Article by David Olsson, Jin Xiong and Maggie Shen
Originally Published 15th December 2008
A guideline issued by the China Banking Regulatory Commission (CBRC) on 9 December 2008 overturns a long-standing restriction on the granting of bank loans for equity investments in China. The initiative will expand the financing channels available to Chinese enterprises and is expected to boost both onshore and outbound mergers and acquisitions (M&A) activity.
The Guidelines for the Risk Management of Merger and Acquisition Loans granted by Commercial Banks (the "Guideline") permits commercial banks incorporated in the People's Republic of China (PRC) to make available loans to domestic companies to acquire both the equity in, and the assets of, a target company.
Implications for onshore and outbound acquisitions
Wholly domestic companies and Sino-foreign joint ventures and wholly foreign-owned enterprises (together, "foreign invested enterprises" [FIEs]) will now have access to alternative sources of funding for both equity and asset acquisitions. Until now, production (industrial) FIEs generally have had to go through the cumbersome registered capital increase process to get limited offshore funding to finance their onshore acquisitions.
The ability of domestic companies to fund outbound acquisitions will also be enhanced. Under PRC law, domestic companies and FIEs are unable to borrow from local commercial banks for offshore investment, and their ability to raise funds in the bond market has been limited. To date most of China's outbound M&A activity has been undertaken by PRC state owned enterprises (SOEs) which are able to obtain preferential funding from the major PRC policy banks. The Guideline provides private domestic companies (as well as SOEs) an alternative source of funding to support offshore acquisition activities.
The devil is in the detail
Acquisition loans may only be granted by commercial banks established in China under the PRC Commercial Banks Law. This includes domestic commercial banks, local subsidiaries of foreign banks and JV commercial banks. PRC branches of foreign banks are restricted from granting acquisition loans.
Lender risk management and internal controls
No separate approval or license is required by a commercial bank before it undertakes the new business, but it does need to meet certain criteria which include:
- sound and well-established risk management and internal control systems
- special loan loss reserve of no less than 100%
- capital adequacy ratio of 10% or higher
- general reserve of no less than 1% of the total loan outstanding for the same period, and
- a professional team with experience in due diligence and risk assessment on M&A loans.
Acquisition financing can only be undertaken by "domestic enterprises". In the case of FIEs, as long as their proposed transactions can pass the qualified lenders' risk assessment process, they should qualify as they are "domestic enterprises" by definition.
It remains to be tested in practice how other foreign "domestic enterprises" (such as foreign invested holding companies and private equity funds established onshore in China) could benefit from the Guideline. Whilst the Guideline clearly contemplates M&A activity conducted by related special purpose vehicles, it also emphasises that when assessing any given M&A transaction, the lenders must consider the "industry relevance", "strategic relevance" and any potential synergy which may emerge between the acquirer and the target. An acquirer must be able to improve its core competitiveness through the proposed transaction by acquiring strategic resources like research and development (R&D) capability, key technology and techniques, trademarks, royalty rights and, supply and distribution networks. Nonetheless, this does not seem to exclude the possibility for private equity players established in the PRC to partner with major PRC industrial players to secure a loan for their jointly conducted M&A transactions.
Purpose of loan
The Guideline states that it applies only to the acquisition of an existing equity interest, the subscription of an increased equity interest or the purchase of assets or assumption of existing debts for the purpose in each case of "merging with, or achieving actual control over " the target company. Although not entirely clear, it appears that loans cannot be made to acquire minority stakes in a company.
The Guideline makes it clear that acquisition financing is consider a specialised form of financing and therefore requires a much closer risk analysis and greater due diligence.
In determining whether or not to grant an acquisition loan, banks, or their external professional advisors are required to evaluate risk factors and use financial modelling to estimate future cash flows. Risks to be examined include strategic risk, legal and compliance risk, integration risk, operation and finance risk and government approval risk.
Provisions must be included for creditor protection. Apart from the requirement for stringent security to support the loan (e.g. by way of mortgages, pledges and third party guarantees), the loan documentation is required to include provisions such as financial covenants, mandatory prepayment out of excess cash flow, change of control, restrictions on asset disposal, etc. Overall it is expected that this will translate into more sophisticated financing documents.
The Guideline provides a welcome additional funding mechanism for domestic enterprises considering M&A expansion opportunities. A number of the provisions are subject to further interpretation but the underlying policy objective is clear. It will be interesting to see which domestic banks are the first to hold themselves out as being the providers of this form of acquisition finance.
The views set out in this publication are based on our
experience as international counsel representing clients in their
business activities in China. As is the case for all international
law firms licensed in China, we are authorised to provide
information concerning the effect of the Chinese legal environment.
However we are not admitted to practice Chinese law and so are
unable to issue opinions on matters of Chinese law.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.