When the first leveraged buy-out of a China business – the Goodbaby Group – was completed this year, it was a signal of the inevitable convergence of two developments in the mainland’s investment environment.
First, financial buyers and strategic investors that in the past would have met tough pre-qualification criteria can now go through stand-alone “strategic investment” gateways where the qualification requirements are lower.
Second, boosted by accession to the World Trade Organisation, China has embraced investment in the services sector. Businesses in services tend to have strong cash flows, which is attractive to financial buyers, especially private equity funds. Put the two together and there is an irresistible driver for mergers and acquisitions led by financial buyers.
Financial buyers prefer to leverage when investing – to use as much debt as possible at the lowest rates – as this maximises return on equity. Typically, in what I call an “off-to-off” structure, an offshore acquisition vehicle is established to acquire the shares in an offshore target that holds the operating businesses in China. Debt funding is made available offshore to the acquisition vehicle on a non-recourse basis. The funding is secured against the shares of the acquisition vehicle and dividends are swept up to service the debt. The structure is off-to-off as both lender and borrower are located outside China, although the target business is based in China.
The purest form of China LBO would be an “on-to-on” structure where the lenders and acquisition vehicle are located in China. However, finding credit from mainland banks is not easy as they are not internally resourced or incentivised to engage in such highly structured financing. Also, with the renminbi predicted to appreciate, it would make sense to obtain US dollar financing. An on-to-on structure would also involve the unusual step of the investor providing security offshore to the Chinese lenders.
A more likely next step may be a hybrid “off-to-on” structure, with offshore lenders lending in renminbi to a mainland acquisition vehicle. It should be noted that offshore lenders in this case would include the branches of foreign banks in China; this year marks the full geographic liberalisation of renminbi business. Approval would be required from the foreign exchange regulator so that the mainland acquisition vehicle and Chinese shareholders could grant security offshore. The security providers as well as the party secured must satisfy strict criteria.
The next convergence point is likely to be domestic and foreign funds coming into China to finance acquisitions in China by mainland companies.
The writer is a partner with White & Case in Hong Kong and author of The Law and Practice of Mergers and Acquisitions in the People’s Republic of China, to be published by Oxford University Press this year
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