On 6 December, the China Banking Regulatory Commission (the CBRC) promulgated the longawaited mergers and aquisitions (M&A) financing rules (Guidelines on Risk Management of Loans Extended by Commercial Banks for Mergers and Acquisitions). The Guidelines represent a remarkable step in the development and modernisation of China’s financial system and are likely to bring about significant changes to the domestic M&A market and facilitate consolidation within Chinese industries. Although they do not directly facilitate foreign investment in China (because they apply only to acquisition financing extended to People’s Republic of China (PRC)-incorporated purchasers), outbound investments by Chinese companies are specifically addressed.
It appears that the new M&A financing may not be accessible to non-strategic domestic investors, such as onshore private equity or venture capital funds – or only in limited circumstances. However, there are good reasons to believe that the Guidelines will facilitate more domestic management buy-out (MBO) activity, which has long been stifled by the absence of acquisition financing, and spell more opportunities for private equity or venture capital players to participate in these transactions.
Under the Guidelines, onshore commercial banks (but not Chinese branches of foreign banks) are generally allowed, after satisfying certain filing requirements with the CBRC, to engage in the so-called M&A financing, subject to certain conditions and limitations outlined below.
Scope of permitted acquisition financing
The Guidelines permit the extension of M&A loans for the acquisition of control over existing target companies operating on a continuing basis (ie going concerns) by way of:
- purchase of existing equity interests;
- subscription of new capital;
- asset acquisitions;
- debt restructurings; and
- other means.
While this broad language seems on the whole to include public takeovers of listed A-share companies, it would appear that, due to the requirement of control, public investments in private equity transactions and similar acquisitions of non-controlling stakes may not be financed under the Guidelines. Also, the Guidelines do not seem to apply to financing new business operations or greenfield joint ventures, unless the greenfield joint venture itself takes on acquisition finance to acquire the assets of an existing Chinese entity (eg the onshore joint venture partner). However, PRC banks are already permitted to finance the business operations of greenfield joint ventures.
The Guidelines apply only to banks incorporated in China (including locally incorporated subsidiaries of foreign banks); they do not apply to onshore branches of foreign banks. Since most major foreign banks have now incorporated in the PRC, they should – at least in theory – be able to undertake this new business by offering acquisition financing, particularly to their traditional foreign-invested enterprise (FIE) customers.
The Guidelines permit the extension of acquisition finance only to domestic Chinese purchasers. This would ordinarily include FIEs, including wholly foreignowned enterprises, as long as they are incorporated under PRC law.
FIEs (including joint ventures and wholly foreign-owned enterprises) are PRC legal persons and are technically eligible to obtain acquisition financing. However, FIEs’ ability to borrow for acquisition purposes is constrained by certain factors, including the need for approval by the PRC Ministry of Commerce (MOFCOM) or its relevant local branch when acquiring a domestic business in a sector ‘restricted’ from foreign investment or when the FIE is a new entity being incorporated solely for the purpose of acquiring assets of a domestic business. The requirement under the Guidelines for the proposed transaction to have been approved, or be about to be approved, by the relevant authorities and to comply with existing M&A and other rules may thus pose an obstacle to FIEs obtaining timely acquisition financing.
It is also noteworthy that the Numerous opinions of the State Council on stimulating economy by financial policies issued by the State Council on 13 December mentions the possibility of M&A lending to offshore companies, which may indicate that a further relaxation of lending rules in this regard is to be expected.
Questions also arise over whether the need for bank financing (which should be disclosed to MOFCOM as part of the approval application) will have an influence on MOFCOM’s approval decision. Furthermore, the ‘scope of business’ limitation to which FIEs (other than investment holding companies) are subject may serve to restrict them in undertaking significant acquisition activities and the statutory debt to equity ratio applicable to FIEs may affect the amount of acquisition financing a FIE may raise. It remains to be seen whether MOFCOM will issue further guidelines to FIEs on the subject of acquisition financing.
A key emphasis of the Guidelines is that, in deciding whether to extend acquisition financing, lending banks should consider whether an industrial or strategic correlation exists between the acquirer and the proposed target company. Article 9 of the Guidelines requires the lending bank to assess the strategic risks of the proposed acquisition by taking into account, inter alia, the industrial and strategic correlation of the parties to the proposed acquisition and its possible synergistic effect.
