Key Takeaways
- Increased scrutiny of the financials of Chinese developers has uncovered transactions that are being reclassified as debt, particularly short-term debt.
- This scrutiny has raised questions about the lax controls and aggressive accounting practices during the boom years, pointing to pronounced governance risk among these entities.
- The market downturn is also hitting cash levels and asset values, leaving some firms with negative equity.
The wraps are coming off China developers' books. Shimao Group Holdings Ltd. in late July disclosed the findings of an independent investigation, revealing arrangements that sharply raised its total debt obligations, particularly its short-term debt.
S&P Global Ratings believes Shimao's practices are not an isolated case. Recent disclosures have raised questions about the lax controls and aggressive accounting practices of developers during the boom years.
Shimao Group, which has defaulted on its debt, is undergoing a debt restructuring. We do not have a rating on the company.
China Evergrande Group's onshore subsidiary, Hengda Real Estate Group Co. Ltd., announced in mid-August that it received a notice about a probe on a suspected breach of disclosure requirements, coming from the China Securities Regulatory Commission.
A batch of auditor resignations have pushed firms to be more transparent, particularly with regard to their joint-venture partners.
The resignations have resulted in delays to financial disclosures, which have triggered trading halts among Hong Kong- listed firms, and have drawn scrutiny from lenders and investors. This has likely forced firms to improve their reporting.
Indeed, new auditors adopted a cautious stance and have commonly expressed "a going concern" statement in their audit opinion. Auditors have lodged such statements for Shimao, Kaisa Group Holdings Ltd., Evergrande, China Aoyuan Group Ltd., and Fantasia Holdings Group Co. Ltd.
We have written that the events suggested auditors were pushing back on aggressive accounting practices, and that this pointed to possible weak governance among some of these firms (see "Auditor Resignations Flag Governance Risk For China Developers," published Feb. 15, 2022, on RatingsDirect).
We have also flagged in a series of reports that China developers' common use of joint ventures, and the potential governance risk this presented. Specifically, we believed the extensive use of structures involving jointly controlled entities (JCEs) could muddle firms' reported financials, making it harder for investors to determine their true risk with regards to debt and cash flows. (see "High Stakes: Analyzing The Risks Of China’s Property Joint Ventures," June 14, 2021, and "China Developer Joint Ventures: The Case Of The Vanishing Revenue," June 10, 2020).
We downgraded Powerlong Real Estate Holdings Ltd., KWG Property Holding Ltd., Dexin China Holdings Co. Ltd., and Agile Group Holdings Ltd. in March-April 2022, and assessed their management and governance as weak (from fair). The moves reflected our revised views on the entities' weak reporting, governance, and risk management. The downgrades followed the firms' inability to issue financial results on time.
We break down two main reporting issues related to JCEs:
1. Nondisclosure Of Debt Guarantees
Some developers have used joint ventures to borrow on their behalf. When developers use the equity method to account for JCEs, they have not had to consolidate the debt of these JCEs. However, developers guaranteed some of the JCEs' borrowings, and some of these guarantees were not disclosed.
The independent investigation into Shimao gives some insight into how this might work. A JCE partly owned by Shimao borrowed trust loans that were guaranteed by Shimao's subsidiaries. The guarantees were not disclosed to Shimao's previous auditor, PricewaterhouseCoopers (PwC).
The Shimao investigation identified about renminbi (RMB) 43 billion of such trust loans as of end-2021 and RMB34 billion at end-2022. At least some of the borrowed money was transferred back to Shimao for its own use to avoid having "idle funds", as the company explained.
By our methodology and ratio adjustment standards, a guarantee to an unconsolidated JCE constitutes a liability to the guarantor. We would have added the amount to our adjusted debt.
After PwC resigned as auditor in March 2022, and following the independent investigation, Shimao consolidated the JCE for its 2021 and 2022 results, thus recognizing the JCE debt on its balance sheet. Shimao released its 2021 and 2022 results on July 28, 2023.
Shimao said the reason for the consolidation was that the "JCE partners completed their withdrawal or expressed their willingness to withdraw" from development projects after the industry went into a downcycle.
We view such a renegotiation of terms as unusual. Genuine equity partners would share both economic benefit and loss according to their stakes, under the normal course of a joint-venture partnership. Put most simply, Shimao should have the right to force its partners to accept losses alongside its own.
Chart 1
Shimao was not alone in its extensive use of the JCE structure. Kaisa's disclosure of its debt guarantee in 2021 and 2022 was also surprising to us.
Kaisa did not report any guarantees prior in 2020. However, it disclosed RMB11.5 billion in financial guarantees to joint ventures and associates in 2021, and RMB23.8 billion in such guarantees in 2022 in its delayed filings in March 2023. Kaisa's auditor (Grant Thornton) resigned in June 2022 and the company's shares were suspended from trading from April 1, 2022, until it released its financial statements for 2021 and 2022.
The Routes To Increased Debt: The Evergrande Example
We are aware of similar unreported debt attributable to JCEs and undisclosed guarantees at Evergrande. However, Evergrande also raised debt-like funding through wealth management products that it classified as equity.
