The Evergrande (HKSE:03333, Financial) crisis has rocked financial markets around the world. The Chinese property developer, which is estimated to have borrowed nearly $300 billion, is on the verge of insolvency. It is due to make interest payments of $84 million on its bonds this Thursday, although there is some flexibility about when the company can make the payment.
At this point, it is impossible to tell whether or not the company will survive or if the government will bail it out. Some might argue that the enterprise has already entered default. It has refused to pay investors in its wealth management products with cash. Instead, it is using property, which looks more like an orderly winddown rather than business as usual.
Over the past few months, many stories and rumors have emerged about the company and its lack of cash. It has also been declared that the enterprise was using wealth management products to pay off other wealth management products, the classic hallmark of a pyramid scheme. There is also a question mark over the total level of company debt, with no one really sure how much the enterprise really owes.
The lessons from the collapse
There are many other analysts and investors with more insight into the company than I. So, I'm not going to try and speculate about how Evergrande got here and what's next for the business.
Instead, I want to look at what we as individual investors can learn from this crisis. Some analysts have started to compare the company to Lehman Brothers. There are some similarities, the biggest one being the total level of liabilities and debt Evergrande has accumulated. The company is another example of how significant levels of borrowing can dramatically impact a company's fortunes.
Evergrande has borrowed aggressively over the past decade to expand as fast as possible. It has used every method possible to increase the availability of leverage. By using banks, bonds and offering products to individual investors, the group has been able to skirt around leverage limits.
Offshore bond investors might have started to question the company's growing debt pile, but to get around this issue, the group began selling so-called wealth management products to individual investors and even inexperienced savers.
When a company decides to tap and shadow a market like this for funding, it can be a sign that traditional financing avenues have been shut or are closing quickly. No enterprise wants to take the time and effort to negotiate with thousands of different savers when they could take a large loan from a single financial institution.
Evergrande's debt mountain is just one part of the company's downfall. It has also come unstuck due to volatility in the Chinese property market. Property prices have been falling, and confidence has weakened.
This is another similarity between Evergrande and Lehman. Both started to struggle when confidence collapsed.
The Chinese property group was able to maintain its facade as long as activity in the property market continued. Still, the second the market started to crack, weaknesses in its business model began to emerge.
This is a vulnerability that comes with high levels of borrowing. High levels of borrowing leave no room for flexibility. It might be possible to maintain elevated levels of debt as long as nothing changes. However, the second there's a change, either in the company's end market or on its own balance sheet, things can quickly spiral out of control.
So, if there's one thing investors should take away from the whole situation, it is the fact that they should avoid any company with a high level of debt. Unless you are an experienced distressed debt investor, highly leveraged distressed companies will probably not be good investments.
