China take-privates: A challenging proposition

When Tianfu Yang, the chairman of Harbin Electric, obtained a $400 million loan from China Development Bank (CDB) to finance a management buyout in return for nothing more than a personal guarantee, short sellers targeting the stock were incredulous. How was this possible, they asked, when several months earlier the same bank demanded a pile of the chairman's shares in the company as collateral for a $50 million loan?

The financing was branded a charade and added weight to the litany of criticisms piling up against the $750 million Harbin take-private: the firm was a fraud, guilty of overstating its revenues, the shorts declared; Baring Private Equity Asia was initially lined up as Yang's partner but backed out a few weeks later - what did it find?

Yet in late 2011, just over a year after the chairman submitted his bid, this time supported Abax Global Capital, shareholders approved the deal and Harbin Electric de-listed.

CDB's financing package, though barely believable to some, is not a one-off. The bank has shown itself willing to cover the debt portion of a number of deals, including Fushi Copperweld, another transaction involving Abax that closed in late December. Much like Harbin, CDB extended a loan to the Fushi chairman's acquisition vehicle on the basis of a personal guarantee.

"A Chinese bank is probably going to feel more comfortable lending to a Chinese company," says Donald Yang, managing partner at Abax. "They can get fixed assets as collateral. A foreign bank can't do this for the same type of loan because domestic assets cannot be used to provide guarantees to foreign lenders."

This is one of the many quirks that characterize the wave of privatizations that began in 2010 as a spate of accounting scandals caused investors to lose faith in all mid-cap Chinese companies listed in the US, sending stock prices plunging. Short sellers probing for weaknesses as they did with Harbin has only made company chairmen more determined to turn their backs on US bourses.

Process management

Speaking earlier to AVCJ, Frank Tang, CEO of FountainVest, which is currently involved in two take-private deals, observed that the biggest challenge has been "the psychological hurdle the entrepreneurs have to get over to accept a privatization."

Once these reservations have been addressed, though, numerous obstacles still remain, ranging from financing and tax implications to regulatory requirements and founders' egos. And situations develop in the public eye: once announced, if a deal fails, everyone knows about it.

Between April 2010 and November 2012, a total of 49 take-private transactions have been announced since April 2010, according to Roth Capital Partners, with 19 reaching a close, four terminated and 26 in process. The last 12 months have seen significant activity: 10 deals were underway at the start of 2012, rising to 20 by the end of it. Fushi's delisting took the number of private equity-backed closes to five and there has been one termination. AVCJ has records of 12 deals still in process, eight of which were announced in the second half of 2012.

In the last two months of the year, three of these transactions received board approval, putting them a shareholder vote away from completion. They included what is by far the largest deal of the lot, a $3.7 billion management buyout of Focus Media, China's largest out-of-home advertiser, supported by a consortium comprising The Carlyle Group, FountainVest, CITIC Capital, China Everbright and Fosun International.

Focus Media stands out not only by virtue of its size but also as a case study in financing and the importance of jurisdiction of incorporation - issues that Michael DeSombre, a partner at Sullivan & Cromwell, singles out as major influences on execution difficulty.

Fuxi and Focus Media represent the two ends of the spectrum: a Chinese solution, a $185 million loan from CDB with a personal guarantee, versus a $1.525 billion international-style package provided by a consortium of foreign and domestic banks.

"I think the standard CDB financing document is 30 pages; for Focus Media it is over 300 pages," says DeSombre, who worked on the Focus Media financing. "When a lot of banks are involved and the facility amount is significant the banks require a real covenant package and it's heavily negotiated."

Partly due to the uncertainty of lending to a company with the bulk of its assets in mainland China, foreign banks tend to require sizeable cash sweeps and dividend maximization covenants. In some cases, the debt is cross-collateralized by cash held in escrow onshore plus whatever can be mustered offshore.

More telling, though, is the maturity of the debt. While these are officially term loans, the terms tend to be very short - to the point that bridge financing might be a more accurate description. For example, the management of online games developer Shanda Interactive, which completed a privatization in early 2012 that valued the company at $2.3 billion, secured $180 million in debt with a six-month maturity. What this means is that financing is only an option for those with the ability to make quick repayments.

"It really only works if the business can generate sufficient earnings so that distributable earnings can be used to service the loans," says Kathryn Sudol, a partner at Simpson Thacher.

Leaking sieves

Companies also have to take into account the tax leakage that occurs when moving capital offshore. This applies to dividend payments used to cover debt as well as balance sheet cash that might be required for the transaction itself.

DeSombre paints a bleak picture for Chinese companies that are incorporated in the US rather than offshore jurisdictions like the Cayman Islands. Distributions come from the China-based business operations, where they are subject to withholding tax on exit, enter the US topco and then are subject to US corporate income tax. Migrating a US-incorporated business into an offshore jurisdiction, without the migration itself incurring US tax, is not easy.

