Lending a Hand
Some investors find Macau junkets an attractive alternative to parking their money in a bank, says CLSA Asia-PacificThursday, 09 September 2010
A possible side effect of the inter-bank lending crisis and its depressive effect on bank deposit interest rates may have been to channel cash to Macau junkets.
Secret Macau, a new 80-page report by the consumer and gaming research team at CLSA, an independent brokerage and investment group, covers all aspects of Macau’s casino gaming business. One development reported by CLSA following its research is that Macau junkets are willing in some cases to pay private investors up to 3% interest per month on injections of working capital equal to HK$5 million (US$640,000) or more.
“Friends/shareholders of junket companies may channel private funds into their working capital through lending (for a certain fee) or gambling these amounts as chips,” says the CLSA report.
“Investing in junkets is also possible in Macau. What we hear from sources on the ground is a minimum of HK$5 million is accepted for interest payments of 1.5% to 3% per month. This is higher than keeping money in banks or even some mutual funds,” adds the CLSA research paper by analyst Huei Suen Ng, Regional Head of Consumer and Gaming Research Aaron Fischer and research associate Mariana Kou.
Macau junket capitalisation is thought of typically by people inside and outside the local casino industry as a specialist field. It’s not generally seen as a mainstream investment opportunity for recognised financial institutions.
CLSA points out, however, there is a precedent for using mainstream capital markets to raise junket working cash. Several companies with interests in Macau junket operations have listed in Hong Kong in order to raise junket capital. Given the current volatility of equity markets, though, share issuance is a less attractive way to capitalise junkets than it was in the bull market of 2007. But the shrinkage of bank retail interest rates linked to a corresponding fall in inter-bank lending rates that happened as a response to counter party risk since September 2008 may be creating opportunities for private investment in junkets.
Parking your money in a junket for a month here or there, with none of the punitively high charges for early withdrawal or punitively low interest rates associated with short term bank deposits, must seem like an attractive option for those local entrepreneurs with a sophisticated understanding of the junket system.
As an illustration, in the first week of August, the Hong Kong Interbank Offered Rate for one month was 0.23000%. During that week, time deposit rates for Hang Seng customers on deposits of HK$1 million and above stood at 0.0100%. The junkets can afford to pay significantly more interest to capital providers because of the spread created by borrowing on monthly terms and lending out to VIPs who then repay on 10-day terms, according to CLSA.
“Casinos extend credit (marked chips) to junkets to be settled within a month. Given the improving economy, these amounts have increased over time,” points out CLSA.
“Casinos book these as casino receivables (a component of account receivables) in their balance sheets. They typically extend credit against last month’s commission to the junkets to safeguard any potential irreclaimable debt. Some agreement can be made to advance up to two to three months worth of credit if the junkets have longstanding relationships with solid performance as well as financial backing,” adds the CLSA team.
If an investor chose to deposit HK$5 million with the Hang Seng Bank at monthly interest of 0.0100% as quoted by the market at the beginning of August, then on a non compound basis the investor would earn HK$500 (before any tax liability owed to the investor’s tax domicile) in one month. Were an investor to lend HK$5 million to a Macau junket at 1.5% monthly interest, he or she would earn HK$75,000 pre-tax during the term of the loan.
According to CLSA’s junket sources, junket players generally pay back their borrowings to the junkets in about 10 days, allowing junket liquidity to be sustained.
Lending to junkets is potentially very profitable for capital providers. That in turn is linked to the fact the junkets must chomp through a lot of capital to generate sufficient rolling to make a profit on the gambling action. CLSA says the amount of capital needed to operate Macau junkets is around six times the revenue generated by VIP players.
“Understanding the math behind junket liquidity is important,” state the report authors.
“To achieve gaming revenue of US$7 billion in the VIP segment, assuming junkets extend credit based on the ratio of 1:1 (US$1 of credit received in Macau for every US$1 pledged by a player), US$35 billion of working capital is needed from the junkets (about 6x revenue from junket VIP).”
Despite the theoretical profit potential of lending capital to junkets, it seems unlikely from IAG’s perspective that financial institutions will become involved in the process to any great extent. That’s because the risk involved is not easily understood by people outside the junket system. For example, a friend of a junket operator may be willing to lend capital to that junket because he personally knows some of its customers and knows their track record for repayment. And although mainstream financial markets are used to dealing with intangible assets, the fact the ‘asset’ on which a junket’s capital debt is secured is the chip rolling of the particular junket’s VIP players may be a step too far in terms of a lending institution’s risk appetite.
CLSA comments: “The clear risks lie in the repayment days, which will have a large impact on subsequent month’s working capital.”
But the report authors say that repayment cycles are likely to remain stable.
“Junket sources we talked to do not see drastic changes in players’ debt-repayment pattern, with the credit cycle remaining at around 10 days with the players.”
In current junket trading conditions with huge year on year growth in VIP play, the junkets are also able to generate significant internal cash flow, suggests CLSA.
The report states: “Internally generated funds (junkets receive 1.25% of rolling chip wagered) have increased as a result [of VIP market growth]. Therefore, lending to players should increase.”
From IAG’s perspective, internal cash flow could also enable junkets to absorb some bad debt. That was much harder during more challenging trading conditions, such as the near two-year commission price war of 2008 and 2009. That only ended with the imposition by the Macau government of a 1.25% commission cap in September 2009.
“A junket operator’s monthly working capital is affected if debt is not collectible,” states CLSA.
“For example, we understand that during the Asian financial crisis [of 1997], 70% of the junkets got wiped out. And during 2009, the number of licences fell 18%.”
Despite the better margins theoretically available to casinos when they issue credit direct to VIPs, in reality the junket system is likely to be around for some time to come, says CLSA.
“While the direct-VIP segment is more profitable, casinos have limited expertise in collecting debts from mainland players.”
The authors add, however, that further consolidation of the Macau junket sector is likely.
“Consolidation of junket operators and agents is inevitable, although the process will be gradual. As more casinos rebate junkets based on rolling-chips turnover, lower-volume operators will not enjoy the same terms and commissions.
“Having scale in this business is advantageous as the smaller-scale junkets will be less able to offer decent rebates to their customers over time. To achieve higher commissions, junket operators need to increase volumes, and higher volumes require greater working capital to prepay casinos for chips. This will favour the bigger junkets that have better access to capital,” says CLSA.