In the past five years, local Chinese banks have been very active in leveraged buyout financings (particularly those sponsored by international private equity (PE) houses, as the terms (including tenor, pricing, financial ratios and size of loan) they can offer to sponsors are more favourable than those of international banks. This trend has been evident in the leveraged financing deals for taking private those Chinese companies listed in the US. 

International banks continue to be the preferred choice of multinational companies in China for their corporate financing.

Mezzanine debt funds have been quite active in the high-yield lending market for Chinese real estate developers who have suffered significantly from the serious shortage of liquidity in the real estate capital market. They were also found in the high-leverage deals of PE sponsors by providing junior facilities to increase the total loan-to-value (LTV)/loan-to-cost (LTC) ratios and investment return. 

The most frequently seen LBO transactions are going-private deals for those Chinese companies listed on NASDAQ, the NYSE or HKSE. The tightened regulatory scrutiny on Chinese companies listed in the US and the uncertain future caused by wider geopolitical concerns have been the major drivers contributing to those attempts to go private. PE houses are the most active sponsors for these transactions, and Chinese commercial banks provide good financing support to PE sponsors and founders. Loan documentation is largely based on Loan Market Association (LMA) standards and is well accepted by Chinese commercial banks. 

Last year, although local banks were still willing to provide acquisition facilities to international and domestic PE houses and other institutional investors, the market saw quite a substantial scale-back of leveraged deals, which is commonly believed to be attributable to the credit crunch caused by the USD interest rate hike, geopolitical tension and the uncertain economic outlook clouded by COVID-19. However, the downward movement of equity valuation and fewer new IPOs in the capital markets of this region make the exit of portfolios by the PE sponsors extremely difficult, and many PE sponsors in this region are looking for refinancing for their existing leveraged deals, or recapitalisation financing of their existing portfolios with an aim to meet the DPI (distribution to paid-in) measurement as requested by their limited partners (LPs). The lenders in this region may be familiar with traditional refinancing but find it tough to do recapitalisation financing deals for the following two reasons:

• The China Banking and Insurance Regulatory Commission (CBIRC) has issued various guidelines concerning lending activities, including imposing strict restrictions on the purpose of loans. For example, only after the Acquisition Loans Guidelines were officially promulgated in 2008 (further revised in 2015), were PRC banks authorised and allowed to fund equity acquisitions via bank loans. That said, PRC lenders are generally inclined to limit the loan purposes only to those explicitly permitted by CBIRC rules. Therefore, as recapitalisation (via dividend distribution or its alternatives) does not fall within the expressly approved loan purposes, this tranche is customarily funded by international lenders or certain offshore branches of PRC lenders.
• Some PRC banks are concerned that providing loans for dividend recapitalisation may raise ethical questions for the banks. In particular, some lenders feel that dividend recap as an exit may only benefit the PE sponsors, as it creates a way to deliver returns to PE sponsors at a stage when the portfolio companies are still far from achieving a meaningful IPO or trade sale, although the level of EBITDA or asset valuation may appear to justify an early distribution. Consequently, this can leave banks taking on increased risk, as presumably the borrowers’ ability to repay its loans will be reduced as a result of the additional recapitalisation of loans.

No information is available in this jurisdiction.

For complex acquisition finance/LBOs where the borrower is an offshore entity, Hong Kong law is frequently used and accepted by lenders and sponsors. 

PRC law has been the prevailing choice for domestic corporate and acquisition loans where both lenders and borrowers are onshore entities. 

APLMA (Asia-Pacific Loan Market Association) standard documents are widely used in cross-border transactions in this region. 

For domestic transactions (particularly where the lenders are Chinese banks), local Chinese banks normally encourage using the template documents formulated by each bank or those prepared by the China Banking Association.

For complicated leveraged financing transactions with foreign sponsors, Chinese banks can accept and execute the English version of loan documents (with no Chinese translation or Chinese version) according to the PRC counsel’s opinion in reconciling the consistency of English terms with their credit committee approvals. 

PRC branches of international banks can only accept and execute the Chinese version of loan documents when their borrowers are PRC local companies, while the prevailing market practice is to adopt the English version for the facility agreement (with the Chinese translation or summary) and the Chinese version for security documents to accommodate local registration requirements.

Counsels are expected to cover the following aspects in their opinion: due incorporation and the valid existence of the borrower; authorisation of finance documents; due execution, not conflicting with the law, legality, validity and enforceability of finance documents; creation of security; applicable tax; choice of law and dispute resolution and venue. 

