Asia's Worst Deal

Wall Street peddled nearly $6 billion in bonds for Asia Pulp & Paper before the Singapore company defaulted. A cautionary tale of greed, blind optimism, and the East-West divide.

Of the many phone calls Singapore-based fund manager Julia Ho received from relentless bond salesmen late last year, one stands out. This salesman, from a leading international firm, made a hard-sell pitch for high-yield bonds issued by Asia Pulp & Paper Co. (PAP ) It sounded irresistible. APP, with $3 billion in revenues, had new, state-of-the-art paper mills across Asia, plenty of fast-growing hardwood in Indonesia, and had moved into the booming China market. It was one of the few big local conglomerates with revenues mostly in hard currency.

Of course, there was the little matter of APP's $13.4 billion debt. The pitch acknowledged that. "This is a very highly geared company," Ho, the investment director of Rothschild Asset Management (Singapore), recalls the salesman as saying. "But the fact that they were able to survive the Asian crisis is an indication of how capable the management is." The salesman referred to APP's founders, the Widjajas, an ethnic Chinese clan from Indonesia.

Ho went ahead and bought about $500,000 of the bonds on the secondary market. She admits she skimmed the pages of the offering prospectus that described the possible problems, assuming they were the usual boilerplate. The salesman "did not highlight the risks," she recalls. Ho won't identify him, or the issue, but was reassured because a top Wall Street firm had signed the prospectus. The yield was well into the double digits.

Ho and other APP investors before her should have been more wary. Since the mid-1990s, documents supporting APP bond and share issues warned of the downsides, from staggering interest costs to volatile world paper prices to political and currency instability in Indonesia, home to most of the company's operations. A 1999 prospectus for $500 million in convertible notes, for example, was blunt about the company's finances: "We expect to incur significant additional indebtedness over the next few years....Such financing or any refinancing may not be available on terms acceptable to us, especially in light of the recent conditions in Southeast Asia and international credit markets and recent credit-rating downgrades." Rating agency reports detailed the risks as well.

Sure enough, in February, 2001, after a 20% plunge in global paper prices over three months, APP defaulted on its bank loans and bonds. The default triggered what has become one of the biggest investment debacles in the history of modern Corporate Asia. "It could be considered the worst of the largest [defaults]," says Mark Mobius, director of Templeton Asset Management in Singapore, "because it involves so many people and so many different kinds of assets." While Rothschild bailed out before the collapse, hundreds of other institutional investors and creditors didn't. They now hold paper worth pennies on the dollar. Some banks and finance companies are suing in Singapore, where APP is headquartered, in the hope of recovering some $62 million. Equity investors also have been stung. On July 3, the New York Stock Exchange moved to delist APP's American depositary receipts, whose value had plunged from about $11 in 1995 to a recent 12 cents.

As the creditors, auditors, and lawyers pick through the wreckage, disturbing questions emerge. Here was a company that won the confidence of investors by securing the imprimatur of the world's leading financial firms, including Merrill Lynch, J.P. Morgan, Morgan Stanley, CSFB, and Goldman Sachs, which collectively underwrote billions in APP bonds and equities. Arthur Andersen, the parent company's auditors since 1994, signed off on its books. APP securities passed muster with regulators in Singapore and Washington. Yet it turns out nobody outside APP really had the full picture of the company's finances, which included a bewildering variety of debt offerings issued by offshore subsidiaries. Nor did Westerners ever penetrate what was, at heart, a traditional ethnic Chinese family company.

J.P. Morgan, CSFB, Merrill Lynch, Goldman Sachs, and Arthur Andersen all declined to comment for this story. In the end, it will be very difficult to trace the money the banks raised for APP in the six years since its creation. What is known about the cost of APP's mills, its interest payments, and its reported bank deposits leaves some $3 billion to $4 billion unaccounted for, according to several financial analysts who have crunched the data. APP also lost money in derivatives investments and real estate in the region. There are three audits underway now, but the company has yet to give a full accounting.

