixis, Deutsche Bank, Barclays, and Societe Generale.

This has been the trick: a lot of borrowing from Chinese state-owned banks mixed with some borrowing from US and European banks. And it worked: Since the beginning of 2016, HNA has done over 30 acquisitions, including:

• The $6.5 billion 25% stake in Hilton Hotels.
• Raising its stake in Deutsche Bank to 9.99%, now under scrutiny by the ECB; the deal was done with a $2.6 billion loan mostly from UBS.
• The $6 billion acquisition of Ingram Micro in California, the world’s largest IT distributor. The deal received US government approval.
• The $2.77 billion acquisition of Swissport, the world´s largest airport ground and cargo handling company.
• The $10 billion acquisition of CIT Group’s aircraft-leasing business, which was added to HNA’s Avolon Holdings to create the world’s third-largest aircraft rental fleet.

On all these deals, US and European banks extracted fees and interest. And on all these deals, their lawyers and auditors examined HNA, The Times pointed out: “Yet, questions persist as to whether the banks have the proper due diligence and risk control processes for dealing with Chinese companies.”

BofA had been discussing lending arrangements with HNA for future transactions, “according to a person with direct knowledge” of the matter. And it was one of several banks trying to help HNA sell at least one of its operations to the public. But now, BofA has walked away.

Among the reasons BofA listed in the email for refusing to get involved in any transaction with HNA:

• Opaque corporate and shareholding structure: The executive wrote in the email that there were “too many irregularities in the historical and current shareholding and corporate structure,” of HNA and pointed at the “opaque nature of some of the existing shareholders.”
• The sudden scrutiny by Chinese regulators of HNA and its complex business model.
• The allegations of political connections – a reference perhaps to accusations by Chinese billionaire Guo Wengui that, as The Times put it, “HNA is controlled by one of the most powerful families in China and by the relatives of people running the country’s anti-corruption campaign” – allegations that HNA has denied as “completely unfounded and false.”

Other Chinese conglomerates that have surged practically out of nowhere and that have been loading up with debt and binge-buying overseas include Anbang Insurance Group, Dalian Wanda, and LeEco. They’re all highly leveraged and have complex and opaque ownership structures that create worries about corporate governance, conflicts of interests, inscrutable transactions with related parties (including friends and family), and ultimately financial soundness. Since they’re burdened by layers and layers of debt, the banks are on the hook.

Chinese authorities are publicly worried about the loans their state-owned banks have extended to these conglomerates to fund their acquisition binge at top prices, and they’re worried about the “systemic risk” these conglomerates pose to the banks. And they’re now pressuring banks to examine their exposure to the conglomerates, including HNA. And numerous deals have since fallen apart due to lack of funding and as LeEco put it, a “cash crunch.”

“The debt addiction is threatening China’s economy as concerns swirl that some of the biggest conglomerates represent a hidden risk to the country’s financial system,” The Times reported separately. “Chinese officials have begun to clamp down on prolific deal makers like Anbang, whose chairman was recently detained by the police for undisclosed reasons.”

Bank of America’s decision to pull out of any deals with HNA shows the concerns other US and European banks must have as well, and that they too might be getting second thoughts about the risks of doing business with Chinese conglomerates, especially since even Chinese authorities are loudly fretting about the exposure of their own banks to these conglomerates, and their fear that the conglomerates threaten China’s very fragile financial stability.

When banks step back from an opportunity to make vast sums of money because they finally see the risks, it’s the moment the music stops for these conglomerates. That’s when debt cannot be refinanced or serviced anymore. That’s when the whole multi-layered debt constructs come tumbling down, and when Chinese authorities come face to face with their own black-swan event.

In the second quarter, Chinese entities accounted for half of the commercial real estate purchases in Manhattan.