• Meemi O.

Danke (Part 3): Concluding the Collapse

In this final installment of our Danke series, we provide a recap of the main points covered in Parts 1 and 2, in addition to discussing relevant questions including:

  • Was Danke Doomed to Fail?

  • Could Danke's J-Curve Have Rebounded Without The COVID-19 Pandemic?

  • Are Rent Financing Schemes to Blame for Danke's Downfall?

We also reflect on some of the lessons learnt and issues brought up from this corporate phenomenon:

  • Registration-Based vs. Regulator-Based IPO System

  • Intervention vs. Innovation

  • Regulating FinTech

Lastly, we consider the question Will There Be Another Danke? by looking at Qingke (NASDAQ: QK), a similar long term Chinese real estate company that expanded aggressively through the use of rent loans and is currently on the brink of collapse.

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A Recap of Danke

History and Purpose

Danke was founded in 2015 with the launch of Danke Apartment, a long term rental accommodation scheme that particularly attracted young working professionals with standardized apartment properties, reliable third-party contractor services, and a supposed emphasis on technology as part of the corporate goals of providing centralization and standardization to China's residential real estate market. The company leases apartments from landlords throughout various major cities in China, renovates the properties to a high standard, and rents the rooms out while also providing quality services as needed.

Rapid Growth and Expansion

Danke expanded very rapidly from only 2,434 Danke Apartment units in Beijing in December 2015 to 438,309 units in 13 cities four years later. This rapid expansion was largely possible because Danke encouraged renters to pre-pay multiple months' worth of rent in advance, with the majority of pre-payments being done through the form of three-way rent loans with partner financial institutions. Specifically, renters who did not have the financial resources to pre-pay their rent could opt to enter into rent financing schemes with Danke and a partner bank, whereby the bank would grant Danke an upfront loan equal to a year's worth of rent, which the renter would gradually pay back to the bank with their monthly rent payments.

Rent Financing Scheme in China
Rent Loan Financing Scheme

Without any regulatory restrictions on the timing or usage of rent loan proceeds, Danke was able to use each entire upfront loan payment from partner banks all at once to lease more properties, while continuously attracting new landlords by promising higher than market rate lease payments and guaranteed rents even in the case that a property could not be rented out. These lucrative perks attracted many property owners to rent their properties out through Danke, and fueled the company to quickly reach monopoly status in key residential areas across many Chinese cities.

Since its inception in 2015 to the end of 2019, Danke received six rounds of financing from notable Chinese venture capital firms and other investors, including Ant Group. The company filed for an IPO on the New York Stock Exchange with an eventual opening share price of $13.5 per share on January 17th, 2020.

The Financial Dark Side Revealed

A look at Danke's financial statements, however, reveals a multi-faceted dark side to the seemingly successful, growing business with multiple warning signs that should not have been ignored. Most noticeably, Danke's operating expenses have been exploding at over 100% of the company's revenues each year, of which leasing costs constituted 78% to 90% during the 2017 to 2019 period. The exorbitantly high operating expenses translate into net losses of RMB272 million, RMB 1.37 billion, and RMB3.4 billion in 2017, 2018, and 2019 respectively.

Deeper investigation reveals that Danke's cash flows are highly unsustainable due to a severe maturity mismatch, where the company had been depending on one-off financing cash inflows from upfront rent loans to support its long term capital intensive expansion and operating losses. Danke's liquidity position has also been in a dire state since 2017 (the earliest data available), with the company's cash and restricted cash balance accounting for only 18.43%, 53.46%, and 26.54% of current liabilities in 2017, 2018, and 2019 respectively.

A Scandalous Reputation

Throughout Danke's short history, the company was involved in two known headline scandals. The first took place in Beijing in 2018, where Danke, along with other major long term real estate rental companies, colluded to drive up the price of the city's average market rent by 50% over the course of a few weeks.

In a second scandal in 2020 that should have raised strong suspicions about the business's financial standing and the integrity of the company's management, Danke was involved in the embezzlement of local state-owned assets. Danke had agreed to founding a jointly-owned company between itself and Jiangsu province's Kunshan City Huaqiao Economic Development Zone at the end of 2019, where each party promised to contribute roughly equal amounts to the joint venture in order to invest in China's real estate rental market. A few days after the funds were deposited in the joint venture bank account, Danke withdrew the entire RMB1.2 billion for its own use, resulting in the subsequent arrest and interrogation of the company's founder and CEO.

