Contributed By Fangda Partners
Acquisition finance in the Chinese mainland market began in 2008. In this year the China Banking Regulatory Commission (CBRC*) officially issued the Guidelines for the Risk Management of Merger and Acquisition Loans Granted by Commercial Banks, which created exceptions to the provisions in the General Rules for Loans (effective as of 1 August 1996) that bank loans cannot be used for equity investments, thereby enabling PRC banks to fund equity acquisitions via bank loans. (*Please note: in 2018, the CBRC was reorganised as the China Banking and Insurance Regulatory Commission, the CBIRC.)
Since that time, PRC local banks have become the protagonists in the PRC acquisition financing market, and China's five state-owned banks (Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China, Bank of Communications and Bank of China) and PRC joint-stock banks (such as China Merchants Bank, Shanghai Pudong Development Bank, China Citic Bank, China Industrial Bank, etc) are now major lender-side players. In addition, some foreign-funded banks (such as Hong Kong and Shanghai Banking Corporation, Development Bank of Singapore, Standard Chartered Bank, Citi bank) also take part in the PRC acquisition financing market.
In addition, after the PRC Free Trade Zone Policy was promulgated in 2013, PRC local banks can provide acquisition financing to offshore borrowers via the FTA account; previously, most PRC local banks could only participate in the offshore M&A financing markets via its offshore branches. Since then, PRC local banks have actively taken part in the offshore acquisition financing market and participated in a series of high-profile privatisation deals and large M&A deals. Among these banks, joint-stock banks (such as China Merchants Bank, Shanghai Pudong Development Bank and China Citic Bank) are extremely important players.
To be specific, the offshore financing provided by PRC local banks is made via free trade account arrangement where the borrower opens a free trade account (FTN account) with the PRC local bank. An FTN account is allowed to be established pursuant to the Free Trade Area policies, and such account is available to all offshore companies and companies incorporated in the Free Trade Area to be opened with PRC banks’ branches incorporated in the Free Trade Area. In particular, the FTN account opened by an offshore company is regarded as an offshore account under the SAFE regulatory regime and is not subject to PRC foreign exchange control. Once the loan provided by a local PRC bank is utilised, loan proceeds in the FTN account can be freely transferred to any offshore account of the borrower or any other person without any SAFE examination or approval. In other words, the loan proceeds disbursed into the FTN Account can be treated like any loan proceeds disbursed under offshore loans. Also, the loan can be disbursed in CNY/USD/EUR per borrower's request.
In summary, although the PRC local bank provides the loan from its onshore branch, the loan itself can essentially be treated as an offshore loan. Another benefit is that all collaterals provided for such an FTN account loan are not subject to any prior review/registration/approval of SAFE according to current SAFE regulations, which will make such an FTN account loan an optimal solution for both lenders and borrowers compared to other types of onshore and/or offshore loans. There are many high-profile cross-border acquisition deals that have been completed successfully using FTN account loan arrangement, such as the Wuxi Apptec privatisation (药明康德私有化) (USD1.2 billion), the Autohome privatisation (汽车之家私有化) (CNY5 billion), Geely Automobile’s acquisition of Mercedes-Benz (CNY7 billion), Shanghai RAAS’ acquisition of BiotestAG (EUR equivalent of CNY3 billion), Jingjiang Group’s acquisition of Plateno Hotels Group (CNY2 billion), Jingjiang Group’s acquisition of Radisson, PGIM’s acquisition of Dinghao Building, etc.
In the PRC acquisition market, PRC acquirers and buyers are accustomed to increasing leverage and reducing costs through acquisition financing. The scale of China's M&A financing increased from CNY129.5 billion in 2011 to CNY364.34 billion in 2016. Although the amount of acquisition financing has declined due to the adjustment of the overall economic environment, acquisition financing still plays an important role in China's M&A market.
In the aforementioned M&A transactions, privatisation transaction and TMT acquisition are very remarkable. From the perspective of privatisation transactions, PRC banks have participated in numerous high-profile transactions, including the following privatisations: WuXi PharmaTech, Mindray, 360, Trinasolar, E-House, Yikang Guobin, Neptune, Focus Media, Belle International.
