Acquisition finance: Familiar territory?

The first flurry of private equity-backed take-privates involving US-listed Chinese companies closed in autumn of 2011. There were four deals: Chemspec International, China Fire & Security, Funtalk China and Harbin Electric. In each case, a chairman who had grown disenchanted with low valuations on US bourses sought an equity partner and a debt provider for a privatization.

The debt portion, where there was one, tended to be small and conservatively priced. Standard Chartered provided $70 million for Chemspec while Bank of America, HSBC and Citi put up $60 million for China Fire & Security. Harbin Electric was the outlier, with China Development Bank (CDB) providing $400 million.

Fast forward to the next batch of leveraged buyouts (LBOs) that began closing in early 2013 and the picture is markedly different. 7Days Group received a $120 million facility from Nomura plus Taiwan lenders Cathay United Bank, Chinatrust Commercial Bank, Ta Chong Bank and Taipei Fubon Commercial Bank. For Feihe International it was a $50 million term loan from Cathay United and Wing Lung Bank.

"If you can form a Taiwanese consortium that is best - they are willing to hold more debt," says Zhen Ji, an executive director at CITIC Capital Partners, which has participated in two take-privates. "However, their total balance sheets aren't that big; if it's more than $250 million then it becomes difficult."

Foreign bankers describe the Taiwanese lenders as, by turns, "lunatics" and "deal chasers." This is in part a function of their domestic financing market, which is fragmented and competitive, and generally willing to tolerate higher leverage multiples, lower pricing and looser covenant packages than would normally be found elsewhere in the region. South Korea is described in similar terms.

Ample liquidity

Yet the developments also point to a broader trend. Once an area in which banks were reluctant to dabble due to foreign exchange controls and the lack of security in providing offshore financing against onshore assets, China take-privates are now sought after by a larger variety of lenders.

And the interest is filtering down into India, the other major Asian jurisdiction in which a soft scattering of buyouts has encroached upon the growth capital hegemony - and offshore holdcos are required to make deals work.

"There is a lot more liquidity finding its way to Asia because it is chasing yield," says Lyndon Hsu, head of Asia Pacific leveraged and acquisition finance at HSBC. "In respect of LBOs, there are two more relevant phenomena. First, regional and domestic banks have stepped up to fill the gaps left by a lot of departing Western banks. Second, sponsors have recently been able to access the US capital markets because of the significant increase in inflows to the term loan B and high yield markets."

While the jump in term loan B for dividend recap purposes remains largely the preserve of the more mature Australian market, there is interest in the mechanism in emerging Asia. Focus Media, the Chinese advertising company taken private earlier this year by a PE consortium for $3.7 billion, including $1.5 billion in debt, recently launched a $500 million recap.

In this context, greater comfort with lending to offshore holdco structures is seen as a positive development for Chinese private equity. Even if the rationale behind the take-privates is easing - US public market valuations have gone up - buyouts in general are expected to see gradual growth, driven by broader economic issues.

"There is increasing familiarity with the structure for these financings," says Douglas Freeman, a partner at Fried Frank. "The leverage finance market is a positive development for M&A in Asia. It helps get higher deal valuations, which means your scope of target expands and it makes the market here more robust."

Asia Pacific ex-Japan syndicated loan volume reached a record $279.4 billion in the first nine months of 2013, up 26.8% year-on-year, according to Thomson Reuters LPC. Hong Kong saw a 75% bump to $58.1 billion due to Chinese offshore borrowing, with e-commerce giant Alibaba Group raising $8 billion in the third quarter.

Emerging Asia LBOs are a dot on this landscape. As it stands, only 10 take-privates of US-listed Chinese companies have closed in the last two years and few of those saw the arrangers do a full syndication into the market.

Terms also remain conservative. While the increased willingness to finance these transactions is evidenced in rising gearing levels, they are nothing like what is seen in a US LBO. Leverage tends to be 3-4x versus 6x in the US and the equity portion of a deal is around 50%, well above the US average of 30-35%.

The consensus on pricing is around 450 basis points, although for 7Days it is said to have fallen below 400 basis points because the leverage was unusually low - apparently about 1.5x.

There are some concerns that the current keenness may overspill, leading to terms that understate the higher risks compared to transactions in jurisdictions where lenders get security at operating company level and protection via effective creditor laws. Banks that lend to an offshore holdco stand behind onshore creditors when it comes to swapping debt for equity and past experience has shown even that can be meaningless.

"If it all falls apart, as an equity owner you have no direct access to the property and in a Chinese context you may discover that the assets have been sold or moved before you can do anything as an offshore equity holder," says Michael DeSombre, a partner at Sullivan & Cromwell. "When times are good I think people ignore some of the downside risk."

The difference between most of the current generation of China take-privates and, for example, the Chinese property developers who defaulted on payments to offshore lenders circa 2008 is visible cash flow. While real estate deals may generate cash from rental income, they are essentially fixed-asset plays where the lender takes on collateral. Focus Media, on the other hand, generates significant operating revenue.

"In these LBOs you rarely have significant collateral. You are taking comfort from ongoing concern value of the business," says Rupert Manduke-Curtis, head of origination for non-Japan Asia at Mizuho Corporate Bank. "You are also looking at a much more significant equity buffer. This means you could burn 60% of the value of the business and be confident that the 40% of debt left will be amply covered should you need to sell to a third party to recover your loan."

There is also greater sophistication of what is required and how to get the best out of the structure. Private equity investors and acquisition financiers exercise greater discipline in using current distributable reserves onshore as a proxy for the amount of debt that is available offshore.