Evergrande's previous auditor, PwC, pointed out such matters before it resigned from the firm. Specifically, the accounting firm flagged the possibility Evergrande was raising capital through wealth management products, which might not have been disclosed, and that it might have had other off-balance-sheet liabilities.
WEALTH MANAGEMENT PRODUCTS:
A independent review performed by Crowe (HK) Risk Advisory Ltd., to investigate issues flagged by PwC, confirmed PwC's views. Two subsidiaries of Evergrande provided guarantees to buyers of the wealth management products.
The unpaid principal and interest connected to the wealth management products amounted to about RMB34 billion as at end-2022. Given their debt-like features, they have been reclassified as liabilities instead of equity.
GUARANTEES TO JV AND SUBCONTRACTORS:
Evergrande had provided guarantees to joint ventures and associates amounting to RMB50.1 billion in 2021, compared with RMB17 billion in 2020.
Evergrande in its 2021 annual report disclosed that borrowing guarantees extended to subcontractors climbed to RMB70.3 billion in 2021, from RMB12.5 billion in 2020.
With Evergrande's guarantee, subcontractors were able to borrow heavily in the boom years, leveraging both its own credit and Evergrande's. However, when property sales tumbled, liquidity risk rose for both Evergrande and its subcontractors.
2. Put The JCE On The Balance Sheet But Disguise The Debt
Alternately, we believe that some China developers might have fully consolidated JCEs, but still used the structure to disguise debt as equity.
Shimao's consolidated JCE received debt-like funding from its minority project partner that the company classified as equity. Shimao in its 2020 annual report described the amounts due to noncontrolling-interests as being interest free, unsecured, and as having no fixed repayment terms. We accordingly did not treat the funds as debt for Shimao back when we rated that entity.
The transactions were subsequently reclassified as "interest-bearing liabilities" after the minority shareholder "claimed its rights and interest as a creditor".
Several other developers had likewise recorded high equity interests for their minority partners in the JCE projects prior to 2021.
For example, China Aoyuan had accepted RMB35.7 billion of equity investment from noncontrolling interests, which it recorded as equity on its balance sheet as of end-2020. This amount dropped to RMB8 billion in 2021, and then to RMB5 billion in 2022. Its cash flow statement reported substantial cash outflows related to the "acquisition of additional interest from noncontrolling interests" and the "withdrawal of capital contribution by a former noncontrolling interest".
Aoyuan's restatement of its financial accounts followed a trading halt, and the publication of its 2021 and 2022 reports in July 2023. Aoyuan hired the Hong Kong accounting firm Shinewing as its auditor after Deloitte resigned in January 2022.
The ratio of cash to short-term debt is falling quickly for entities that have used JCEs heavily: Shimao, Kaisa, and Evergrande. Indeed the ratio for these three firms is approaching zero. The decline reflects both a sharp drop in accessible cash during this downcycle and, we assume, a spike in declared short-term debt (see "Credit FAQ: Will Country Garden's Woes Further Hobble China's Property Market?" Aug. 16, 2023 , and "As The Escrow Flies: China Developers Navigate Convoluted Rules On Presales," Jan. 20, 2022).
Chart 2
Much of this debt could be related to the entities' JCE dealings, in our view. Furthermore, the debt has only recently come onto developers' balance sheets after auditors started pushing back on the firms' accounts, we assume.
Some entities' 2021 and 2022 financial reports revealed negative net equity, with more liabilities than assets. The market downturn, which has devalued developers' inventory of land and unsold units, has amplified this trend.
Governance Is Key
We view events as a kind of reckoning for the China property sector. The industry adopted some aggressive accounting practices during the boom years, when the market might have overlooked amid high growth and returns. The downturn has underscored a maxim of markets: when transparency falls, investor risks build.
Regulatory incentives and penalties may start to address the most aggressive practices. Ultimately, investors will apply a risk premium to issuers that use aggressive practices, and to reward those that are transparent. Peering through the peaks and troughs of the business cycle, we assume the firms with a record of prudence and a consistent transparency will ultimately stand out.
Writing: Jasper Moiseiwitsch
Related Research
- Credit FAQ: Will Country Garden's Woes Further Hobble China's Property Market?" Aug. 16, 2023
- China Developers' Earning Weakness To Persist Another Year, April 11, 2023
- Auditor Resignations Flag Governance Risk For China Developers, Feb. 15, 2022
- As The Escrow Flies: China Developers Navigate Convoluted Rules On Presales, Jan. 20, 2022
- High Stakes: Analyzing The Risks Of China’s Property Joint Ventures, June 14, 2021
- China Developer Joint Ventures: The Case Of The Vanishing Revenue, June 10, 2020
This report does not constitute a rating action.
| Primary Credit Analysts: | Fan Gao, Hong Kong + (852) 2533-3595; fan.gao@spglobal.com |
| Edward Chan, CFA, FRM, Hong Kong + 852 2533 3539; edward.chan@spglobal.com | |
| Secondary Contact: | Lawrence Lu, CFA, Hong Kong + 85225333517; lawrence.lu@spglobal.com |
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