Ice Breaking in Acquisition Finance

On 9 December, 2008, The China Banking Regulatory Commission (“CBRC”) promulgated The Guidelines for the Risk Management of Merger and Acquisition Loans Granted by Commercial Banks (the “Guideline”), which removes the quandary that commercial banks in China are excluded from funding acquisitions. Equity acquisitions have been increased dramatically in recent years. The needs in the market of getting onshore banks’ debt financing for such acquisitions have long drawn the regulators’ attention. CBRC organized several rounds of discussion within the market circle and the drafting work of the Guideline commenced last year. Meanwhile, it’s widely held that the Guideline corresponds to the recent measures of the State Counsel enhancing credit support for acquisitions with an aim to increase domestic demands and stimulate China’s economy.

Definition of Acquisition Loans

“Acquisition” is defined as such deals that an onshore acquiring company takes over or achieves an actual control of target companies by way of acquiring the target’s issued and outstanding shares, subscribing new shares issued by the target, or acquiring the assets or taking on the debts of the target. Accordingly, “Acquisition Loans” refer to banking loans granted to the acquiring company or its wholly-owned or controlled subsidiaries for the purpose of payment of the purchase price.

Guidance and Requirement on Risk Management and Control

The Guideline puts great emphasis on the risk management and control of the Acquisition Loans, encouraging banks to follow the best practice in controlling and safeguarding against exposures associated with the Acquisition Loans by pointing out pivotal risks usually seen in acquisition transactions and providing risk-mitigating control measures, which mainly include:

Prudent Risk Management Process and System According to the Guideline, banks should evaluate the overall risks in relation to Acquisition Loans based on analysis of various risks in connection with the acquisition transactions. Prudent financial modeling and projections shall be formulated and provided for both the offeror and the target, with a focus on financial and debt service tests.

Ratio Requirements The Guideline provides various thresholds to be observed by the banks engaging in Acquisition Loans:

• -the tenor of each Acquisition Loan shall be no more than 5 years;
• -the aggregate of outstanding Acquisition Loans on a bank’s book shall not exceed 50% of the core capital of the bank for the each calculation period;
• -the aggregate of outstanding Acquisition Loans granted to a single borrower shall not exceed 5% of the core capital of the bank for each calculation period;
• -Acquisition Loans shall not finance more than 50% of the purchase price of the Acquisition.

Specialized Teams Banks are required to build up teams specialized in due diligence and risk evaluation of Acquisition Loans. The Guideline urther sets out the qualification requirements on the team leader and team members in terms of their respective experiences and expertise. At the same time, banks are expected to resort to external professionals for necessary assistance factoring the sophistication of and expertise required in specific transactions.

Security Arrangement According to the Guideline, banks are required to obtain higher security coverage for Acquisition Loans than that for other types of loans, reinforcing on the legality and validity of the security arrangement as well as perfection requirements of the security.

Documentation The Guideline shows great emphasis on legal documentation of Acquisition Loans, and squarely provides some creditor-protective provisions that need to be incorporated into loan documents,

which mainly include provision regarding financial covenants given by both the offeror and target; mandatory prepayment in case of excess cash, account and cashflow control at the borrower and/or the target’s level; lenders’ right of consent and information for certain material events. Specific risk mitigating measures are required to be built into documentation dealing with adverse change of control, material investment and assets disposal, operation costs, etc. at both the offeror and the target.

 

Key Observations

Qualified Commercial Banks The Guideline clearly indicates that commercial banks that are ncorporated in the PRC shall be permitted to be engaging in Acquisition Loans. Foreign bank branches in China would be precluded from this new business.

Standard of Risk Management The Guideline requires that commercial banks shall apply more stringent risk management in providing Acquisition Loans than other forms of debt financings.

The Industrial and Strategic Correlation between the Offeror and the Target It is worth noting that the Guideline emphasizes the Acquisition’s effect towards enhancing the core competitive advantage of the offeror and the synergy to be achieved post the Acquisition in terms of strategy, assets and business etc. of both the offeror and the target. However, it is yet to be explored in practice as to how to define the Industrial Correlation and Strategic Correlation, and whether they are designed to rule out private equity funds or financial investors as offeror from receiving Acquisition Loans. Besides, the Guideline confines the offeror to domestic companies, which means Acquisition Loans could not be extended to offshore investors as offeror. However, it remains unclear whether onshore investment/holding companies or other entities established by offshore investors could take bank loans in their onshore Acquisitions.

Leverage Ratio The Guideline provides an upper limit for the leverage ratio of Acquisition transactions
at 50%. It’s worth noting that there is no specific requirement on the types of consideration or how it should be paid. In Acquisition transactions, if share swap or other non-cash payment method is adopted, it seems to be unclear as to how the leverage ratio shall be calculated. Along with bank loans available to the offeror for payment of Acquisition consideration, usually the lenders would grant loans to the target for refinancing of its existing financial indebtedness and meeting its working capital needs. We understand that such refinance and working capital loans shall not be calculated into the leverage ratio.

Types of M&A Transactions The Guideline has taken into account of the diversity of acquisition transactions, and accordingly points out special risks and risk mitigates for different types of Acquisition transactions. It recognizes special purpose vehicles established by an offeror in acquisitions, and requires banks to focus on risk assessment of the target. The Guideline requires lenders to pay attention to hybrid financing instruments used in acquisition transactions and the impact on the repayment of loans. This should refer to those instruments such as convertible notes and warrants, and would anticipate population of more sophisticated debt/equity financing instruments in acquisition deals.

Conclusion

The Guideline uplifts the restriction on granting bank loans for equity investments set forth by The General Principals of Lending since 1996, and it reflects CBRC’s intention that domestic banks operate prudently in a market oriented environment. Under such prudent yet flexible supervision, banks could actively and continuously pursue of upgrading their risk management. It is foreseeable that the market will witness an explosion of acquisition transactions and sophisticated financial instruments along with the accumulation of experience of banks.

Should you need any further information, please contact:
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WANG Ling
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LIU Zhigang
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Jack Wang
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Roy Zhang
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Email：Roy.zhang@kingandwood.com