ONLY THE STRONG SHALL THRIVE
Financially sound companies may find gold in the credit mayhem even as weaker players fear the game is up.
By Tom Leander and Avital Louria-Hahn

In today’s looking-glass market it’s the investment bankers who urge caution, while CFOs are open to opportunity.

The head of an investment bank in India likens the current environment to the moment after an earthquake. “You go outside, and see the buildings still standing,” he says. “Yet you don’t know what kind of structural damage those buildings have sustained. It will take time to find out. But you can’t go about normal business until you do.” This banker—requesting anonymity because he didn’t want to imply that his bank was weakened—reckons that the world won’t know just how badly the banking system has been affected until December.

Compare this to the sanguine view of Michele Mandonini, finance director, Hewlett Packard, Singapore. Banks form a large portion of HP’s client base in the Asia Pacific region. He admits that HP’s finance team was wary of bank problems in mid-August, particularly the large Chinese banks which, it turned out, had substantial holdings in asset-backed commercial paper. But by the end of September, HP was confident again. “Our bank clients,” he says, “seem quarantined from the problems in the subprime market.”

As for HP’s own financial health, Mandonini says, “We’re in a strong cash position. We have little debt and a high credit rating. We’re planning to expand in Asia.”

Some Confidence, Some Doubts

Which is the realistic view? No one knows. What’s confusing about the credit crisis in Asia is its latency. Although the toll appears to be meager, whether the damage is deep or isolated remains uncertain. But there’s no shortage of potential instability to fret about. Asian bank exposure is big enough to create worries that a continued re-pricing of assets may eventually put some banks in distress. Banks exposed to price volatility in the asset-backed commercial paper—often held in special investment vehicles known as conduits—include Hong Kong-based HSBC, Standard Chartered, and CITIC International Financial Holdings, as well as Singapore’s DBS Group Holdings, United Overseas Bank (UOB) and OCBC Group.

And there have been casualties. DBS’s CEO—a former CFO—Jackson Tai exited the bank after it announced that it would double its previous estimate of its exposure to collateralized debt obligations. (Tai said he was leaving to spend more time with his family.) The bank also announced that the added exposure will not have a significant impact on earnings, but investors were spooked anyway—bad news for a stock that already lags its peers UOB and OCBC.

For CFOs outside of banking, the threat is less tangible. The companies most exposed are those that engaged in overseas acquisitions with high amounts of leverage. Most of these are based in India. One of the highest profile deals of this year—Tata Steel’s purchase of US$19 billion in revenues Corus early this year—underwent an emergency financing as markets re-priced debt this summer. After many banks pulled out of offering credit, Tata arranged a US$1 billion emergency loan to refinance US$7 billion worth of bridge loans used to fund the deal.

Dr. Reddy’s, the Indian pharmaceutical company, bought Betapharm Arzneimittel for US$571 million earlier this year, in a deal that pushed Dr. Reddy’s consolidated group debt to US$700 million. An American depositary receipt issuance by the company has helped wipe away half of that debt. However, head of finance for Europe, K. Rajani, says that higher financing costs are affecting the P&L of Betapharm, and that the company has turned to inter-company loans to mitigate the impact.

Even underleveraged, cash-rich Asian companies face some unexpected challenges. Kumar Ramu, CFO of Tioxide Malaysia, owned by chemicals firm Huntsman, says his company is rethinking its China strategy as costs soar and prices decline in the chemicals market. The reason is the knock-on effect of the U.S. housing bust on chemical suppliers. As sales dropped and construction declined in the United States, overcapacity developed among chemical suppliers in Europe, driving the costs down on products at the same time that cost of petroleum has soared (petroleum is a major component of some chemicals products). Tioxide was in the middle of negotiating its entry into a joint venture for production in China before the crisis changed pricing conditions. “We’re now re-examining the thresholds that would make the investment worthwhile,” says Ramu.

And the re-pricing of risk in the debt markets continues. Indian bank ICICI’s US$2 billion bond offering on September 27 was a closely watched exception. The pricing of the bond’s coupon appeared to be generous, given the eventual US$6 billion in demand that the offering generated. Investors who grabbed the offering noted that they would have been willing to buy at a lower coupon rate, implying that ICICI—and its investment bankers—might have low-balled the deal and inadvertently raised the bank’s cost of capital. But this reservation is easily made from the vantage of 20/20 hindsight. As the first big investment grade deal from Asia since the subprime crisis began, the generous pricing appeared to be a necessary buffer. Given the edgy mood in the market, “It was inevitable that the pricing would be at such levels to attract interest,” says Nonda Nicolaides, senior analyst covering Indian banks for Moody’s Investor Service.

Depending on the industry, however, companies with strong balance sheets and a lot of cash may find themselves in an M&A sweet spot. In the days of extreme liquidity, private-equity buyers drove up prices, often snatching deals from strategic buyers. “Private-equity buyers were able to raise their bids because they were able to borrow so much—seven times cash flow plus 25 percent equity,” says Steve Bernard, director of M&A market analysis at R.W. Baird & Co. “It has probably come down to four or five times cash flow.”

Strategic buyers now have a window of opportunity, although capital costs on LBOs have risen. Brett W. King, partner for law firm Paul Hastings in Hong Kong, says that pricing on leveraged buyout deals has already increased substantially—from 50 to 75 basis points. The good news is that the M&A slowdown has driven the purchase price of assets down. King adds that the size of leveraged deals is likely to be smaller, topping off at US$2 billion, and that the days of a single bank underwriting a major transaction are over, as diversified underwriting to spread the risk becomes the rule.

Competition from private-equity firms may be diminished, but will remain a factor. Major buyout firms have been raising funds for acquisitions in Asia. Most recently TPG and CVC Asia Pacific have put together multi-billion dollar funds to invest in Asian targets. Private equity transactions in Asia more often than not have a high component of cash, as the firms look to organic growth and tight management, rather than financial engineering, for the best return on their investment. In doing so, they’re taking
a sanguine view of Asia’s long-term growth prospects.

One sign of growth here is a thriving domestic M&A market in China, where the stock market is booming. Chinese firms have been using stock as a currency for acquisitions with greater frequency this year. Purchases by Chinese firms in domestic deals reached US$29.4 billion in the first nine months of 2007, surpassing the US$19.6 billion pledged by foreign firms. As for Indian firms, analysts predict only a mild slowdown of M&A. There will be deals, but they will feature higher funding costs, lower leverage levels, larger equity components and, as in the United States, a greater number of mid-market transactions.

Tom Leander is editor-in-chief of CFO ASIA. Avital Louria-Hahn is senior editor of CFO in the US.