China mezzanine: Hybrid solutions

China Everbright (CEL) started providing structured solutions six years ago and they have become the firm's core strategy. These hybrid debt-plus-equity instruments offer a flexibility largely unavailable elsewhere in private equity and CEL - the offshore asset manager of state-backed China Everbright Group - has been able to tinker with them in response to changing bond yields: the lower the yield, the higher the debt-to-equity conversion ratio.

"To investees, the hybrid structure does not significantly dilute their equity, and they find it fair that we share part of their success once they have significant progress and we convert to equity," says Henry Tao, managing director of CEL's capital investment and financing department. "To investors, the hybrid investments provide solid downside protection to investors while preserving the upside potential through equity kickers."

Growth-oriented mezzanine investment is not new to China, with several offshore and onshore players setting up funds, but it has yet to develop into a significant scale. Now that the country's economy slowing, does mezzanine have more of a role to play in capital structures?

It's much easier to engage with management teams when investing through hybrid financing – Henry Tao

"It makes sense there is more interest in this area. If you think of the challenges facing China - slowing growth and concerns for debt levels - mezzanine has performed well in these circumstances for investors in developed markets," says Stuart Schonberger, managing director at CDH Investments, which has a renminbi-denominated mezzanine business.

Changing circumstances

There has long been a theoretical opening for growth mezzanine in China, given 90% of small and medium-sized enterprises (SMEs) find it difficult or impossible to access to traditional bank financing. Although the government has launched a pilot program that will see 10 commercial banks provide mezzanine financing to early-stage companies, activity is restricted to the technology sector.

Faced with slowing growth - China's GDP expanded 6.9% in 2015, the lowest rate in 25 years - some of these SMEs' need for capital and support has never been greater, but they remain reluctant to dilute their ownership by selling large equity stakes to PE investors. A side-effect of the weak macro environment is uncertainty as to how much their companies are worth.

"They need capital to grow in a Darwinian society and by borrowing from us they can do this with less equity dilution. Then there is the option of selling shares to private firms at a more favorable valuation in two years' time. Our focus is on bridging that valuation gap," says Barry Lau, co-founder and managing partner at Hong Kong-based Adamas Asset Management. The firm is currently raising $500 million for a joint fund run in conjunction with Ping An Trust, a subsidiary of Ping An Group.

Customized mezzanine propositions are potentially attractive to companies in sectors such as healthcare and advanced manufacturing that are looking to generate growth through domestic industry consolidation or overseas acquisitions. If they lack the expertise as well as the capital to engage in complex M&A, CEL has an answer. It wants to partner with industry leaders and create investment platforms that identify acquisition targets and take the lead on deal structuring and negotiation. Agreements will be put in place so that CEL can exit through a trade sale to the corporate partner.

"It's much easier to engage with management teams when investing through hybrid financing. We aren't a buyout fund and we only provide growth capital and structured financing solution to the company," says CEL's Tao.

Privatization is another investment theme, but CEL is less bullish in this area. It supported the Focus Media take-private on a pure equity basis - there was none of the downside protection typically found in mezzanine - and the business is performing well. However, Tao observes that it can take up to seven years to exit a take-private investments and most Chinese technology companies are far less stable, and therefore far more risky, than Focus.

Renminbi rules?

Established China-focused private equity firms including Hony Capital, CITIC Capital and CDH have been operating in the mezzanine space for few years, predominantly in renminbi. CDH, for example, started out focusing on real estate investments but has expanded its coverage in line with demand growth and now services a broad range of corporations.

"There is a lot of demand from renminbi investors, typically insurance firms that want lower risk and lower return investments. But I don't see this kind of demand from US dollar LPs because they are looking for private equity-type returns. That's why you have more renminbi mezzanine vehicles," observes a US dollar fund-of-funds LP.

At the same time, China mezzanine is not for everyone. OCBC Bank closed its debut Asia SME fund at S$550 million ($392 million) late last year but the firm is more comfortable with mezzanine opportunities in Southeast Asia than China. "The legal framework in China is not conducive for hybrid instruments and is more inclined towards plain vanilla loans or pure equity solutions for onshore companies," says Daniel Kwan, head of the bank's mezzanine capital unit. "However, for Chinese companies with an offshore structure, a structured investment can be arranged."

For their part, Chinese entrepreneurs prefer renminbi-denominated loans because they expect the currency to depreciate over the next few years, which means lower interest rates than if borrowing in US dollars. This does not mean offshore investors cannot participate: the debt component of a deal is structured onshore and the equity kicker part is offshore under the assumption that the company will pursue an offshore IPO.

According to Vincent So, co-founder of Asia-focused mezzanine fund Swan Capital Management, fund managers would like to raise capital from foreign LPs as it is inherently more stable. The problem with renminbi investors is they prefer short-term debt solutions - despite potentially lower returns - because they are more wary of the default risks posed by some Chinese companies. Nevertheless, progression is slow in the US dollar space.

"There are opportunities to support Chinese companies investing overseas, but how can a purely China-focused player help identify acquisition targets if it doesn't have regional or global networks? These deals also require a lot of structuring to secure the best returns or they won't appeal to foreign LPs," So explains, adding that most US dollar mezzanine funds position themselves as multi-strategy Asia managers in order to secure more deal flow.

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• Topics
• Greater China
• Mezzanine
• Financing
• Expansion
• Growth capital
• OCBC
• China Everbright
• Adamas Asset Management