PRC banks have also participated in numerous high-profile M&A transactions, including R&F Properties' acquisition of Wanda’s real estate, Jinjiang Group's acquisition of Platinum, Home Inns Group's acquisition of Motel 168, and CVC Capital’s acquisition of South Beauty.
According to Chinese laws and regulations, if there is no foreign-related factor in a transaction, the governing law of the transaction documents thereunder must be the PRC law. Therefore, whether it is a corporate loan or acquisition finance or LBOs, if the borrower and the lender are both PRC onshore entities and the relevant transaction takes place in the mainland of China, the governing law must be the PRC law. However, if the transaction is conducted out of the mainland of China, the borrower and the lender often choose the governing law according to the requirements of the transaction – for example, if it is a privatisation transaction in Hong Kong, Hong Kong law is usually chosen as the law of jurisdiction. Generally speaking, the most common governing laws are Hong Kong law, English law and US law, of which Hong Kong law is the most common.
PRC local banks usually use their own standard version or the version of the China Banking Association as the standard template for acquisition financing. Foreign-funded banks usually use the APLMA template as the standard template for acquisition financing.
There is no requirement relating to the language used in documentation. However, local PRC banks tend to choose Chinese (Mandarin) as the language of documentation.
Usually, lawyers are required to issue legal opinions in respect of the financing transactions to lenders. The following legal opinions are usually included: (i) status; (ii) due authorisation of each obligor; (iii) execution; (iv) legal, valid, binding and enforceable obligations; (v) filings, registrations or consents; (vi) choice of law and (vii) enforcement.
It is worth mentioning that PRC local banks often have their own independent risk control measures established, based on the law and the requirements of the CBIRC – in other words, they do not only rely on legal opinions issued by lawyers to rule out risks. For example, PRC local banks often require: (i) witnessing (even photographing) the client's signature of the authorisation documents and financing documents; (ii) verifying the original documents of the borrower’s certificates, and so on.
In addition, PRC local banks often ask lawyers to comment on the compliance of mergers and acquisitions transactions, especially in cross-border or offshore transactions.
According to the relevant PRC laws and regulations, the financing funds provided by banks must not exceed 60% of the total acquisition consideration. Therefore, in practice, an acquirer needs to raise the remaining 40% of the total acquisition consideration in a variety of ways.
In order to briefly describe the typical financing structure in the PRC M&A market, we generalise an acquirer group from the upper to the lower levels into a four-tier structure: sponsor, holdco, parent and bidco.
The acquirer group usually takes out the aforementioned bank loan which equals to 60% of the total acquisition consideration at the bidco level – it is also usually the most important M&A financing or leverage in the PRC market. Usually, such structure is also required by the bank to achieve a goal that the loan funds are closer to the target and the source of the repayment. The parent company will usually provide a guarantee in favour of the bank under this structure and the securities mentioned below will be provided to secure such a bank loan.
The acquirer group usually does not seek debt financing at the sponsor level and are more inclined to use their own equity funds to establish a sponsor entity to achieve risk isolation. However, in practice, some of the acquirer groups are financing at the sponsor level through the form of debt in the name of equity (明股实债). The funds raised by the sponsors will be injected into holdco through shareholder loans or equity investments.
Acquirer groups usually raise mezzanine financing at the holdco company level. Common mezzanine financing methods include trust funds, asset management products and bank loans. However, since financing banks often require confirmation of 40% of the source of M&A funds, the funds of trusts and asset management products often need to be injected through the form of debt in the name of equity (明股实债) for compliance purpose. In recent years, China's regulatory authorities are strictly monitoring and regulating the investment methods of debt in the name of equity, so the funds of the trust and asset management products that have flourished in the past are gradually shrinking.
The acquirer group usually raises bridge loans at the parent company or bidco company level. This part of the bridge capital is often part of the acquisition loan provided by the bank, but considering the short period and amount of the bridge funds, the bank can usually provide more favourable prices and other preferential conditions.
