Following the lead of the Chinese State Council which recently announced a massive fiscal stimulus package, the China Banking Regulatory Commission (CBRC) has overhauled the merger and acquisition (M&A) acquisition finance regime. It has provided the framework for increased availability of leverage for foreign investors contemplating onshore acquisitions in China and has therefore expanded the business opportunities for foreign banks with subsidiaries in China.
The guidelines issued by the CBRC on ‘Risk Management of Loans Extended by Commercial Banks for Mergers and Acquisitions’ on 6 December (Guidelines) look set to provide a timely boost to domestic Chinese M&A and foreign M&A by Chinese companies. However,though the Guidelines bring a necessary deregulation to the Chinese regulatory environment by shifting the burden of responsibility for lending and risk appraisal to commercial banks in the Chinese economy, it remains to be seen how quickly or freely available M&A financing will be in practice. With poison pills inserted in the Guidelines (for example through extensive risk assessment and due diligence procedures and through the somewhat vague requirement for an ‘industrial and strategic correlation’ of the contemplated M&As with the business of the borrower), the CBRC still keeps a strong grip on the development - and success - of acquisition finance in China.
A Boost to Inbound and Outbound M&As
At the end of 2008, the Chinese State Council announced a massive fiscal stimulus package in an effort to bolster the Chinese economy in the face of the worldwide financial upheavals occurring at that time. A brief summary of the detail of this stimulus can be found at this link. Recent changes to the M&A financing rules promulgated by the CBRC represent a significant modernization of China’s financial system as well as providing another boost to the economy combined with the effects of the stimulus package.
The Guidelines replace the prohibition set out in the ‘General Principles of Loans’ CBRC guidance from 1996 which prevented PRC banks from advancing loans to domestic Chinese borrowers for the purpose of M&A investments by such borrower.
The Guidelines permit loans to be made for the purposes of the purchase of both the equity and the assets of a target company (although it is unclear at this stage whether the acquisition of minority interests is covered by the scope of the Guidelines).
The Guidelines appear to be applicable to existing ‘foreign invested enterprises’ (including wholly owned foreign companies and sino-foreign joint ventures) (FIEs) although acquisitions by FIEs would also be subject to approval from various local regulatory bodies which may logistically delay or restrict the availability of funding to them (further clarifications should be provided on this issue by the relevant authorities).
In this regard, foreign private equity funds that have set up a RMB denominated fund in China appear particularly well positioned to benefit from the Guidelines and to leverage their investments in China.
The Guidelines also provide a mechanism for domestic Chinese companies to obtain funding for offshore investment. Previously it was extremely difficult for domestic Chinese companies to borrow money from Chinese banks for offshore acquisitions. As a result, to date, most offshore acquisitions have been made by China state owned companies. The Guidelines, by offering a new source of funding for overseas acquisitions to Chinese domestic companies, may, in the current market, result in an expansion of such acquisitions.
It should be noted that the Guidelines do not appear to contemplate the financing of new business operations or new joint ventures in China.
New business opportunities for subsidiaries of foreign banks in China
Under the Guidelines onshore Chinese commercial banks (including locally incorporated subsidiaries of foreign banks and joint-venture commercial banks, but not onshore branches of foreign banks) are now generally allowed to engage in M&A finance lending on the Chinese market, subject to certain rules and limitations.
One of the most important provisions of the Guidelines (and one which forms part of the strategic risk assessment of the whole M&A project that the lending bank is obliged to make) is that in deciding whether or not to make financing available, a commercial bank should consider ‘the industrial and strategic correlation between both parties’ and the ‘expected strategic effects and driving force for the increase of enterprise value after the M&A.’ This provision is doubtless intended as a credit control measure and to prevent commercial banks from providing finance to M&A projects with little discernible overall benefit (thereby presumably prohibiting acquisitions with asset-stripping motives). This may also prevent investment holding companies or private equity funds with a portfolio of diverse but unrelated holdings from obtaining finance in order to make an acquisition in a new sector. How strictly this position is interpreted will be crucial to determining the success of the Guidelines.
Commercial banks are required to have in place the procedures and personnel to perform thorough due diligence and a credit risk assessment on the parties to the proposed acquisition. This includes an analysis of the legal, compliance and regulatory risks, the strategic risks (such as the ability of the parties to successfully integrate) and of the operational and financial risks (such as reviewing cash flow and business models). For an overseas acquisition, commercial banks must consider factors such as exchange risks and applicable foreign country risks.
From a practical point of view, no specific approval is required for commercial banks to start providing M&A loans under the Guidelines. They just need to file a lending business plan and description of their internal risk control plan (including their ability to comply with these requirements and specific capital adequacy requirements) with the CBRC.
A step in the right direction towards a more sophisticated approach to acquisition finance
According to the Guidelines, specific provisions must be included in M&A loan documentation that should increase the sophistication of loan documents under Chinese law. For example, along with the requirement that borrowers should provide adequate security for a loan, the loan document must contain certain prescribed basic terms (such as mandatory pre-payment, change of control, restrictions on asset disposal and financial covenants) which would commonly already be found in most loan agreements in foreign jurisdictions.
The fact that the term of any loan is limited to 5 years and more importantly that the total value of a loan must not exceed 50 per cent of the total acquisition price (which reflects the cautious approach towards acquisition finance taken by the CRBC), paves the way for future reforms if the implementation of the Guidelines by commercial banks in China proves to be successful.