Merrill Lynch completes pre-IPO CB for Chinese water utility firm

Terms on the $150 million convertible for Golden State Environment set to ensure IPO happens in the second half of 2008.
Joining a growing trend within pre-IPO financing, Golden State Environment Group has raised $150 million from a convertible bond to pay for its continued expansion before going public in 2008.

The China-based company is in the business of water supply and waste treatment and is one of the few players who has been participating in the governmentÆs privatisation efforts in more than one city.

The CB, which was arranged by Merrill Lynch and sold through a private placement, has elements similar to a private equity investment in that the investor group will get board representation, but contrary to an equity investment the bondholders wonÆt have any significant influence over the operations or the management, making it a more attractive financing option for a company which already has a clear business plan.

At the same time, there is a natural demand from investors looking for alternative high return investments, which suggests that the pre-IPO CB trend, which has counted three deals in the past seven months, is likely to continue.

ôWhat we are seeing at the moment is that hedge funds are moving away from the traditional CB business and private equity firms are moving away from transactions where they need to own the whole thing and control it. These deals fall into the territory in the middle where these investors meet,ö says a member of the Merrill Lynch equity-linked team.

For Merrill Lynch, at least, these type of highly structured transactions are becoming a substantial part of its CB business and the bank is currently expecting to close another two pre-IPO CBs over the next six weeks, both of which will be bigger than Golden State which currently ranks as the largest such deal out of China.

Golden State is one of the most recognised environmental services companies in China and has been providing various services within project management, engineering, design, maintenance and operations, to water supply and waste treatment facilities owned and operated by local governments for 18 years. It still gets the bulk of its revenues from this division.

However, since the government started to privatise its water utilities in 2002, the company has also successfully bid for ôa handfulö of concessions for water supply and waste treatment facilities in various regions, including Beijing, Shanghai and the Jiangsu province. The aim is to grow this side of the business by securing more such projects.

ôThe purpose of this financing is to give them the firepower to go and make these bids,ö says the Merrill source.

The contracts are typically awarded on a Build Operate Transfer or a Transfer Operate Transfer basis with concessions lasting between 25 and 40 years and an initially allowed return of about 12-15%. Of the projects it has already secured, most are still in the building state but are scheduled to be operational by the time the company goes public.

The convertibles have a seven year maturity and carry several features that will work as an incentive for the company to complete the IPO according to plan in the second half of 2008. At that time the CB investors will have the option to convert into shares or hold on to the bonds and convert at a later date.

The conversion discount will depend on the level of the IPO price, but will be set in accordance with one of two possible options.

The most likely scenario is that the CB holders will be converting into a number of shares that will give them a bit less than half of the companyÆs total equity. The conversion price for doing that has already been fixed, but wasnÆt disclosed, and since the IPO price is not decided yet the potential discount will remain unknown until the time of the listing.

Under the other scenario, which will kick in only if it results in a lower conversion price than the first option, investors will be able to convert at a 25% discount to the IPO price.

ôThe conversion at the fixed price is what we expect will happen. If things donÆt work so well, the 25% discount is a sort of consolation price,ö the Merrill source says. ôInvestors would then have the ability to sell the shares after the IPO and while they wonÆt necessarily get the IPO price, they will likely get a higher price than that at which they have converted and will be able to make some extra money at that point.ö

ôThis is a company at the early stages in its business life with huge expansion plans û I would say there is quite a lot of risk. If the business plans donÆt work out, investors here would be taking a lot more risks than they would in a conventional public convertible bond,ö he adds with regard to the deep discount.

The bonds have a 6% annual cash coupon, which will step up to 9% if the IPO hasnÆt happened by the end of 2008. It will be reduced to 6% again after the listing, if it does go ahead at a later date.

After 3.5 years and at every six month anniversary after that up until the fifth one, investors have the option to put the CB back to the issuer. Again, if the IPO hasnÆt taken place by then, the investor will receive a return that will equal a 5% annual yield on top of the 6% cash coupon. Similarly, if Golden State is still a private company by the time the bonds mature, there will be a premium redemption that will also translate into an annual yield of 5%. If the IPO has taken place, the bonds will be redeemed at par.

The bonds, which had been in the making since about mid-March, were bought by five investors, which included financial institutions, hedge funds and private equity firms. Merrill Lynch declined to comment on whether the bank itself was among those investors, but over the past year it has invested in other transactions of this type, making it a real possibility it did this time too.

Because of their board representation the investors are expected to be working closely with the company over the next couple of years before the IPO but as far as their rights go, those are mainly to do with the right to receive information. They will also have a seat on the audit and finance committees.

This will be crucial since they would want to know how their money is being spent by this relatively young (in terms of the asset business) and rapidly growing company. However, aside from the usual bond covenants, there is no sense in which this investor group control the company, and they wonÆt have any shareholders votes or vetoes as would have been the case if the company had opted for a private equity investment instead, Merrill Lynch noted.

For the investment banks involved, part of the attraction of these highly structured deals is that they generate higher fees than traditional CBs û typically no less than 3% but it could even go above 4% as they require more work to ensure investors are comfortable with the risk and feel they are getting adequate compensation to take it on.

In addition, they help build the future IPO pipeline for these banks as it is seen highly likely, although no guarantee, that they will also get mandated for the IPO after completing the pre-listing financing.

Merrill Lynch and JPMorgan has so far been the most visibly active investment banks when it comes to pre-IPO CBs with Merrill having done a $151 million deal for Indonesian specialty chemicals group PT Sulfindo in December last year and JPMorgan having arranged a $130 million offer for property developer Greentown China Holdings in January.

Greentown is currently in the market trying to raise up to $413 million from an IPO led by JPMorgan and UBS. The company will use part of the proceeds to redeem the $65 million non-mandatory conversion tranche of its pre-IPO CB. The other half of the bonds can be converted at 104% of the IPO price, starting six-months after the listing.
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