In the case that the acquirer meets certain qualifications, such acquirer can also raise funds through the issuance of capital market bonds. To do so, the acquirer needs to explain the use of the relevant bonds, risk control mechanism and securities provided in accordance with the relevant PRC laws and regulations to raise funds. The issuance of bonds requires approval of the relevant approval authority.
According to current PRC laws and regulations, private equity funds need to be filed with the China Fund Industry Association. Private equity funds usually participate in mergers and acquisitions at the sponsor level and become the initiators or co-participants of such merger.
In the domestic M&A financing market, there is generally no intercreditor agreement that will be entered into by relevant parties. Banks have an absolutely dominant position in the PRC M&A financing market, hence they are not willing to sign intercreditor agreements with other debt fund providers to share any rights or benefits. A syndication will be established if there are several banks providing loans for one acquisition deal – in this case the banks can share their rights according to the facility agreement and no intercreditor agreement is required.
However, in cross-border transactions, onshore and foreign banks often need to sign intercreditor agreement to share related security interests and co-ordinate other rights and obligations. Such intercreditor agreements typically co-ordinate three sets of relationships:
Generally speaking, since onshore banks are closer to the target and repayment resource, and often hold major onshore security interests, onshore banks will share some interests with offshore banks through an intercreditor agreement.
An intercreditor agreement will not be signed under bond issuance in China.
The relationship between onshore lenders and offshore lenders is subject to the negotiations between the two parties. Generally speaking, the following matters need to be confirmed by onshore banks and offshore banks:
Aggressive offshore lenders may require that onshore banks shall not enforce onshore securities without the offshore lenders' consent and the proceeds of the onshore securities shall be shared between the onshore lender and offshore lender – such requests are often a matter of lengthy negotiations and communication.
In the current market, if the onshore bank and the offshore bank belong to the same group, they often co-ordinate their relationship in the intercreditor agreement according to the instructions of the headquarters. If onshore banks and offshore banks do not belong to the same group, banks tend to stipulate only communication and decision-making mechanisms, while specific decisions will be discussed and agreed upon after the relevant matters occur. This approach avoids lengthy negotiations and decision-making procedures and can speed up the process of transaction.
The relationship between offshore hedging banks and offshore lenders will be negotiated and confirmed by offshore banks and offshore hedging banks, and local PRC banks often do not need to review the content. Further to the relationship between onshore and offshore borrowers' associated parties and onshore and offshore lenders, it will be stipulated in the intercreditor agreement that all amounts owed by the borrowers to these associated parties shall be subordinated to the onshore and offshore banks’ right.
Acquisition financing involving PRC local banks are often denominated in CNY – the loans provided by the banks will be denominated in CNY directly or the loan will be directly converted into foreign currency after the drawdown. This is also the method that PRC local banks tend to adopt – they have a lot of CNY but often don't have enough foreign currency. On the other hand, even if the PRC local bank participates in a financing denominated in foreign currency, the PRC local bank often hopes that the lender itself will act as a hedging provider to increase the bank's profits in the transaction. However, recently, with the volatility of the CNY exchange rate, more and more acquirers want to include hedge counterparties in the loan financing to avoid exchange rate risk.
Subject to the relevant PRC laws and regulations, the following guarantees are often used in M&A transactions:
Please note: an account cannot be pledged as accruing to the PRC law, but the cash therein can be pledged in favour of the banks.
In practice, in addition to real estate mortgages and cash pledges, other securities are all applicable to onshore banks and offshore banks. In the case of real estate mortgages, offshore banks may not be able to register as mortgagees in the real estate registration department; in the case of cash pledges, offshore banks often need to designate a domestic bank as an account bank to meet the PRC law requirements for cash pledge.
In terms of the requirements for security perfection, the mortgage of real estate needs to be registered in the real estate registration department in advance; the pledge of accounts receivable needs to be registered in the registration system established by the People's Bank of China (PBOC); the equity pledge needs to be registered in the State Administration for Market Regulation (SAMR); the mortgage of movable assets needs to be registered in the registration system established by the SAMR; trade mark pledges need to be registered in the SAMR.
There is no special form requirement for security agreement in China. However, subject to local practice, for the purpose of perfection and registration, the registration authority may raise certain requirements on the content of the agreement – for example, having a schedule setting out the basic elements of the security.
