Analysis of equity-debt structures of quasi-REITs

By Mathew Ching and Chen Jiahui, Jingtian & Gongcheng
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When setting up a new special purpose vehicle (SPV), shareholder loans from private equity funds and reverse mergers between the SPV and project company are considered the most ingenious deal arrangements in the conventional quasi-REIT restructuring process – with the purpose of establishing an equity-debt structure and avoiding fund idling at project companies.

However, since the China Securities Regulatory Commission’s strengthening supervision of private equity funds and launch of the first batch of pilot publicly offered REITs in recent years, the transaction structure of traditional quasi-REITs has changed significantly.

Apart from explicit exclusion of private equity investment funds by the regulators, the innovation and breakthroughs of publicly offered REITs in equity-debt structuring have inspired as well as challenged the deal structure design of quasi-REITs.

One of the keen market concerns is that, as the regulators have explicitly excluded private equity funds from the quasi-REIT structure, special asset management plans will “directly face” the SPVs or project companies. In this case, could the setup and development of an equity-debt structure be accomplished by issuing shareholder loans directly to the SPVs or project companies?

Defining ‘asset securitisation’

The Notice on Issues Concerning Pilot Asset Securitisation Business of Securities Companies defines asset securitisation as “special asset management activities where a securities company promotes asset-backed beneficiary certificates to domestic institutional investors, sponsors and establishes a special asset management plan, and uses the proceeds to purchase specified assets (i.e. underlying assets) that can generate predictable and stable cash flows from the original beneficial owners according to the agreement, and distribute income from such assets to the holders of beneficiate certificates”.

Mathew Ching, Jingtian & Gongcheng, Analysis of equity-debt structures of quasi-REITs
Mathew Ching
Partner
Jingtian & Gongcheng

Accordingly, it is generally believed that underlying assets should come into existence before the special plan – and shareholder loan issuance to the SPV after setup of the special plan goes against the fundamental principles of asset securitisation.

In essence, asset securitisation is a process of converting assets into securities, implying that “assets” should predate “securities/special plan”. However, some believe that the “asset” before the “plan” in this context should not be limited to the subject matter directly held by the special plan under the law (i.e., the underlying asset in the legal sense).

Instead, a “look-through” approach should be adopted to check for pre-existence of any asset able to directly generate stable cash flows prior to setup of the special plan.

In fact, for certain specific purposes including but not limited to building a tax shield, avoiding fund idling, and establishing creditor-debtor relationship for collateral registration, the underlying asset directly held under a special plan often refers to assets in the legal or accounting senses ‒ created based on financial engineering and legal techniques to meet the needs of specific projects ‒ while assets that themselves directly generate cash flows or cash flow interests usually take the legal form of underlying assets.

It has been pointed out that no matter what kind of deal structure is adopted, as long as the assets that directly generate stable cash flows predate the special plan, the basic requirement of “asset before the plan” is satisfied.

Quasi-REIT cash flows

In quasi-REITs, cash flows from commercial property or other real estate based on rental or other charging rights exist before the establishment of the special plan, which holds equity interests in, and issues shareholder loans to, the SPV or project company. Such cash flows are converted into and locked in as shareholder dividends and loan principal and interest, and will be held by the special plan after its forming and completion of asset transfer.

Chen Jiahui, Jingtian & Gongcheng, Analysis of equity-debt structures of quasi-REITs
Chen Jiahui
Associate
Jingtian & Gongcheng

The issue of shareholder loan to the SPV or project company under the special plan does not change the fact that cash flow interests predate the plan. The assertion that such deal arrangements violate the basic rationale of asset securitization, merely on the ground that the shareholder loan issue is preceded by the setup of the special plan, is attending to trifles while neglecting essentials.

In the authors’ opinion, the above view, while somewhat radical, fits the basic idea of asset securitisation. It also has a practical side, since it lends legal principles to simplifying the process, and lowering the costs, of building equity-debt structures for quasi-REITs, or even public REITs.

The authors also note that five among the first nine publicly offered REITs in China – namely, Fullgoal Capital Water, HuaAn Zhangjiang Everbright Park, Soochow Suzhou Industrial Park, CICC GLP Warehouse Logistics, and Ping An Guangzhou Comm Invest Guanghe Expressway – have based their equity-debt structuring on direct shareholder loans from the special plans to project companies.

Regarding the compliance of such deals, taking the CICC GLP Warehouse Logistics REITs project as an example, the project lawyers expressed their opinions as: “… the content of the contract on shareholder loans to project company does not violate any mandatory provisions of Chinese law and will become legally binding with signatories of all relevant parties and satisfaction of the conditions precedent (if any) agreed in these documents, and shall be legitimate and valid.” The lawyers, however, did not elaborate on the compliance of the special plan predating the equity loan.

Why different standards?

The authors understand that although publicly offered REITs and quasi-REITs are completely different financial products in terms of return and risk characteristics, they are substantially identical in terms of legal relationship and legal basis of the asset-backed scheme. So it is not appropriate to adopt different compliance standards for both. As it is allowed under the special plan to directly issue shareholder loans to the SPV or project company in publicly offered REITs, quasi-REITs should not be restricted from adopting the same deal structure.

With regard to the legal nature of shareholder loans from the special plan to the SPV or project company, the authors believe that since securities companies and fund subsidiaries are not licensed to issue loans, the special plan manager issuing shareholder loans to the SPV or project company on behalf of the plan should be regarded as private lending.

Matthew Ching is a partner and Chen Jiahui is an associate at Jingtian & Gongcheng

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