Looking to the future: leveraged finance transactions in China

Leverage not taboo

The requirement for a high level of leverage is neither unusual nor taboo in China. However, historically leveraged finance has mostly been used on transactions generating tangible assets such as new plant and infrastructure. This is now extending to structured transactions designed to finance assets such as loans, rentals and trade receivables but so far the exuberance for leverage has not reached Chinese corporate takeovers.

Ambivalence to takeovers

A domestic corporate takeover lacks appeal to the Chinese policy-makers, since no asset is created. Indeed, where the company is state owned, simply to give the government funds in exchange for control of the company in the view of the Chinese government begs the questions of how to reform the company, and how to define the government’s ongoing role in the economy.

One case where this might happen, however, is financial institutions, where conflicts exist between the purely financial motives of those whose residual income is placed in financial institutions and the fiscal (or less salutary) motivations of the central and local governments that own such institutions. Although, for example, the Guangdong Development Bank transaction could not be approved as a takeover, there is nothing to say that this situation could not change in the future. This is likely to be an iterative process, as the provision of credit is a highly sensitive industry.

A second area where takeovers may be welcome is companies in distress (but which, for the purposes of leveraged takeovers, still have positive book net worth). The majority shareholders of the target company are likely to be various governmental entities, and the motivations of such shareholders are not those typically prevalent in Western economies. A fundamental disagreement with management cannot yet readily be solved in China by proxy battles, derivative suits or takeovers. This is because for the foreseeable future it is these governmental entities that will be left carrying the can for the failed management of significant enterprises, whether as stockholders or otherwise, and there are not quite yet sufficient managerial pools to support an active takeover market. So, particularly in light of the cramdown provisions of the new bankruptcy law (see box below), distressed investing and workouts may well take on new meaning.

Whilst this article discusses foreign organised acquirers, there is a spectrum of other ownership possibilities which the Chinese government is likely to consider, including domestic funds (such as the Bohai Fund and others) or other domestic investor groups taking co-investment positions (either at the investee or investor level).

Foreign takeovers legally possible

The two leading precedents are the pending acquisitions (not takeovers) of Guangdong Development Bank (“GDB”) and Xugong Group Construction Machinery Co Ltd (“Xugong”). While both are companies in need of improved competitiveness, operating in “bedrock” industries (banking and construction machinery) that are also in need of improved competitiveness:

• GDB is in an industry in which conversion to “foreign invested” status (greater than 25% foreign ownership) entails legal consequences which the China Banking Regulatory Commission would consider “prudentially” unacceptable for a bank that already was operating a Rmb retail business; and
• Xugong is in an industry considered to be sensitive to national security.

In other words these, and any other proposed takeovers of companies in industries which do not forbid majority-foreign ownership as a matter of law under the post WTO accession rules, are stopped only at the discretion of the approved authorities. Examples of industries in which foreign owners are not permitted to hold a majority stake include rare earth mining, utilities, futures companies and much of the Chinese media space.

What an lbo by a foreign sponsor might look like

The following hypothetical situation would, we believe, stand the best chance of sustaining a sponsor driven takeover. It is similar in some but not all respects to what is known publicly about the Xugong transaction.

The target is an unlisted PRC company (“target”) that owns a substantial stake in another PRC-incorporated company (“listco sub”) which has A shares listed in China, as well as other unlisted subsidiaries in China (collectively, “target group”). Target is indirectly majority-owned by the government by virtue of the government’s ownership of the majority owner (“parent”) of target (see diagram). Target operates in an industry as to which, post WTO accession, China does not prohibit majority foreign owned companies. The acquirer is ultimately owned by a creditworthy foreign entity that meets the qualifications set out in the “Administration of Strategic Investment in Listed Companies by Foreign Investors Procedures” (the strategic investor rules), but neither the acquirer nor such foreign entity is, or is affiliated with, a Qualified Foreign Institutional Investor (QFII). Neither the acquirer nor the foreign entity has appreciable sales in China. Target group has steady revenues primarily from domestic sales, and has little financial indebtedness relative to the book value of its assets (or at least would remain solvent after giving effect to indebtedness incurred by target group members in connection with the takeover). Target group has substantial assets.

Acquirer and parent agree that acquirer will acquire x% of the fully diluted equity (the stock) of target from parent for a price of Rmb equivalent of $A (the acquisition price). Under the Administrative Procedures for the Acquisition of Listed Companies (effective 1 September 2006) (the offer rules), unless an exemption is granted by the China Securities Regulatory Commission (“CSRC”), the maximum interest in a listed company’s “issued shares” that can be acquired (directly, or indirectly by acquisition of the stock) by negotiated purchase is 30%. Any excess over 30% must be obtained by means of a general or partial (5% or more) tender offer. Clearly, obtaining the CSRC exemption will be very important to ensure a successful LBO (see Risks below).

