Note: This is cross-posted from my blog today over at AsiaHealthcareBlog:
As North American senior care operators expand into China, one of the first decisions they will make – who to select as their real estate partner – is also likely to be one of the most critical. This would always be a pivotal decision entering any foreign market, but in the midst of very specific concerns related to the financial viability of well-known Chinese real estate developers during what appears to be a massive slowdown in China’s real estate market, understanding the condition of potential developer partners is more important than ever.
A word on what is going on in China’s real estate sector is, unfortunately, a necessary detour. Readers may be familiar with the story of Chinese property developer China Evergrande, one of the ten largest property developers in the country. For those not familiar with the backstory, reading the following from China Economic Review will help capture the sort of downside risk many fear is endemic with China’s property developers:
“Property developer China Evergrande (0333.HKG) said it was considering legal action against Citron Research after the short-seller group accused Evergrande of financial irregularity and bribery, Reuters reported. Evergrande’s shares fell more than 4% and its bonds dropped 1.3 basis points on Friday, following a 11.4% fall in the company’s stock on Thursday that wiped out about US$1 billion of the firm’s market capitalization. Evergrande Chairman Hui Ka Yan, who owns 63% of the company, denied allegations that it was insolvent in a conference call on Thursday, saying the company has RMB13 billion (US$2 billion) of cash on hand, sufficient to cover its operations. In a note on Friday, Barclays Capital said there was “still no clarity on whether the accusations are true or false.”
In my mind the absolute best real estate analyst, and also one of the best at explaining the banking system and overall economy in China, is for my money Patrick Chovanec. Writing about the Evergrande situation, he had this to say about the concerns it brings up for him:
“… They do resonate with me, because they resemble or are connected to many of the systemic risks I see building up across China’s property, trust, and banking sectors. The big question I have been asking myself all Spring — with so much developer debt coming due, and with their cash flow so visibly impaired by the property downturn — is why we’ve hardly seen any Chinese developers (and the trusts that have fueled their building binge) go bust. The hidden losses alleged by Citron may help answer that question, and the explanation is unlikely to be limited to one ‘bad actor.’ Like the losses that have been brushed under the rug in the Zhongdan Guarantee fiasco, they are just one piece in a much bigger and interconnected mosaic. “
I’ll leave it to the readers to pursue stories about China’s ghost cities for further background on how deep the problem may go, as well as two other what I consider “essential” reads on the condition of China’s real estate, both by Chovanec. The first was published in December 2011 by Foreign Affairs and the second is from May 2012 on his blog. I really encourage senior care operators who are serious about understanding the pressures the overall real estate sector is under to take the time to read these both. The point is to understand the downside risk at this particular moment in time within China specific to real estate developers is unique.
If this all has your attention, good, it should. Where due diligence about the financial condition of a potential real estate partner in China was always going to be important, it just became exponentially more so. The problem is, simply put, completing due diligence in China is not a science – it’s an art. Unlike in developed economies, rating agencies like D&B and S&P have very, very, very little light to shed on the financial health of a potential partner. So doing this well is an essential part of your market entry work.
Having said this all, acknowledging the art still means we have to distill the practice of competent due diligence down to a set of principles that can be followed. The following seven are a combination of my own research as well as an extended conversation I had with a good friend, Kent Kedl, who runs Control Risks in China. Control Risks is one of the pre-eminent due diligence firms around the world, and their China practice is focused on strategic due diligence. Kent is one of the original China hands; he is into his fourth decade living in China and to my mind one of the best in the business. Prior to running Control Risks in China he was a Principal with Technomic Asia, a China consulting firm that played essential roles in helping many Fortune 500 MNCs first enter China, a body of work that firm continues to build on today. What you will recognize in each of these is the highly intangible aspect of what each of the lessons stress. If this makes you uncomfortable that’s one thing, but none of this should stop you from developing a China strategy. Perhaps the right way to think about all these “intangibles” is to make you careful, diligent and patient.
Due Diligence Lesson #1: What they have already done is interesting; what they’re doing now is critical. Let me expand on this a bit. Keep in mind that many potential real estate partners in China have been amazingly successful over the last thirty years by pursuing a strategy of “build it and they will come.” So yes, and most obviously, you need to understand what they have built and the models they have used to finance and operate their developments; however, because this particular moment in time is potentially fraught with downside risk specific to China’s real estate sector, it is absolutely essential to understand what they are building today, and the offers they are making potential customers at these developments.