Not everyone was fooled. "It was such an obvious disaster waiting to happen," says Hugh Young, managing director of Aberdeen Asset Management in Singapore, whose firm did not buy any APP bonds or shares. What turned him off were derivatives losses in 1994 and 1995, the company's opaque structure, and a record of payment disputes with suppliers. Young figures that even if paper prices hadn't plunged, APP's cash flow probably wouldn't have covered its debt payments for long, given the rate at which it was borrowing and investing. Yet some of America's biggest asset management firms, including Fidelity, New York Life Insurance, Putnam Investments, Massachusetts Mutual, and John Hancock Financial Services, bought APP securities.

"TOUGH NUTS." APP is an excellent lesson in the problems of emerging-market corporate finance. Fee-hungry Western investment banks, investors greedy for yield but blind to regional risk, lax regulators, a local company with global ambitions but little regard for corporate governance--they all contributed to the disaster. Similar combinations produced meltdowns at many Asian conglomerates in the 1990s, including Thailand's Alphatec, Indonesia's Bank Central Asia, and China's Guangdong International Trade & Investment Corp. To be sure, investment bankers point out that most buyers of APP's paper were mutual and hedge funds that specialize in junk bonds--not widows and orphans. "Investors bought these bonds knowing they were high-risk securities," says a senior executive at Morgan Stanley's capital markets group in Asia. But debacles such as APP's have poisoned the region's markets. "The sharp decline in asset prices in Southeast Asia and Indonesia in particular since mid-2000 can largely be put at the door of APP," says Elizabeth Wood, managing director of Chinawood Associates, an Asian distressed-debt advisory firm in Singapore.

At the center of this drama are the Widjajas. Eka Tjipta Widjaja, the 77-year-old Chinese-born patriarch, started out selling dried meat and tea to Indonesian soldiers fighting against Dutch colonial troops in the 1940s. He went into the pulp and paper business in the 1970s, helped by government subsidies for the forest plantations he acquired under former President Suharto. APP is part of the Widjajas' Sinar Mas Group, which also has vast holdings in banking, real estate, and food processing.

Since the early 1990s, Sinar Mas's daily operations have been run by Eka Tjipta's eldest son, Teguh Ganda. According to one analyst who has dined with him, Teguh Ganda doesn't appear to be conversant in the complexities of the international bond deals he signed off on. "None of the Widjajas had an understanding of finance," says the analyst. Nevertheless, says an investment banker who has worked for APP, "the managers and owners are tough nuts. Very secretive. Very clanny. They can be very evasive." Neither the Widjajas nor any APP executive would comment for this story. Kenneth C. Ellis, a partner at the law firm White & Case, who represents APP in talks with its creditors, did not respond to repeated requests for interviews or to written questions.

In the early 1990s, the Widjajas successfully raised millions from foreign investors through several issues on Jakarta's stock exchange floated by their Indonesian company, PT Indah Kiat Pulp & Paper. But they never would have been able to raise their billions in the overseas debt markets had it not been for their chief financial officer, Hendrik Tee, who holds a BA and MBA from the College of William & Mary in the U.S. According to APP public-relations material, he worked for Chase Manhattan Bank before joining Sinar Mas in 1993.

TAX HAVENS. Tee's notion, say analysts and investment bankers who have worked with him, was to turn APP into an international player. The plan was to add more sophisticated mills in Asia, then boost share rapidly in the region--especially in China, the world's second-biggest paper market. Tee's first step was to move the company's headquarters from Jakarta to Singapore, where all the scattered operations of the Widjaja family were consolidated into APP as a holding company in 1994. The idea was to put some distance between the company and its past. "If one portrays oneself as Indonesian, money costs a lot more than it does for a Singaporean," an auditor in Jakarta told BusinessWeek in late 1994, when the company was being formed.