PRC lenders may also look for opinions on compliance with certain regulatory requirements, including compliance with the LTV/LTC regulatory ratio. 

To contemplate an easier route of investment exit given the cross-border foreign exchange control (from the investor’s perspective) and enjoy certain tax benefits offered by an offshore sale structure (from the seller’s perspective), sellers of PRC assets prefer, or are asked by investors, to set up an offshore investment holding structure and place their PRC operating companies or assets under such offshore holding companies. The acquisition is usually constructed as a sale and purchase of shares in offshore holding companies. 

Given such a deal construct, the senior loans normally comprise two tranches: 

• one offshore tranche extended to the acquisition vehicle of the buyer financing the purchase consideration; and 
• one onshore tranche extended to the main onshore operating company to take out the existing corporate or construction loans. 

The offshore tranche is still categorised and priced as a senior loan, but technically, the offshore loan is structurally subordinated to the onshore loans. For real estate loans, offshore lenders will seek to have a second lien mortgage over the onshore real estate properties to improve their subordination position, which may face challenges as outlined in the upstreaming security section. Hence, this request is rarely accepted in sponsor-financed transactions.

Many offshore lenders also manage to enter into intercreditor agreements with onshore lenders to share security or achieve co-ordinated security enforcement arrangements, which can also prove to be quite challenging, as discussed in 4. Intercreditor Agreements.

Mezzanine loans are not commonly seen in sponsor financing, as PE sponsors may easily access 60‒65% LTC loans from senior lenders in this market (with combined use of onshore and offshore loans since onshore lenders are subject to a regulatory cap of 60% LTC for acquisition loans). 

Mezzanine loans are more frequently seen in real estate financing extended to real estate developers, who cannot use bank loans to finance their land acquisitions or who are restricted to bank loans to finance their operating expenditures or capital expenditures when they fail to meet certain regulatory financial ratios. Such real estate developers will place their onshore development companies under an offshore holding company, which will utilise mezzanine loans from credit funds and then infuse equity into onshore project companies. Such a mezzanine loan will normally yield 12‒18% interest but will obviously be structurally subordinated to onshore senior creditors without the protection of an intercreditor arrangement. 

There are bridge loans in LBO deals, where the target is cash-rich but cannot provide cash security to the acquirer due to financial assistance restrictions. In a typical reverse merge deal, the lenders may extend a cash bridge facility to the merger subsidiary of the sponsor, 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 closing the contemplated merge. The cash bridge loan will remain if the target’s PRC operating subsidiaries do not want to pay dividends from 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. 

PRC companies may adopt two different types of issuer structures to issue bonds/high-yield bonds in the offshore capital market: 

• offshore issuer; and
• onshore/domestic issuer. 

Offshore Issuer

The founders of a PRC company may establish a Cayman entity as an offshore holding company and bond issuer, which will, in turn, own a series of PRC operating entities via one or more British Virgin Islands and/or Hong Kong (HK) intermediary holding companies. Bonds issued by such issuer may utilise the following credit enhancement routes. 

• A pure credit bond: Investors may be entirely comfortable with the credit profile of the issuer and its onshore subsidiaries and require no other credit enforcement. 
• A Listco guarantee: Some HK Listcos may carve out some PRC assets and place them under a standalone Cayman issuer, which will issue bonds/high-yield bonds. Listco will still guarantee these bonds to enhance its credit profile. 
• Upstreaming security: To improve the bondholder’s structured subordination position, PRC operating entities may provide asset collateral (including a real property mortgage, an equity pledge, etc) to secure the offshore bonds. This is regarded as an outward security securing offshore debt under PRC law, which must be registered with the State Administration of Foreign Exchange (SAFE). Such registration is a merit review and will not survive SAFE scrutiny unless the offshore bond issuer (on a standalone basis) can prove that it has stabilised cash flow to service offshore debts, and the likelihood of the upstreaming security being enforced is low. Failure to complete the registration will not render the guarantee/security documents invalid, however, outbound remittance of the enforcement proceeds or performance payments could be delayed or blocked, as the account banks processing such remittance are under regulatory obligation to verify the SAFE registration certificates.
• Keepwell: Considering the challenges from the guarantee or upstreaming security structure, Keepwell undertakings from the onshore parent of the issuer are also commonly adopted. Typically, the parent acting as the Keepwell provider will undertake to investors that it will disburse funds offshore from the PRC to provide certain financial or liquidity supports to the offshore issuer. The parties will acknowledge that the Keepwell arrangement is not a guarantee. 