Upstream security is allowed under PRC law. An upstream security may be subject to the following.
Firstly, shareholder resolutions with the concerned shareholders excluded from voting.
Secondly, in addition, an upstream security may constitute certain type of cross-border security that triggers foreign exchange controls. For example, if the upstream guarantee constitutes a Nei Bao Wai Dai transaction – a transaction where the obligor (ie, the borrower) and creditor (ie, the lender) are both non-PRC entities and the security provider/guarantor is a PRC entity – the security provider shall register the security with the State Administration of Foreign Exchange (SAFE) within 15 business days after execution of the security agreement. Failure to complete the registration will not affect the validity of the security agreement, but may prohibit subsequent repatriation of funds out of China upon enforcement of the security.
There is no clear definition of "financial assistance" under PRC law; the concept of financial assistance only applies to public companies. There is no particular prohibition on private companies providing financial assistance.
For public companies, the current rules prohibit the provision of financial assistance by a public company (whether listed in the PRC or listed offshore) to the investors who subscribe the securities or acquire the shares issued by such public company. Therefore, the provision of guarantee, security or loan by a listed target company to the acquirer may be prohibited.
For private companies, financial assistance is permitted. It is worth noting that when the company is providing guarantee or security for a shareholder or a third party who has control over the company, the granting of that security must be authorised by shareholder resolution; any interested shareholders must be excluded from voting.
There is no corporate benefit test under PRC law. Accordingly, the fact that no sufficient benefit can be demonstrated is not a reason to deny the validity of a security so long as the granting of the security complies with the applicable PRC law and the articles of association of the security provider.
According to the PRC Company Law, if a PRC company provides security for a third party, it shall, in accordance with its articles of association, pass a board resolution and/or shareholders' resolution to approve such security. If the articles of association set an amount limit or other restrictions on providing security, the company must follow such restrictions. Moreover, if a company provides “upstream security” for its actual controller, such security shall be approved by the disinterested shareholder(s) of the company.
There may also be some practical restrictions – for example, a foreign lender is not prohibited by PRC law to hold security over real estate. However, as a practical matter, some local real estate registration authorities may refuse to register a real estate mortgage in favour of a foreign entity (regardless of whether it is a bank, a non-bank financial institution, or another types of entity), which leads to the mortgage not being effective.
PRC law provides that a security interest would become enforceable when an obligor fails to perform the secured obligation, or upon the occurrence of other triggering events as agreed between the parties.
With the co-operation from the security provider, a lender may have out-of-court enforcement in respect of the security (including a conversion into value/title transfer, auction or sale – “consensual enforcement”). If the security provider is not willing to co-operate, the lender may file a lawsuit before the PRC court or submit the dispute to an arbitration tribunal, as provided in the relevant security documents, to enforce its security interest (“court-assisted enforcement”).
The consensual enforcement requires the co-operation of the security provider and may take the form of auction, private sale and conversion into value.
Auction or private sale
The lender will need to reach an agreement with, or obtain consent from, the security provider to dispose of the collaterals through an auction house or by private sale to a third party. If the auction/sale proceeds exceed the secured debts, the surplus shall be returned to security provider; if the auction/sale proceeds are less than the secured debts, the deficit shall be made up by the relevant obligors of such secured debt.
Conversion into value
As an alternative option, the lender may reach an agreement with, or obtain consent from, the security provider to transfer the collaterals to the lender to discharge the secured debts to the extent of the agreed transfer price.
The agreement with, or obtaining consent from, the security provider for purpose of auction, private sale and conversion into value shall be made at time of enforcing the relevant collaterals. An upfront agreement with, or consent from, the security provider at the time of signing the security agreement would be void and not enforceable due to the restriction under the PRC Property Law.
Summary proceeding for security enforcement
Different from the traditional approach of “suing and enforcement”, PRC law provides for a special procedure for security enforcement, which is a single-instance process that aims to achieve a prompt realisation of security. It is available only when parties are not able to reach consensus regarding the approach of security enforcement but do not dispute the existence and amount of the secured debts, the validity and enforceability of security, etc. Consequently, the courts are not supposed to review the merits of the case before granting order to enforce security. The lender can apply to the competent PRC court for such special procedures without any upfront litigation.
