Overview of Evergrande Debt Crisis

The purpose of the report is to analyze the capital structure decisions made by corporates and the impact of the decisions on the functioning of the companies involved. The report focusses on the Evergrande debt crisis which unfolded in China in the end of 2021. In August 2021, a Chinese real estate developer alerted the Guangdong authorities that it was experiencing cash flow problems. It also attempted to generate funds by selling assets, but this failed in October 2021. Its credit ratings had previously been downgraded. They also defaulted on their loan payments beginning in the fall of the year 2021. The report focused on explaining the impact of debt financing on companies taking into considerations the events at Evergrande and the debt crisis related to it. The report also focused on explaining the consequences of Long-Term Capital Management after it decided to took external debt funding to expand operations. The financial performance of Long-Term Capital Management before and after the debt crisis and the aftermath of the crisis was explained in a detailed and comprehensive manner. 

Evergrande is the second largest real estate company in People’s republic of China and is headquartered in Shenzhen, China. The company has been involved in expanding rapidly during the housing boom experienced by the country (Goddard 2022). The company bought land and delivered innumerous luxury apartments and developmental sites in more than 280 cities of China. On the back of falling sales in residential apartment and properties, the company witnessed a surge in debt and went on to diversify its business in multiple other sectors like electric vehicles, football and bottled water. Evergrande is responsible for giving employment to more than 200,000 people and has an indirect influence in employment of more than 3.8 million people across the globe.

The primary strategy for Evergrande was to grow using externals source of debt and was involved in selling the biggest dollar bond within the Chinese property developers in the year 2010. After the completion of the largest dollar bond offering, the company has gone on a debt spree to fund development, becoming the highest dollar loan borrower among peers and China’s fifth largest developer by contractual sales. The company had already faced liquidity issues in the year 2020 and had chalked a plan to reduced the level of debt by $100 billion from the company till the year 2023. Due to regulatory curbs and falling demand, the housing market in China was quite volatile and became the main reasons for a debt crisis unfolding in the company which scared investors and economies all around the world.

Opportunities and Drawbacks of Debt

The regulatory environment in China has been increasingly strict as the government tried to control prices of houses and reduce the level of borrowing currently prevailing in the industry. In the year 2020, the Chinese government identified key areas and decided to impose few regulatory restrictions by the name of Three Red Lines on certain developers to reduce the debt level in the company and compelling the companies to deleverage the company up to an accepted level of debt (Hobbs 2021). The policy introduced by the government are highlighted below:

• A ceiling of 70% was imposed on liabilities to assets of companies falling under the purview of the policy.
• A 100% cap was imposed on the net debt to equity ratio of the companies with alarming levels of debt in the company which included Evergrande in it.
• The company falling under the new law had to maintain cash to short-term borrowing ratio of not less than one.

These above-mentioned new regulations imposed by Chinese authorities had a great impact on the functioning of Evergrande which had a history of having enormous leverage. Although the company’s stock price has outpaced the growth of the general market represented by the Hang Seng Index between the years 2007 to 2019, the company has gone on to become the most indebted property group in the entire world in the process to achieve the fate. In between rumours of Evergrande facing liquidity crisis in the company, Evergrande witnessed several credits down grading by reputable credit analysts.

The new regulations had put a limit to the debt raising capacity of the company and as a result at the end of August 2021, Evergrande warned the regulators that if they were not allowed to raise debts it may amount to missing the coupon payments of various bonds issued by the company. In the month of September, the company missed its coupon payments on off-shore bonds which was equal to $83.5 million. In the month of October, the company further missed payments on three bonds which were off-shore which equalled to the amount of $148 million. The company went to miss final deadlines of few more bonds during the end of 2021 which sent shocks around the world regarding an economic collapse of the company (Banerjee, Akhtaruzzaman and James 2021).

This event has put bondholders, governments and investors at risk as it could become China’s one of the biggest defaults with a deficit of around $300 billion. Failure in raising debt to fund the bond coupon payments, the company had to resort to selling its assets in the market to raise capital but except for the sale of a stake in a regional bank, none of the company’s assets witnessed material progress in finding buyers. The shares of the company following the crisis and the attempted asset sale, fell down by around 13.6%. The company had to face additional sanctions by the government like freezing of assets and demolition of buildings and it is assumed by experts that a successful restructuring of the company is no longer feasible.

