Chinese property firms' use of JCEs brings benefits & risks

   Chinese property developers are likely to increase the use of jointly-controlled entities (JCEs) owing to rising land costs and rising competition, according to a report, titled "The Pluses And Pitfalls Of JCEs For China's Property Developers," that S&P Global Ratings published today.
  However, such an approach has risks too, the credit rating agency noted.
  "JCEs enable developers to share the financial burden of projects and benefit from the strengths of their partners. They also lower competition at land auctions and reduce the concentration and financial risk on high-ticket projects," said S&P Global Ratings credit analyst Esther Liu.
  "However, they create hurdles in analyzing developers' creditworthiness because of their opacity." she added.
  JCEs can create significant contingent liabilities and could be used for financial window-dressing. In the recent case of Greenland Holding Group Co. Ltd., the developer may end up paying for more than its share of debt (based on its stake in the JCE) as one of the partners in the JCE failed to meet its obligations.
  Window-dressing may also happen if developers buy back JCE stakes at the latter stage of the project cycle. This allows them to consolidate the project and include the entire earnings, while keeping debt off the balance sheet prior to the buyback.
  S&P also sees a risk that JCEs may help disguise debt as equity. In some cases, the JCE counterparty is an unknown individual or financial company seeking a fixed return, usually with buyback agreements, or guaranteed returns.
  "The benefits of JCEs can outweigh risks in most cases. However, unless the risks are understood and properly analyzed, investors may find unpleasant surprises and, in the long run, developers may be worse off from both the financial access and business reputation perspective," said Liu.
  S&P Global Ratings employs a "see through" approach to assess the creditworthiness of rated Chinese developers that get a significant portion of their sales from JCEs.
  The agency includes the off-balance-sheet JCE debt, revenue, and EBITDA to arrive at its credit ratios for developers. However, the approach relies heavily on a company's disclosure of off-balance sheet items such as debt, EBITDA, and cash flows at the JCE level.
  S&P believes that, as investor awareness grows, companies will be forced to improve public disclosure and increase transparency of their JCEs.
  "The credit metrics of property developers generally improve when we consolidate JCE projects," said Liu.
  "This is mainly because the parent usually funds the expenditure for land acquisitions. Parents use internal resources or external financing to acquire a land plot and inject it into the JCE. The JCE can then use the land plot as collateral to obtain construction financing. The leverage of JCEs is therefore lower than that of their parent." she noted.
  Nevertheless, in some cases the leverage of the JCE is higher than that of the parent. For example, some developers use JCEs to finance land premiums by using an asset management plan or taking out a trust loan. This borrowing is in addition to construction financing that is typically sourced from banks.