The rise of Chinese private equity

With the continued slowdown of China's annual growth rate and the primary drivers of the high growth of prior decades no longer as robust, it is no surprise that China's private equity (PE) industry is also facing a period of transition. While a large amount of so-called “dry powder” in China's PE sector (approximately US$36 billion as of 2013) is available for investment, finding attractive opportunities in China remains challenging due to too few good deals being chased by too many investors.

Although the vast majority of investments in China remain in the form of growth capital and minority investments, the changes to China's macroeconomic conditions mean that many investors are increasingly shifting their investment strategy to focus on buyouts or other forms of control deals in order to manage the strategic direction and operational challenges of the target. Moreover, as investors look to increase their investment returns, the use of acquisition finance as a source of capital is an increasingly important component of the investment models for many deals in China.

More than half of the going-private transactions involving US-listed Chinese companies completed between January 2013 and July 2014 were funded, in part, by some type of acquisition finance. For example, for the US$3.7 billion Focus Media transaction that closed in 2013, the banks provided US$1.5 billion in debt financing, and for the US$3.0 billion Giant Interactive deal that closed in July this year, the banks provided an US$850 million loan facility.

While still more commonly seen in the recent PE-sponsored privatisations of US-listed Chinese companies, acquisition finance is now being used in various other types of PE investments, in both control and minority deals, as both equity investors and financing sources look for ways to leverage each transaction.

The typical structure

The typical acquisition by a foreign PE sponsor of a controlling stake in a China business is effectuated by the acquisition of shares in the offshore holding company of the onshore group.

Figure 1 shows that the asset-holding and revenue-generating subsidiaries are typically onshore and that the offshore target is a mere holding company. In many cases, intermediate holding companies are interposed between the Target and the onshore subsidiaries.



To complete an acquisition, the PE investor will usually form a parent holding company (parent), which in turn establishes an additional holding company (bidco) to acquire the target through a direct purchase of the target's shares or through a merger. This is illustrated in Figure 2. The bidco will borrow the acquisition debt from the offshore lender (or syndicate of lenders) to partially fund the purchase price to acquire the target. If the acquisition is done through a merger, the bidco will merge with and into the target with the latter as the surviving entity so that, upon closing, the target assumes the bidco's place as the borrower for purposes of the loan.



The loan documentation between the bidco and lender will contain a customary suite of representations and warranties, mandatory prepayment events, financial covenants, information undertakings, restrictive covenants and events of default, not too dissimilar to those typically seen in leveraged acquisitions of European or US-based targets. After the PE investor gains control of the target group following the acquisition, the loan terms will also apply to the target group, both offshore and onshore.

Cross-border challenges

Under the current legal and regulatory regimes in China, there are certain challenges that offshore lenders face when providing acquisition finance for China related deals, specifically restrictions on cross-border security and guarantees, limitations on cross-border remittances of cash and foreign exchange controls.

Limitations on guarantees and security

Historically, Chinese entities have been subject to strict restrictions on cross-border guarantee and security arrangements. Onshore entities are generally not permitted to provide guarantees or security over their own assets to offshore lenders for acquisition finance. Such cross-border restrictions have been somewhat relaxed by the Provisions on Foreign Exchange Control in Connection with the Cross-border Provision of Security (Hui Fa [2014] 29) (跨境担保外汇管理规定) (Circular 29) issued by the State Administration of Foreign Exchange (SAFE) in May 2014. However, if offshore debt is used to finance the acquisition of a target group that has more than 50% of its assets in China, the cross-border outbound security arrangements do not fall within the registration guidelines of Circular 29 and still require SAFE approval, which as a practical matter, is very difficult to obtain. As a result, if a foreign sponsor wishes to access financing to complete an offshore acquisition of a China-focused business, it is often faced with the challenge of providing adequate security to the bank in support of the loan.

For example, in Figure 2, where all of the operative assets and revenue streams are held onshore by certain domestic Chinese subsidiaries of a wholly-foreign owned enterprise (WFOE), the offshore lender has traditionally faced difficulties in obtaining the required level of collateral to support the loan and, if applicable, making the deal attractive for syndication.

However, most financing sources, including offshore branches of Chinese banks, have become comfortable with a security package that consists of offshore assets only (mostly share pledges and banks accounts).

Pledge of equity interests in WFOEs or FIEs

The typical offshore security package would include a pledge of shares in the borrower by its parent, guarantees by the borrower's offshore subsidiaries and a pledge of all offshore assets (mainly banks accounts and shares of subsidiaries, including shares in the WFOE or other foreign invested entities (FIEs), as described) of the borrower and offshore guarantors.

The pledge of the equity interests in FIEs and WFOEs that are owned by the offshore borrower or guarantor requires Ministry of Commerce (MOFCOM) approval and registration with the State Administration for Industry and Commerce. These procedures are generally completed without any issues; however, due to typical timing constraints, they are usually procured after the offshore acquisition transaction closes, rather than as a pre-condition. In rare cases, the registration of a pledge may be delayed or may encounter difficulties, particularly in cases where the FIE is not a WFOE or the relevant regulatory authorities have limited experience in dealing with such pledges.