Domestic Issuer

PRC companies may, save for setting up the offshore holding structure, issue bonds/high-yield bonds directly into the offshore capital market. Typical credit enhancement measures may include: (i) a standby letter of credit (SBLC) issued by a commercial bank, which is counter-guaranteed by the parent group if the issuer is separated from its parent group, and (ii) if the issuer is separated from its parent group, a guaranteed provided by the parent group. 

The structure for private placements/loan notes is almost identical to that outlined in 3.4 Bonds/High-Yield Bonds. 

In the acquisition finance area, direct purchase of the assets may not be a preferred choice mainly due to tax considerations. As mentioned, PE sponsors typically carry out acquisitions by way of equity rather than asset transactions.

Therefore, in the PRC market, asset-based financing deals are not frequently seen in industries other than the real estate sector. For real estate loans, lenders usually adopt similar secured lending structures to those discussed in 3.1 Senior Loans, with the typical security package comprising the following, with the purpose of ring-fencing the asset values and the future cash flows of the borrower:

• a mortgage over the property;
• a pledge over the account receivable if the property is leased; and
• assignment of rights under the material contracts, including insurance policies and leases (to the extent that such rights are not subject to the receivable pledge above).

In asset-based lending, considering the assets (together with the cash flow generated during the loan tenor) will be the core repayment sources, this structure is less attractive to international banks if there is an offshore tranche because of the structural subordination issue. 

Some PRC banks, on the contrary, will consider extending the offshore tranche loans through their free-trade zone (FTZ) branches. As the FTZ branches are PRC entities, second lien mortgages created in favour of those bank branches will not constitute outward security requiring SAFE registration. As such, PRC banks with FTZ branches are the key participants in this niche market.

A typical intercreditor agreement under an offshore/onshore dual tranche transaction includes the following arrangements. 

Priority of Payments

As discussed in 3.1 Senior Loans, the offshore loan is structurally subordinated to the onshore loan, and the intercreditor agreement will specify the types of payments that the onshore lenders can receive pursuant to the onshore finance documents. While the scope of such types of payments is deal-specific and will be negotiated, the market consensus is that only enforcement proceeds recovered by the onshore lenders should be subject to payment subordination, while other regular payments under the finance documents (including payment of interest or default interest, repayment or prepayment of onshore loans, and payment of indemnities, costs and expenses) should be permitted as long as no default has occurred and/or is continuing.

Standstill

All the lenders must refrain from taking any action to accelerate the loan or otherwise enforce any part of the security package within 90 days (and if agreed, a further 90 days) of the occurrence of an event of default, and must do their best to reach a consensus on how to enforce the security package (either an offshore sale of shares, or an onshore sale of real properties and other operational assets). 

Sharing of Security Proceeds

Onshore and offshore lenders agree to share the security enforcement proceeds on a pro rata basis. This is not easily achievable due to PRC foreign exchange control rules, including: 

• PRC lenders are not allowed to voluntarily waive part of their entitlement to the outstanding loan amounts or security proceeds unless they have special approval from the banking regulator; and
• PRC borrowers or security providers may not provide upstreaming security to offshore lenders unless such security is registered with SAFE, is a merit review and meets specific conditions that are not easy to satisfy. 

Call Option

Onshore and offshore lenders will grant each other a call option to purchase the entire portion of outstanding loans held by another group of lenders when both sides cannot reach a consensus on how to enforce the security package. 

The approach to bank/bond deals is similar to that detailed in 4.1 Typical Elements. 

The role of hedge counterparties is similar to the roles described in standard LMA International Council on Archives (ICA) documents. The hedging arrangements may be put in place prior to or post signing. Typically, the hedging liabilities for the senior debt and the senior debtor will rank pari passu, and the hedging counterparties will benefit from the same guarantees and security package of the senior debt.

In sponsor financing, the borrower will also request to select, at its discretion, a hedge counterparty that is not a syndication lender. However, the lender will usually ask for first right to offer and last right to match the hedging terms, thereby limiting the possibility for a third-party creditor to come in and share the guarantees and securities.

Shares

Pledges can be created over shares in a limited liability company. 

Inventory

A mortgage on the inventory (including raw materials, semi-finished products and finished products) can be created. 

