CHINA: Latest development of leveraged financing by PE sponsors

Latest development of leveraged financing by PE sponsors

Though we have seen a substantial scale-back of PE investment in the field of hi-tech internet company, education and healthcare, equity investment and associated leveraged finance in consumer, real estate and “new infrastructure” sectors, including logistic property, internet data centres, life-science parks, and green energy, remain very active in the past months. The most frequently seen LBO transactions are still the following two categories: (1) going-private deals for those Chinese companies listed on Nasdaq, NYSE or HKSE; (2) the sale of PRC businesses or regional businesses (with PRC part as core) by multinational corporations or financial sponsors to other financial sponsors. The tightened regulatory scrutiny on Chinese companies listed in the US and the uncertain future caused by the inability to meet the SEC’s requirement to submit audit material have been the major drivers contributing to those going-private attempts. From the angle of financial sponsors, our observation is that they have the following anticipations having been well addressed by the main lenders in the market.

Covenant-lite Loan 

“Covenant-lite”, a US import, is not a term of art - it can simply mean a loan agreement with fewer or looser covenants. However, it is probably most commonly understood to refer to loan agreements which behave more like high yield bonds: they contain no traditional financial maintenance covenants but instead restrict the borrower from taking specific actions (e.g. incurring financial indebtedness) if agreed financial ratios might thereby be breached.

We note that some financial sponsors have requested some major regional banks to provide covenant-lite facilities in their acquisition transactions. The main ask is that certain financial covenants (including Loan to Value (LTV) and Interest Coverage Ratio (ICR)) will not be tested during the life of the loan until the occurrence of a change of control. The lenders take comfort from the reputation and financial strength of the PE sponsors, and thus will restore the regular testing of financial covenants only if the target ceases to be controlled by such PE sponsors.

Share Roll-over 

PRC banks must comply with a stringent 60% Loan-to-Cost (“LTC”) test in extending acquisition loans as a regulatory requirement of China Banking Regulatory Requirement, meaning 40% of the total acquisition cost should be funded by the sponsors.

Financial sponsors will not inject equity funds as much as 40% of all transaction consideration in every transaction, particularly for those large taking-private transactions. Such going-private deals will normally be structured as a reverse merger and in such merger, not all shareholders (other than those members of a buyer consortium) will be retired by cash considerations. Those strategic shareholders who have confidence in the target company’s future growth will choose to stay and roll over their shares into the acquisition vehicle set up by the buyer consortium.

When such strategic shareholders participate into the buyer consortium by contributing their shares in a target company not so redeemed in the going-private process into the acquisition vehicle (referred to as “roll over”), value of such rolled over shares could be recognised by the PRC commercial banks as the proprietary capital contribution of the consortium members in their LTC calculation. This recognition will save a lot of equity funds contribution of the financial sponsors and increase the overall leverage ratio and consequently level of their investment return substantially.

Incremental Debt Facility
In the context of a leveraged financing, borrowers should expect that lenders will need good reasons to permit competing financial indebtedness and any exceptions will need careful negotiation. That said, financial sponsors in this region managed to obtain much more flexibility in incurring additional financial indebtedness in recent years.

In a few transactions we the JunHe team were involved in, the borrower was allowed to borrow incremental debt facility from third party lenders (outside of the existing syndicate of lenders) which could share security with the existing lenders on a pro rata basis as long as the borrower group will not breach the “leverage ratio” (usually defined as total net debt to EBITDA) related financial covenants after taking such incremental debt into the calculation of total net debt of the borrower group. This construct proves to be very challenging to many lenders in this region given the prospect of a new lender group sharing security package and competing various debt payment resources with them. We can still see some lenders accommodate such ask when the starting “leverage ratio” stays in a safe range (e.g. below 4 or 4.5) and the financial model could demonstrate a declining trend of “leverage ratio” supported by financial covenants to the same effect.

Cash Bridge Facility 

Due to the financial assistance restriction widely applicable to listed company targets, the sponsors may not use target cash or borrow loans backed by security over target cash in their acquisition. In a typical reverse merge deal, given the certain prospect that the acquisition debts borrowed by the merger subsidiary of the sponsor ("Merger Sub”) will be assumed by the target, which will either be the surviving entity after the merger, or merged into the Merger Sub, the lenders are willing to extend a cash bridge facility to the Merger Subs, supported by the agreed amount of cash from the target company being placed into an escrow account opened with the lender (not a security given the financial assistance restriction). Such escrow arrangement will be replaced by a cash pledge or account charge arrangement after the financial assistance restriction being lifted associated with closing of the contemplated merger.

The cash bridge loan will remain if the target’s PRC operating subsidiaries do not want to dividend out the charged cash to the offshore borrower due to the potential tax leakage but will otherwise be paid off if they want to distribute dividends to an offshore borrower.

Recapitalisation Loan 

Enterprise valuation in capital markets has dropped significantly in the past year, which in turn has slowed down the IPO paces of many portfolios invested by private equity houses in this region. In the absence of investment exit via IPO, a few PE sponsors have started to look for recapitalisation loans from senior or mezz lenders in this region to extract cash from their portfolio investment. The loan size has been set at a certain percentage (in the range of 50% to 60%) of the enterprise value or property value (for real estate) of the portfolio companies.

Given the continuous rate hike of the US Fed this year, it is unknown if this could lead to another round of credit crunch. If it does, it will be quite uncertain if the above attempt of sponsors will be accommodated by lenders in this region.