The situation is pertinent to a lot of Chinese companies that listed in the US via reverse mergers and opted for Nevada or Delaware as their jurisdiction of incorporation. It is estimated that the additional costs tied to privatizing a US-registered Chinese companies make the process economically unviable for firms with a market capitalization below $200 million.

The primary issue is fiduciary duty. Within days of a take-private being announced, class-action law suits are filed on behalf of minority shareholders, claiming that the board has been acting in the interests of the chairman behind the bid and neglecting those of other investors. "US-domiciled companies raise the bar in terms of potential legal liabilities for the directors and that is why the process takes longer and is more tedious," says Abax's Yang.

The costs of this are fees for legal and financial advisors who work with the board-appointed special committee to ensure that decisions are taken on their merits. There is additional pressure to seek out potential rival bidders, although in situations where the major shareholder already has a substantial stake this is often futile. Some boards also opt for a more stringent voting threshold. Rather than accept a majority of the total outstanding shareholders, they require a majority of the minority shareholders that haven't rolled over their interests into the acquisition vehicle.

"If the transaction is approved by the special committee and voted on by a majority of the minority shareholders, then a different level of judicial review applies," says Akiko Mikumo, Asia managing partner at Weil. "It helps determines the process is fair and in Delaware it shifts the burden to the claimant shareholders to prove that directors have breached their fiduciary duty."

In Cayman, where class action law suits are virtually unheard of, the process is less fraught. When Focus Media's privatization is put to a vote, the consortium needs the support of at least two-thirds of the shareholders who choose to participate, so a low turnout shouldn't derail the transaction. TPG Capital, which is participating in the $173 million buyout of ShangPharma has it even easier - the buyers already control more than two thirds of the company so it is in effect a done deal.

"The whole reason people use Cayman and the British Virgin Islands is that it's pretty simple and straightforward and in broad terms there is nothing that gets in the way," says Greg Knowles, head of Maples and Calder corporate practice in Asia. "Dissenters though do have a right in theory to go to a Cayman court to try to demonstrate that the fair value of the shares is a higher price, although this would be difficult, particularly in the face of a fairness confirmation given by financial adviser."

Cayman has certainly benefited from the introduction of mergers legislation in 2011.

The concept doesn't exist under UK law and so investors were previously left with a choice between a tender offer - which requires 90% shareholder acceptance to squeeze out the minority - or or a scheme of arrangement - a court-supervised process that mandates a 75% vote in favor and a judge to be satisfied that the deal is fair to all parties. In both cases, the threshholds must be reached excluding shares held by the buyer group.

"It's probable that not as many China take-privates would have happened without the change in Cayman law," says Weil's Mikumo. "A tender offer isn't necessarily an obstacle, but the merger structure facilitates a going-private transaction, especially if leveraged."

Additional complexities are presented in Nevada and Delaware by beneficial ownership restrictions. Once a private equity firm teams up with a significant shareholder and submits a buyout offer, it is deemed an "interested stockholder and, in certain circumstances, is thereby prohibited from increasing its holding in the company for a period of two years.

Triumph in adversity?

As several private equity professionals are keen to stress, these issues are not insurmountable but a failure to address them properly can cause headaches later on. This is particularly the case if the buyers' ultimate goal is a relisting on an Asian exchange. It took Morgan Stanley Private Equity Asia just under a year to take SihuanPharma private in Singapore and re-list the company in Hong Kong in 2011. For US-domiciled Chinese companies, the path isn't so smooth.

Firstly, the Hong Kong Stock Exchange is selective about the jurisdictions where potential issuers are incorporated. Hong Kong, mainland China, Bermuda and Cayman are favored, while certain US jurisdictions, including Nevada, are not. Due to a combination of this and tax considerations, a US-incorporated entity usually re-domiciles offshore before seeking a re-listing.

Secondly, Hong Kong listing applicants are subject to merit review, which means that certain weaknesses that might be accepted under the US disclosure-based system are unlikely to pass muster.

Jeffrey Sun, a partner at Orrick, cites the example of a retailer with many chain stores that has failed to file property leases with local registrars, perhaps because the landlords have defective title or want to minimize tax exposure. "For a US listing it's not deal killer - you can address this by making full disclosure on potential risk so investors are aware of the situation," he says. "But in Hong Kong it's a serious concern and the IPO would likely be delayed or vetoed."

Such concerns are unlikely to dissuade chairmen and there is a general expectation that take-private deal flow will continue. However, Mark Tobin, co-director of research at Roth Capital Partners, argues that the 2012 levels are unlikely to be matched while Focus Media will remain an outlier in terms of transaction size. He points to an improving US equities market - even for Chinese companies, with the YY IPO having been well received in December - and the fact that many of the larger firms are performing relatively well. Why would they want to delist?

