Your write-up should begin with an opening paragraph that defines the main problem in the case and your recommended solution. The remainder of your paper should support your c

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Dean’s Research Fellow Michael Kane prepared this case under the supervision of Professor Benjamin C. Esty. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

Copyright © 2001 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

B E N J A M I N C . E S T Y

Chase's Strategy for Syndicating the Hong Kong Disneyland Loan (A)

We are investment bankers, not commercial bankers, which means that we underwrite to distribute, not to put a loan on our balance sheet.

—Matt Harris, Managing Director, Chase Securities

In August 2000, Hongkong International Theme Parks Limited (HKTP), an entity jointly owned by The Walt Disney Company and the Hong Kong government, awarded Chase Manhattan Bank the mandate to lead a HK$3.3 billion bank financing for the construction of the HK$14 billion Hong Kong Disneyland theme park and resort complex. Disney chose Chase from among 17 major banks invited to bid on the deal because of its global leadership in syndicated finance and its firm commitment to underwrite the full loan amount. Given this commitment, Chase was responsible for raising the funds regardless of how the bank market reacted to the deal.

Although Chase’s Global Syndicated Finance Group was headquartered in New York, its Hong Kong office was responsible for executing the deal. The deal team, including Managing Directors Matt Harris and Charles Pelham, Vice President Jose Cortes, Senior Associate Vivek Chandiramani, and Analyst Lynnette Yeo, had to deliver a syndication that met both the bank market’s expectations for participation levels and credit quality, and the sponsors’ desire for a rapid closing with a supportive bank group. Chase’s ability to execute this transaction would have direct consequences on its reputation as a leader in syndicated finance, its returns as an underwriter, and its credit exposure as a lender. As the team evaluated alternative syndication strategies, they had to decide whether to proceed directly into a general syndication or whether to pursue a two-stage syndication with a sub- underwriting prior to general syndication. In either case, they had to decide which banks to invite, how to allocate fees and titles, and how much of the loan they wanted to retain on their balance sheet.

Hong Kong Disneyland

Hong Kong

In 1997, after 150 years as a British Colony, Hong Kong became the Hong Kong Special Administrative Region (HKSAR) within the People’s Republic of China. Under a transfer of sovereignty agreement, China assured the SAR a “high degree of autonomy” under a “one country, two systems” concept. Despite some concerns about political freedoms and civil rights, the transfer

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preserved the British legal system and a free market economy. The new government maintained a system of low taxes, unrestricted capital movement, a stable Hong Kong Dollar (officially linked to the U.S. Dollar since 1983 at HK$7.80=US$1.00), and a duty free port.

As one of the Asian “tigers,” Hong Kong’s prosperity ranked it with the largest countries in Western Europe. Its economy was based on services, tourism, and international trade, reflecting the fact that Hong Kong had few natural resources and relatively high labor costs. Like other countries in the region, Hong Kong fell into recession following the Thai currency crisis in 1997. The unemployment rate more than doubled, GDP fell for the first time in 20 years, and the stock market crashed (see Exhibits 1 and 2). While some saw a tentative recovery in progress by mid-1999, the decline in output remained a subject of public concern:

So many people in Hong Kong are banking on a Disney theme park to create more jobs and end a slump in tourism that Mr. Rowse [Commissioner of Tourism and a top negotiator on the Disney project] laments he can no longer attend a dinner party without being pumped on the progress of his work.1

The Walt Disney Company

From modest beginnings in 1923, Disney had become a multinational, multimedia entertainment giant with revenues in excess of $20 billion, an “A” debt rating, and more than $5 billion in annual operating cash flow (Exhibits 3a and 3b present Disney’s financial data). Disney operated five business segments: Theme Parks and Resorts, Media Networks, Studio Entertainment, Consumer Products, and Internet/Direct Marketing. CEO Michael Eisner described the company this way:

We now have seven theme parks (with four more in the works), 27 hotels with 36,888 rooms, two cruise ships, 728 Disney stores, one broadcast network, 10 TV stations, nine international Disney channels, 42 radio stations, an Internet portal, five major Internet web sites, interests in nine U.S. cable networks and . . . [a library containing thousands of animated and live films and TV episodes].2

In its Theme Parks and Resorts segment, the company owned and operated the original Disneyland in Anaheim, California, and the Walt Disney World resort complex in Orlando, Florida. It also earned fees and royalties on Tokyo Disneyland and Disneyland Paris—opened in 1983 and 1992, respectively. In contrast to the successful U.S. and Tokyo parks, Disneyland Paris had experienced financial problems after opening due to a European recession, large initial capital expenditures, and what proved to be an overly aggressive capital structure dependent upon real estate sales for debt service (project debt accounted for 75% of project value). To avoid the theme park’s bankruptcy, Disney agreed to forgo some of its management and other fees while banks, some of whom were active in the Hong Kong market, restructured their loans.