Bank Accounts

A pledge over bank accounts (in essence, a pledge over the deposits therein) will only be recognised when:

• the pledgee has actual control over such account; or
• the inflow and outflow of funds are for one specific category of use. 

Receivables

Pledges of account receivables can be used rather than the security assignment or the debenture as frequently used in other jurisdictions.

IP Rights

A pledge over IP rights can be created. 

Real Property

Mortgages over real properties can be created. 

Movable Properties

A pledge over movable properties is possible when possession of such properties could be delivered to the creditors. If possession is not deliverable, then a mortgage over movable properties can be created. 

There are no such form requirements under PRC law.

Share Pledge

Shares of a non-public company are to be registered with local branches of the State Administration of Market Regulation, and the shares of a listed company are to be registered with the China Securities Depository and Clearing Corporation (CSDCC). 

Bank Account Pledge

There is no registration requirement, however, the pledgee should either control such an account or designate an agent to control the account. 

Receivables Pledge

Registration with the online registration platform of the People’s Bank of China (PBOC) is required. That is, registration with the Unified Registration and Publicity System for Movable Property Financing of the Credit Reference Centre of the PBOC (the “PBOC System”). 

IP Rights Mortgage

Registration with the China National Intellectual Property Administration is required. 

Real Property Mortgage

Registration with the real estate exchange centre in different localities is required. 

Movable Property Mortgage

Registration with the PBOC System is required.

When both the parent company (“ParentCo”, LBO loan borrower) and operating subsidiaries (“Opco”) are PRC domestic companies, there appear to be no legal constraints preventing Opcos from providing upstream security to the ParentCo. When the Opco is a joint venture with a partner outside the ParentCo group, then such upstreaming security must be approved by the shareholders’ meeting of the Opco, with the ParentCo refraining from voting. 

When the ParentCo is an offshore company and the Opcos are PRC domestic entities, the Opcos are unable to provide upstream security to the ParentCo unless they can manage to register such upstream security with SAFE as an outward security for offshore debts, which is not easily achievable, as discussed in 4.1 Typical Elements. 

The Administration Rules for a Listco Takeover provide that a listed company in the PRC is not permitted to provide financial assistance to an acquirer. 

Such restriction does not apply to non-public companies which can provide security to support the financing of an acquirer, as long as such security is property approved by the shareholders/directors. 

PRC law does not have a general corporate benefit test requirement, although, if a company is to provide security for the indebtedness of a third party, this security must be approved by the shareholders’ meeting or board meeting, pursuant to the stipulations of the articles of association of the company. 

PRC company law provides that a connected shareholder must refrain from voting on resolutions regarding the company providing security to a creditor for the benefit of such connected shareholder, to avoid the majority shareholders of a company from abusing the assets and resources of the company. 

In a typical onshore/offshore PRC acquisition financing, there are three principal methods of loan enforcement for the offshore lender. 

Option 1: Enforcement of the Offshore Security

The sale of the offshore borrower’s equity interests pursuant to the enforcement of the relevant share charge; or the sale of the PRC wholly foreign-owned entity (WFOE), which is owned by the offshore borrower pursuant to the enforcement of the equity pledge. 

Subject to the stipulations under the borrower share charge and the applicable laws in the foreign jurisdiction where the borrower is incorporated, the offshore lender typically has contractual rights under the borrower share charge to effect certain self-help remedies to sell the shares of the offshore holding company to a third party. This would be the quickest method, if the offshore lender can locate a third-party purchaser ready to close the deal. 

Option 2:  Sale of the Onshore Business/Assets in Connection With Exercising the Offshore Security

By enforcing the security over the shares in the offshore borrower (by appointment or a receiver; or, if permitted, sale to a nominee of the offshore security agent), the offshore lender can effectively control the borrower and the WFOE from offshore.   

Upon taking such control, the offshore lender can:

• initiate the onshore sale of the business/assets;
• to the extent possible, repatriate sale proceeds by way of dividend; 
• if there is a shareholder loan, the offshore lender can cause the WFOE to repay the shareholder loan in full; or 
• cause the directors of the WFOE to commence onshore liquidation and repatriate the remaining funds post the liquidation proceeding.       

Option 3: Enforcement of the Onshore Property Mortgage

Enforcement of the first-priority mortgage over onshore assets (including real property and other movable assets); and then the repayment of the onshore loan and repatriation of the sale proceeds outside the PRC to repay the offshore loan through repayment of a shareholder loan, declaration of dividends or winding-up of the WFOE. 