Those directly involved in transactions have a slightly different perspective, noting that there is still a strong appetite for privatizations among major shareholders. "The CEOs in most cases are determined," says Abax's Yang. "They are motivated to get out of the US and so they are normally the stronger parties in the deal. They can also get a higher shareholding percentage in the company post privatization, especially in a leverage buyout deal."

Abax claims to have received plenty of inquiries from the founders of US-listed Chinese companies in the wake of Harbin and Fuxi, which were early movers in the privatization wave. The key consideration, though, is how often initial interest ends up in a successful transaction. One lawyer who gets involved reasonably early claims his hit ratio is 50%, but far more deals are abandoned before they even reach the stage at which legal counsel is required.

The take-private process can be volatile, particularly when a company has been listed for a few years and raised a couple of rounds of funding. The chairman might only have a 20-30% stake but he wants to control the entire process, perhaps dealing with the conflicting need to pursue his own interests while maintaining commercial and political relationships back home. This can lead to conflicts with investment partners.

For private equity firms, it can be difficult to walk away from a deal after time and money has been spent on it, especially if the transaction has entered the public domain. This might afford the founder considerable power when negotiating the consortium agreement, but fear of failure works both ways. Financial sponsors are likely to be wary of companies that have been abandoned by rivals.

"The chairperson or founder is in a strong position but is typically still worried that the PE firm will pull out after the announcement; and the PE firm doesn't want to be in a position of pulling out once an announcement is made," says Simpson Thacher'sSudol. "There is definitely pressure to get it done on both sides."

 

SIDEBAR: Duck and cover - Take-privates and VIEs

After an eight-month investigation, China's Ministry of Commerce (MofCom) allowed Wal-Mart to take majority ownership of Yihoadian, the country's largest online supermarket, in August 2012 - but regulatory approval came with conditions attached.

MofCom, which was reviewing the deal under Anti-Monopoly Law (AML) provisions, prohibited the US retailer from turning Yihaodian into an e-commerce platform that facilitates third-party transactions. It could not, repeat not, offer such services through a variable interest entity (VIE), the structure often employed to invest in areas where foreign ownership is frowned upon.

It was the first time MofCom had explicitly outlawed a VIE - the regulator previously withheld approval and remained silent - and foreign investors were rattled. Many US-listed Chinese companies that consider take-private deals rely on VIEs, and if these transactions involve a change in control of an asset, an AML filing is usually required.

"Particularly following the Wal-Mart decision, people have been hesitant about moving forward even when there are no substantive antitrust or anti-monopoly issues. If there is a VIE in the structure, it can be a deal killer," says Kathryn Sudol, a partner at Simpson Thacher in Hong Kong. "There is an expectation that MofCom will not grant its approval or will require that the VIE is terminated."

Companies that are incorporated overseas routinely invest in China via an offshore entity, which controls a wholly-owned foreign enterprise (WFOE) in the mainland, and profits are transferred back as dividend payments. Through convenience or necessity - i.e. in certain sectors where direct foreign ownership is not permitted - a structure is created in parallel to the WFOE under VIE rules; it holds business licenses and is controlled by Chinese nationals.

MofCom's distaste for VIEs dates back several years and one of the highest-profile casualties was a proposed $1.4 billion merger between Sina and Focus Media, China's biggest web portal and biggest out-of-home advertising network, respectively. AML approval was not forthcoming, supposedly because of VIEs, and the companies gave up on the deal in late 2009.

Now Focus Media could be in MofCom's sights once again. The company is the target of a $3.7 billion buyout offer from The Carlyle Group, FountainVest Partners, CITIC Capital, China Everbright, Fosun International and company management. Will this deal be thwarted as well?

The prevailing view is not. According to sources familiar with the transaction, no single party will have a majority stake in the business, so there will be no change of control and therefore no need to make an AML filing. Other take-private transactions can also avoid running the MofCom gauntlet if the current controlling shareholder, usually the company founder, remains in control post-privatization.

Nevertheless, Akiko Mikumo, Asia managing partner at Weil, preaches caution. "A minority investor typically has veto rights over operations, so people are limiting those rights," she says. "An investor might own 25% of the company but its veto rights would be limited to shareholder type rights. We have seen transactions where this is utilized."

At the same time, a lot of US-listed Chinese companies are getting rid of VIEs because they are more trouble than they're worth. If there are no longer regulatory restrictions on a particular branch of the business - or maybe there never were in the first place - the VIE can simply be rolled into the WFOE.

"The amount of business in these VIEs - apart from internet companies where VIEs hold the ICP licenses - is much smaller than it used to be," says Michael DeSombre, a partner at Sullivan & Cromwell. "The whole issue with the VIE is that it gives local shareholders, usually the founders, a lot of power."

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• Topics
• Greater China
• Buyouts
• Regulation
• China
• buyout
• Abax Global Capital
• Fountainvest Partners