Tianjin Binhai New Area Construction & Investment Group Co. Ltd. (BHCI) has become the first local government financing vehicle (LGFV) in China to seek the consent of offshore bondholders to waiver a “technical breach of covenant. S&P Global Ratings explores the matter, noting that BHCI could have avoided this situation if it had taken a more proactive approach to covenant management.
Which notes are BHCI requesting consent to amend?
On May 26, 2017, BHCI announced that it had solicited consent from all noteholders concerning two tranches of the senior unsecured notes issued by Zhaohai Investment (BVI) Ltd.: (1) US$300 million notes due 2018; and (2) US$500 million notes due 2020. Both notes were guaranteed by BHCI's wholly owned subsidiary Binhai Jiantou (Hong Kong) Development Ltd. (Binhai HK: BBB+/Stable/--; cnA+/--) and supported by BHCI under a keepwell deed and an equity interest purchase undertaking (EIPU) agreement.
How did the "technical breach" occur?
Binhai HK's consolidated net worth and its aggregate total owners' equity became deeply negative as of the end of 2016, breaching the financial covenants under the notes. The covenants require these two items to be at least US$1.00 and HK$10 million, respectively, at all times.
Volatility in the renminbi was the underlying cause. During the 18 months to the end of 2016, the renminbi depreciated more than 10% against the U.S. dollar and Hong Kong dollar. Since Binhai HK reports in Hong Kong dollars, its accumulated exchange loss has been rising as the renminbi depreciates. The company reported a net foreign exchange loss of HK$157 million (US$24.2 million) in 2015 and HK$345 million (US$49.6 million) in 2016. The amount more than offset the company's HK$300 million share capital by the end of 2016.
We view the situation as a "technical breach" because it was not caused by a deterioration of Binhai HK's debt-servicing capability. For example, the company had not exhausted its financial resources to pay due interest or principal, and parental support from BHCI has not weakened. As far as we know, Binhai HK has maintained sufficient cash and bank balances to settle its offshore bond interest payments. The breach is in essence due to the accounting treatment of an unrealized exchange loss and has no immediate cash flow impact.
BHCI was one of the first few LGFVs to tap the offshore bond market as early as 2015. Binhai HK, established in December 2014, is the sole offshore financing platform of its parent company. In July 2015, the issuer on-lent most of the proceeds of its US dollar-denominated notes to Binhai HK, which converted them into renminbi at the then prevailing exchange rate to finance the parent's onshore business.
Why didn't BHCI take immediate action to remedy the breach?
In our view, BHCI could have more proactively managed the bond's financial covenants. As an offshore financing platform, Binhai HK doesn't have any material businesses whose net worth and equity are significantly exposed to exchange-rate volatility. Indeed, the large amount of exchange loss incurred had already significantly reduced Binhai HK's net worth by the end of 2015. However, BHCI didn't seem aware of the depleting net worth, let alone take any immediate action to prevent the potential breach from happening in 2016. The breach was only discovered when the company was preparing its audit report for 2016 and subsequently reported this to the trustee.
We believe BHCI has the financial resources to replenish Binhai HK's capital to cure the breach, and intends to do so. However, it will take time for BHCI to complete all the relevant regulatory approvals, including the approval from China's State Administration of Foreign Exchange (Safe) to increase capital for its Hong Kong unit in a timely manner. It is therefore asking noteholders to waiver the technical breach for the first time.
On top of external factors, BHCI's lack of vigilance, experience, and knowledge of offshore debt financial management led to the breach, in our view. We believe this incident could increase the company's awareness of the need to improve financial management and actively manage various risks in the offshore market, including monitoring exchange risk and debt covenant compliance.
Why does BHCI want to convert the bond structure to a guarantee?
We believe BHCI aims to remove the risk of currency volatilities and covenant breaches under the keepwell deed by converting the structure to a guarantee. Bonds under a direct guarantee structure have unconditional and irrevocable payment guarantees by the onshore parent, and their enforceability provides better protection for noteholders than a keepwell.
If SAFE gives the greenlight to the bond structure conversion and BHCI completes the change, all the bond documents under the keepwell structure will terminate (the structure includes the keepwell and liquidity support deeds and EIPU). The company will no longer be subject to the financial covenants under the keepwell. In such a case, we may consider raising the rating on the bond to be equalized with the rating on BHCI.
If BHCI cannot complete the guarantee registration with SAFE within one month, the keepwell structure will remain in effect for the offshore bond. At that point, its consent solicitation will be only relevant for the waiver of a technical breach. Accordingly, BHCI is required to remedy the financial covenant beach before December 31, 2017, which is the end of the suspension period per the consent solicitation memorandum.
What's the difference between a keepwell and a guarantee?
Keepwell is not a guarantee but an indication of the commitment of the onshore parent company to support the offshore subsidiary issuer. Under a typical keepwell deed, the parent undertakes to ensure the offshore issuer remains solvent and has sufficient liquidity to service the interest and principal of the bonds. Typically, additional documents--such as the EIPU and the liquidity facility support agreements--outline the measures that the parent could take to help its subsidiary. The validity and enforcement of the keepwell structure has not been tested in mainland courts.
Uncertainty also surrounds the effectiveness of the enforcement of the keepwell, including its vulnerability to the government's capital controls. Capital controls may hamper the liquidity support of the parent under the keepwell in terms of whether it is full force and in a timely manner. This is an important external factor that may impede the remedy measures under the keepwell structure, such as the undertaking of the parent to purchase equity interests in the onshore assets owned by the offshore issuer.
In contrast, an unconditional and irrevocable guarantee has the legal and binding obligations of the guarantor to pay the noteholders timely and in full if the issuer fails to do that. In China, the registered guarantee has received the approval of the National Development and Reform Commission (NDRC) and SAFE. The exercise of the guarantee obligation is less likely to be subject to any cross-border currency conversion and payment issues. We believe the guarantee structure provides more protection to noteholders with stronger credit strength than under a keepwell deed.
How does S&P Global Ratings treat the different structures?
We rate such keepwell transactions by assigning an issuer rating to the offshore issuing subsidiary. To this end, we assess the strategic role of the offshore issuer as the financing platform to the parent and the potential parental support. The issuer credit rating on the offshore entity and the bond rating are usually below the rating on the onshore Chinese parent except in very limited cases, where the offshore is a core part of the group and is fully integral to the group's primary business or makes a significant contribution to the parent, among other factors.
This article is authored by S&P Global Ratings analyst Gloria Lu.
S&P Global Ratings is hosting a webcast to discuss this matter further on Monday June 12 at 2PM Sing/HK time. Register here.