Controlling risks of investing in non-performing assets post-pandemic

By Li Jing, DOCVIT Law Firm

Recently, due to the outbreak of the pandemic, many enterprises have been unable to carry on normal production and operations, a situation which can often lead to a break in an enterprise’s funding chain, and give rise to non-performing assets. Notwithstanding the fact that governments have issued numerous support policies to reduce the adverse effects suffered by enterprises as a result, a significant number of non-performing asset projects are bound to arise due to the long period of time during which enterprises were forced to shut down, with their large liabilities and excessively high operating and labour costs coupled with the economic downturn.

Li Jing DOCVIT Law Firm non-performing assets
Li Jing
Senior Partner

For reasons of risk aversion and profitability, a lot of capital has chosen the counter-economic cycle business of the non-performing asset industry as an investment target. Accordingly, the non-performing asset industry is bound to usher in a period of significant growth.

The non-performing asset field is one in which there is information asymmetry, and as there are no uniform pricing standards this attribute determines that investment in non-performing assets is a high-risk and high-return proposition, giving rise to today’s investment feast. The value of the non-performing asset industry lies in the investors’ ability to seek profit margins by seeing the diamond in the rough. Only in this way can they sift the gold from the sand. How to effectively control risk is the key to investing in non-performing assets.

An investment in non-performing assets needs to be built on a detailed and accurate due diligence report. Through due diligence, the bright spots of a project can be exposed, the relevant risks assessed, and the rate of return preliminarily estimated. The outcome of the due diligence will directly affect the investors’ assessment of the price of the asset bundle, and the subsequent profit margin.

Due diligence

Investors should focus on the asset bundle in “two dimensions” in the course of due diligence – the market dimension, and the industry dimension. The market dimension refers to the assessment made based on the number of participating project buyers, and determining whether they are liquid via an examination of the status of the assets underlying the claims. The industry dimension refers to the assessment made based on the influencing factors and development space of the project in the industry.

Additionally, investors should focus on two issues in the course of the due diligence – the issues at the factual level, and at the legal level. The factual level refers to the specific circumstances of each entity involved in the asset acquisition, and the legal level refers to the legal means and procedures for realizing the claims.

Non-performing asset due diligence work includes the review of materials, interviews with relevant personnel, as well as online searches and industry and commerce inquiries, etc. All of the above-mentioned means are reliant on the facts of the project, and the legal thinking serves as the logical guide for the work.

Non-performing asset due diligence should focus on two entities – the borrowing entity, and the security providing entity. The basic particulars of the borrowing entity and the security providing entity can be obtained through an examination of files and relevant litigation material, and a review of business registration information and relevant government documents. Attention should be focused on whether the borrowing entity and the security providing entity have the repayment capacity, and whether there are other realizable assets.

Investors also need to review such documents as claim transfer agreements and claim transfer notices to verify the scope of the qualifications of claim acquirers. Efforts should also be expended on determining whether the debt security methods are legal and valid, and whether there is a possibility that the project will add new obligors.

The valuation

The key in non-performing asset risk control lies in a reasonable valuation of the asset bundle. Bank non-performing assets mainly refer to the last three tiers in the five-tier classification of loans. In general, banks will sell such assets at a discount. The investment institution needs to estimate the probability of realization of the principal of, and interest on, the non-performing assets, the bank transfer price, and the final amount of principal and interest that will be realized. These are where the investment institution’s profit margin lies.

There are two methods of valuation of a newly bundled asset bundle – the comprehensive survey valuation method, and the sample survey valuation method. In a comprehensive survey, the valuation of the asset bundle is derived by aggregating the values of all of the surveyed enterprises.

Limited by time and personnel, due diligence on a new bundle will generally be conducted using the sample survey method. In this method, a valuation coefficient is derived by dividing the valuation of the sampled enterprises by the claim amount of the sampled assets; this coefficient is then multiplied by the total claim amount of the asset bundle, giving a preliminary valuation of the total assets, and then this valuation is adjusted based on certain special circumstances to finally give the valuation of the entire asset bundle. The sampling for due diligence on a new bundle is generally determined based on the bundling characteristics of the asset bundle.

Many factors affect the valuation in the course of an investment in non-performing assets, with the most important being the nature and the format of the assets. The principal source of returns on an investment in non-performing assets is the difference between the price at which the assets are disposed of and the investment costs. The outcome of the disposal of the non-performing assets directly affects the investment return rate and the nature of the non-performing assets plays a decisive role in the efficiency of disposal.

Instances where real property is involved in a non-performing asset project are relatively common, and the format of the real property also has a significant impact on the efficiency with which the non-performing assets can be disposed of. Real property, such as residential premises, shops, office buildings, plant buildings, etc., in different formats determines its value and price in the market.

Finally, when conducting the valuation of non-performing assets for investment purposes, pricing is key. When pricing such assets, consideration should be given to whether the assets can be quickly realized, and the costs and expenses of realization.

Li Jing is a senior partner at DOCVIT Law Firm

Li Jing DOCVIT Law Firm non-performing assets

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