Leveraged finance review: Asia's learning curve

With LBOs expected to increase in China, domestic banks are learning the nuances of leverage financing through their offshore units

Dwindling pre-IPO deals; undervalued Chinese companies listed on foreign exchanges; entrepreneurs/owners facing succession issues … These are among the likely factors behind what some believe will be a gradual but inevitable increase in buyout deals in China.

The data shows that since 2009, China has averaged about nine domestic LBOs annually, and the total value has actually been declining. Last year, eight such deals were completed, with a total value of $226 million – down from $511 million the previous year and $910 million in 2010, according to Thomson Reuters data. 
This year, sources believe, LBO activity may increase. “China is going through a fundamental structural turn and pre-IPO investments just can’t get the returns [anymore],” says Eric Xin, managing director of CITIC Capital. “Buyouts will be the norm rather than the exception in four to five years.”

China’s largest ever LBO, the $3.7 billion take-private of US-listed Focus Media, may be the start of this. In late 2012, The Carlyle Group, FountainVest Partners and CITIC Capital acquired a majority shareholding in the business, which had been accused of overstating its assets by research firm Muddy Waters (and seen its share price suffer as a result). 

There was also a succession issue, according to industry sources: the founder was near retirement age and had no family members interested in taking the reins. Selling out to a trade buyer would have reduced him from boss to employee, so he opted to give up a majority stake to private equity while retaining a 40 percent holding.

Lenders for the Focus Media deal included the offshore divisions of China Development Bank, China Minsheng Bank and the Industrial & Commercial Bank of China (ICBC) alongside Western banks, a source close to the deal confirmed. 

Due to regulatory constraints, the PRC’s domestic banks don’t provide leverage to private equity deals at home, but work through their offshore units. So while banks are willing to lend, leverage for a China deal can be smaller and harder to get than in more mature markets.

“Generally speaking, sponsors have been able to obtain [leverage] of up to 3.5x EBITDA for offshore holdco loan structures,” explains Lyndon Hsu, head of leveraged and acquisition finance in Asia Pacific at HSBC. That’s lower than in Western markets, where 4x-5x is standard.

A main reason is that in China, offshore debt has to be serviced through dividends rather than directly from company cash flow.

“Leverage is largely restricted by the target company’s ability to lawfully pay dividends from retained earnings and then expatriate those to service offshore holdco loans,” Hsu adds. Dividends are also subject to withholding tax and other regulatory hurdles (for instance when VIE structures are used), which could make leverage financing more difficult to obtain for China-based LBOs.

However, banks are eager to lend to China deals – and the Chinese banks are also getting more aggressive, according to one China-focused GP. For example, to finance last year’s private equity-led $7.6 billion buyback of Alibaba’s shares from Yahoo, the offshore arm of CDB provided $2 billion in debt, while ICBC is said to have hired a whole financing team from Bank of America Merrill Lynch in Hong Kong.

“Acquisition finance in Asia has not been very developed in comparison with North American and European markets,” adds Weijian Shan, chairman and chief executive of PAG, which runs a China buyout fund. “Today, it has become much more available – largely because banks are more familiar with this particular product and are willing to [lend].” ?