Is China ripe for leveraged buyouts?

Mark your calendar, this is the year for LBOs in China.
Could this be the year when leveraged buyouts (LBOs) become common place in China?

Lawyers at Paul, Hastings, Janofsky & Walker, who advise on such deals, say 2006 may be a big year for the LBO scene in the mainland.

They reckon that as foreign investors vie to put money and their expertise in Chinese companies, there is mounting interest in access to a broader range of financing options to put their plans to work. And that means LBOs are on the table.

ôIÆm hearing that there are lots of deals in the pipeline,ö says Brett King, a leveraged finance specialist and partner at Paul Hastings in Hong Kong. ôSo it's reasonable to forecast there will be about 10 significant LBO transactions, by that I mean of at least $100 million in total debt, coming out of the PRC market over the next two years.ö

Given that Paul Hastings has one of the largest full-service, multi-jurisdictional legal practices in China, with over 85 lawyers in Beijing, Shanghai and Hong Kong, the firm is in the position to hear the gossip.

Of course, how ôpureö those LBOs are remains to be seen. A leveraged buyout involves the takeover of a company, or the acquisition of a controlling interest in a company, using a significant amount of borrowed money where the target companyÆs assets often serve as collateral for the loans. It is also non-recourse debt, so the lender assumes a substantial portion of the business risk. Typically LBOs are all done on-shore, but in China, transactions that have thus far been labelled LBOs havenÆt quite fit that bill û so itÆs an evolving universe on the mainland at the moment.

King points out that JPMorgan PartnersÆ acquisition in 2004 of Sanda Kan, one of the worldÆs leading hobby train manufacturers, is commonly cited as a landmark leveraged finance deal and indeed often referred to as ôChinaÆs first LBO.ö

But while almost all of Sanda KanÆs assets were in China, it was incorporated in Hong Kong and all the debt was raised in Hong Kong under local law. Thus, critics dismiss Sanda Kan as an LBO of a Hong Kong company that had substantial PRC assets and business activities.

The Carlyle GroupÆs pending purchase of 85% of Xugong is another deal touted as ôChinaÆs first LBO,ö but rival private equity funds counter that the financiers lent money to a Cayman Islands company, which then made shareholder loans to the PRC operating entity.

In neither Sanda Kan nor Xugong did the lenders take security over the hard assets of the group that were located in the mainland. This meant the amount of leverage the sponsors could achieve was reduced, so King points out that to purists, the title of ôChinaÆs first LBOö is still up for grabs.

But smaller, less complicated deals with offshore financing may be how the LBO market in China grows. It may not be ôpureö but itÆll sort of fit the bill for now.

After all, the growth of the LBO market has traditionally been slow. In the US, the first modern leveraged buyout deal was in 1964 between two Wall Street investment bankers who acquired Orkin Exterminating Co.

There were intermittent deals over the years, with Warburg Pincus offering its first investment fund in 1971, for example, but it took until the 1980s Reagan era before LBOs were commonplace in America. The 1982 Gibson Greeting Cards LBO stands out in many industry watchersÆ minds as the landmark case, not the least for its sheer value: It was bought for $80 million and sold a year later for $280 million. While the US LBO scene arguably peaked in 1988 û with 410 transactions worth $188 billion û there were still relatively few LBOs in Europe in the 1980s.

The Internet ôboomö cooled the US LBO market in 1997, but thatÆs about when other markets took off. King says that 1999 marked AsiaÆs first true LBO transaction with the completion of the ASAT Holdings deal, in which CCMP Capital Asia (then known as J.P. Morgan Partners) acquired 50% of ASAT Holdings for $110 million. Three years later the European LBO market was roaring, but AsiaÆs was still in fledgling stages.

King says that as recently as 2002 there were only three banks with full-time dedicated LBO finance teams in the region, JPMorgan Chase Bank (which was first to set up shop in Hong Kong in 1998) Calyon and Citibank. Now he says there are as many as 15 different banks with teams dedicated to such service.

So, even if Asia follows the US model û and takes nearly 20 years to develop - weÆre underway. Proof: The number of completed Asia LBOs increased from four in 2000 to 13 in 2004 to 18 in 2005, says King.

He admits those arenÆt sweeping-you-off-your-feet numbers when compared to the US and Europe, and that other industry watchers may have different figures, depending on what transactions are considered an LBO, but his point is that the number of deals are growing.

This despite the fact that there are hurdles, particularly in the China market. ôIn China, existing secured lending laws do not yet allow lenders to structure LBO transactions in the manner that would be typically used in US or European transactions," he says. "ItÆs unclear if a PRC borrower can grant a lien in some types of assets.

"Moreover, because ChinaÆs lending laws are relatively new, there are few hard precedents governing the procedure for the foreclosure of assets. In addition, current laws generally prohibit PRC companies from guaranteeing the debt of their offshore shareholders. Banks therefore find it difficult to fund a potential acquirer at a level that would qualify in the West as a true æleveraged buyoutÆ."

In short, points out his colleague Maurice Hoo, a partner focusing on private equity, it not only takes time to do a deal in China, thereÆs a high level of uncertainty about such deals.

Which begs the question (again): Why be bullish on China? There are advantages. PRC tax laws are relatively straightforward, marginal rates are comparatively low and foreign investors are often entitled to tax holidays. Most importantly, sponsors have dedicated funds and want to do deals, and the competitive lending environment in Hong Kong means thereÆs ample liquidity for PRC transactions. And with foreign banks expecting increasing flexibility and more capacity to lend on the mainland thanks to regulatory reforms that should be made to live up to the WTO agreement, the prospects for LBOs in the mainland should increase as well.

So keep your eye out for the deals - they're due to land this year.
¬ Haymarket Media Limited. All rights reserved.