A Collapse to Chaos

To precipitate (or perhaps hasten) the fall of an already financially unstable Danke, the onset of the COVID-19 pandemic in early 2020 coincided with the lunar new year during which many Chinese residents were trapped in their hometowns during lockdown and could not return to the cities where they worked. Without new renters to keep fueling the Ponzi scheme, Danke's arguably anticipated cash flow problems started materializing, as the company voided promised lease payments to landlords and furloughed 80% of its employees.

By the time lockdown restrictions were lifted in April, the company's reputation was so poor that no landlord nor renter dared to lease or rent from Danke. The founder and CEO was arrested in June, while Danke continued to default on payments to landlords and contractors, resulting in numerous lawsuits that resulted in the freezing of most of the company's assets. Conflicts erupted between renters and property owners, since many renters had already paid a year's worth of rent in advance but were being evicted by landlords who never received their rent payments from Danke. Renters who were enrolled in a rent financing scheme with partner financial institutions were continued to be demanded by the banks to pay off Danke's rent loans, even after they were evicted from their rented properties.

Eventually, chaos ensued as hundreds of property owners, renters, service providers, and employees gathered in front of Danke's headquarters.

In early April 2021, Danke was delisted from the NYSE.

Was Danke Doomed to Fail?

Perhaps one of the biggest questions that comes to mind is, "was Danke doomed to fail?"

We argue that Danke had a promising business model that could have, but not necessarily would have, succeeded if it were backed by a more sustainable cash flow structure.

Specifically, from our view, the business model of standardized housing with reliable services for working professionals is an attractive and viable solution for renters who often struggle to find quality and consistency in their search for rental accommodation. Similarly, the existence of a credible intermediary to bridge the gap between landlords and renters helps to facilitate the leasing process for both sides by alleviating the adverse selection and hold-up problems that typically characterize the real estate rental market. Moreover, Danke's embrace of a digitalized approach via using an online platform allows property owners, renters, and third-party contractors to connect with greater ease, thus streamlining and providing greater efficiency to the rental process.

However, we argue that Danke's cash flow structure is problematic and inconducive to long run sustainability. From a general perspective, Danke had significantly negative net operating and investing cash flows from its operating losses and capital expenditure investments, offset by positive net financing cash inflows from partner banks (note: advance rent payments from tenants not enrolled in a financing scheme are classified as operating rather than financing cash inflows).

Danke Cash Flow Summary
Source: Danke 2019 Annual Report

A deeper delve shows that Danke was relying on one-off, upfront rent financing scheme payments and advance rent payments from tenants to cover for its high levels of (long term) ongoing capital expenditures and operating cash expenses. The company specifically emphasizes in its financial report that the upfront payments serve as important sources of cash inflows and are crucial to maintaining business operations.

We provide a summary of relevant key financial statistics in the exhibit below.

Danke cash flow ratios
Source: Danke 2019 Annual Report

***We are using the word "total" in a rough manner. Notably, Danke also has other sources of cash inflows and outflows in addition to the ones included here, although they have a much smaller weight.

***Cash operating expenses was calculated by summing all operating expenses except depreciation and amortization

Danke's two main sources of cash inflows are: (1) proceeds from borrowings (including rent financing and other loans from banks), and (2) advance payments from residents. While Danke seems to receive a large volume of loan proceeds each year, a significant proportion of the proceeds go to paying off outstanding debt. Specifically, 58%, 62%, and 79% of the loan proceeds received were used to pay off existing loans in 2017, 2018, and 2019 respectively. Approximating Danke's total cash inflows as the sum of Net Proceeds from Borrowings and Advance from Residents, the former constitutes 89%, 92%, and 83% of the total inflows in 2017, 2018, and 2019 respectively. The dip in 2019 is perhaps indicative of Danke's shift away from rent loan financing as mandated by the regulators, as well as potential difficulties in securing alternative sources of funding from financial institutions (e.g. direct bank loans).