Tee's next coup came in April, 1995, when he got APP's American depositary receipts listed on the New York Stock Exchange. Morgan Stanley, CSFB, and Nomura International (Hong Kong) Ltd. underwrote the $330 million offering. The listing followed a 24-day Widjaja road show that hit 27 cities in 10 countries. Management zipped around in two Gulfstream jets. Investment bankers and analysts who have met Tee describe him as a smooth talker who skillfully played the eager investment bankers against each other. The Widjajas had their role, too. Over 16-course Chinese dinners, Teguh Ganda charmed investors with stories of his humble college education in China during the Cultural Revolution and his days working in a railroad switchyard. "He didn't come across as an operator," says an analyst who dined with him in Singapore that year.

But the Widjaja team did have a well-honed pitch. Its Indonesian hardwood matured in a third of the time that North American trees did, making its acreage more productive. While its rock-bottom costs were in cheap local currencies, its revenues were in dollars and other hard currencies.

The stock offering was a hit. The shares, which started trading at around $11 in 1995, rose as high as $16.69 by October, 1997. The initial public offering brought Wall Street to the door, looking both for equity and bond business. Over the next five years, Morgan Stanley, Merrill Lynch, Goldman Sachs, and J.P. Morgan underwrote a total of $5.6 billion in bonds for APP and its subsidiaries.

When Asia's financial crisis hit in 1997-'98, the investment banks still managed to sell APP's bonds as the great Asian recovery play. One fund manager, who asked not to be named, says her U.S.-based firm, which lacked an Asia research team, bought the bonds because a major investment bank had underwritten them. "If Morgan Stanley or Goldman signs a prospectus, there's an assumption that it's sort of O.K.," explains Aberdeen's Young.

Meanwhile, as the debt piled up, it became increasingly hard to track. Starting in 1995, Tee created dozens of companies incorporated in such tax havens as the Cook Islands, the Cayman Islands, and Mauritius. Many corporations use shell companies to reduce the tax liabilities of deals, but APP created a new shell company for almost every new issue. To get the full picture of APP's structure, investors would have had to scour through several prospectuses. "You can't track it. There are too many companies involved," says an investment banker who worked with APP last year.

Also, some of the largest deals were never filed with the U.S. Securities & Exchange Commission. They were private placements and were thus exempt from registration under Rule 144A of the U.S. Securities Act, which allows underwriters to sell such securities directly to "qualified institutional buyers," say investment bankers familiar with the deals. In 1997, Goldman, Sachs & Co. privately placed $845 million in APP bonds. Between 1997 and 2000, J.P. Morgan & Co. arranged more than $1 billion in financing for the company in this manner. There's no requirement to disclose the deals to the public, although the additional debt was included in APP's prospectuses.

TOO FANCY. As the debt issues began to pile up, some investors and analysts grew uneasy. In 1995, the company's interest payments were $448 million. By 1999--the last year APP reported full-year results--annual interest payments had climbed to $658.6 million. That year the company lost $23 million. According to Standard & Poor's, APP's interest coverage--the ratio of cash flow to interest costs--averaged only 1.5 from 1996 to 1998, far below that of blue-chip debt issuers in the global pulp and paper industry. That meant that the company generated only one and a half times the cash it needed to meet payments. That's one reason APP never received an investment grade rating. In February, 1997, S&P rated APP notes a B+. By May 18, 1998, they were downgraded to CCC+. The ratings, in other words, were inching closer to the danger zone. "Once a company goes into triple-C, the grade is saying, `These guys are going to default,"' says Dhileepan Parameswaran, a pulp and paper industry analyst at ratings company Fitch (Hong Kong) Ltd., which gave the company a noninvestment grade when it started rating it last year.

For a while, it seemed that the fears would prove groundless. When pulp and paper prices rebounded in the second half of 1999, APP's cash flow from operations turned positive again, and loyal investors piled in to fund the company's China expansion in 2000. APP's China card turned out to be a bad play, however. APP China Group piled up at least $2 billion in debt to build plants there. But its paper was too fancy for the market. In February, 2000, reports began circulating that crates of luxury-grade paper were mildewing under tarpaulins at APP's Ningbo (China) plant.