Additional onshore credit arrangements

While most security packages consist solely of assets of the offshore borrower and guarantors (including shares in WFOEs/FIEs), in certain transactions where the lenders require extra protection, they incorporate certain onshore arrangements to obtain added comfort with respect to the onshore group.

Under the current regulations, it is difficult for an offshore acquisition finance lender to directly lend to onshore companies. For instance, the offshore lender of any foreign debt to a FIE would be unable to receive the same onshore security as an onshore lender and any foreign debt incurred by a FIE would be subject to applicable foreign debt quota limitations, as well as SAFE's merit review, prior to any foreign exchange conversion. Moreover, the use of loans by offshore lenders to repay the target group's existing onshore debt is typically restricted.

In certain cases, additional debt financing at the onshore level may be required or desired, customarily for additional working capital purposes or to repay existing onshore loans. While such debt financing is not strictly a part of the underlying acquisition financing arrangements, these concurrent onshore loans would be typically lent by the onshore affiliates of the offshore lenders.

In addition, some lenders have tried to utilise their onshore affiliates to gain indirect control over the activities of the onshore group, as the interests of the offshore and onshore lender affiliates are most likely to be aligned. For instance, certain lenders have required account control agreements to be in place between the onshore lender affiliate and the WFOE or a revenue generating subsidiary. Although the offshore lender does not have any direct legal right of access to the funds in the relevant onshore accounts, such account control arrangements effectively serve as a way to mitigate the risk that onshore cash may be misused or misappropriated. While such types of additional onshore credit support are not common in all deals, they are sometimes used to help bridge the offshore and onshore gap in financings.

Debt service obligations

In addition to the foregoing challenges related to cross-border security arrangements, another major structuring issue facing PE investors and financing sources is ensuring that the debt can be properly serviced and repaid in the future, particularly due to legal restrictions on cross-border remittances from onshore subsidiaries to offshore parent shareholders.

In order to service and repay the offshore loan, the revenues and cash generated onshore need to be remitted to the offshore borrower, generally, by way of dividend distribution (and occasionally by repayment of existing shareholder loans).

Pursuant to applicable SAFE regulations, a FIE may only declare and pay dividends to its shareholders out of retained earnings less any required reserves and amounts required to make up for the losses of any previous years. This means there may be circumstances where the onshore subsidiaries of an offshore borrower have sufficient cash resources to service the debt, but are unable to move the funds offshore by way of dividends due to insufficient distributable reserves – thereby increasing the risk of default by the offshore borrower.

Furthermore, the dividends are ordinarily subject to a 10% withholding tax (unless a lower rate is available pursuant to a tax treaty or arrangement between China and the home jurisdiction of the parent shareholder). Under applicable SAFE rules, banks in China are required to review various documents, including relevant tax clearance filings and corporate resolutions, prior to any cross-border remittance of dividends. While recent SAFE rules promulgated in February 2014 have simplified the document submission procedures, the general limitations and restrictions with respect to dividend payments still remain an issue.

In light of the above, various methods have been used to mitigate the risk of funds not being available offshore for debt service on a timely basis.

Debt service reserve amounts

Loan agreements often contain a covenant that requires the offshore borrower to maintain the reserve amount in a blocked offshore account charged in favour of the lender. The actual amount (referred to as the debt service reserve amount) will depend on many factors, including the expected dividend capacity and timing of such dividends. PE investors and the banks will often work together to model the dividend schedule and debt service in order to minimise the risk of a default solely due to timing issues related to remittances of cash offshore.

Trapped cash

In addition, as with many cross-border financings globally, the banks may require that what is called “trapped cash” (onshore funds which may not be distributed offshore for the time being due to insufficient distributable reserves or otherwise) be paid into specified or blocked onshore holding accounts until the funds may be lawfully distributed offshore. These trapped amounts are typically held in accounts of the onshore affiliates of the offshore lender to maximise the lender's control over these funds. Parties will need to negotiate the necessity and the level of flexibility of these accounts.

The future of acquisition finance

China's regulatory regime still poses certain challenges to both PE investors and lenders looking to tap into the acquisition finance market. The most common problems are providing lenders with adequate security in support of the loan and moving onshore funds to the offshore borrower to service the loan. Although Chinese regulations are unlikely to be revolutionised in the short term to enable the China market to become as facilitative as those of Europe and the US, recent SAFE reforms, coupled with structures designed to reduce certain regulatory and other risks associated with acquisition financing, are continuing to open the doors for investors and lenders, both domestic and foreign.

Considering the appeal of acquisition finance, as it allows investors to leverage their capital as well as raise the internal rates of return and also provides lenders with potential returns that are often significantly higher than traditional corporate loans, we expect the China acquisition finance market to continue to develop and mature, as shown by the increased number of leveraged acquisitions in recent months. In addition, as the market becomes more familiar with workable acquisition financing structures and competition increases among financing sources, the terms of borrowing are likely to become even more flexible for PE investors and more closely aligned to those available to them in Europe and the US.


Anthony Wang and Soo-Jin Shim, Weil Gotshal & Manges, Hong Kong