Danke's cash outflows primarily consist of capital expenditure and operating cash expenses. Approximating total cash outflows as the sum of CAPEX and cash OPEX, the latter constitutes 69.5%, 73%, and 82% of total outflows in 2017, 2018, and 2019 respectively. The increasing trend in percentage of cash OPEX and decreasing trend in percentage of CAPEX is reflective of the company's rising leasing cost obligations as well as a gradual slowdown in its expansion.

W Danke's strategy does not seem viable because the company's operating expenses and annual losses have been ballooning year-on-year, with the main driver being high leasing costs.emely Wunhealthy and deteriorated very rapidly across the three years, with the company having 0.73 times as much inflows as outflows in 2017, roughly half as much inflows as outflows in 2018, and only 0.23 times the amount of inflows as outflows in 2019.

In a large sense, we think that Danke's failure stems from basic asset-liability management (ALM) issues which management did not seem very intent on rectifying. The notes to Danke's 2019 annual report state that the company's accumulated losses, negative working capital and negative operating cash flows "raise substantial doubt about the Group's ability to continue as a going concern".

Could Danke's J-Curve Have Rebounded Without The COVID-19 Pandemic?

Many companies operate at a loss in their early stages and turn very profitable later on. However, in the case of Danke, we don't believe that the losses would have been recoupable, even without the onset of the COVID-19 pandemic.

According to Danke's Q1 2020 earnings report, the company's strategy has been to sustain (or even grow) short-term losses as part of a "rapid expansion stage" in order to generate long run profit in a subsequent "developed stage".

Danke's business strategy
Source: Danke Q1 2020 Earnings Report

We argue that Danke's strategy is not viable because the company's operating expenses and annual losses have been ballooning year-on-year, with the main driver being high leasing costs.

Conceptually, as shown in the diagram below from the company's Q1 2020 report, leasing costs constitute the bulk of each rented-out apartment's profit as well as the majority of each vacant apartment's loss.

Danke daily unit revenues and costs
Source: Danke Q1 2020 Earnings Report

Empirically, as shown below, leasing costs constituted 77.9%, 81.2%, and 89.8% of Danke's total revenues in 2017, 2018, and 2019 respectively.

Danke Operating Expenses
Source: Danke 2019 Annual Report

We think that Danke's commitment to paying property owners above-market rates and promise of rent guarantee even for vacant apartments played a very significant role in preventing Danke's J-Curve from rebounding. Both measures were implemented in order for Danke to rapidly expand its market share, although they ultimately proved to be a significant drag on the company's operating cash flows over time. Without these two commitments, and the latter in particular, we think that Danke would have been able to expand gradually but perhaps more sustainably.

Are Rent Financing Schemes to Blame for Danke's Downfall?

What first comes to mind when the financing structure of Danke (or any other similar real estate rental company in China for that matter) is mentioned is undoubtedly the use of rent loan financing. Although the use of rent loan financing may seem like the obvious culprit to blame for Danke's downfall (i.e. by encouraging aggressive and unsustainable expansion), we don't think that the use of rent financing schemes in and of itself is necessarily detrimental, given that the proper loan covenants are in place (although in the case of Danke, they were not). Such covenants can include limits on when or how different portions of the loan proceeds may be used, such as restrictions that prevent rental companies from withdrawing the entire loan amount upfront all at once, or coverage requirements for companies to be able to pay off existing liabilities first before taking on more debt.

Nevertheless, we do agree with the decision of the Chinese regulators to limit real estate rental companies' reliance on rent loan financing, since such financing schemes by nature tend to foster a certain degree of moral hazard. As witnessed in the collapse of Danke, renters were (at least initially) liable for paying off the upfront loan proceeds used by the company after Danke had defaulted on its payment obligations. While covenants limiting the amount or timing of money a rental company can withdraw would help to mitigate the moral hazard risk, companies such as Danke could still be exposed to other risks through the (excessive) use of rent financing, such as the risk of correlated renter defaults. For example, factors such as averse changes in macroeconomic conditions could trigger many renters to default all at once, leaving the company suddenly liable for a potentially substantial sum of combined debt.

Lessons Learnt from Danke

Next, we discuss some of the important lessons learnt and key issues brought up by the rise and fall of Danke.

