Pearl River Properties: a HK$600 million acquisition against a 3.5x covenant
Pearl River Properties (PRP) is a Hong Kong-listed industrial landlord. Net debt is HK$1,560 million and trailing EBITDA is HK$480 million; the term loan covenant is net debt/EBITDA of 3.50x, tested半annually. A HK$1,200 million term loan priced at HIBOR + 180bp (HIBOR 4.3%) matures in nine months. PRP has agreed to buy a Kwai Chung cold-store asset for HK$600 million at a 6.2% capitalisation rate, adding HK$37 million of annual EBITDA. Management wants to fund it entirely with a new term loan. The family holds 55% of the 380 million shares, which trade at HK$4.62 against a net asset value of HK$8.40 per share; the family has limited free cash and would need to subscribe HK$220 million to hold its stake in any rights issue. A bank has offered HK$400 million of perpetual securities at 7.5%, which the rating agencies would treat as 50% equity. A capital partner has offered to take 60% of the asset in a joint venture.
1. Test the covenant under the proposed debt funding and determine the maximum debt that can prudently be raised.
Read the worked answer
The proposal breaches the covenant twice over
Current position: 1,560 ÷ 480 = 3.25x, headroom 0.25x.
Fully debt-funded:
- Net debt = 1,560 + 600 = HK$2,160 million
- EBITDA = 480 + 37 = HK$517 million
- Ratio = 2,160 ÷ 517 = 4.18x - a breach of 0.68x
Even a 50/50 split fails: net debt 1,860 ÷ 517 = 3.60x, still above 3.50x.
Maximum prudent debt
- Maximum net debt at covenant = 3.50 × 517 = HK$1,809.5 million
- Additional debt capacity = 1,809.5 − 1,560 = HK$249.5 million
So at least HK$350.5 million must come from equity-like or JV capital. If the acquisition's EBITDA is not credited in the first test period (lenders only permit pro forma adjustments once the asset is consolidated and may cap them), capacity falls to 3.50 × 480 − 1,560 = HK$120 million.
Practical points before the board relies on HK$249.5 million
- The test is semi-annual and backward-looking. A single soft quarter in the existing portfolio could wipe out the margin.
- Interest cover is comfortable but should be checked: existing interest at roughly 6.1% all-in is HK$95 million; adding HK$249.5 million at 6.1% adds HK$15 million, giving cover of 517 ÷ 110 = 4.7x. Fine if the covenant is 4.0x, tight if it is 5.0x.
- The HK$1,200 million refinancing in nine months is the bigger event. Lenders will set the new covenant with the acquisition already in the numbers, so the covenant must be negotiated before the deal closes, not after.
Conclusion: debt alone is not available. The structure must change.
2. Compare the rights issue, the perpetual securities and the joint venture, and recommend a funding structure.
Read the worked answer
Three instruments, three different costs
| Rights issue HK$400m | Perpetual HK$400m at 7.5% | JV - sell 60% for HK$360m | |
|---|---|---|---|
| Covenant effect | Reduces net debt | Typically excluded from net debt; 50% equity credit | Reduces consolidated net debt; asset deconsolidated |
| Cash cost | Dividends, discretionary | HK$30m distributions a year, not tax deductible | Forgo 60% of HK$37m EBITDA = HK$22.2m |
| After-tax cost | Cost of equity ~11% | 7.5% (no tax shield) | Implicit, plus loss of control |
| Control | Dilution unless family subscribes HK$220m | None | Loses control of the asset |
Rights issue mechanics. At HK$4.20 (9% discount), PRP issues 95.2 million shares. Post-issue NAV = (3,192 + 400) ÷ 475.2 = HK$7.56 per share against HK$8.40 - a 10% NAV dilution for any shareholder who does not subscribe. It also crystallises a transfer of value from the family to new investors unless it funds HK$220 million, which it cannot.
Perpetual is the cheapest covenant-clean instrument. Its 7.5% compares with debt's after-tax 6.1% × 0.835 = 5.09%. The 2.4 percentage point premium buys covenant headroom and does not dilute at a 0.55x P/NAV.
Recommended structure:
- HK$240 million new term loan - inside the HK$249.5 million headroom, leaving a small buffer, with a covenant reset negotiated alongside the refinancing.
- HK$300 million perpetual securities - replaces equity, no dilution at a depressed share price, treated as half equity.
- HK$60 million internal cash - signals discipline to lenders.
Hold the JV in reserve as the fallback if the perpetual is not placed at 7.5% or below. Do not launch a rights issue at 0.55x NAV: it transfers value to new investors, signals that the board thinks equity is expensive only when the price is high, and hands the family a HK$220 million cheque it cannot write.
3. The finance director argues that issuing equity at 0.55x NAV is 'always value-destroying' and therefore the acquisition should be abandoned. Assess this argument.
Read the worked answer
The argument confuses the financing decision with the investment decision
Under Modigliani–Miller without frictions, how a positive-NPV asset is financed does not change whether it should be bought. The acquisition is worth doing if its return exceeds the risk-adjusted cost of capital for that asset. At a 6.2% capitalisation rate against an after-tax cost of debt of 5.09%, the asset has a positive spread and should be acquired on any funding mix that does not push PRP into distress.
Where the finance director is right:
- Issuing at 0.55x NAV transfers value from existing to new shareholders. Each HK$1 of assets sold for HK$0.55 means existing holders subsidise the buyer. This is a real cost of equity funding at this price.
- Signalling and adverse selection. A company that issues at a deep discount is telling the market something; Myers–Majluf predicts a negative price reaction because managers know more than investors and issue when they believe equity is dear. Investors will read a discounted rights issue as confirmation.
- Pecking order. Internally generated funds, then debt, then hybrid, then equity is the observed order of least resistance, and PRP's circumstances fit it.
Where the finance director is wrong:
- The 0.55x is a market price, not an intrinsic value. If NAV of HK$8.40 is itself overstated (capitalisation rates in Hong Kong industrials have moved), the discount may be smaller than it looks.
- Refusing a good asset because of a financing constraint destroys value too. The comparison is acquisition plus hybrid funding (accretive) against no acquisition (zero NPV), not acquisition plus the worst available funding.
Conclusion: abandon the equity route, not the asset. Fund with debt within the HK$249.5 million headroom plus perpetual securities, keep the JV as the backstop, and revisit equity only if the shares return above roughly 0.85x NAV.