When 31% Recovery Is a Thing of Beauty for Bond Holders

(Bloomberg Opinion) -- The most beautiful daughter gets married off first, a Chinese saying goes. But sometimes, a favorite child can be so pampered, so high-maintenance, that she’s homebound well past her prime years. Eventually, everyone starts wondering if she will have any suitors at all.

This is what’s happening at Tsinghua University, the prestigious, nearly 110-year old school that is President Xi Jinping’s alma mater. After defaulting in mid-November, Tsinghua Unigroup Co., a commercial arm and “favorite daughter” of the university, has brought in a government-led working group to diffuse its debt crisis. On Wednesday night, the company warned that it will not be able to repay a $450 million dollar-denominated bond due on Dec. 10. 

With sprawling operations from memory chip manufacturing to smartphone and smart card chip design, Unigroup is the closest China’s got to Samsung Group. Without it, President Xi’s  microchip dreams — outlined in his signature Made In China 2025 program — can’t be fulfilled. That ambition has come at a steep price. As of June, Unigroup was bleeding operating cash, burning through 15.4 billion yuan on research and development alone. It had 46.7 billion yuan of debt due within a year, with more than half owed to bond investors, but sat on only 42 billion yuan of unrestricted cash. 

Even before Wednesday night announcement, investors pretty much believed more Unigroup defaults were inevitable. The only uncertainty is how the company proceeds with restructuring, and how much money the investors can claw back. Nomura Holdings Inc. estimates creditors could recover 31% to 45% of their money from Unigroup. Distressed returns, yes, but many would be happy with that. As I’ll explain, those hopes may be too optimistic.

Much may depend on which bonds investors hold — and what Unigroup decides to do about its debts. Overseas holders of the dollar bonds due this year will benefit if Unigroup chooses to avoid restructuring now and pays it off soon. To do that, the company could use some of the 9.4 billion yuan of cash it held outside China as of June (Chinese companies cannot quickly wire money out of the country because of currency controls). That will, however, come at the expense of investors who hold the longer dated notes.

On the other hand, if the conglomerate goes into bankruptcy proceedings, the restructuring process would likely favor notes due next year and beyond. That’s because they happen to be guaranteed. The 2020 bond only has a keepwell clause, essentially a gentlemen’s agreement, from Tsinghua Holdings, the university’s wholly owned subsidiary that controls Unigroup. Earlier this year, a Beijing court rejected the validity of the keepwell clause in bonds issued by Peking University Founder Group, another conglomerate that went into bankruptcy. Unigroup and Founder were often held up in comparison because each was the favorite commercial offspring of two rival state-run universities. 

Based on bond pricing data compiled by Bloomberg, investors appear to be leaning towards the less dramatic scenario — that somehow Unigroup will continue to hang on. The 2020 bond was asking 33 cents on a dollar, while longer-dated ones were as low as 22 cents — very distressed levels.  

Are investors too pessimistic? Unigroup is not your ordinary state-owned entity. Its flash memory chipmaker is cutting-edge. It also controls Unisoc, China’s second largest mobile chip designer and now a supplier for Huawei Technologies Co. because the sanctioned company’s in-house designer HiSilicon Technologies Co. no longer has access to U.S. tech products. Nomura based its rosier recovery estimates on Unigroup having these assets and operations. 

But enterprise valuations like these may be pointless exercises. After a recent series of defaults, there’s a deepening suspicion that China’s state-owned-enterprises transfer good assets out of the way before creditors can get at them through the courts. Unigroup has played that kind of hide-and-seek before. Last month, a few days before defaulting, it pledged a 16% stake in smart-card chip designer Unigroup Guoxin Microelectronics Co., worth about $1.4 billion, to Bank of Beijing, with which Unigroup and its subsidiaries have had a long business history. Liquid assets like stock holdings can easily be shifted while those that require time-consuming appraisals — such as the nailed-down and depreciable factories and equipment of Unigroup’s Yangtze Memory Technologies — are often left to the courts and the creditors.

White knights may come to the rescue — or they may not.  Finding one for Unigroup is particularly hard because the chip manufacturing at its core burns cash at terrifying rates. A rescuer would probably have to pay off the short-dated bonds first — benefiting those holders — to diffuse the debt time bomb. Another dollar-denominated bond is due at the end of January.

Over the years, Tsinghua University has tried multiple times to sell its controlling stake in Unigroup — without success. Past suitors have included municipal governments but they were deemed not prestigious enough for the favorite daughter. China National Nuclear Corporation, a central SOE, was looking into Unigroup’s assets, Debtwire reported Tuesday. Let’s see.

So investors who bought into President Xi’s chip dream are stuck. The speeches are grand, but the reality is plagued with cash burn, poor governance, and scant access to bailouts in a country just starting to test bankruptcy proceedings. Gentlemen’s agreements can be empty promises. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.

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