LBOs in Asia: too much optimism?

Paul Hastings partner, Brett King, provides a legal perspective on why growth of LBOs in the region will be consistent but not exponential.
As a lawyer, Brett King has worked on leveraged buy-outs (LBOs) throughout his career in Hong Kong, first at Milbank, Tweed and now at Paul, Hastings, Janofsky & Walker.

How would you term the growth in AsiaÆs LBO market?
The number and volume of LBOs in Asia are steadily growing but bear in mind that this is from a very small base. Asia witnessed its first US-style LBO in 1999, which was the buy-out of ASAT Holdings, a Hong Kong manufacturer. This was followed by the LBO of Korean auto parts manufacturer, Mando Corporation, which was KoreaÆs first leveraged buy-out, so the LBO market in Asia is still very strong.

The ASAT transaction was easy to structure within the prevailing legal system, while the LBO in Korea was more challenging due to local law restrictions. Since then LBOs in Asia (ex Japan and Australia) have grown slowly but consistently from 2-3 per annum to currently maybe 20 to 25 per annum, depending on how one defines a ôleveraged buy-outö.

Which Asian geographies provide the best legal framework within which to structure LBOs?
Japan is the easiest jurisdiction by far, followed by Hong Kong and Singapore. Laws in these countries facilitate structured and leveraged financing. Taiwan is not too far behind.

India is probably the most difficult û due to a variety of legal restrictions, including rules on external commercial borrowings û followed by China. In both China and India there are so many restrictions on onshore leveraged lending that using a traditional LBO structure is impossible. The only way to obtain leveraged finance in this case is for banks and sponsors to use an offshore holding company structure. This is not a desirable situation for senior lenders, because in an insolvency situation being in an offshore holding company is the least attractive location for a creditor. In the worst case in insolvency situations, offshore lenders donÆt even have a seat at the table to discuss the workout. Holdco structures therefore increase the risks in LBOs, but they are the only way to complete a LBO in places like China and India.

Also, LBOs are best suited to large, mature companies which are in the cash generating stage of growth. In India and China companies are more at the stage of needing growth capital. Very few Chinese and Indian companies use LBO structures. LBOs put a premium on capital allocation and are hence preferred by financial sponsors. LBOs donÆt find much favour with strategics either.

What regulation is required to make this market more conducive to LBOs?
So many Asian jurisdictions are seeking to be a financial centre to rival New York or London, but few have the legal infrastructure that is required. What is needed is for Asian jurisdictions to put in place the right legal regulatory framework û such as modern secured lending laws, corporate laws, trust laws, partnership laws, etc. Places like New York and Delaware revise their laws regularly to ensure they are facilitating transactions and adapting to modern financing needs. Even the UK cannot claim to be as current as NY and Delaware in this respect, although they are working on updating many of the English laws that relate to financing and are making good progress.

Most Asian jurisdictions in this respect are years or even decades behind in updating their corporate finance laws. Hong Kong would be well served to update its corporate finance laws much more frequently. This would be very beneficial to attract investment and make Hong Kong a more attractive jurisdiction as a finance centre.

IÆm not sure regulators and lawmakers in Asia realize how much of an impediment out-of-date corporate finance laws can be. As one example look at China û most investment bankers would be able to tell you a number of deals that could not be pursued because the current legal structure made financing the transaction impossible.

India is still operating under the much of the same corporate and legal code the British bequeathed to it û which is now generally considered outdated. The India Companies Act has not had a full scale revision since 1956.

All this combines to put a cap on the number of deals that can be completed. Therefore we tend to have less deals and a different kind of deals in Asia with 20-25 LBOs closing per annum û the weekly number of closed transactions in a developed markets such as USA.

What specific events could trigger an increase in defaults?
Overall default rates are at an all time low due to economies and business doing well. The risks will become more apparent if there is an economic downturn and business conditions deteriorate. In that situation, it may turn out that a lot of paper sold in Asia was mis-priced, but of course only time will tell.

The hope and expectation in the private equity market is that returns will stay quite high and sponsors will stay disciplined. This seems possible in Asia û for example in an economy like China which is growing at 8-10% GDP growth year on year, there should be a continual flow of opportunities to make money at superior returns.

History is not kind to investors who are aggressive buyers at the top of a credit cycle.

What else is required to spur growth?
In mature markets, LBO debt is freely tradeable, where as currently in Asia there is only a very small secondary market for sub-investment grade debt. This is changing but slowly. There are very few institutional investors in Asia, so most debt is purchased by commercial banks. There are few CDOs, insurance companies or pension funds willing to pick up this type of paper.

What are your views on the new covenant-lite structures?
ItÆs hard to say whether covenant-lite structures will migrate to Asia, given the unique aspects of this market, although historically trends in the USA and European finance markets have often their way to Asia eventually.

In Asia, this is difficult to replicate within less developed legal frameworks. Covenant-lite structures obviously offer better terms for the borrower but banks become more sensitive to tenor and pricing if the deal is covenant-lite.

How would you sum up the market?
Overall, I am optimistic on the market but feel there may be too much optimism right now and growth could take longer than people are predicting. Three years ago LBOs were not on the radar screen in Asia. Today post a publicity blitz everyone is talking about them. We think the market is growing consistently but not exponentially.

This is actually quite similar to Europe û the market there took almost 15 years to take off. There is more money than deals right now and IÆd say it will take at least 5-10 years for that to change.
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