Investors began demanding higher yields to offset the perception of increased risk. In March, 2000, Morgan Stanley & Co. successfully underwrote a 10-year, $403 million bond for APP China Group with a 17% yield--800 basis points above any corporate dollar-denominated bond ever issued in China. APP's interest payments in the first half of 2000 alone were a staggering $378.2 million. Its ratio of cash flow to interest expense actually improved, thanks to a rise in world paper prices, but that seemed hard to sustain. "Everybody was asking, `How can we continue to expand? We've got to be paying off our debt, not taking on new debt,"' recalls a former employee of APP in Singapore.

DOWNGRADED. Borrowers played along through July, 2000, when the Widjajas offered up a 1-year, $100 million bond with a 30% interest rate, in a private placement handled by J.P. Morgan. Other investment banks, including Goldman, Sachs & Co., declined the business. That issue found takers, but the rate was an unmistakable sign that things had gone wrong. "By mid-2000, management started losing credibility," says Mobius, whose firm sold its APP shares in late 2000.

The game was finally up in September. APP's attempt to refinance $1.4 billion in debt that was coming due failed after the U.S. Securities & Exchange Commission raised questions that neither APP nor the underwriter of the issue, J.P. Morgan, could answer, according to analysts and investment bankers. The prospectus stated that the Widjajas had pledged some of their 67% stake in APP as collateral against personal debts, and that if any creditor called in their loans, this "could lead to a bankruptcy or liquidation of some or all of our companies."

In February, 2001, the inevitable occurred. APP missed two interest payments totalling $43 million, and the company unilaterally declared a debt moratorium. Although APP has not officially declared bankruptcy, it has not made a payment on any dollar-denominated debt since. In April, S&P downgraded APP debt to "D," signifying default.

APP's investors are now slogging through a cruel summer. On June 21, after three months of off-and-on negotiations with bondholders, APP agreed on the rules of engagement for future talks with bondholders, who are represented by Bingham Dana, an international law firm based in New York. The bank creditors have formed another committee, represented by the law firm Shearman & Sterling. At a Singapore proceeding last spring, one of those creditors tried to force APP into bankruptcy, but the company won a stay from the court. Out-of-court negotiations are proceeding with the bondholders. "We have made progress, but we're not all happy," says Richard A. Gitlin, a partner at Bingham Dana. "They [APP] have a lot to prove." APP's financial adviser in the proceedings is Credit Suisse First Boston.

TOUCHSTONE. No one is alleging fraud publicly or in court. But "the creditors are starting to ask where all the money went," says one securities analyst who follows the company. Three sets of auditors are now combing through APP's books: KPMG for the creditors; Arthur Andersen for APP; and Deloitte & Touche, which is investigating Widjaja derivatives contracts. The latest blow to creditors' hopes: In mid-July, an APP affiliate announced that it may be unable to retrieve deposits of $762 million from a Widjaja family-controlled bank in the Cook Islands.

The Widjajas have since moved from Singapore back to Indonesia, where they have pledged $1.9 billion in fixed assets against their $1.3 billion local debt under a government workout. The company is negotiating to sell off subsidiaries to pay its bills, with J.P. Morgan advising the company on asset sales. Meanwhile, APP's Indonesian plants are operating at 80% capacity in an industry where the break-even point is above 93%, says Peter Cain, a pulp and paper analyst at Salomon Smith Barney in Singapore.

The collateral damage from APP continues to widen. APP was billed as a great port of entry into Asian investing for American investors. Now, it is a touchstone for all that is wrong with Asian finance. "We've lost so much money for our customers that we don't want to talk about Asian bonds anymore," one fund manager recently told Carson R. Cole, CEO of DebtTraders Ltd. in Hong Kong, a bond brokerage. That disintegration of confidence is a loss just as grievous as the billions sacrificed by unhappy bond investors.

By Michael Shari in Singapore

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