Capital Structure Theories

Debt financing can be carried out through various products like bonds, bills and other short-term debt securities which can be differentiated based upon the tenure of the instruments. A bond is a financial product in which a lender lends money for a longer period of time and receives monthly interest payments, with the principal returned when the bond matures. Bonds, bills, and notes are examples of debt that a business might issue to obtain funds for a variety of objectives. These securities pay bondholders semi-annual or annual interest payments, which are a cost to the corporation.

The primary opportunity that a company looking to finance projects using debt is that it does not have to dilute its stake in the company in the process of raising funds through debt financing instruments, like in the case of equity (Zhang 2016). Taking up debt can assist in the long-term development of credit for a company looking to expand through credit like in the case with Evergrande. The company went to become one of the largest players in the real estate industry using debt sources as capital funding. Prompt loan repayment will assist to improve credit score, boosting the possibilities of obtaining a larger loan for long-term investment objectives like in the case of Evergrande before the unfolding of the crisis. The interest payments that a company is required to service the debt is also tax deductible for the company which would help reduce the taxable income of the company. Hence, it gives the company an opportunity to grow further and use the additional profits to return to the shareholder or to invest in expansion projects.

There are some drawbacks of debt funding which includes that the company has to pay the interest that is required to service the debt, on a regular basis irrespective of profitability of the company. Even if there is a loss or a drop in sales, the corporation must satisfy its bond coupon payments (Yazdanfar and Ohman 2015). In the instance of Evergrande, the corporation had to satisfy its coupon payments despite dwindling revenues and rigorous regulatory rules that had a negative impact on the company’s financials; failing to do so resulted in asset freezes and property demolition. Lenders evaluate a company’s credit quality before imposing specific covenants that are aimed at limiting the company’s activities and, as a result, function as a constraining influence on the company’s management’s ability to make choices freely.

The purpose of capital structure theories is to give a roadmap of planning for debt and equity financing for corporates to strike the perfect balance between both and increase the value of the company in the market. The value of the organization depends upon the performance of the company, its earnings and the cost of capital of the company. There are multiple capital structure theories which can be followed by corporates:

1. Trade-off theory – The proportion of debt and equity should be based upon the cost of each source of funding. If the cost of debt is greater the leverage in the company must be reduced, whereas if the cost of equity is greater the amount of debt in the company should be raised to buy back the shares of the company. The theory also proposes that if the tax rates in a country is greater, that implies a greater tax shield achieved by companies due to interest payment on debt. Hence, the level of debt in the company should be increased. According to the theory, equity issuance costs are greater than debt issuance costs, and debt distress costs rise as well in case of higher debt raising. The ideal debt equity ratio may be determined by analysing the issuance and distress costs (Agyei, Sun and Abrokwah 2020).
2. Modigliani-Miller approach – The Modigliani-miller proposition 1 posits that a firm’s worth is independent of its degree of debt or equity, and is calculated by capitalising its projected return at the risk class-appropriate rate r. The second postulate of the Modigliani-Miller theory states that any firm’s average cost of capital is fully independent of its capital structure and equal to the capitalization rate of a pure equity stream in its class (Chang 2015).
3. Pecking-order theory – According to this theory, the firm follows a set template in making financing decisions. The corporation uses internal sources of funds or the amount of retained earnings to fund a project or expansion strategy. If the investment requires extra funds, the firm will turn to debt financing, and the company’s final financing option will be the selling of shares. The pecking-order idea is in line with several well-known facts, such as the fact that many lucrative investment proposals are funded from internal sources. When the number of shares terminated using debt raised exceeds the number of shares issued by the firm, net stock issues occur frequently. A successful company’s capital structure is dominated by equity rather than debt (Serrasqueiro and Caetano 2015).

