Leveraged Finance: Patchy, tricky and jinxed!
Acquisition financings from China are on the rise and lenders globally are vying for piece of Chinese LBO action. However, the poor response that most Chinese LBOs have received suggests activity will remain patchy. Cong Cong Tang reports.
China has long been a hotbed for mergers and acquisitions and with ample opportunities to book high-yielding assets, international lenders have been quick to establish leveraged financing teams in a bid to get a share of the Chinese LBO pie.
Interest in Chinese LBOs seems to exceed their success, however, as so far only one deal – GUM Holdings' US$181m five-year LBO financing – has succeeded in syndication.
The real challenge in getting GUM’s LBO away was the market’s perception of regulations in China such as the ability to pledge the shares and assets of the target company as security for the financing. The leads on GUM’s financing attempted to secure a share pledge, but could not do so because they could not track down all the minority shareholders required to get 100% shareholder approval for the pledge – one of the requirements in China for a debt secured by a share pledge.
Although not every invited got internal approval, it nonetheless provided a significant opportunity to establish what the pressure points are for lenders weighing up Chinese LBOs and was a small but vital step in the sector's development.
The result brought out the differences between lending practices in Asia and those in developed markets. In Europe and US, LBOs are essentially seen as cash flow lending with the financing structure only adding another layer of comfort to lenders. Asian lenders, by contrast, are typically brought up on a diet of asset-based lending.
If sometimes it is the security on LBOs that is the issue, other times it is the government that is the road block. Carlyle Group’s US$375m acquisition of an 85% stake in China's largest construction machinery maker, Xugong Construction Machinery, in October 2005, is the best example of the government acting as the blocker instead of a facilitator. Carlyle was forced after a 2-1/2-year wait to revise its stake to 45% but is still awaiting approval.
Xugong’s LBO refinanced a bridge loan and featured an offshore holding company as the borrower. The deal also featured security in the form of a pledge over 85% of the shares of the holding company, which could not be enforced for three years as per a shareholders’ agreement between Carlyle and the remaining holding company shareholders.
Many believe Carlyle’s failure to bag the asset was largely due to the government’s unwillingness to allow foreigners to acquire strategic assets. Further proof that Chinese regulations were not conducive to LBOs came in March 2006 when the US$282m five-year LBO for Harbin Pharmaceutical Group Holding, which came close to becoming the country's first syndicated LBO financing, was cancelled because of a sudden change in regulations.
Some, however, believe that LBOs can still be done in China and that deal flow will become more regular in time. “Foreign buyers acquiring Indian companies face similar regulatory hurdles as in China, thus killing many possibilities of classic LBO financings as well. However, the Flextronics deal in India got a blowout response from the market,” said one loan banker.
Indeed, the US$368m seven-year deal backing KKR's US$900m buyout of Software Development Systems in September 2006 is the only true Indian LBO. Key to its success was the clever structure that ensures the repatriation of cash flows to Cayman Islands-incorporated SDS so that it could service the debt being raised partially to fund the acquisition.
In contrast, China's latest and largest ever LBO – a US$430m 5-1/2-year LBO that backs 3Com Technologies' purchase of a 49% stake in Huawei-3Com Technologies – continues to flounder. After receiving only two commitments since its January launch, the deal was flexed in early April after lender concerns about the sector, a 18-month non-compete agreement with stronger partner Huawei and the company's business model without the latter’s involvement.
Another deal that failed in syndication was Asia Timber Products' US$86m LBO loan on which the two leads ended up holding US$76m – 88.4% of the loan – between them because of concerns over the long tenor and high leverage.
“China is a developing LBO market and lacks a fully developed legal system and a straightforward security structure. The outcome on GUM Holdings’ transaction provides breakthrough for China LBOs that can be possible provided there is a strong sponsor, a clever structure and good creditworthy private-owned target companies,” said a banker in Hong Kong.