In discussing Disney’s strategy for the next Disney Decade, Eisner stressed the importance of international growth, saying, “The United States contains only 5% of the world’s population, but it accounts for 80% of our company’s revenues.”3

Hong Kong Disneyland

In December 1999, Disney and the Hong Kong government signed a comprehensive agreement for a new theme park and resort complex to be located on the northeastern end of Lantau Island. According to the agreement, the project would have three phases. Phase I would include a

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Disneyland-style park offering several themed “lands” featuring Disney rides and attractions, one or two hotels as well as a retail, dining, and entertainment complex (Exhibit 4 presents an artist’s rendition of the resort). Phases II and III were less well defined, but included options to develop adjoining sites at some point in the future. Jon Headley (HBS 1996), Disney’s director of corporate finance, described the strategy this way:

Learning from our experience with Disneyland Paris, the strategy for Hong Kong was to start small and then to add capacity over time as demand grew. In fact, Phase I included plans to double capacity within the first ten years of operations. The real keys to success are having the land available for growth and the ability to finance this growth out of operating cash flow.

Because most of the construction site was currently ocean, the first step in the project was to reclaim land. The H.K. government, at its expense, agreed to extend the coastline and construct the roads, utilities, and other infrastructure needed to support the park. At a cost of HK$14 billion, the land reclamation and infrastructure development was scheduled to begin at the end of 2000. Two years later, resort construction was scheduled to begin and would last until late 2005 when the park would open for business.

The government supported the project because it expected the project would generate sizable public benefits. One local economist estimated that land reclamation and construction would generate 16,000 new jobs, while the resort would generate employment for 18,000 people at opening and up to 36,000 within ten years.4 The government stated that the expected financial rate of return on its investment was between 17% and 25% per annum, and at least 6% per annum under a worst case scenario.5

A new corporation, Hongkong International Theme Parks Limited (HKTP), would construct, own, and operate the resort. The HK$14 billion construction cost would come from four sources (see Exhibit 5). The Hong Kong government and Disney would provide HK$3.25 billion (57% share) and HK$2.45 billion (43% share) of equity, respectively. Although the government initially held a 57% share of HKTP, it received a special class of equity as compensation for the reclaimed land and infrastructure development that could be converted into HKTP common stock, which could eventually increase its equity ownership position to as much as 75%. In addition, the Hong Kong government agreed to provide HK$6.1 billion in subordinated debt with repayment starting in year 16 and ending in year 25. This left a shortfall of HK$2.3 billion.

The government wanted to fill the shortfall with some form of external finance for several reasons. A commercial bank loan would not only show that the project was viable in the eyes of the international banking community, but also provide independent oversight of construction and monitoring of ongoing operations. Eventually, the two owners agreed to raise a HK$2.3 billion, 15- year, nonrecourse term loan for construction and a HK$1.0 billion, nonrecourse revolving credit facility for working capital needs post-construction.

Because HKTP did not need significant construction funds until after the land reclamation was done, it had the option of waiting until 2002 before raising the bank debt. By waiting, it would save on the commitment fees charged by the banks. On the other hand, Jon Headley noted:

Although we had two years in which to place the commercial loan, the Asian loan market was showing signs of recovery by early 2000. Knowing the structuring and syndication process could take six to nine months, we decided to start the process sooner rather than later. Our fear, given the recent volatility in the Asian banking

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market, was that if we waited until 2002, we might not be able to get a loan, never mind a loan with attractive pricing.

Winning the Mandate

Jeff Speed (vice president, Corporate Finance and assistant treasurer), headed the Disney deal team for the HK$3.3 billion Hong Kong Disneyland financing, supported by Jon Headley (director, Corporate Finance), Steve Dorton (manager, Corporate Finance), Carrie Ferman (senior analyst, Corporate Finance), and Sue Lai (vice president and counsel). The Disney team developed a term sheet for the bank financing and contacted the company’s relationship banks as well as other banks it viewed as having expertise in the Hong Kong syndicated loan market. In these discussions, they hoped to get a preliminary expression of interest and an assessment of current conditions in the Hong Kong bank market. Disney explained they wanted to raise a HK$3.3 billion nonrecourse loan package on a fully underwritten basis and expected to select up to three lead arrangers for the transaction. (See the Appendix for background information on syndicated bank lending.)

