China mezzanine: Not the norm

Mezzanine fund managers globally are performing triage on portfolios crammed with subordinated debt in companies that are unable to open for business. According to Robert Petty, co-founder of Hong Kong-based credit investment firm Clearwater Capital Partners, in many cases the chances of revival are slim. “When companies run into difficulty, the mezzanine is going to go to zero,” he says. “It's a poor risk-reward. You're essentially taking equity risk and you have the upside of credit.”

In China, however, mezzanine capital has arguably never been more popular. Last month, CDH Investments closed its fifth renminbi-denominated mezzanine vehicle at RMB8 billion ($1.1 billion), nearly two-and-a-half times the size of its predecessor. The private equity firm now has ambitions to raise a US dollar fund as well – in what it claims would be a first for a domestic GP.

“We are preparing our track record and paying close attention to cross-border investment policies,” says Francis Ho, founding partner of CDH’s mezzanine strategy. “The regulator is opening up special situation investments to foreign investors, so that’s where we will start.”

Largely cocooned by foreign exchange restrictions and subject to rules written at a certain time for a particular purpose, mezzanine in China appears to be at odds with international norms. It is sparsely populated by credible managers, its regulatory environment lacks clarity, even the definition of what constitutes mezzanine is debatable. Investments do not follow a standard structure as much as work towards a common outcome: safe but satisfying returns with annual cash distributions. Managers are as likely to take plain vanilla equity positions as construct complex structured debt solutions.

Only four groups have established themselves as major players in the space: CDH, CPE – formerly known as CITIC Private Equity, China Everbright, and Hony Capital. And over the past five years, fewer than 10 funds have been raised.

It is ironic, therefore, that mezzanine strategies are favored by one of China’s most prestigious and active set of private equity investors: insurance companies. Of the RMB12 billion CDH has raised across five mezzanine funds, RMB8.5 billion came from 27 domestic insurers. When CPE closed its debut mezzanine vehicle at RMB5.1 billion in 2012, insurers accounted for 30%. The firm raised nearly three times as much for its latest fund, which closed at RMB13.3 billion in 2017, yet the contribution from this LP group increased to 60%.

Everbright is nearing a first close on its third mezzanine vehicle, having set an overall target of RMB3 billion. Zhichao Lu, head of the firm’s mezzanine team, tells AVCJ that he expects insurers to contribute 80% of the corpus.

The key selling points are stable cash distributions during the investment period plus a reasonable back-end income. CPE claims its funds have generated cash distributions of 8% in recent years, while the IRRs for CDH’s first two mezzanine vehicles – now fully exited – are 15.1% and 11.5%. 

Asked to name some of its competitors, CPE points to some 70 trust companies that pitch debt financing at lower interest rates. The difference is sophistication. “Trusts offer a single solution. Mezzanine funds offer products that are creative, flexible, and well structured,” a CPE executive says.

Starting points

When CDH and CPE entered the space around 2010, their initial target was property. China’s real estate industry was at the peak of a multi-year boom and mezzanine investors swallowed up fully collateralized deals with low risk and high return. As concerns about a speculative real estate bubble mounted, the government imposed a series of cooling measures and price growth slowed. According to several lawyers, these included a ban on fundraising for vehicles that made loans to property developers, which was essentially the mezzanine investment approach.

“We made a judgment call: the market for office buildings would be weaker, while data demand would grow exponentially,” says CDH’s Ho. “The trend has become even more obvious due to the COVID-19 epidemic. No one cut back on their meetings, they just moved them online. Our dependence on office buildings will continue to weaken, while the importance of data center will continue to strengthen.”

Data centers and 5G infrastructure are now central to the firm’s mezzanine strategy. Much like property, location is a key consideration. For example, CDH recently invested RMB850 million in a Shanghai-based data center and cloud services provider that is expected to list on Shanghai’s Star Market later this year. All its data centers are in first-tier cities, which means it is easier to attract large blue-chip customers.

Jingjing Jiang, a partner at law firm King & Wood Mallesons (KWM), adds that data centers and 5G are ideal investment targets for mezzanine funds because they are asset-heavy. Even though no collateral is involved, the perceived risk is lower. “Datacenters, to a certain extent, are similar to commercial real estate,” Jiang says. “They are stable operations that provide continuous cash flows.”

CDH’s investments do not fit the typical profile of mezzanine investments, but neither do they have much in common with the deals pursued by CPE or China Everbright. The former has well-defined sector coverage, with separate teams for areas including consumer, healthcare, financial services, and technology. The latter is sector-agnostic but prefers to make commitments in equity rather than debt.

If there is a consistent theme across the three strategies, it is participation in pre-IPO rounds. This is largely driven by market need. Entrepreneurs are reluctant to dilute their holdings with equity investment but struggle to secure financing from banks because they don’t have enough collateral.

“For many growth-stage companies, their factories or properties are not particularly valuable. An entire industrial park might be worth RMB100 million, and after factoring in a 50% discount, a bank only offers RMB50 million in senior debt of RMB50 million. That’s where we can enter the game,” explains CDH’s Ho. CDH prioritizes healthy corporate cash flow over real estate values when assessing potential investments. “We have effective ways to monitor that cash flow, so our investment is safe, and our return is higher than for bank loans,” adds Ho.

Everbright claims to deliver the stable, yield-like returns required of mezzanine through regular public market sell-downs. It invests in equity where the target company has a clear path to IPO,on occasion making trade sale exits prior to the listing in order keep distributions on schedule. Debt financing is available should companies require it,  but only after a meaningful initial equity commitment. 

For example, Everbright invested RMB300 million in Hope Education, a higher education provider, in 2016. It was the company’s only private equity backer at the time. A year later – and 12 months before the company’s Hong Kong IPO – Everbright put in a further RMB600 million. Part of that investment was structured as convertible bonds.