Here is the sort of due diligence you will want to do. Get a list of the developments they are currently marketing and selling. Get them to tell you about their pricing scheme, when they will be ready, etc., etc. Then, as the firm Muddy Waters so eloquently puts it, “approach them the way a potential customer would.” With the information about the current developments they are selling firmly in hand, send out your Chinese associates to approach these developments as potential customers, and then have them ask the same questions.
One thing I can almost promise you will come of this is eye-watering discounts at many developments. I can personally vouch for multiple developments I have been at over the last quarter of 2012 around China where very nice condo and other residential housing was going for up to 50% discount from list. A great anecdote about this can be read over at ChinaLawBlog. Massive discounts are not the sign of a healthy developer. That’s someone focused on cash flow over profitability and sustainability, and it’s happening all across the country. If you get a Chinese associate posing as a potential buyer to visit the majority of your potential partners’ current developments and you see massive discounts, be careful.
None of this is to suggest that looking at what they have already built isn’t important. You do want to understand what sort of operating models they have found to be best suited for their owners and management team. Do they stay involved with a property, or do they look for an early exit? Do they have experience building for, or staying engaged with, an operating model that has a hospitality or healthcare element to it? If so, they are more likely to understand the longer-term commitment many senior care operators from North America will need. In addition, it is important to understand whether the financial structures of their deals have materially changed over the last several years (i.e. are they using more debt than equity, and if so, where is the debt coming from, and what is the form of debt they are taking on?). Trends, themes and narratives from each of these questions are deep veins to explore, and in many cases will illuminate a lot about the financial condition of a potential partner.
Due Diligence Lesson #2: What did they earn, versus whom they know. Let’s get the obvious out of the way: China is a land where transactions close as much because of guanxi (relationships) as they do underlying commercial sensibility. Consequently, you need a real estate partner with good guanxi. But what you need to understand is how they came about getting this. Are they just well connected, or do they have a high ability to execute a business plan? On this point, Kent added, “You want to be able to tell the story of this guy: How did he get to where he got? In his background is a person – or persons – who this person knows who got him to where he is today. You need to know what he has done in the past – not just the ones he puts on the website or presentation – but what he actually did in each one of his projects. What were they given because of guanxi, versus what they earned because they understood the business?”
Think about this as a combination of relationship mapping and really understanding the narrative of their path to success. None of this is mutually exclusive. A potential partner that has been successful likely has great guanxi, and may be (and probably is) well connected with the local government. What you’re looking for is more – more than just guanxi. Because the concept of guanxi is one of the first ones most early entrants to China grab ahold of mentally, it is one of the ideas that people tend to look for and see – whether the conclusions they come to because of this are appropriate or not. Since guanxi is this highly informal concept with very formal implications, it is important to understand not just the guanxi they have, but how they built the relationship network they have today. Look for competence tied to connections, and if the option exists to get great connections over competence, that might not be the right trade at this particular moment.
Due Diligence Lesson #3: Reputational Due Diligence. So what does “more” than just guanxi actually look like? Here we need to introduce the idea of reputational due diligence. Kent first introduced me to this phrase when I was researching a deal in Moberly, Missouri with a Chinese company called Mamtek. To make a long story short, the city of Moberly stepped up to finance a deal for a new artificial sweetener plant to be built in their city. It should have been a great example of Chinese investment into the US, but it fell apart, leaving the city holding the bag. The city made a series of mistakes, not least of which was capitalizing much of the deal themselves; however, there was also a problem with a fundamental lack of due diligence. I was researching the story and reached out to Kent who raised the idea of “reputational due diligence.” Had it been done with Mamtek, the deal would likely never have moved forward.
Related to the real estate sector in China, Kent suggested that you want to understand, “what is their reputation around what they have done. In the US we do things like credit checks and litigation review, but in China so much is not in the public record or any government files and so much is just in the local community, where these people grew up and have become successful. You need to go talk to their partners and suppliers to find out who they are.” You are extremely unlikely to find a financial report showing your potential partner is deeply in arrears with his vendors, but his vendors will tell you that. How? You can obviously hire a company like Control Risks who can deftly handle these questions. You can also use your Chinese associates to interview key vendors in the real estate developers’ supply chain under the auspices of your desire to understand the whole picture. I can’t tell you the number of times in supply chain projects this sort of information has easily presented itself over the ubiquitous long business lunch or dinner. It’s out there for the getting, but you have to be thinking creatively and put yourself in a position to ask the question indirectly.
