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HONG KONG
The Impact of Financial Assistance Prohibition on Leveraged Buyouts Elliot Leung
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t all started in the United States (U.S.) in 1988 with the fierce takeover bidding war between RJR Nabisco’s own management, private equity firms, and other investment banks. The battle ended with a leveraged buyout of the corporate giant Nabisco by a private equity firm, Kohlberg Kravis Roberts & Co. (KKR), for US$31.1 billion. That was the largest-ever buyout deal at the time. What followed was a proliferation of leveraged buyouts in the U.S. and the investment strategy soon travelled to Europe and Asia. Concept of an LBO
A leveraged buyout (LBO) is a transaction in which an acquirer (also known as the financial buyer or sponsor) purchases a company or its assets using high leverage, i.e. significant levels of debt from banks and other creditors, in addition to minimal equity. To finance the acquisition, the sponsor would often raise funds by borrowing from a group of lenders. After the takeover is completed, the sponsor will typically hold the company for several years, during which it will
HKSLG · Spring 2013 · Issue 2
seek to improve the value of the firm through corporate and/or financial restructuring. They would then either sell off the entire company or portions of the firm’s assets at profitable prices. High leverage would magnify the sponsor’s potential profits and allow them to invest in mega-sized transactions that would have been impossible as a sole investor. General prohibition on financial assistance In Hong Kong, there are very few LBOs and most are smaller in size than those in the U.S. One major reason is that the presence of legislation prohibiting a company from giving financial assistance (FA) for the purpose of an acquisition of its own, or its holding company’s, shares. Such statutory restrictions are absent in the U.S. The provisions on FA can be found in sections 47A to 47G and section 48 of the current Hong Kong Companies Ordinance (Cap 32), whose origins can be traced back to sections 42 to 44 of the English Companies Act 1981.
While FA can take on many forms, its meaning includes “financial assistance given by way of guarantee, security or indemnity, other than an indemnity in respect of the indemnifier’s own neglect or default, or by way of release or waiver” (section 47B(b)). In effect, section 47A makes it illegal for a target company to provide financial guarantee or security for creditors who are participants of an LBO. In other words, creditors of an LBO deal are restricted from providing recourse debt in most cases. After the collateral has been seized, recourse debt lenders will not be allowed to go after the borrower’s other assets. If the acquired company becomes financially distressed, the creditors do not have priority over secured creditors or trustees in bankruptcy. Coupled with a high leverage ratio, this type of transaction possesses an extremely high default risk, which partially explains the scarcity of debt capital for LBOs in Hong Kong. Trends in the common law world The prohibition on FA exists in many common law jurisdictions. While the prohibition has remained strict in some countries, such as Malaysia, the trend in other jurisdictions, such as the United Kingdom (UK), Australia, Canada and Singapore, is towards liberalisation. Since Hong Kong’s jurisprudence emanates from UK law, it is more practical to consider recent developments in the UK.