The shutdown of capital markets is causing a major headache for private equity firms, hedge funds and investment banks that piled in to Chinese and Indian companies ahead of expected stock market listings.
It is estimated that, over the past two years, billions of US dollars has been invested in so-called pre-initial public offering financings, where investors acquire a stake in a private company in the expectation of quick returns when it lists. The notion of pre-IPO financing is hardly new: private equity investors have for years acquired stakes in companies that later list on the stock market.
However, in recent years investors have targeted China and India, gambling on making a quick buck amid the prolonged stock market frenzy.
The seizure of the capital markets has left many of these pre-IPO investments illiquid, triggering a wave of behind-the-scenes talks as parties involved negotiate what to do next.
The pre-IPO investment rush was sparked by several factors, including the red-hot equity markets in countries such as China, where companies with patchy track records were commanding stratospheric valuation multiples. In addition, over the past two years scores of companies in India and China - including those in property, healthcare and heavy industries - have been on the lookout for capital to fund expansion plans in fast-growing economies. Hedge funds keen to make a mark in Asia have also been swift to invest.
Bankers say that a typical deal would involve, for example, a Chinese property company looking for a $150m capital injection and financial endorsement by a western investor ahead of a flotation.
These pre-IPO financings were mainly structured as convertible bonds, or loans to the company that would convert from debt to equity once the company went public.
The contracts often included a promised interest rate hike if the company did not list by a specified date.
However, people familiar with the matter say that some of these companies are now so cash-strapped that they are not able to meet the higher rates of interest.
"These supposed downside guarantees are questionable," says one private equity executive familiar with a number of deals. "I can't see any investor seeking redress through the Chinese courts, especially if the company is financially challenged anyway."
Actual details of specific deals are thin on the ground as the investments were made privately, and investors jealously guard contract terms.
One private equity firm that eschewed pre-IPO investments was Oaktree Capital, a US-based fund with operations in Asia.
Bill Kerins, managing director of Oaktree's Hong Kong office, said: "We were offered the opportunity to invest in many of these pre-IPO deals, but were not comfortable with the short timeframe to do proper diligence."
He added: "We watched a lot of people make a lot of money for a while but now that the market has turned, the flaws in the structures have become apparent."
Pre-IPO financings typically did not involve guarantees on board representation.
Investment bankers familiar with the deals say that up to 100 pre-IPO financings were arranged over the past two years, and that only about a third of the companies achieved a stock market listing.
One of the few public examples was the pre-IPO financing of Evergrande, a Chinese property developer, which received $400m in loans from a group of investors including Deutsche Bank, Merrill Lynch, Singapore's Temasek and several hedge funds.
Evergrande has twice attempted to float this year. Its failure to do so dashed investor hopes of a quick and lucrative return, forcing the company to seek successive rounds of re-financing.
Depending on the structure of the deal, people familiar with the situation say that investors are exploring a variety of moves.
Private equity firms, with their longer-term investment models, are not under as much pressure as hedge funds, many of which are facing redemption calls from investors.
"Of course if the investors can wait then the markets might one day rebound and they will make some money," one dealmaker says.
"But many of the hedge funds simply don't have the luxury of time and are considering offloading their stakes at a massive discount."