DEAL: Giant Interactive pushes Chinese LBO financing

The sponsor-led leveraged buyout (LBO) of Giant Interactive highlights banks' increasing comfort with Chinese borrowers' underlying credit.

Baring Private Equity Asia and Hony Capital's $3 billion take-private of the massive multiplayer online game (MMOG) developer, which closed on July 18, follows Focus Media in terms of size, profile and the mix of banks.

But as an online games company, Linklaters' David Irvine, who acted for the banks on the financing, said this latest deal involved a different and more challenging credit story.

"The online games sector is not one that has a long-established track record that credit committees are comfortable with," he said. "It's very hard to get visibility on how robust the business is, such as how many people will buy magic axes…and what price they would pay."

Lenders were comfortable with Giant because its franchise games have a so-called sticky following; its ZT Online is a popular MMOG in China. Irvine said that gave a strong sense of forecast cash flows which, in turn, allowed the banks to determine a financeable base case.

One issue faced by deal counsel was that all revenues were reliant on a variable interest entity (VIE) structure. PRC law prohibits foreign investors from investing in the online gaming space, so contractual arrangements are needed to connect onshore companies with offshore holding companies. This is the first large-scale LBO in which 100% of the revenues are reliant on a VIE structure. That's very different from deals like Focus and Alibaba, in which the VIE arrangements were less significant.

"As a result, there was a lot of analysis on the VIE structure, what that meant for upstreaming cash to service offshore debt, and what happens when enforcing, among other issues," Irvine said.

As they become more common, lenders have changed their approach to China LBOs. Irvine explained that one trend that started with Alibaba.com's Hong Kong take-private is banks' growing willingness to look through the holdco structure and at the underlying business.

This means the emphasis is on seeing the business generate enough free cashflow to service debt, rather than simply seeing if that amount of cash had been received offshore.

In previous deals, Irvin said, banks focused on the holdco cashflows – when dividends are received and how that matches debt service.

Lenders used to require companies to dividend cash up as quickly as possible, and excess over debt service was subject to a full cash sweep. Focus Media's LBO included a capped cash sweep, signalling that lenders were still paying attention to the offshore cash.

In contrast, Irvine said, he's seen an alternative trend in deals such as 7 Days, AsiaInfo-Linkage, South Beauty and now Giant. Lenders are looking at the overall performance of the business for both debt service cover ratio and the cash sweep.

"The cash sweep is no longer running off of holdco cash flows, but the whole consolidated operating cashflows," he said.

Lenders that evaluate a company's underlying assets rather than its offshore cashflow have a more comprehensive view of its businesses. While cash receipts offshore are still fundamentally important, not receiving cash offshore means a company will quickly run into a payment default anyway.

"You want to know how the underlying business is performing before that happens, and an opco debt-service coverage ratio (DSCR) can be a better test of that than the leverage covenant of a holdco DSCR," Irvine said.

He recommended measuring an opco's business performance through covenants. Lenders can protect against upstreaming of cash through dividend maximisation arrangements and debt service reserve account arrangements, which can bridge any delays in payments from onshore to offshore.