New Guidelines Now Allow PRC Banks to Extend M&A Loans

Previously, pursuant to Article 20(3) of the PRC General Lending Rules (the Lending Rules), any bank loan for the investment of any beneficial interest in shares or equity is prohibited unless otherwise specified by law. The Guidelines remove the prohibition under the Lending Rules and PRC banks may now extend loan to borrowers to finance or fund payment of the price of a merger and acquisition transaction (M&A Loan). M&A Loans refer to those loans extended to PRC purchasers or their subsidiaries and may include loans for cross border acquisitions but do not include loans made to financial investors.
Definition of merger and acquisition transaction
According to Article 3 of the Guidelines, merger and acquisition transaction (M&A Transaction) is defined as a transaction in which a PRC company merges with another company and/or acquires the actual controlling interest of another target company as a going concern either by way of acquiring the existing shareholding, subscribing for new shares, assets acquisition or assumption of loans.
It is still not possible to utilize the M&A Loan to set up new companies or greenfield investments or in a M&A transaction of a non-controlled nature. The Guidelines do not place any limitation on the place of incorporation of the target company. As stated above, subject to compliance with the relevant foreign exchange regulations, PRC companies may use the M&A Loan to acquire the controlling shareholding of an overseas company.
Under the Guidelines, a bank may only make M&A Loans if :-
(a) the adequacy ratio of its loan loss reserves is not less than 100%;
(b) its capital adequacy ratio must not be less than 10%;
(c) the balance of its general reserves shall not be less than 1% of the balance of its loans.
Risk management obligations of the bank
For the purpose of risk management, the Guidelines impose the following requirements on banks in extending any M&A Loan to finance a M&A Transaction :-
(a) The total amount of outstanding M&A Loans extended by a bank shall not exceed 50% of its core net capital;
(b) The total amount of outstanding M&A Loan of a single borrower shall not exceed 5% of its core net capital;
(c) The amount of M&A loan shall not account for more than 50% of the total funding used for a single M&A transaction;
(d) The term of the M&A Loan shall not exceed 5 years;
(e) The borrower shall provide sufficient security to cover the banks lending risk.
The Guidelines also require banks to adopt more stringent requirements towards securities to be provided by the borrowers for M&A Loans than in the case of other types of lending.
In addition, for the purpose of risk assessment, the Guidelines also require the bank to form a special team to conduct the following investigations, analyses and assessments and make a written report before extending any M&A Loan :-
(a) Strategic risk including the industry prospect, market structure, business strategy, management team, corporate culture and shareholders support;
(b) Legal and compliance risk;
(c) Merger and integration risk;
(d) Operational and finance risk;
(e) Financial model and forecast of the financial data of the purchaser and the target company and indication of the finance leverage and ability of repayment; and
(f) Sufficiency of the source of funds of the borrower for repayment.
Whilst the Guidelines aim to encourage PRC companies to consolidate or expand domestically or overseas, it is too early to comment on the practical effect of the Guidelines considering the onerous obligations on the bank for the evaluation and risk management of M&A Loans.
ABOUT THE AUTHOR: Angela Wang & Co
Angela is a graduate from the National University of Singapore and has practised with major international law firms in Singapore, Australia and Hong Kong. Angela regularly advises major international clients including well known Fortune 500 companies on a wide range of corporate matters including the takeover of listed companies, IPOs, substantial asset restructuring, capital fund raising, cross border private equity transactions and structured financing in Hong Kong China and South East Asia. She also acts for China state owned enterprises and Chinese domestic companies and entrepreneurs in their various investments overseas.