“If you start with debt investment, you stay on the surface and it’s hard to develop a deep relationship with the management team,” says Lu of China Everbright. “I’ve done risk control at banks for many years and it is hard to control risk when you don’t really know the business. Collateral sometimes becomes a formality.”

China Everbright also looks to build itself positions of influence by investing big and often exclusively, becoming the second-largest shareholder in companies with a guaranteed board seat. To many industry participants, it looks a lot like conventional private equity. “Those are interesting transactions, but I would call them growth equity investments,” says Clearwater’s Petty.

Indeed, China Everbright makes a concerted effort to avoid competition from PE investors. Lu claims to avoid the “new economy,” where valuations are often highest. He focuses on areas where there is inelastic demand, such as food and offline education. Lu leads a team of 10 that looks to complete two to three deals each year with an average ticket size above RMB300 million. Prospective investees typically have at least RMB100 million in net income, EBITDA, or operating cash flow.

Making a market

There is certainly a case to be made for deeper mezzanine penetration in China. Across Asia, central banks try to ease liquidity shortages arising from the COVID-19 outbreak by stimulating credit flows to the real economy. However, banks tend to favor highly rated corporates over smaller, less proven businesses. “Even though there is ample liquidity – best evidenced by low policy rates and yields on investment-grade credit – a large proportion of the borrower universe continues to struggle with access to financing,“ according to Dignari, a regional credit and special situations investor.

Mezzanine funds can help fill this gap. They are essentially junior debt that bridges the gap between equity and senior loans. But they are not the only financing solution available. Jiang of KWM has seen growing interest in credit and special situations funds. Dignari is among those evaluating the possibility of launching a vehicle exclusively focused on China onshore opportunities.

In the case of CDH, the connection between mezzanine and credit strategies is explicit. Over the past three years, the firm has invested in 19 projects that it categorizes as special situations, deploying RMB2 billion and generating distributions of RMB1 billion. A dedicated credit fund was established in 2019. “Our mezzanine fund started making special opportunities investments in 2015 and we’ve now taken some of them through to exit. We want to leverage these experiences and deploy a more specialized special situations fund,” says Ho.

A US dollar fund is next on the agenda. CDH wants to ease itself into the space, first raising capital for project funds that will invest in non-performing assets, before raising blind pool vehicles for credit and then mezzanine.

This gradual progression to mezzanine is endorsed by other investors, who caution that bringing international LPs directly into Chinese mezzanine funds could be challenging, given the broader scope these vehicles enjoy compared to the US. Benjamin Fanger, founder of ShoreVest Partners, which targets distressed debt and structured credit opportunities in China, argues that credit represents the easier starting point.

“If it’s written in your contract that you’re raising a US dollar mezzanine fund and then you go and invest in equity, you’ll get fired. It would also be confusing if you target credit investments with your mezzanine fund,” he says. “US dollar LPs expect mezzanine funds to invest in performing loans rather than non-performing loans. The companies should not have any issues that need to be resolved.”

Chinese regulations around mezzanine can be equally problematic. Even though mezzanine is a debt structure with embedded equity instruments, it is classified as equity. Managers are not allowed to enter into contractual agreements to provide guaranteed returns or fixed interest rates.

“As it is an equity investment, regulators insist that investors take the appropriate risk. GPs cannot ask for guaranteed returns from portfolio companies; similarly, LPs should not expect guaranteed returns from GPs.” says Mulong Gong, a managing partner in KWM’s Beijing office.

There are workarounds. For instance, a company may agree to buy back 20% of the equity invested by a fund each year, which is effectively the same as repaying the investor’s principal. Similarly, GPs can commit to make dividend payments to LPs amounting to a certain annual percentage return; this mechanism appears to derive from an equity investment, but it is in fact debt. The problem with these arrangements is that they rely on trust between counterparties. Only big-name GPs can do it.

Filling the void

The good news is that regulatory controls appear to be loosening. The China Banking & Insurance Regulatory Commission (CBIRC) announced this month that the country's five largest state-owned banks could offer investment plans underpinned by debt-to-equity swaps such as convertible bonds. Pension funds and qualified retail investors are expected to participate in these plans as well as insurers. 

Shiduo Xu, a Beijing-based partner at law firm Zhong Lun, believes the rule change may enlarge the fundraising base for mezzanine funds, which is currently dominated by insurers. Dayi Sun, a managing director at Jade Invest, expresses similar sentiments.

Foreign investors looking to come onshore must still deal with the bureaucracy of cross-border fund flows and make sure they comply with local tax law, but the landscape is becoming more navigable.

Candy Tang, a partner with law firm Fangda Partners in Shanghai, believes credit is relatively accessible from a regulatory perspective. The industry is divided into two segments: special situations and non-performing loans (NPLs). Like mezzanine, special situations is classified as equity and most deals fall within this remit. Even debt is feasible in some cases. As for NPLs, approval from the National Development & Reform Commission is not hard to obtain, according to Benjamin Fanger.

Nevertheless, there are few overseas participants in China’s onshore credit market; ShoreVest claims to be the only active player with US dollar LPs. As with other geographies, this is largely a resource issue. Investors need local teams to source and manage portfolios. CDH, CPE, Everbright and Hony run mezzanine or special situations alongside other strategies, allowing them to pool talent and information. Everyone else must invest to be competitive. With greater regulatory clarity, more investors might be willing to take the leap.

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• Topics
• Mezzanine
• Greater China
• Credit/Special Situations
• Restructuring
• Credit
• China
• CDH Investments Management
• China Everbright
• Citic Private Equity
• Hony Capital
• Structured finance