The following article was published on Debtwire on February 2, 2015

CDH Investments, one of China’s biggest private equity firms, has been forced to repay a USD 500m loan backed by its shares in Hong Kong-listed pork products company WH Group after the stock price plunged on poor earnings and triggered a margin call, three sources close to the matter said.

Like many private equity firms in emerging Asian markets, CDH is under pressure to return money to investors and use the loan to pay profits out from its WH Group investment. But it was the investors that ended up paying back the loan, plus a penalty of 12 months interest, the three sources said.

The additional cost to investors was around USD 25.6m for the interest cost and fees on the loan, according to Debtwire calculations.

“I don’t think CDH will do a loan like this again for a long time. It was embarrassing for them and angered some of the investors. Besides, the financial benefit of these loans is marginal in terms of fund returns,” a fourth source close to the firm’s strategy said.

Share-backed loans are a niche product provided by specialist teams at investment banks. While they have been used by private equity firms before in Asia, three separate bank sources said they are seeing rising demand for the product, which sponsors see as a way to get profits back to investors while shares in listed companies are still locked up.

The failed loan adds to CDH’s woes after a botched initial IPO for the world’s biggest meat processor, where media revelations about a USD 600m payment to WH Group executives and the hiring of 29 bookrunners led to the offering being cancelled. CDH had put up nearly USD 660m of shares in that IPO, but sold nothing in the eventual listing.

The firm, which holds around 30% of WH Group, has a one-year lock on its shares.

Drive for profit

CDH’s early successes in China have seen it raise over USD 7bn from investors including California Public Employees’ Retirement System and Canada Pension Plan Investment Board. But recent funds have not matched earlier performances, and CDH has been on a drive to get more money back to its investors.

After failing to sell any of its stock at the WH Group IPO, CDH agreed the USD 500m share-backed loan, arranged by Goldman Sachs, Morgan Stanley and UBS, with JPMorgan as the lender, according to a term sheet seen by Debtwire.

WH Group announced on October 16 that seven borrowers, all funds of CDH, had pledged 14.13% of the company’s total shares on issue to a commercial loan on October 14, without providing further details.

While details of the loan were undisclosed in the October announcement, news of its existence, combined with poor third-quarter sales of packaged meat products in China for Henan Shuanghui, which is 73% controlled by WH Group, sent the company’s stock into a slide.

WH Group does not have a blue-chip cornerstone investor following its initial problems with the IPO, and its stock is widely held by hedge fund investors, increasing trading volatility, the fourth source close to the matter said.

“CDH’s internal perception of WH is different than the public perception, and that is part of the problem. They see this as their best asset, so they didn’t realise how the market might react to news of the loan, and the consequence of putting it in place so close to earnings, which they missed,” the fourth source said.

WH Group shares fell 37.6% from HKD 6.09 a share on October 14 to a low of HKD 3.80 per share on December 17, according to Bloomberg data. The loan agreement features a first margin call if shares fall below 30%, then a second margin call if they fall a further 25%.

CDH paid back the loan around the third week of January, the fourth source said, adding that the loan had been distributed to investors, but CDH had to issue a capital call from its funds to repay the deal.

“Investors are upset about the loan, but I think they’re more upset about the stock price,” one of the three sources close to the situation said.

WH Group shares closed at HKD 4.40 on 30 January, 29% below the HKD 6.20 listing price.

CDH, Morgan Stanley and UBS declined to comment.

Goldman Sachs and JPMorgan did not respond to requests for comment.

Under pressure

CDH invested in the same asset from four separate funds, starting with a 2006 investment from its second buyout fund into China’s Shuanghui Group. The investment with Goldman Sachs of CNY 2.6bn (around USD 256m at the time) was one of the first foreign investments into a state-owned enterprise. Subsequent investors included New Horizon Capital and Singapore sovereign fund Temasek; CDH has continued to invest through successive funds.

Shuanghui made headlines when it agreed to buy Smithfield Foods in the US for USD 5.3bn, a deal which ranked as the single biggest acquisition of a US company by a Chinese buyer. At the time the deal with Smithfield was completed, WH Group was valued at USD 7.4bn, according to Asia Private Equity Review.

“If you’re an investor in CDH’s fund two, it’s a bang-out return. Fund three is still good, but fund four is so-so, and fund five — it’s average, a pre-IPO investment and it’s probably returning about 0.7 right now,” one of the sources said.

CDH should eventually make a handsome profit from its pork investment, but the WH Group investment mirrors a common problem for private equity in Asia’s emerging markets, where fickle capital markets and minority stake investments make it tough to exit deals.

New data released by PwC last week shows that 2014 was a banner year for new China-related private equity investments, with M&A volumes up 51% to around USD 80bn from 593 deals, and average deal values more than double at USD 792m. There were more than 15 deals over USD 1bn in value, and outbound PE-backed M&A deal volume almost doubled, PwC said.

But the same data also reveals the extent of the deal overhang in China: private equity and venture capital firms made 1,927 investments in 2014, but just 232 exits.

The lack of liquidity from Asia is ratcheting up tensions between firms and their investors, pushing sponsors to seek novel ways to get money back to their LPs.

Loan details

CDH’s USD 500m two-year loan was priced at 3-or-6-month LIBOR+ 350bps, repayable quarterly, with a front-end fee of 1% of the final loan amount, or USD 5m.

Planned participants in the term sheet seen by Debtwire were CDH Shine, CDH Shine II, CDH Shine III, CDH Shine IV, CDH Shine V, CDH V Sunshine I and CDH V Sunshine II, the same seven units that were listed in WH Group’s October 14 announcement.

Collateral shares in the term sheet were 1,989,906,471 shares, based on a base share price equal to 13.3% of issued shares in WH Group, or 44.6% of CDH shares, although figures were subject to change based on the final set base share price.

The loan to value ratio was 35%.

The loan featured a first margin call if the share price was 30% below the base share price, and a subsequent margin call if the share price was 25% below the share price from the previous margin call. Terms also included a hard trigger if the closing share price was 50% of the base share price.

Terms also included change of control and material adverse change clauses.

The borrower can prepay the loan in whole or in part, but if the pre-payment happens within the first 12 months, the borrower still needs to pay the interest up to the first 12 months, the term sheet reveals.

by Stephen Aldred