Infrastructure refers to the physical engineering facilities that provide public services for societal production and resident living. It is a public service system that ensures the normal societal and economic activities of a country or region, relating to social undertakings on which the society depends for maintenance and development, including roads, railways, airports, communications, utilities (water, electricity and gas) education, sports and culture, etc.
In China, these infrastructure projects are usually implemented in three ways: (1) local governments construct on their own investment; (2) local governments set up platform companies for financing and construction; and (3) the public-private partnership (PPP) model.
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In earlier days of development, restricted by the foreign investment approval system imposed on state-owned enterprises (SOEs), local governments had to invest in infrastructure construction through fiscal funds.
With the elimination of investment restrictions imposed on SOEs after the state investment system reform in 2004, financing platform companies backed by local governments mushroomed, using land pledges as leverage and drawing on bank financing for infrastructure investment and construction. Meanwhile, the financing cost was repaid with the land sales margin brought about by the appreciation of the land price, thus making great strides in infrastructure construction.
During the five-year period of absence of top-level legislative norms, as well as rapid development of the economy, by relying on the PPP model, where the government transfers its right to build and operate infrastructure, the projects gradually yielded fixed return commitments, then formed repurchase programmes, and issued debts in the guise of equities. These were all borne by local governments, whose over-spending had become debt that seriously deviated from the original intention of PPP projects, which was to improve quality and efficiency.
Under the influence of unfavourable factors such as diminishing construction profit during the construction period, ever more stringent performance appraisals tied to government payments, rising operating costs due to the adjustment of construction, and financing channels hindered by financial regulatory policies, the social capital shareholders, out of operational considerations such as changing hands on unachievable profits or recovering their investment returns, tended to choose to transfer existing infrastructure projects and exited, for safety’s sake. This in turn has provided opportunities for large-scale operating enterprises to acquire infrastructure projects.
Through the acquisition of the special purpose vehicle (SPV), which the infrastructure projects implemented, the tedious preparatory and procurement phase of the infrastructure project could be minimized and the project operation period could be entered directly, and give full play to the SPV’s own capital and operational advantages to ensure service quality during the project operation period. At the same time, it can achieve larger business scale or build a diversified comprehensive platform through peer-to-peer mergers and acquisitions (M&A).
Unlike the usual M&A projects, what is special about the M&A of existing infrastructure projects is that their trading model is usually equity acquisition and does not involve asset acquisition. According to the provisions of the No. 2 Interpretation of Accounting Standards for Business Enterprises, infrastructure built by the BOT (build-operate-transfer) model shall not be accounted as a fixed asset of the SPV. The ownership of the project assets is usually held by the government.
The SPV only holds the possession, use and income rights of the project assets during the co-operation period, and shall not transfer the assets. In addition, the operation rights or concession rights of the existing infrastructure projects are usually granted by the government to the SPV, and the equity acquisition method will not affect the concession rights already acquired by the SPV.
Due diligence checks on compliance of infrastructure projects are key to the M&A of existing infrastructure projects. If there are flaws or major legal risks in the infrastructure projects constructed and operated by the SPV, it may directly lead to the failure of the M&A projects. Therefore, the compliance team should pay close attention to the guidance papers issued by the regulating authorities and ministries to ensure the compliance of the project, and avoid risks of being cleaned out in the future and in government payments.
The project review should focus on:
- Strict implementation of the procedures for examination, approval and filing, passing the preliminary review and approval procedures such as “two evaluations and one plan” (value-for-money assessment, financial affordability demonstration, preliminary implementation plan);
- Inclusion in the PPP Integrated Information Platform Management Library of the Ministry of Finance;
- Projects that have entered the operational period should have explicitly included government payment responsibilities into the annual budget and medium-to-long term fiscal planning;
- No government or government-funded representatives to repurchase investment capital from social capital, promise fixed returns or guarantee minimum income, sign inconsistent twin-contracts, or provide various forms of guarantees for project financing and repayments. Nor should the government cover all the risks in the investment; and
- The debt balance of the signed debt contract, debt maturity date, special restrictions on equity transfer, special agreement on early repayment, etc.
Infrastructure construction is the foundation of China’s economic development, and its operational quality must be adequately guaranteed, rather than extracting construction profits and then reselling the project via some social capital and indulging the operation responsibility of a project for as long as 20 or 30 years in the future.
M&A of existing infrastructure projects combines the traditional equity M&A with infrastructure projects. In terms of operational difficulty, it is necessary to consider the target company’s due diligence, equity delivery, price payment and other matters involved in equity M&A.
At the same time, more attention needs to be paid to the target companies set up as hosting infrastructure projects, and the compliance of the infrastructure projects it operates, which undoubtedly put forward higher verification requirements for lawyers, and require lawyers to have comprehensive ability in finance, fiscal and taxation, engineering construction and an understanding of industries.
Zhai Songjun is a partner at East & Concord Partners
East & Concord Partners
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E-mail: zhaisongjun@east-concord.com
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