New M&A financing rules amid the financial crisis

SCOPE OF PERMITTED M&A LOANS

The Guidelines apply to the acquisition of existing equity interest, the subscription of increased capital or the purchase of assets or assumption of existing debts for the purposes of either merger and acquisition or controlling an established, continually operating target company.

Although not entirely clear, it appears that loans cannot be made to acquire minority stakes in a company. The Guidelines do not seem to apply to financing new business operations. Also, it remains to be tested as to whether takeovers of listed A-share companies could be financed under the Guidelines.

LENDER REQUIREMENTS

M&A loans may only be provided by commercial banks established in China: a qualified bank shall be a duly registered and validly existing PRC legal person. This includes domestic commercial banks, local subsidiaries of foreign banks and joint-venture commercial banks, but excludes PRC branches of foreign banks.

Under the Guidelines, no separate approval or licence is required by a commercial bank before it undertakes M&A lending but the bank must have:

• a well-established risk management and effective internal control system;

• special loan-loss reserve of no less than 100%;

• capital adequacy ratio of 10% or higher;

• general reserve balance of no less than 1% of the total loans outstanding for the same period; and

• a professional team with experience in due diligence and risk assessment on M&A loans.

BORROWER REQUIREMENTS

M&A loans can only be extended to a “domestic enterprise” or its wholly-owned or majority-holding “subsidiary” that is established specifically for merger or acquisition purposes and is not expected to engage in other business.

The extent of “domestic enterprises”, technically speaking, shall include any foreign invested enterprise (FIE), comprising joint ventures and wholly foreign-owned enterprises. However, the requirement under the Guidelines to obtain approval from relevant governmental authorities and to comply with M&A and other rules may bring an obstacle to FIEs in obtaining M&A financing. It is further required that “either 'industry nexus' or 'strategy nexus' must emerge between the acquirer and the target. And an acquirer must be able to improve its core competitiveness through the proposed transaction by acquiring strategic resources such as R&D capability, key technology and techniques, trademarks, royalty rights and, supply and distribution networks.” This leads to an uncertainty as to whether foreign invested holding companies and private equity funds could benefit from the Guidelines.

It is not yet clear whether the “subsidiary” extends to an offshore special-purpose company. If it does, the Guidelines will have a greater-than-expected effect on stimulating the revival of round-tripping investments by means of acquisition and the use of tax-haven vehicles in domestic and offshore acquisitions.

LENDING REQUIREMENTS

The Guidelines emphasise that M&A financing is a special form of financing and therefore requires a much closer risk assessment and greater due diligence.

As provided in Article 8 of the Guidelines, in determining whether or not to extend an M&A loan, banks are required to use a financial model to evaluate potential risks (including strategic, legal and compliance, integration, operating and financial risks) and to the extent that any cross-border transactions are involved in an M&A loan, country-specific, foreign exchange-rate and fund-transiting risks shall also be analysed.

CBRC requires that, for commercial banks providing M&A loans:

• the loan shall not exceed 50% of the total funds sourced for merger or acquisition;

• all the outstanding loans extended to a single borrower in a period shall not exceed 5% of the bank's net core capital during the same period;

• the term of an M&A loan shall not exceed five years; and

• the borrower should provide adequate security for the loan, such as mortgage over assets, pledge over shares, or third party guarantees.

The Guidelines also welcome complex documentation to govern M&A loans, which may include obligations posed on the borrower of financial covenants, mandatory prepayment with excess cash flow, change of control, restrictions on substantial asset disposal and so on. It is expected that this will lead to more sophisticated financing documents.

CONCLUSION

The Guidelines are noteworthy for breaking through the prohibition of M&A financing posed since the promulgation of the Lending General Provisions in 1996 and will theoretically facilitate the domestic M&A market. However, given the strict requirements of extensive risk assessment and due diligence exercise, it remains to be seen how the banks will implement the new rules and whether the benefits of the Guidelines will promote M&A transactions in practice.