A more common court-assisted enforcement for the collateral is through litigation and enforcement of court judgment.
The PRC judicial system adopts a two-instance approach for court trial proceeding (ie, a first instance hearing and an appeal). Accordingly, the lender would take the following steps to enforce the security:
Unlike the express time limit for first instance process and second instance process in relation to a domestic lawsuit, there is no statutory time limit for a foreign-related lawsuit. Though the court would not deliberately act more slowly in a foreign-related proceeding, a number of technical issues (such as serving documents to a foreign address, translation works, etc) may make the process longer than an ordinary domestic court proceeding.
Once a final and effective judgment has been rendered, the court with competent jurisdiction will accept the application for enforcement made by the lender if (i) the obligor fails to perform its obligations under the judgment, and (ii) the application for enforcement is made within the statutory time limit (normally within two years from the performance deadline stated in the judgment).
The PRC court may, at its discretion, order a public auction or private sale when disposing of the collateralised assets. In practice, the PRC court is more likely to opt for a public auction. The public auction will generally consist of no more than three rounds (or two rounds if auctioned through an internet platform) of bidding and the court must order the next round of auction within 60 days if a prior auction fails.
If the auction has failed three times (or two times if auctioned through an internet platform) and the lender is unwilling to take title to the collaterals to offset its claim, the court may announce a private sale. If the private sale still fails and the lender is unwilling to take title to the collaterals to offset its claim, the court may release the collaterals from the court enforcement proceeding. The release will not affect the lender's security rights and, in practice, some courts would elect to continue the enforcement (through either auction or private sale) instead of releasing the collaterals from the process.
Guarantees are commonly used in acquisition finance in China. Under PRC law, there are two types of guarantees: (i) general guarantees, which cannot be enforced unless the creditor cannot get fully repayment after it has enforced the debtor’s assets; and (ii) joint liability guarantees, which can be enforced immediately after the debtor defaults. If a guarantee agreement is silent on the type of guarantee granted, it will be deemed as a joint liability guarantee.
In financing deals in China, joint liability guarantees are much more frequently used than general guarantees.
Applicable restrictions on a guarantee are the same as those on a security, specifically:
Under PRC law, there is no requirement for guarantee fees.
There are also no significant financial costs for creating a guarantee. Generally, there is no registration fees or stamp tax.
Under PRC law, there is no such concept of equitable subordination that allows bankruptcy courts to subordinate a creditor’s claim if that creditor is guilty of inequitable or wrongful conduct (eg, fraud, illegality, breach of fiduciary duties). However, in practice, there have been cases where a bankruptcy court found that a creditor was guilty of inequitable or wrongful conduct and therefore took actions similar to the concept of equitable subordination.
There is a claw-back concept under PRC Bankruptcy Law. In bankruptcy proceedings, the administrator may request the court to revoke certain conduct made by the bankrupted company within one year prior to the bankruptcy proceeding, including (i) provision of security to the creditors for any debt which was originally unsecured, and (ii) prepayment of any undue debt. In addition, certain acts shall be treated as null and void – eg, concealment or transfer of property for the purpose of avoiding debts.
In the context of acquisition financing, if the borrower goes bankrupt, certain actions taken under the financing transaction (eg, prepayment or provision of security that may be captured by the claw-back concept) may be challenged by the administrator according to the claw-back rule.
It is also worth noting that, under PRC law, once a debtor enters into bankruptcy proceedings, any enforcement process against the debtor shall be suspended, and creditors have to participate in the bankruptcy proceedings to enforce their rights. In bankruptcy proceedings, the creditors generally cannot directly dispose of the debtor’s assets; rather the creditors are required to follow the bankruptcy law, the administrator’s instruction and decisions made by creditor’s meeting in disposition and distribution of the debtor’s assets. Having said that, the bankruptcy proceedings will not cause the lender's security right to fall away or become invalid, and the lender is still entitled to be repaid from the proceeds of the collaterals prior to unsecured creditors.
