Interview of Roy Zhang of King & Wood’s Banking Department by Zhang Tianhui and He Ran of King & Wood’s Publications Group

Financing is a critical consideration in M&A transactions. For a long period of time, financing large scale strategic M&As of listed companies in China has been a bottleneck. As such, it is important for companies to study successful M&A experiences from abroad and develop additional venues and tools for financing and venues for such transactions.

 Q: What are the features of M&A financing transactions engaged by domestic banks?

Since Chinese commercial banks have excessive capital liquidity, they are inclined to take sizeable projects such as those sponsored by large state-owned enterprises or central or local governments. In deciding whether to issue a loan, these Chinese commercial banks tend to focus on the credit standing of the sponsors instead of credit or financials of the projects themselves.

The loans issued by Chinese commercial banks are typically corporate lending rather than M&A loans. Thus the loans will be charged at low interest rates (all-in) of 5% – 7% p.a. In comparison, foreign banks would charge much higher rates in a range of 15% – 17% p.a. with a benchmark of possible return on equity investments. Foreign banks are not competitive in the M&A loan market in terms of funding costs when compared to Chinese banks. Moreover, simpler documentation requirements and quicker credit approval process also offer the Chinese commercial banks unparalleled advantages. Chinese private equity funds share the same advantages in swift deal closing, quick exits and high returns. Companies seeking financing therefore are inclined to choose Chinese banks and local investment funds for financing in their M&A transactions.

Q: Will foreign financial institutions be gradually marginalized in the fast growing China capital markets?

Yes, this marginalization may happen. But not all foreign banks and fund companies are uncompetitive. There are two types of foreign banks and/or fund companies. Some foreign financial institutions are market oriented and they are willing to customize lending products according to the needs of the customers and reduce lending costs with advanced technologies and methods. On the other hand, some foreign financial institutions are not market oriented, and they are unwilling to change their rigid business models and do not have technical expertise. For the second type of foreign financial institutions, localization is an obstacle and they have difficulties in obtaining transactions in China.

Q: The Opinions of the State Council on Promoting Mergers, Acquisitions, and Reorganization of Enterprises ("Decree No. 27") encourages Chinese commercial banks to engage in M&A loan businesses, and offer loan support to small and medium-sized enterprises (SMEs). In practice, are there any specific supportive policies regarding this?

We do see enormous demand from SMEs for financing. But bank lending requires KYC ("know your customer"), credit approval and risk management after loan drawdowns. Hence the process can be lengthy and costly. SME loans also require a much higher tolerance for bad debt rates while the Ministry of Finance has strict write-off regulations for bad debts which apply to both large corporate borrowers and SMEs. Traditional commercial banks rely on stable cash flow in issuing loans now need to resolve the conflict between their lending practices and regulations and SME loans. They now face higher lending costs and higher risks in the SME loan market. These problems are difficult to resolve because they are rooted in traditional practices. As a result, it is necessary to introduce special policies and specific new business models to reduce the costs and risks in the SME loan market. For example, one of our clients intends to establish a purely online bank, which aims to issue loans to micro-sized enterprises. With the help of the internet, tracking the credit standing and consumer behaviors of the borrowers becomes an efficient and cost-saving task. Another client intends to establish a new type of bank that specializes in debt-financing for small and medium-sized high-tech enterprises. For serving these clients, some commercial banks already have established their high-tech branches.

Q: Decree No. 27 also discusses cross-border M&As. Are there any supportive policies regarding this matter?

The Circular of the State Administration of Foreign Exchange on the Administration of External Guarantees Provided by Domestic Institutions ("Circular No.39") has a profound impact on cross-border M&A. It initially encourages outbound investments and overseas M&A transactions with the backing of the investors’ Chinese onshore assets or operations, but now goes even further. There have been dramatic changes to the bank guarantee quota system etc, e.g. the guarantor and the debtor are not necessarily parent and subsidiary. The debtor does not need to be profitable.

Q: What are the roles of the lawyers in the robust M&A market of China?

There are many. First, we should understand what is in the minds of the regulators and market players, as well as the current changes to the market. The key is to communicate effectively with them to develop business models and products that cater to their business needs and get deals done. After the global financial crisis, the China Banking Regulatory Commission and the other authorities have stipulated stringent loan-deposit ratio requirements for the commercial banks. The lending abilities of the commercial banks are greatly restricted. Chinese banks have taken various measures, such as issuance of bonds and subordinated debt in Hong Kong and domestic markets, to increase their liquidity. Foreign-funded banks also attempt to conduct asset securitization and credit assets transfer for better liquidity. Apparently, these commercial banks have accumulated abundant capital and client bases and they are seeking arbitrage opportunities. Besides the commercial banks, Renminbi-denominated private equity funds, insurance companies, and trust companies also strive to enter this turbulent financing market, which create both opportunities and challenges for law firms and lawyers. Legal professionals play indispensible roles in these transactions. We have excellent client resources, and we act as one integral team (including Insurance, banking, securities and private equity practice groups), to assist clients in formulating practical business solutions customized to their specific needs.