There are two alternative structures which could be employed to implement an LBO: one uses a participation agreement between parent and acquirer and the other relies on a post-acquisition down stream merger of acquirer into target.

The Participation Agreement structure

The acquisition price will be largely funded by a loan from a bank (“bank”), booking through one of its offshore offices, which has a branch or subsidiary (“branch”), in China.

Acquirer, foreign entity, parent, target group members, bank and branch enter into a participation agreement. The key provisions of the participation agreement are summarised below.

• The acquisition price is paid to parent and parent will hold the stock “in trust” for the acquirer (which remains the exclusive beneficiary of all indicia of economic ownership including dividends (after all required debt service), voting rights and the right to transfer the stock)
• Disbursement by branch, at the instruction of the acquirer, of the proceeds of the acquisition loan to the parent
• Target group members can draw funds under a secured credit facility (secured facility) between branch and target group members. This provides the consideration for the target group companies’ grant of security over their assets and cross-guarantees of all payment obligations of the group (including the purchaser’s acquisition debt) in favour of branch (which is subject to shareholder approval; see below)
• Payment to branch by target group members is good discharge, to the extent of such payment, of required debt service on the loan and other indebtedness under the secured facility
• There is no recourse to parent for any obligations under the secured facility, except that the parent indemnifies branch against any losses suffered as a result of the deliberate violation of covenants related to dividends, voting, application of free cash flow towards debt reduction and other corporate policy under the “trust” arrangement
• The foreign entity agrees to pay bank the difference between required debt service under the secured facility and amounts actually received by branch from free cash flow of target group (as well as after enforcement of rights), unless that difference is due to the deliberate breach of parent’s obligations under the trust arrangement (when the bank relies upon the parent indemnity instead).

The key role in this transaction is that of branch. Branch must be able to carry the amount of the exposure under the secured facility (an Rmb asset) on its books, with or without funding from bank. There is also a currency mismatch between the branch’s loan assets and the “investment” in the branch by bank in such amount.

The Merger structure

The acquisition price is largely funded by an unsecured US dollar bridge loan to the acquirer (guaranteed by the foreign entity) from one or more offshore lenders. After the acquisition a downstream merger is implemented, under which acquirer is merged into target, with target constituting the surviving entity. The bridge loan is then refinanced (prepaid) by a dual currency ($/Rmb) loan facility from one or more domestic lenders (the secured facility). Target draws under the secured facility to fund the refinancing and target and other target group members may draw on the secured facility from time to time to fund their working capital needs. The whole of the secured facility (including the portion which refinanced the acquisition debt) is cross-guaranteed by all target group members and secured on all target group’s assets.

Funds might also be available under the secured facility to make payments necessary to cash out certain shareholders of target group members as discussed under “risks” below, to the extent such cash-outs (as conditions precedent to drawdown/release from escrow) are not funded by internal cash.

If this structure is chosen, the foreign entity remains on record as ultimate owner of target and listco sub, which as a matter of form places all the complexities of foreign ownership and control on the table. The refinancing of the bridge loan will constitute a significant upfront cross-border debt service flow (which will need to be approved in advance by the exchange control authority, SAFE) unless the refinancing is structured using the onshore branches or subsidiaries of the bridge lenders.

There is also potentially the disadvantages of complex intercreditor negotiations in connection with the merger and the fact that the Ministry of Commerce (“MOC”) will be afforded two bites at the apple as it will need to give two separate approvals for the transaction – one for the initial acquisition of target by the acquirer and a second with respect to the change in ownership of target to the foreign entity resulting from the merger (see discussion in “Risks, Under Company Law” below). The refinancing and merger structure is designed to avoid concerns about using domestic bank funds to acquire stock, and banking law and corporate benefit concerns if the borrower of the domestic bank funds is a foreign entity that is not a target group member. The alternative participation agreement structure avoids these potentially troublesome aspects in the first place (although has some risks of its own as identified below).

Risks

The lenders’ main post drawdown risks are:

CSRC

This is the risk that the CSRC do not waive the requirement that acquirer must make a partial or general offer for any part of the shares of listco sub indirectly to be acquired that constitutes an excess over 30% of the issued shares. In this event, since acquirer itself has no power to purchase A shares in its own name, it would have to “entrust” a party, such as target, to make the offer and hold the A shares in trust for acquirer.

Conversion to Foreign Investment Enterprise (“FIE”) Status

If the merger structure is adopted target will become an FIE, and this conversion will require approvals from a host of regulatory bodies (including the MOC and the State-owned Assets Supervision and Administration Commission (“SASAC”)) and the Tax Bureau, at either central or local levels depending on the transaction. Whilst these approvals are generally given, the MOC in particular retains discretionary authority to disapprove transactions on various grounds such as national/economic security and harm to competition. However, most of these approvals can be made conditions precedent either to drawdown or to release of funds from escrow. The exception is that 20% of any additional equity contribution to target in relation to target’s conversion to FIE status (if acquirer subscribes to an increase in capital of target) is required before a business license will be issued to the FIE, and certain tax procedures cannot be finalised until the monies are released to the target or parent.

