Evergrande's Debt Spiral

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The Evergrande Train Wreck

The calamity surrounding The Evergrande Group—the massively over-indebted Chinese property developer—is the train wreck that the world can’t help but watch.

It’s fascinating—and carries a lot of interesting learnings on finance and business—so I wanted to share more about the situation with all of you curious folks out there!

Here’s a breakdown on the business, background, and its rapid, very public demise:

Background

The Evergrande Group is a Fortune 500 real-estate developer with headquarters in Shenzhen, Guangdong, China. It was founded in 1996 by Hui Ka Yan in Guangzhou and scaled up over time from a small local player into a national behemoth.

Today, it's big…very big. As recently as 2020, it had sales of >$100 billion and adjusted core profits of ~$5 billion. The below chart of its financials gives a perspective on its recent and rapid growth.

At its core, it's a homebuilder business—developing from the ground up and selling properties to Chinese consumers. Its website states that it has over 1,300 projects across 280+ cities.

But recently, it has pushed the boundaries of its homebuilding circle of competence, making investments in electric vehicles (Evergrande New Energy Auto), an internet and media production unit (HengTen Networks), a theme park (Evergrande Fairyland), a soccer team (Guangzhou F.C.) and a mineral water company (Evergrande Spring).

The Business Challenge

As a developer, Evergrande had to contend with a highly cash-consumptive growth profile.

Why? Well, building a new development project may take many months (even years) and requires a lot of cash outflows along the way—you have to buy the land, pay for construction costs and permitting, etc. Meanwhile, with the exception of smaller upfront deposits, cash collections from buyers typically don’t come in until much later, after the project is completed.

This creates a challenging cash conversion cycle (the time it takes to convert investments in inventory/resources into cash) that almost any property developer has to deal with.

So how did Evergrande fund its impressive growth?

Debt—it borrowed aggressively, even by real estate property development standards.

It became the world's most heavily-indebted developer, with a debt load of over $100 billion and over $300 billion in outstanding liabilities.

As is pointed out in the brilliant thread below (tip of the hat!), there is a bit of a moral hazard problem that was created along the way. Evergrande was largely indifferent to pricing on the land and properties it was purchasing and building, knowing that the risk would be passed off to banks or other financial institutions financing the purchases.

The debt-fueled growth propelled Evergrande—and its now billionaire founder—into an elite class. It entered the Fortune 500 at #496 in 2016 and reached #122 by the latest ranking. As the company amassed an enormous debt burden, it also paid out handsome dividends, with Hui Ka Yan (its largest shareholder) reportedly receiving over $5 billion in dividends since 2018.

The Debt Spiral

But debt is a double-edged sword—and Evergrande was overdue to catch the other edge.

As its debt burden grew, so did the interest payments on that debt. This is (mostly) fine, so long as revenues and profits—with which you can make these payments—continue to grow. But if the growth or profitability slows (or government restricts borrowing!), it's...well…not fine.

Imagine a metaphorical boa constrictor tightening its grip on its prey. You can try to resist—borrow more to make your payments—but that only fuels the snake. Moreover, the knowledge of your precarious position increases risk and makes that borrowing more challenging and costly.

In Evergrande's case, the snake formally tightened its grip in 2020. It had its first major liquidity scare—a potential inability to meet its liabilities—sending a letter to the local provincial government warning that its upcoming payments could cause a crisis with systemic financial sector risks.

In a cynical sense, sending a letter to the government warning that your collapse poses “systemic financial risk” is a pretty savvy tactic—hype up your importance to force the government’s hand. If you collapse and they did nothing, you can point to the letter and say “I told you so” and make them look bad. More likely, they act in advance and bail you out to save you.

With most de-leveraging spirals, there are two sides:

Technical: An inability to make payments.

Psychological: The knowledge of instability impacting your market standing.

Most financial reporting focuses on the technical, but the psychological is equally (if not more) damning. Reports of Evergrande’s letter sent its stock and bonds tumbling.

The short-term crisis was avoided when an investor group waived its right to force a big repayment, but the long-term challenges and issues remained.

Dornbusch's Law—a personal favorite that I need to write more about in the future—says that crises take longer to happen than you expect, but then happen faster than you ever could have imagined.

This certainly proved true for Evergrande...

The Crisis

To meet its ever growing obligations, Evergrande began tapping into "creative" financing strategies. It pushed employees to provide short-term loans to the company—which it called "high interest investments”—in order to ensure they received their year-end bonuses. If that sounds shady, it’s because it is.

But the company quickly fell behind, missing payments earlier this month and leaving thousands of employees in a lurch. With over $7.4 billion of bond payments due in 2022, and large interest payments coming up as soon as this week, the crisis appears to be accelerating rapidly. Its stock dropped almost 20% on Monday.

To reiterate the earlier point, the psychological side of a financial crisis can be just as impactful as the technical side. It was recently reported that Evergrande was offering to sell properties at a deep discount in order to pay off its vendors and liabilities—indicating a fire sale required to make its payments and sending further panic spiraling into the market.

Protests have broken out at Evergrande offices in China—with up to 1.4 million homebuyers left in a devastating limbo, having paid deposits upfront for homes worth ~$200 billion that may never be built. The media narrative cycle of demise ramped up in earnest and further fueled the fire.

Importantly—and yet another reason why the world is paying attention—the Evergrande situation does pose a potentially systemic risk to the Chinese economy. With deep ties to financial inst...