Chase Manhattan Bank

It was highly predictable Disney would contact Chase. In addition to being one of Disney’s top 10 relationship banks, Chase was the third largest bank in the United States with more than $400 billion of assets and $175 billion of loans in 1999, and was a leader in the field of syndicated finance. In 1999, Chase was the lead arranger for 34% of total syndicated loans by dollar volume in the world’s largest market, the United States, compared to 21% for the next largest competitor.6 In the U.S. market for loans greater than $1 billion, its dominance was even more pronounced: it led 47.5% of the deals, three times more than its nearest competitor. The financial press had recognized Chase’s leadership with numerous awards: Best Loan House of the Last 25 Years 1974-1999 (International Finance Review), Best at U.S. Syndicated Loans—1999 (Euromoney), and Best Project Finance Arranger in the U.S.—1999 (Project Finance). Although it was not the market leader in all loan types or all locations, Chase was a formidable competitor in most markets, including Asia (see the league tables in Exhibit 6.) It had over 400 professionals in its Global Syndicated Finance Group with offices in New York, London, Hong Kong, Tokyo, and Sydney. Each office had structuring and distribution teams. In its 30-person Hong Kong office, Matt Harris led structuring while Charles Pelham led distribution. As Matt Harris described it, “We have by far the largest syndicated lending platform in the Asia Pacific region. Because we have more people and greater coverage, we are able to do the largest and most difficult deals.”

Making the Short List

Following an initial conference call, the Chase deal team (Harris, Pelham, Cortes, Chandiramani, and Yeo) studied Disney’s term sheet and wrestled with several questions, mainly the bank’s desire to win the mandate. Harris described their thought process this way:

There are three ways to approach a deal: bid to win, bid to lose, and no bid. Although Disney was an important global client, the deal did not seem that attractive to us initially. It had a long tenor which banks don’t like, we had to contend with the problems at Disneyland Paris, the sponsors wanted to mandate as many as three lead arrangers which hurts our economics, and our competitors, especially the local banks like Bank of China and Hong Kong Shanghai Banking Corporation (HSBC), were

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likely to bid aggressively. And so, we decided to bid to lose. Yet to protect our reputation, we wanted to bid aggressively enough to make the short list for this high- profile deal. If we happened to win the mandate, it would have to be on terms that met our earnings targets.

The Disney finance team met separately with Chase and 16 other banks in Hong Kong during May 2000, to review key loan terms including the pricing (an unknown), amount (HK$3.3 billion), maturity (15 years), and covenants. In its meeting with Disney, the Chase team emphasized its flexibility on key strategic terms, its credentials as a leading syndication bank, and its knowledge of and relationship with the local market. As for pricing, Chase indicated it would need an underwriting fee of between 100 bp and 150 bp, and that the market would probably require interest rate spreads of 135 bp to 150 bp over HIBOR to accept the deal. Although the Chase team expected ultimately to bid to lose, they agreed the deal would be much more attractive if Disney chose to award a sole lead arranger mandate.

Chase revised its outlook on market pricing in the weeks after the initial meeting in Hong Kong for two reasons. First, spreads on syndicated loans in the local market were continuing to tighten as liquidity improved (see Exhibit 2). Second, a senior H.K. government official underscored the government’s commitment to the project at the Asia Pacific Loan Market Association Conference. Seeing increased potential for a successful syndication, the Chase team began to revise its objective towards winning the mandate.

On May 25, Disney notified Chase and five other banks—HSBC, Bank of China, ABN Amro, Citibank, and Fuji Bank—that they had been short-listed for the mandate, and asked them to submit final proposals by July 19.

Preparing the Final Proposal

In preparing the final proposal, the Chase team had to assess the loan’s credit risk, decide whether to underwrite the full amount, commit to an underwriting fee and interest rate spread, and develop a preliminary syndication strategy. Harris also wanted the team to come up with creative features, not mentioned by Disney, which could help them win the mandate. As an example, they envisioned splitting the revolving credit facility into two parts, a HK$250 million portion that would be available for construction cost overruns and a HK$750 million portion that would not be available until completion. While the “available” portion would carry a market-based commitment fee of 37.5 bp per annum, the unavailable portion would carry a discounted fee of 15 bp per annum. Harris felt that such leeway was possible given the loan’s seniority and modest size relative to HKTP’s total capital.