Due Diligence Lesson #4: Take any publicly available information with a grain of salt. I have already made this point, but it bears repeating: put very, very, very little credibility into the information you can access through rating agencies. If you pull back the layers to the Evergrande story, one of the obvious lessons is that even documents prepared for a publicly listed company cannot be trusted. If you have been watching the numerous stories coming out related to the crisis North American accounting firms are facing in China, one of the most obvious points is that even the absolute best accounting firms in the world – those that should know where to look to find half-truths and under-stated liabilities – are not able to do so effectively in China.
Due Diligence Lesson #5: A network of competitors. Obviously information that comes from a competitor has to be taken with a grain of salt. But, what you will get as you sit down and talk to competitors, obviously with the objective of understanding whether they might be good fits in their own right, is a sense of the market. Talk to 5-10 potential real estate developers in a particular city and a narrative will begin to evolve, one that will have a couple of key points about the challenges they are all facing, and more than likely themes about particular companies. Again, look for themes, common threads, general unifying anecdotes that seem to shed light on your potential partner. If none of them cause you to worry and seem pretty standard for how competitors view and talk about one another, then check that box and move on.
Due Diligence Lesson #6: Get the government involved in your deal. This may seem counter-intuitive, but it is again a lesson that comes out of the Mamtek deal. As important as the Chinese concept of guanxi is, the role of “face” is as much so. Consequently, this is something you can use to your advantage. As you are evaluating potential partners, get feedback from the municipal government officials and get them engaged in how the deal is coming together. Some of this will happen organically for you as you get the necessary commercial licenses from the Bureau of Civil Affairs and healthcare approvals at the Ministry of Health; however, do not allow this to be the only way you get the government involved. Early on, make a point of building your own guanxi with local government officials. Get them to become a stakeholder in your investment, admittedly in an indirect fashion (a hat-tip here to Malcolm Ridell over at China Debate who keyed me onto this concept as it could have been used by Moberly). What this will do is create another person who stands to lose face if the right deal doesn’t come together. Consequently, you have another individual who is going to be invested in making sure you get paired off with the right partner and that the underlying problems (regulatory approvals, land rights, etc.) are addressed.
Due Diligence Lesson #7: Never take land rights for given. Many much larger MNCs have been fooled by bad due diligence over land rights. Companies who thought they had properly secured the necessary land rights have found, some well into a build-out, that the land had not been properly purchased. This is likely to become more of an issue given the central role property rights hold as one the top grievances by rural Chinese. Among the many causes of social discontent within the country are China’s land right policies, or what may be more accurately termed China’s land taking policies. Knowing for sure that your development partner actually has the necessary land rights is something you cannot take for granted. You need to make sure a local lawyer has properly evaluated this. The process for doing this is fairly involved and laborious, and is the sort of work only a local lawyer will be able to do for you.
On this point Kent shared, “while you own the building on the land, there are two commercial relationships you can have with the land. You can lease the land use rights or you can own the land use rights. You need to find out the commercial relationship the developer has with the land. Specifically, if he doesn’t, who does – does he just lease them? If he owns them it is greater protection against eminent domain should the government decide to build a highway through your development. Does the person you are dealing with own the land use rights or represent someone who does?” Again, this is information the developer is more than likely not going to tell you himself. You should ask, and file his answer away as a test of his integrity once your own due diligence confirms or denies this, but take his answer with that in mind. The only way to confirm land use rights is to hire a local lawyer to review the local files, chops and registrations.
On this point, I think it is worthwhile to elucidate in a bit more detail exactly what goes into this sort of local examination. My friend Dan Harris over at ChinaLawBlog has written extensively on the question of evaluating company seals and chops. Here is what he has to say on the matter:
“When asked how they go about confirming the validity of a seal, the lawyers told me that ‘you have to go the town where the company is located.’ Once there, you then have to determine if the seal is registered. Often the seal is not registered as registration of seals is not mandatory in China. Then you inspect various documents filed with the local authorities to determine if the same seal was used on those documents. If the seal is registered, or if the same seal was used on all company documents filed with the local authorities, you know that the seal is valid.”
It may seem un-necessary, but it is the sort of basic due diligence that you will never regret engaging, especially if you understand how tenuous property rights are in China, and how common it is for land issues to reverse developments that previously had the green light.
These seven due diligence practices constitute basic principles that should go into how you evaluate potential real estate partners. They are, admittedly, very intangible. Many are inexorably inter-related and may seem counter-intuitive, none more so than how guanxi is both necessary and yet not sufficient. As such, if this all makes you a little uncomfortable, that is perfectly normal. The challenge of due diligence in China is being able to use reputational factors in place of the more empirical means we have of evaluating potential partners in developed economies. Getting good at this sort of due diligence is part of knowing the right questions to ask in the first place, and it is essential you have someone working with you who at least knows the right questions.