The attractiveness of enforcing through the property mortgage will depend on a number of factors, including:

• who benefits from the mortgage (ie, just the onshore lender or also the foreign shareholder) relative to who is initiating the enforcement process (eg, the offshore or onshore lender); and
• the degree of mortgage coverage and the likelihood of other creditors. 

Unless the onshore borrower agrees, enforcement of mortgages is a court process, which could be time-consuming. An offshore lender is unlikely to look to the mortgage as a means of enforcement if it has no or limited mortgage coverage (often the case), while an onshore lender will view mortgage enforcement as one of its primary means of enforcement. 

Under PRC law, a creditor with a mortgage over a debtor’s property may enforce its remedies under the mortgage through a consensual sale and/or a judicial sale. In each case, the creditor will have lien priority over all junior secured creditors and all unsecured creditors with respect to the proceeds of the sale of the property. 

Since sponsor deals are usually non-recourse deals, there will be no sponsor guarantees, and the typical type of guarantees will include:

• before acquisition closing, guarantees from the acquisition SPV and the intermediary holding companies underneath it; and/or
• after acquisition closing, guarantees from the target company (if not merged with the acquisition SPV) and its operating subsidiaries (or selected material subsidiaries). 

When both the ParentCo/LBO loan borrower and the Opco are PRC domestic companies, there are no legal constraints preventing the Opcos from providing upstream guarantees to the ParentCo. 

When the ParentCo is an offshore company and the Opcos are PRC domestic entities, the Opcos are unable to provide an upstream guarantee to the ParentCo unless they can manage to register such an upstream guarantee with SAFE as outward security, which is not easily achievable. 

The Administration Rules for Listco Takeover provide that a listed company in the PRC is not permitted to provide financial assistance (including a guarantee) to an acquirer.

Such restriction does not apply to non-public companies, however. Non-public companies can provide security (including a guarantee) to support the financing of acquirers as long as such security is duly approved by the shareholders/directors. 

It is not mandatory under PRC law for parties to collect guarantee fees. In the market, it is also rare that an affiliated guarantor will charge guarantee fees to another guaranteed affiliate. 

There are no enacted laws or regulations clearly recognising equitable subordination. Contractual subordination agreements between senior and junior lenders are generally recognised by PRC law. 

When the target company provides security to an acquirer within the claw-back period before filing for bankruptcy of the target company (one year before the court’s acceptance of a bankruptcy petition), then such security may be viewed as a preferential or fraudulent property transfer of the target company. The bankruptcy administrator may then decide to void such security provision and recover the property if they can prove that the property transfers were made with the intent to hide assets or the transfers of property were for less than the fair market value before bankruptcy of the target company. There are not many such precedents in PRC insolvency law practice. 

The main mitigant could be that such security creation was approved by a shareholders’ meeting of the target company with the connected shareholder refraining from voting on the same resolution. 

PRC tax authorities will generally charge each lender and borrower stamp tax of 0.05% of the committed loan amount. 

There is no such concept in the PRC.

According to the PRC Enterprise Income Tax Law, the interest expenses paid by a PRC company to its affiliates for outstanding loans not exceeding the prescribed ratio of the debt investment and equity investment from its affiliates are deductible for corporate income tax (CIT) purposes, while the interest expenses for the excess portion of loans may not be deductible.  

The prescribed ratio of debt investment and equity investment is generally 2:1, except in the case of financial enterprises, where the ratio will be changed to 5:1.  

In respect of a tender offer on a listed target, the financial adviser must conduct due diligence over the acquirer’s financial capability and source of funds. The acquirer must provide at least one of the following facilities to demonstrate its payment ability: 

• for cash consideration, the acquirer must deposit cash in an amount of no less than 20% of the total consideration with a bank designated by the CSDCC; for stock consideration, the acquirer must deposit all stock consideration with the CSDCC for custody; 
• a bank guarantee to secure the payment of the entire offer consideration; or
• joint and several undertakings from the financial adviser to pay any shortfall of purchase consideration not paid by the offeror. 

For leveraged deals where banks provide financing, the lenders can provide debt commitment to sponsors on a certain funds basis, which are on terms conforming to LMA standards. 

See 9.1 Regulated Targets. There is no regulatory guarantee concept in the PRC.

There are no other relevant acquisition finance issues in the PRC.