Leverage Not Taboo
The requirement for a high level of leverage is neither unusual nor taboo in China. However, most of this activity has been in the context of transactions generating tangible assets such as new plants and infrastructure. This is now extending to structured transactions designed to finance assets such as loans, rentals and trade receivables.
In China, however, the exuberance for leverage has not, so far, reached corporate takeovers. It is one thing for the government partially to divest its holdings in state-owned enterprises. It is another for it to acquiesce to the change in control of Chinese companies. This article will examine, in relation to listed companies: (a) the reasons in favor of at least some types of takeovers by foreign entities and (b) the methods by which such takeovers can utilize leverage to enhance the acquirers’ incentives.
Ambivalence to Takeovers
A domestic corporate takeover lacks appeal for 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 begs (in the view of the government) the questions: (a) how to reform the company and (b) how to define the government’s ongoing role in the economy.
One case where this might happen 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 (GDB) transaction could not be approved as a takeover, there is nothing to say 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 (which, for purposes of leveraged takeovers, 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 resolved in China by proxy battles, derivative suits or takeovers, as (a) 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 (b) there are not quite yet sufficient managerial pools to support an active takeover market. Particularly in light of the cramdown provisions of the new Bankruptcy Law, distressed investing and workouts may well take on new meaning in China.
Domestic sponsors are being set up, both within existing bank groups as private equity arms and as start-up LBO firms using the new, tax-favored Partnership Law provisions. While this article discusses foreign-organized acquirers, there is a spectrum of other ownership possibilities which the Chinese government is likely to consider, including 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, in “bedrock” industries (banking and construction machinery) that are also in need of improved competitiveness: (a) GDB is in an industry in which conversion to “foreign invested” status (greater than 25 percent foreign ownership) entails legal consequences which the China Banking Regulatory Commission would consider “prudentially” unacceptable for a bank that already was operating an RMB retail business, and (b) 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 approval authorities.
What a Leveraged Buyout (“LBO”) by a Foreign Sponsor Might Look Like
We contemplate the following hypothetical situation, which 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”) that 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. Target operates in an industry which, post-WTO accession, 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 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 percent of the fully diluted equity (the “Stock”) of Target from Parent for a price of RMB equivalent of $A (the “Acquisition Price”). Under the CSRC’s Administrative Procedures for the Acquisition of Listed Companies (effective September 1, 2006) (the “Offer Rules”), unless an exemption is granted by the 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 percent.
Any excess over 30 percent must be obtained by means of a general or partial (five percent or more) tender offer. See Articles 47 and 61.
Alternative Structure A: 80 percent of the Acquisition Price will be funded by a loan (“Loan”) from a bank (“Bank”), booking through one of its offshore offices, that has a branch (or subsidiary) (“Branch”) in China.
Acquirer, foreign entity, Parent, Target Group members, Bank and Branch enter into a participation agreement “PA.” The key provision of the PA is the agreement of the parties that: (a) 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, i.e. including dividends (after all required debt service), voting rights and the right to transfer the stock); (b) disbursement by Branch, at the instruction of the acquirer, of the proceeds of the Loan (to the Parent) and other drawdowns under a secured credit facility (“Secured Facility”) between Branch and Target Group members (to Target Group members) in consideration for the grant of security over the assets and cross-guarantees of the payment obligations of various members of Target Group in favor of Branch; (c) 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; (d) 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 relating to dividends, voting, application of free cash flow towards debt reduction and other corporate policy under the “trust” arrangement and (e) 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.
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.
Alternative Structure B: Seventy percent of the Acquisition Price is funded by an unsecured USD bridge loan to the acquirer (guaranteed by the foreign entity) from one or more offshore lenders. This loan is refinanced (“Prepayment”) by a dual currency (USD/RMB) loan facility from one or more domestic lenders (the “Secured Facility”), under which Target (as surviving corporation in a merger (the “Merger”) by acquirer into Target that marks the termination of the bridge facility and of the effectiveness of the Secured Facility) and other Target Group members may draw, which is cross-guaranteed by all Target Group members and which is secured by all Target Group assets. The Target draws an amount equal to the Prepayment under the Secured Facility, while other Target Group members draw on the Secured Facility from time to time for working capital needs. Funds might also be available 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.
In Structure B, the foreign entity remains on record as the ultimate owner of Target and Listco Sub and there may be significant upfront cross-border debt service flow (the Prepayment) and the potential for complex inter-creditor negotiations in connection with the Merger (see discussion in “Risks Under Company Law” below). The refinancing and Merger are for the purpose of avoiding 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. Structure A avoids these potentially troublesome aspects, subject to the risks discussed below.
The Lenders’ main post-drawdown risks are:
CSRC: This is the risk that the CSRC does not waive the requirement that the 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 of over 30 percent of the issued shares. In this event, since the 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 the acquirer.
Conversion to FIE Status: By virtue of the takeover, Target has (at least under Structure B) become an FIE, a conversion which requires approvals from a host of regulatory bodies and the Tax Bureau, at either central or local levels, depending on the transaction, and while these approvals are generally given, the Ministry of Commerce, 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, with the exception that 20 percent 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 finalized 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, that grant could be rejected to the extent given for inadequate value, under Article 31 of the Bankruptcy Law, with the result that in relation to the obligations of that Target Group member, the lenders would hold only general unsecured claims. The perfection of security interests in rights and in bank accounts is also uncertain. However, registration is possible at the local notary public in relation to the former (per a ruling of the Ministry of Justice) and the consent of the account debtor (in the case of the former) and acknowledgment of the account bank (in the case of the latter) would preempt rival claims of other creditors, absent deliberate breach by the account debtor or account bank.
Under Company Law: Subject to the possibility of cashing or merging out dissident shareholders of any given Target Group member security grantor, (a) the use of corporate assets to secure the borrowing by upstream entities must be approved by a majority of shareholders (exclusive of 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 and (b) for the Merger, in addition to approval of two-thirds of the shareholders present at a shareholder meeting, the non-objection (within the later of 30 days after actual notice or 45 days after publication in a newspaper) of creditors of Target, is a condition to the effectiveness of the Merger. Objecting creditors have a right to prepayment or equal and ratable security. A cash-out could be funded with internal cash as a condition precedent to drawdown or through draws on the Secured Facility as a subsequent condition. Whether or not a cash-out is necessary, the all-in costs of the financing would rise, either to pay the guaranteeing companies (e.g., guarantee fee) or to increase the amount of group stock purchased.
Under Banking Law: This is the risk that the Secured Facility in Structure B would be recharacterized as a loan extended to finance the acquisition of shares, which is prohibited.
Liquidity, Currency and Political Risks: These are exacerbated by the recent State Council Decree No. 478 Administrative Provisions Applicable to Foreign Funded Banks (effective December 11, 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 were 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 can no longer be so.
Entrustment Arrangements Not Enforceable Against Entrusted Party: 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 received the proceeds of the Loan, adequate consideration for its obligations under the PA would have been given. The question is whether the acquisition, financed by domestic bank loans of control of the Target and, indirectly, Listco Sub and other Target Group members by a foreign entity, 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 Structure A, 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/willful breach, should not succeed. However, the risks of fraudulent preference, failure to close 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.
This article was published in slightly different form in the November 2007 issue of Finance Asia.