Cognitive Dissonance and Semis Funding

We have written a lot about (and here) China’s seemingly infinite pool of money for investing in semiconductors as part of their national strategy. So we got a few questions with yesterday’s news that China’s Tsinghua Unigroup is defaulting on payments for $198 million of its bonds. Doesn’t that contradict our previous statement about giant pools of capital?

The short answer is no. There are a few things going on here.

Unigroup is one of China’s largest semis companies. They have stakes, or outright ownership, of some of China’s best known chip companies including Spreadtrum, RDA and Yangtze Memory. They are essentially the flagship of the national policy.

China seems to be going through a bit of a debt mini-crisis, emphasis on the mini. Despite operating its economy largely with debt funding, bankruptcy is pretty rare in China. This is possible because most of China’s debt is owned by domestic lenders and investors. Foreigners own something like 3% of China’s debt issuance, and most of those holdings are of government bonds.

Instead, the vast majority of corporate debt issuers are government backed entities. In practice, this means before companies really go bankrupt some other company is directed by fiat to acquire them. This sounds odd to Western ears, and certainly it carries significant risks with it, but for the time being it is a workable solution. And inherent in all these bond deals is the assumption that the government will ultimately backstop any state-owned company’s debt. This is likely true even for companies like Huawei, which are ostensibly “private” but whose debt trades at a premium to companies that are outright owned by the State.

A second factor with Unigroup is that it is owned by Tsinghua University, and earlier this year the government set up new regulations essentially requiring academic institutions to separate themselves from commercial holdings. Again, this is getting into some complex territory. China’s corporate governance structures look very odd to Western Capitalist eyes. The proximal problem is that Unigroup no longer has the backing of its parent. Of course, this means that Unigroup has not been able to support its debt for some time, and we are just seeing that revealed in light of the new regulations.

Finally, it is important to remember that China’s approach to investing in semis has largely been to channel funding through professional private equity and venture investors. As we noted in our piece on this a while back, these investors expect commercial returns. But if Unigroup, the biggest of these nationally directed firms is unprofitable does that mean the whole sector is unprofitable? And if so, is the whole strategy unviable?

All this highlights the difficulties inherent in national Industrial Policies. State subsidies can easily get diverted to political rather than commercial leaders. (If you want to dive deep into conspiracy theories, you can also wonder if Unigroup’s backers are part of a political faction that is far out of favor, but we would caution against trying to parse China’s Communist Party internal machinations, no one really understands these.)

That all being said, Unigroup is not going to go bankrupt. Some entity will step in and refinance the debt. These can be ugly negotiations. We have been on the inside a few of these in China, and they are raw capitalism with some very sharp elbows. Unigroup is not going away, but it may emerge with new owners.

Nor is the broader strategy going away. China’s government’s goal is to build up its semiconductor industry. They are using capitalism and free market mechanisms to handle individual investment decisions, but the end goal is not eye-popping returns to private investors.

Like we say in the title, wrapping heads around the situation is not easy, but we do not see this as signaling some kind of broader change.

Photo by Vinicius “amnx” Amano on Unsplash

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