There is no designated secondary market to trade the debt arising out of a particular loan. However, lenders can issue securities backed by the credit assets consisting of the debts arising out of a number of loans of a number of borrowers in the national inter-bank bond market or stock exchanges, in which the qualified investors may be able to negotiate and trade such securities. The information of debts (including the name of the borrowers and the loan agreements) in the asset pool of the securities should be disclosed in detail.
Under PRC law, stamp duty is levied on legal instruments that transfer ownership of assets. Each of the transferor and the transferee is responsible to pay stamp duty which varies from 0.03% to 0.05% of the transfer consideration based on the type of assets transferred (ie, a total of 0.06% to 0.10% stamp duty payable).
In acquisition financing, each of the borrower and the lender is responsible to pay 0.05% stamp duty (calculated based on the loan amount) for the loan agreement.
There is no such concept as a qualifying lender under PRC tax law.
No withholding tax is required if the lender is an onshore financial institution or an onshore branches of offshore financial institutions. If the lenders are located outside the PRC, the payment of interest or other fees (other than the principal) to lenders is subject to withholding tax.
There is no direct reference to thin capitalisation rules under PRC law. However, rules have provided that, generally, if the ratio between debt investment and capital investment from a related/affiliate party in a company exceed 5:1 (for financial institutions) or 2:1 (for other entities), the interest payment cannot be deducted when determining the taxable income.
In addition, the requirements on the capital of foreign invested companies may also be a factor when determining the financing arrangement. If the target company will become a joint venture after the acquisition, the shareholding of the foreign investors shall be no less than 25% of the total registered capital. Furthermore, if the target company will become a foreign invested company (whether as a joint venture or a wholly foreign-owned enterprise), the registered capital and the total investment shall follow specific ratios. This restriction will limit the borrowing gaps for foreign invested companies, which may affect the financing arrangement for the whole acquisition transaction.
It is advisable to consult a tax advisor on tax-related matters.
There is no consolidated “regulated company” concept under PRC law. Under PRC law, a certain type of companies may have special requirements on the acquirers of their shares (see below for examples). There is no certain funds requirement with general applicability on these regulated companies.
Regulated Industries under Foreign Investment
If a foreign investor invests in the PRC's restricted industries (as stipulated in the Catalogue of Industries Guide for Foreign Investment), such as media, finance, or transportation, there will be certain restrictions on such acquisition – for example, the post-acquisition shareholding ratio and other aspects of the entity. The foreign investment may also be subject to a state security scrutiny check if the acquisition involves sensitive target companies or industries.
Industries Regulated by the Competent Industrial Regulatory Authorities
If the target belongs to certain regulated industries (eg, commercial banks, securities companies, insurance companies, internet service/content providers), acquisition of such regulated target may be subject to approval by the relevant industrial regulatory authorities, regardless of whether it is an acquisition by foreign investors or a purely domestic acquisition. Moreover, the industrial regulatory authorities may also require re-application of the relevant industry licences for the regulated target to continue its operation of the business after the acquisition. Certain industries such as steel, automobile, graphite, and electroplating may require approval from the National Development and Reform Commission (NDRC). The requirement on obtaining such approval is relatively stringent. Usually, the NDRC would expect to see that the projects have scale economics effects or have cutting-edge techniques. In practice, for certain industries, the NDRC has stopped approving any new project.
The various approval or licence requirements mentioned above may complicate the acquisition process. Also, in practice, it is relatively hard to get financings from onshore banks for the acquisition in regulated industries.
For acquisitions of public companies, the following applies.
The investor may acquire the shares by way of trading on exchange, transfer by agreement, tender offer, private placement or strategic investment (by foreign investor). The investor may also have assets acquisition. Different rules and different approval/report requirement may apply depending on the investor’s manner of acquisition.
There is no clear rule restricting the funding of the acquisition of the stocks of a listed company, except that the source of the funding may need to be disclosed pursuant to relevant rules. In addition, the facility supporting the acquisition from PRC commercial banks shall be in compliance with the relevant banking regulations. In practice, a fully negotiated and executed credit agreement would usually be required to be in place at the time the offer is made.