This is typically supplemented several other agreements: dividend maximization covenants, ensuring that dividends flowing from a Chinese company's onshore subsidiaries to the offshore holdco to service the debt don't fall below a certain level; cash flow covenants requiring the cash brought offshore is in excess of the amount needed for each debt-servicing period; and cash sweeps to ensure any offshore cash in excess of the amount required in a debt-servicing period is used to pre-pay debt.

With the benefit of hindsight, these constructs have seen modifications, such as pre-agreed caps on cash sweeps and dividend maximization based on performance expectations and the introduction of forward-looking debt-servicing periods to accommodate the protracted process by which cash can be taken offshore.

Know your product

If there is one factor above all that instills confidence in lenders, though, it is repetition and necessity. Enough deals have now been done through offshore holdcos - corporate financing as well as LBOs - to convince the market that the model works and banks' credit committees are becoming accustomed to it. In this sense, India is still a few steps behind.

"India-based transactions are fundamentally the same as China in financing structure but China has a longer track record of closing offshore financed deals," says HSBC's Hsu. "India is now starting to get a few on board."

The immediate obstacle for Indian offshore LBOs is economic. Dividends flowing offshore to a Chinese holdco are subject to a 5-10% tax. Mizuho's Manduke-Curtis puts the cost at 12-13%, including fees and offshore margin; for Indian holdcos the dividend tax alone is 17-22%.

This isn't necessarily a problem for a high-growth business, but the few Indian buyouts completed in the last year have another characteristic in common that might facilitate financing: developed market revenue streams.

There have been deals involving two business process outsourcing (BPO) businesses - Partners Group and CSS Corp. and Baring Private Equity Asia and Hexaware Technologies - as well as KKR's acquisition of a majority stake in Alliance Tire Group. Each company's clients are primarily based in the US and Europe.

The quality of the revenue is an important consideration here - stable, recurring revenue from multinational companies is always attractive - but there is also the potential for taking security over certain operating subsidiaries based outside India, essentially removing part of the holdco risk.

Indeed, in the case of Alliance, in which KKR bought at approximately 80% stake for $450-500 million in April, there was no senior debt at all. A $300 million equity contribution was topped off with a mezzanine financing tranche out of the US. Asia-based senior lenders who looked at the deal say they were uncomfortable with the leverage and structure. The global nature of Alliance's business may have offered ways of satisfying the mezzanine lenders' risk profile.

There are similarities with SPi Global, a Philippines-based BPO company acquired by CVC Capital Partners in January. Much of SPi's revenue derives from call center services for corporate clients in the US and Europe, which opened up the possibility of lending on US territory.

"With some recent Asian-headquartered deals, it was possible push debt into a US-based borrower - borrowers gain direct access to US dollar revenue flows to service debt and there's also a natural foreign exchange hedge so therefore no currency or swap structures required," explains HSBC's Hsu.

Even with these workarounds, offshore holdcos are essentially imperfect security lending structures and the flexibility of the terms attached will vary depending on the strength of the asset and the lender's perception of risk. It comes down to how far private equity firms can push in negotiations and as long as there remains ample liquidity, banks that want a piece of the action may be obliged to give ground.

There are, after all, longer-term considerations at stake: being one of a the lead financiers on a high-profile deal is good for brand building.

"There is an element of franchise in these deals but there are also growth companies," adds an Asia-based banker, who asked not to be named. "There will be a lot of future financing opportunities - maybe exit fees, IPO mandates. Banks want to form early relationships with these companies."

 

SIDEBAR: China banks, Learn as you lend

China Development Bank (CDB), a policy lender, was the first Chinese bank to figure prominently in offshore acquisition finance, extending generous sums at lower interest rates.

In the world of private equity-backed take-privates, it provided substantial loans in support of the likes of Harbin Electric, Fushi Copperweld and Zhongpin, but since then has restricted itself to financing state-owned enterprises overseas. According to industry participants, CDB began to scale back following the departure of its Hong Kong branch head, which in turn sparked rumors that senior officials felt the bank had strayed beyond its remit.

Whatever the reasoning, are China's commercial banks going to assume CDB's mantle? Rupert Manduke-Curtis, head of origination for non-Japan Asia at Mizuho Corporate Bank says no. "Chinese banks do not look like an immediate competitive threat given their relative absence in completed sponsor-led holdco deals and certainly not ones of scale with meaningful leverage and I would count anything over 2-2.5x as meaningful."

There is plenty of anecdotal evidence detailing Chinese banks' comparative slowness in processing transactions. One PE manager tells AVCJ that his firm started out using ICBC International on a deal but switched to a Japanese bank before ICBC had trouble getting approval at headquarter-level.

It is also said that some lenders lack sophistication: according to one source, CDB's loan document with Zhongpin was 30 pages long; the document used by the banking syndicate behind Focus Media ran to 300 pages.

While Chinese banks might be learning on the job, this doesn't mean they can't succeed at the highest level. Indeed, their commercial futures may in part depend on it.

"Once interest rates open up, Chinese banks' domestic spread will no longer be protected by the government," says Zhen Ji, an executive director at CITIC Capital Partners. "They will have to look more for the intermediary, fee-driven income and so acquisition finance will become more important. These high-profile deals are a positive for the long-term development of onshore loans."

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• Topics
• Financing
• Buyouts
• Greater China
• South Asia
• CITIC Capital Partners
• HSBC
• Baring Private Equity Asia
• CVC Capital Partners
• China Development Bank
• Leveraged finance
• buyout
• China
• India