From a credit perspective, Disney’s term sheet contained several aggressive elements, particularly the 15-year final maturity and a provision that allowed repayments to start as late as three years after opening. Most bank loans, especially loans in emerging markets, were fully repayable within three to five years, and Chase expected the market to be leery of the 15-year tenor. Other credit issues were Disney’s desire to use operating cash flow for expansion (capital expenditures) and its unwillingness to subordinate management fees and royalties—both features were somewhat unusual for project loans. A final concern was the fact that the borrower’s principal asset, usually viewed by lenders as their fallback collateral, was oceanfront land which would not exist for nearly two years. After careful analysis, including stress testing the financial implications, Chase decided these credit issues were adequately mitigated by the borrower’s conservative capital structure and the government’s commitment to the project. As a result, Chase resolved to show maximum flexibility by making its proposal as close as possible to Disney’s original request, although it would include covenants requiring minimum debt service coverage ratios.

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The next issue was the commitment to underwrite the full amount. Although a fully underwritten deal exposed the bank to greater risk, the team decided to seek senior management approval for a full underwriting as requested by Disney. Such a proposal would show Chase’s support for the client, signal its confidence in the deal, and provide greater profit to the firm. It might also set Chase apart from other banks that were unwilling to underwrite the deal and increase the probability of winning a sole lead mandate.

Part of the internal approval process also centered on deciding how much credit exposure Chase wanted to hold on its books after general syndication. At Chase and other major syndication banks, management differentiated between underwriting risk (the risk that the market would not buy the deal from the underwriter) and credit risk (the risk that the borrower would not be able to service the debt). As a lead arranger, Chase’s general policy was to hold 10% of the loan, a percentage that declined as loan size or risk increased. Yet at times, it had to hold larger shares to signal its confidence in a particular deal. In this case, Chase decided that a final hold position of HK$300 million, slightly less than 10%, was appropriate given the 15-year maturity.

In terms of pricing, the standard procedure was to benchmark the proposed deal against recent comparable transactions with adjustments for competitive dynamics and current market conditions; the use of comparable transactions required careful analysis because no two loans were exactly alike, especially project loans. The Chase team looked at a broad universe of syndicated loans going back over several years and selected the loans in Exhibit 7 as the primary “comps.” Based on these loans, Chase proposed an initial spread of 100 bp over HIBOR, stepping up to 125 bp in year six, and to 137.5 bp in years 11 to 15. Step-up pricing, a common feature on project loans, appealed to borrowers who focused on reducing expenses in the early years and often planned to refinance the debt before the step-ups took effect. It also appealed to lending banks, which viewed the increases as compensation for longer maturities and greater future uncertainty. With regard to the underwriting fee, they still thought a number between 100 bp and 150 bp was appropriate.a Harris said:

If anything, we thought our fee might be on the high end, but we didn’t feel bad about this for two reasons. First, we were not afraid to lose this deal on up-front pricing—we care about deal quality and profitability, not deal volume. Second, if properly marketed, borrowers viewed the up-front fees in terms of their annual cost, not the nominal first-year cost.

Having resolved some of the key credit and pricing issues, the team turned their attention to the syndication process. Based on previous experience, they knew that clients, as well as Chase’s senior management, liked to get a sense of how the syndication might unfold. Towards that end, they included two possible syndication strategies in their presentation to Disney. (Exhibits 8a and 8b present these two strategies; Exhibit 8c presents a third strategy, but not one that was shown to Disney). In all three cases, Chase would fully underwrite the deal.

Under the first option (Exhibit 8a), Chase would be the sole mandated lead arranger (shown as the coordinating arranger in the exhibit). It would invite four banks to act as sub-underwriters with lead arranger titles in exchange for commitments of HK$660 million. By sub-underwriting the deal, Chase could reduce its exposure from HK$3.3 billion to HK$660 million. The final allocations in the general syndication would be: Chase and the four lead arrangers at HK$300 million each, four arrangers at HK$250 million each, four co-arrangers at HK$150 each, and two lead managers at HK$100 million, for the required total of $3.3 billion. The advantages of this strategy were

a While the actual fee was included in the final proposal, it has been omitted here to preserve confidentiality.

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administrative simplicity—Disney had to deal with only one lead bank, reduced underwriting risk for Chase, and possibly easier syndication given the sub-underwriter support.