The Guidelines set out specific examples of when such correlation exists, including if the purchaser would, through the acquisition, be able to tap into the target enterprise’s research and development capabilities, key technology and processes, trade marks, supply or distribution networks and other strategic resources that improve the purchaser’s core competitive strengths.
The express requirement of industrial and strategic correlation under the Guidelines appears to be linked to its overall objective of credit risk management: lending banks should refrain from providing financing to acquisition projects with little perceptible benefit to the parties concerned. This requirement is also generally in line with the PRC government’s long-term goal of consolidating existing industries and promoting the emergence of large-scale, high-tech enterprises with global networks and high-quality products.
However, in practice, questions arise over whether acquisition financing will be available under the Guidelines to investment holding companies or private equity funds with a portfolio of disparate investments spanning several unrelated industries. If such funds have existing investments in the same sector, the strategic nexus will in principle exist if the acquisition is carried out through the relevant existing portfolio company. But even if the investment is made by a sister company controlled by the same fund or funds, it would appear that a sufficient nexus exists if the PE fund has the intention of creating synergies between the two investments.
Capital adequacy tests
Banks may engage in M&A lending only if they meet certain risk management requirements and capital adequacy tests prescribed in the Guidelines – they must have:
- comprehensive risk management and effective internal control systems;
- a loan loss special reserve ratio of 100 per cent or above;
- a capital adequacy ratio of 10 per cent or above;
- a general reserve balance of at least 1 per cent of the loan balance over the same period; and
- a professional team for credit due diligence and risk assessment.
These requirements must be satisfied on an ongoing basis while the bank engages in M&A lending.
The Guidelines do not provide for any special approval procedure. Banks that satisfy the above requirements may engage in M&A lending after filing their lending business plans and descriptions of their internal control systems with the relevant regulator (the CBRC or a local branch).
The Guidelines also set out specific provisions for risk control purposes, including:
- the loan shall not exceed 50 per cent of the total acquisition price;
- the loan to a single borrower shall not exceed 5 per cent of the bank’s net core capital;
- the terms of an M&A loan shall not exceed five years; and
- the borrower should provide adequate security for the loan, such as a pledge over shares or assets, or third party guarantees.
The Guidelines seem to allow shares or assets of the target company to be offered as security in the context of a leveraged acquisition. If this indeed proves possible, it could provide a major impetus to MBO-type deals in China. It should, however, be noted that under the PRC Company Law, the provision of security by a company in respect of the debt obligation of a shareholder or its actual controller requires the majority approval of non-interested shareholders.
Due diligence requirements
Although the Guidelines are technically speaking bank regulatory rules, they indirectly prescribe minimum standards for leveraged M&A transactions by making those standards a prerequisite for M&A lending – ie banks may extend acquisition finance only in transactions that meet the requirements on control, jurisdiction of incorporation of the purchaser and strategic nexus outlined above.
In addition, the bank needs to assess certain legal, compliance, operational and commercial risks relating to the parties and the transaction itself.
- Legal and compliance risks to be evaluated include the capacity of the parties, the regulatory and other approvals for the transaction and the legal validity of the underlying documents and of the collateral granted to secure the loan.
- Strategic risks include the ability of the parties successfully to integrate their operations, assets, organisations and even their cultures.
- Operational and financial risks to be assessed include the parties’ business models, future cash flows, adequacy of the purchase price, profit sharing and the effect of any bonds or foreign exchange instruments used in the financing.
Meeting these due diligence standards will require significant resources from the bank itself and very close involvement in the negotiation of the transaction documents, not only with regard to the financing itself but also on the M&A side.
The Guidelines mark an end to the prohibition of acquisition finance in China promulgated under the General Rules on Lending issued in 1996 by the People’s Bank of China. This is consistent with the 10 measures to stimulate the economy and the nine financial measures recently announced by the State Council, which provide that commercial banks should strengthen financing support for M&A transactions. In addition, the CBRC has indicated that the Guidelines are designed to promote outbound investment by PRC enterprises.
Overall, the Guidelines make a timely appearance in the midst of the global financial crisis and seek to strike a proper balance between market needs for greater M&A financing, on the one hand, and the necessity of credit risk management on the other. However, the requirements for lending banks and borrowers to be PRC-incorporated, the nebulous concept of ‘industrial/ strategic correlation’ and the extensive risk assessment and due diligence exercise that lending banks have to undertake before extending acquisition financing may just be some of the factors that deter actual M&A financing arrangements, particularly from the viewpoint of foreign investors.