Long-term capital management was a huge hedge fund managed by prize winning economists and very famous wall street traders, formed in the year 1994 in the United States. The company was a hedge fund that operated using complex mathematical trading models developed by the managers of the fund and used leverage as the primary strategy to earn return for the investors. With $1 billion in assets LTCM primarily focussed on bond strategies where the strategy of the fund was to identify temporary divergence of prices of bonds in the international and domestic markets and take trades accordingly based on the notion that the prices would converge after a specific period of time earning profit for the company. The company had very little margins in trade involving bond and the strategy designed by them, hence they depended hugely on leverage to amplify the profits made by the strategy.

At the peak of success in the year 1998, the fund owned assets worth around $5 billion and had control over assets that were worth more than $100 billion. The company had open positions on trades the combined value of which was equal to $1 trillion which was financed using external leverage. The borrowed amount of assets was worth more than $120 billion in value. The company was highly leveraged in its operations and had huge positions on Russian Bonds due to a strategy. Following the default of Russian governments on Russian bonds, the company faced huge economic crisis as the company began to suffer huge losses on its positions in the bond (Thebalance 2022). The company was unable to raise debt from additional sources to carry on the trades till the prices of the bond improves and becomes favourable. The risk of defaulting on its own bonds, the company was forced to cut some of the losses in its position. The total position in bonds that LTCM held at the time of the crisis was equal to the 5% of the total global fixed income market and was involved in the trading using borrowed funds and leverage the trade to extraordinary levels.

Excessive leverage in the capital structure and faulty risk management framework and protocols, the LTCM was on the brink of collapse instigating a series of financial crisis led collapses of major institution across the nation. To save the company and the economy from an imminent collapse triggered by the company, the US fed led consortium of several banks and financial institutions came to the rescue of the company which allowed the company to stay afloat till the positions in the bond market recovered and the company could liquidate in an orderly fashion (Golub, Kaya and Reay 2015). The bailout cost around $3.6 billion, and while it was not directly public money, it was indirectly public funds that originated from large financial firms. The major cause of collapse for the company was the overuse of financial leverage in trading that was an evident concern that LTCM failed to adequately manage. The company had $4.7 billion in equity and about $124.5 billion in debt in 1998, resulting in total assets of around $129 billion and a debt-to-equity ratio of around 25:1 which is huge in terms of comparable companies.

Conclusion

The goal of this research is to examine corporate capital structure decisions and the influence such decisions have on the operations of the firms concerned. The Evergrande debt crisis, which occurred in China at the end of 2021, is the subject of the report. A Chinese real estate developer notified the Guangdong government in August 2021 that it was having cash flow issues. The company was found to be impacted by regulatory decisions and an overall underperforming industry which reduced the margin of the companies in operations. The research aimed to demonstrate the impact of debt financing on businesses, taking into account the events at Evergrande and the resulting debt crisis. The study also went through the ramifications of Long-Term Capital Management’s decision to take on external debt finance to expand operations. The analysis found that the company was focussed upon exploiting arbitrage opportunities in the bond market based upon mathematical complex models. The company had to resort to leverage to extract the most amount of profit from the markets. Long-Term Capital Management’s performed superiorly till the year 1998 and due to poor capital structure decision the company had to liquidate.

References

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Banerjee, A., Akhtaruzzaman, M. and James, W., 2021. Is Evergrande fiasco set newer ripples in world financial markets?. Available at SSRN 3956277.

Chang, K.P., 2015. A Reconsideration of the Modigliani-Miller Propositions. In The ownership of the firm, corporate finance, and derivatives (pp. 17-22). Springer, Singapore.

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Golub, S., Kaya, A. and Reay, M., 2015. What were they thinking? The Federal Reserve in the run-up to the 2008 financial crisis. Review of International Political Economy, 22(4), pp.657-692.

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How a 1998 Bailout Led to the 2008 Financial Crisis (2022). Available at: https://www.thebalance.com/long-term-capital-crisis-3306240 (Accessed: 27 March 2022).

Serrasqueiro, Z. and Caetano, A., 2015. Trade-Off Theory versus Pecking Order Theory: capital structure decisions in a peripheral region of Portugal. Journal of Business Economics and Management, 16(2), pp.445-466.

Yazdanfar, D. and Öhman, P., 2015. Debt financing and firm performance: an empirical study based on Swedish data. The Journal of Risk Finance.

Zhang, S., 2016. Institutional arrangements and debt financing. Research in International Business and Finance, 36, pp.362-372.