Under the second option (Exhibit 8b), Chase and two other banks would share a joint mandate and a joint underwriting commitment, but they would skip the sub-underwriting phase. The mandated banks (co-ordinating arrangers) would each underwrite HK$1.1 billion of the total amount and split the underwriting fee three ways. The final allocations in the general syndication would be: Chase and the two other mandated banks at HK$300 million each, four arrangers at HK$250 million each, six co-arrangers at HK$150 million each, and five lead managers at HK$100 million each. This strategy required only two additional underwriting commitments instead of four prior to the general syndication, but it meant sharing league table status as well as giving up two-thirds of the underwriting fee.

The final option was a combination of the first two (Exhibit 8c). In it, Chase would be the sole mandated bank and it would proceed directly to the general syndication where the final allocations would be: Chase at HK$300 million, four arrangers at HK$250 million each, eight co-arrangers at HK$150 million each, and eight lead managers at HK$100 million each. Relative to the other two strategies, this strategy would improve Chase’s compensation and league table status, but would expose it to the greatest amount of credit and syndication risk and would result in the largest syndicate as measured by the number of participating banks.

After describing the possible syndication strategies, Chase analyzed the likelihood of successful syndication based on the terms of the transaction and their knowledge of the banking market. Chandiramani described the process:

The key to success in this business is being close to the market. This means being in touch with banks on a weekly, if not daily, basis. We started with a universe of approximately 90 banks and created a target lender list that might be interested in this deal. We then partitioned the target list into commitment size categories and assigned participation probabilities for each category. This process gives us a sense of liquidity and an indication of whether the deal will clear the market. Based on our analysis for the Disney deal, we expected it would be oversubscribed by 57%. This kind of analysis illustrates our closeness to the market and our confidence in the deal (see Exhibit 9).

Per Disney’s request, Chase submitted its final proposal on July 19.

Arranging the Loan

After several conversations about Chase’s proposal, and agreements to amend certain aspects, Disney verbally awarded the sole mandate to Chase on August 10th. Jeff Speed said: “We chose Chase because its pricing was competitive, it agreed to underwrite the full amount, and they showed a high degree of flexibility on structuring, particularly their willingness to permit on-going capital expenditures without burdensome covenants.”

As the next step in the process, Disney proposed a meeting in which they would execute a commitment letter with final terms, discuss the syndication strategy in greater detail, and map out a syndication timetable. Agreeing on the content of the formal commitment letter would invariably require some negotiation. From experience, Chase knew their standard “market flex” provision was problematic for certain borrowers. The standard clause read:

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Chase shall be entitled, after consultation with Disney and the Borrower, to change the structure, terms, amount, or pricing of the Facility if the syndication has not been completed due to a change in the Hong Kong Dollar market and if Chase determines, after consultation with Disney and the Borrower, that such changes are advisable to ensure a successful syndication of the Facility.

Whereas borrowers disliked the provision, Chandiramani argued for its inclusion:

Chase was the pioneer in the use of market flex terms. It makes good business sense to include this clause, even though our competitors sometimes use it against us in competitive mandates, because things can change between the time you sign a deal and the time you try to close it. Unlike the “material adverse effect” (MAE) or “material adverse change” (MAC) clauses, which allow us to pull a commitment, the market flex provision is not an out. Instead, it provides room to maneuver, to adjust key terms as with a bond issue. But to date, we have never invoked the market flex clause in Asia. Nor did we invoke the MAC clause, even during the Asian financial crisis of 1997-1999, and we tell this to clients.

Once they had agreed on the final terms and signed the commitment letter, Chase had to select a syndication strategy. Because Chase had committed to a fully underwritten deal, the syndication strategy was technically their decision alone. However, for relationship reasons, Chase knew it was important to accommodate Disney’s priorities as much as possible, and these favored a sub- underwriting approach. Disney requested that some of the short-list banks and some other strong banks that did not participate in the bidding have senior status. Disney also wanted to keep the final bank group down to a manageable size. Jeff Speed said:

In structuring the syndicate, we saw a tradeoff. On the one hand, a larger syndicate generates more competition for the deal and often results in better execution. The downside, however, is that we have to share confidential information with more people. In addition, it’s harder to reach agreement with a larger group of banks. Because we often need to amend the project documents, a process that requires consent from banks holding at least 60% of the loan (a group known as the “Instructing Banks”), we wanted the lead banks to hold larger shares.

With Disney’s preferences in mind, the Chase team had to decide whether to pursue a sub- underwriting and, if so, whom to invite a

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