Bankruptcy and Perfection

If a target group member becomes insolvent within one year after its grant of security, to the extent given for inadequate value, that grant could be rejected under Article 31 of the new Bankruptcy Law, with the result that the lenders would hold only general unsecured claims in relation to the obligations of that target group member.

The perfection of security interests in certain intangible assets has been clarified in part, but not completely, under the new Property Law. Security interests in accounts receivable and other contract rights can now be perfected under Article 228, by registration at the Credit Reference Centre of the PBOC. A pledge of bank account, however, remains uncertain; it is best to obtain the acknowledgement of the account bank that there are no conflicting claims to the cash in the account and that it will not permit the outflow of any cash from time to time in the account other than for the exclusive use of, or otherwise with the consent of, the secured party.

Under Company Law

Subject to the possibility of cashing or merging out dissident shareholders of any given target group member which is to give security, the use of corporate assets to secure the borrowing by upstream entities must be approved by a majority (two-thirds, if the collateral value exceeds 30% of total assets) of shareholders (exclusive of those shareholders that are the borrowers) present at a shareholder meeting of each target group member providing collateral. These approvals should, if possible, be made conditions precedent to drawdown.

For the merger to be effective, in addition to approval of two-thirds of the shareholders present at a shareholder meeting, the creditors of target must not object (within the later of 30 days after actual notice or 45 days after publication in a newspaper). Objecting creditors have a right to prepayment or equal and rateable security. A cash-out could be funded with internal cash as a condition precedent to drawdown or through drawing on the secured facility as a condition subsequent. Whether or not a cash-out is necessary, the total costs of the financing would be higher if the merger structure is chosen as opposed to the participation structure, either to pay the guaranteeing companies (for example, guarantee fee) or to increase the amount of group stock purchased (as it may be necessary to purchase dissident shareholdings at different levels in the group structure).

Under Banking Law

There is a risk with the merger structure that the secured facility could be recharacterised as a loan extended to target to finance the acquisition of shares in itself, which is prohibited.

Liquidity, Currency and Political Risks

These risks are exacerbated by the State Council Decree No. 478 Administrative Provisions Applicable to Foreign Funded Banks (effective 11 December 2006), which requires branches of foreign banks wishing to engage in either credit card or retail Rmb-denominated business to re-incorporate in China. Whereas in the past bank and branch could be one accounting entity (regardless of the bank’s internal policies on quantifying the political/inconvertibility risk of its capital in China and regardless of Chinese banking laws requiring each branch of a foreign bank to adhere to capital requirements on a stand alone basis), banks that wish to engage in such businesses must now be an independent Chinese entity.

Entrustment arrangements not enforceable against entrusted party

This risk is relevant to deals using a participation agreement structure. Generally, under PRC Contract Law, a contract (including its remedial provisions) will be enforceable so long as adequate consideration has been given for the obligation and the performance of that obligation does not violate law. Since the parent receives the proceeds of the loan, adequate consideration for its obligations under the participation agreement would have been given. The question is whether the acquisition of control of the target (and, indirectly, listco sub and other target group members), by a foreign entity financed by domestic bank loans, would be considered a violation of PRC law. Given the hypothesis of non-prohibition under the Catalogue of Foreign Investment, and the formal features of the participation agreement structure, in which it is not the acquirer that is the actual borrower of domestic bank funds but other parties, such an argument by parent and target seeking to abrogate the trust arrangement, either in a distress situation or due to fraud/wilful breach, should not succeed. Specific performance may be problematic though in some circumstances in the light of Articles 56 and 57 of the offer rules and the need for SASAC approval to include “indirect” transfers of shares.

The risks of fraudulent preference, failure to obtain necessary post-drawdown corporate approvals (as for cash-outs of dissidents or post drawdown mergers), or failure to obtain required licenses and approval for continued operation could be further mitigated through an escrow of the acquisition price.

Lovells is one of the largest international business legal practices, with over three thousand people operating from 26 offices in Europe, Asia and the United States. For more information about the firm go to www.lovells.com.

Fred is a Partner and Ying an Associate in Lovells’ banking practice, each based in our Beijing office ( This e-mail address is being protected from spambots. You need JavaScript enabled to view it and This e-mail address is being protected from spambots. You need JavaScript enabled to view it ) Members of Lovells’ Islamic Finance team advised the lead managers Barclays Capital and Dubai Islamic Bank on the Dubai Ports World sukuk and the lead arranger WestLB on the Aston Martin financing. Lovells advised the borrower on the Egyptian Fertiliser Islamic refinancing.