How Chinese real estate credits are using credit enhancement

Author: Ashley Lee | Published: 11 Jun 2013
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  • Keepwell deeds and deeds of equity interest purchase undertakings have been popular credit enhancement structures for ChinaCos issuing debt since Gemdale completed the template deal in October 2012;
  • The structures are meant to give investors comfort while mitigating regulatory approvals required by the PRC to guarantee bonds. It is important to note that these structures are not equivalent to guarantees;
  • Investors remain concerned about the enforceability of these deeds in a restructuring scenario, but these credits remain popular with investors looking for higher yields and China exposure.

Chinese bond offerings are increasingly incorporating credit enhancement structures to enable deals to go to market faster. But investors fear such deals do not offer adequate compensation for the additional risks involved.

In October Chinese real estate company became the first A-share company to list a bond without a guarantee by utilising a keepwell deed and deed of equity interest purchase undertaking (EIPU).

Other Chinese real estate companies have since mirrored the Gemdale structure to tap the dim sum and US dollar-denominated bond markets. But as Chinese companies must clear regulatory hurdles to receive approval to guarantee bonds - most bonds must be issued through an offshore subsidiary – usually Cayman incorporated. Investors are thereby structurally subordinated in a restructuring scenario.

Investors’ scepticism about such subordination is growing. But the global search for yield may keep them purchasing these bonds.

Keepwell deed

What?

Keepwell deeds are intended to give comfort to the investor that a parent company will support the offshore subsidiary issuing the bonds. It is a contractual obligation between the supporting and supported company. It merely suggests willingness to keep the issuer solvent and is not subject to approval by mainland authorities.

They are not new structures, and counsel have stressed that investors are well aware of the difference between a keepwell deed and a guarantee.

Speaking in relation to Beijing Capital Land’s March offering of $400 million perpetual bonds with a coupon of 8.375%, Clifford Chance’s Connie Heng said that a guarantee as a form of credit enhancement gives the bondholders a direct claim against the guarantor for the amount of debt owned under the bonds.

But with a keepwell deed, the issuer’s parent company undertakes to the trustee of the bonds to ensure that the issuer stays solvent and has sufficient liquidity. The parent company also in certain instances undertakes that the issuer will retain certain financial ratios during the tenor of the bonds.

Why?

This is because the legal nature of the claim that the trustee has under a keepwell deed is for a breach of contract, which is different from a debt claim under a guarantee.

"Under PRC law, the keepwell deed – if properly drafted – does not require PRC regulatory approval as it is not a guarantee," she added.

If the company fails to fulfill its commitment to maintain sufficient levels of equity and liquidity to service obligations to the offshore bondholders, it constitutes an event of default.

However this is a way for real estate companies to attract international investors in the debt markets without requiring extensive Chinese regulatory approvals.

For Chinese companies to guarantee bonds, the country’s State Administration of Foreign Exchange (Safe) must approve the notes post-pricing so that the company can pay interest in principal offshore renminbi during the tenor of the bonds. This is seen as risky as the bond has already been priced when it applies for registration.

Although Chinacos such as China Railway Group and Zoomlion Heavy Industry Science and Technology have applied for and received guarantees, the approvals are difficult to obtain.

Deed of equity interest purchase undertaking

What?

The other structure of interest in the Beijing Capital Land deal is the EIPU, first used in the RMB bond issue by the offshore subsidiary of Gemdale Corporation.

"We understand that this technique has previously been used in direct investments or private equity transactions but not in a capital markets bond issue," she added.

Deeds of EIPU are increasingly supplementing keepwells, in a bid to bridge gaps in bond repayment amounts.

Heng explained that under an EIPU the parent company in China will undertake to buy assets of an offshore subsidiary’s onshore companies. This creates a channel for onshore funds to come from the parentco in China. If there is a default under the bonds, the parent will identify onshore assets in the form of equity interests in companies, which they can purchase from the offshore issuer and its offshore subsidiaries.

However, she noted, the completion of the purchase is subject to the relevant Chinese regulatory approvals at the time.

Why?

This structure is meant to resolve investors concerns that they do not have recourse to the company’s onshore assets.

Under the undertaking, the onshore parent company will purchase the assets of the offshore issuer and its offshore subsidiary for a price that will cover any debt obligations of the offshore issuer.

This structure circumvents the National Development and Reform Commission approvals required if a Chinese company wants to provide an offshore subsidiary for more funds. Because this structure involves the onshore subsidiary purchasing onshore assets, only the approval of China’s Ministry of Commerce and Safe would be required.

Enforcement uncertainties

In a May 9 report titled 'Subordination of Chinese Offshore Debt Issues: Always Subordinated to Onshore Debt,’ Fitch Ratings said that the structure, with legally binding deeds, demonstrates the strong intent of the issuer to service the offshore debt.

The report added the corporate governance track record and reputation of the issuer in both onshore and offshore funding markets, was a key consideration.

Fitch said that the treatment of the instrument rating will necessarily be on a case-by-case basis, because this evaluation requires significant judgment.

In a March report titled 'FAQ on Credit-Support Structures Used for Chinese Offshore Bonds,’ Moody’s concluded that given weaknesses that apply generally for keepwell agreements, the relatively new nature of these structures in China and the untested nature of enforcing such arrangements on the Mainland, the agency is unlikely in most circumstances to rate the subsidiary at the same level as the parent.

But investors are uncertain of how these structures will be enforced. Restructuring lawyers warn that the deeds may not be enforceable in the event of a restructuring, and that it depends on whether the parent company is committed to supporting its subsidiary.

Neil Weller, director of alpha strategies at Blackrock, speaking at Euromoney Conferences’ Global Offshore Renminbi Funding Forum earlier this month, agreed that the key issue around these covenants was that a lot of the structures were untested.

"Companies have broken covenants, or they haven't been enforced," he said. "It's as important to understand a company's intentions and management's commitment to investors rather than just the precise legal terms of the document."

Further, he noted that recent issues in which companies had sought to double up in multiple guarantees by onshore parents hinted at desperation as opposed to confidence that the covenants were enforceable and would deliver to investors what the text stated.

"For the development of the market, we need to see the structures tested when it really matters," he said.

In an April editorial in the FT blog beyondbrics titled 'Beware 'enhanced’ Chinese bond market,’ Fidelity’s Sabita Prakash and Bryan Collins expressed similar sentiments.

What to expect

Bank counsel have predicted that these structures would be used as long as there is demand in the market. Indeed they have been excited to attract new Chinese credits, especially from the real estate sector, to the market. This January saw Chinese real estate company issue $6 billion in debt – compared to $7 billion throughout 2012.

Sources told IFLR that investor fatigue was growing following a wave of Chinese real estate credits hitting the market. The market is now running out of real estate developers that are prepared to debut in the international markets.

But these bonds remain popular with international investors looking for higher yields than are currently available in the US high-yield space. They also provide China exposure, albeit from a risky sector given the country’s slowing growth.

Further, counsel predict that these credit enhancement structures will remain popular as they lower the cost of funding and allow investors to get comfortable with the credit.

Related links

Asset managers call for RMB market standard http://www.iflr.com/Article/3206626/Debt/Asset-managers-call-for-RMB-market-standard.html

What’s next for China’s offshore RMB market http://www.iflr.com/Article/3196172/Whats-next-for-Chinas-offshore-RMB-market.html

The latest Asian high-yield disclosure trends explained http://www.iflr.com/Article/3117372/Debt/The-latest-Asian-high-yield-disclosure-trends-explained.html