Registration-Based vs. Regulator-Based IPO System

Traditionally, China relied on a purely regulator-based IPO system where companies require approval from a regulator before they are able to go public. In recent years, the Chinese government has been trialling the registration-based system, first with the launch of the STAR Market in 2019 and subsequently on ChiNext in 2020. The registration-based system allows companies to go public without getting prior approval from a regulator as long as they fulfill the necessary disclosure requirements, akin to the system in the US.

Naturally, both IPO systems have their own pros and cons. The regulator-based system can entail significant hurdles for companies trying to obtain public funding via an IPO, since the regulator (in the case of China) has stringent requirements on each company's cash flows, profitability, etc., and also reserves the ultimate power to determine the final IPO price. These restrictions can substantially hold back companies that initially bleed cash but have very good growth potential, such as many tech companies.

In contrast, the registration-based system grants funding opportunities to a much broader set of companies, given that the main hurdle to going public is just fulfilling the necessary disclosure requirements. From an investor's perspective, the registration-based system provides a larger investment universe at the cost of greater potential exposure to companies that are not financially sound. Danke is an exemplification of this last point. We are not making an argument in favour of one system over another, but we do think that Danke was far from fit to go public when it did, irrespective of the IPO system.

Danke raised $130 million from its IPO, 25% less than its anticipated $175 million. The disappointing performance was both due to a lower than expected trading price and a much smaller than expected number of shares sold. Initially, Danke's shares were predicted to trade at a range of $14.5 to $16.5 per share with a target of 10.6 million shares to be sold. Ultimately, only 9.6 million shares were sold at $13.5 per share. Danke's IPO forecasts could have been overly rosy, and/or many investors may have already been sceptical of the company's health and financial standing.

Intervention vs. Innovation

A particularly popular regulatory debate, especially in recent years, is if and when regulators should intervene when it comes to new, innovative companies that could be the future driving force of a company's economy. On the one hand, too much (negative) intervention could prevent a company from fully realizing a new and perhaps positively disruptive business model, in addition to disincentivizing companies from innovating as a whole. On the other hand, too little government regulation can have the potential to result in a systemic crisis if a systemically important innovator collapses.

In the case of Danke, we argue that the regulators should have intervened, and that early intervention would have been socially optimal. Although Danke prided itself on being a semi-tech company that relies significantly on advanced technology in its business processes, nevertheless Danke's core business model resembles that of a traditional real estate rental company, albeit with more standardized properties and reliable services.

Regulating FinTech

As much as Danke's management (or lack of management) is to blame for the company's downfall, partner financial institutions including Tencent's WeBank also played a crucial role in the story by serving as the financial intermediaries necessary to facilitate the issuances of rent loans. Specifically, it was the unrestricted use of rent loan financing that allowed Danke to expand at such a rapid and unsustainable pace. Were these partner banks not concerned about Danke's ability to repay, and hence continued to grant more loans without any restrictive covenants? Did WeBank, the counterparty to a majority of Danke's rent loans, not consider the risks associated with its increasing exposure to Danke? Given the amount of public information available, we don't believe that these banks were completely oblivious to Danke's precarious financial position.

Regardless of what the motives may have been for the partner banks, and especially WeBank, to continue granting (unrestricted) rent loans to Danke, one thing that is clear is how quickly companies can expand and how rapidly risk exposures can build up through the use of fintech or online finance platforms. Whereas in the past real estate companies typically operated in a more localized manner and borrowers usually went to local banks for loans or mortgages, with the advent of fintech, real estate firms can easily monopolize many key strategic cities while the same few banks can lend to a greater number of borrowers across the country. In some sense, this could imply greater efficiency and economies of scale. But from another perspective, risk exposures have the potential to build up more quickly as borrowers and lenders become more interconnected through the same few intermediaries, giving rise to systemic risk.

Will There Be Another Danke? The Example of Qingke (NASDAQ: QK)

To conclude our series on Danke, we raise the question, "will there be another Danke?"

This is not necessarily an easy question to answer, since many similar long term rental companies are private and there is very limited public data available. Nevertheless, common sense might suggest that there are other long term rental companies in the same boat as Danke. We take a look here at one such example.

Qingke, full name Q&K International Group Limited (NASDAQ: QK), is a real estate company founded in Shanghai in 2012 with a very similar goal to Danke, namely to provide standardization to China's long term rental market by serving as an intermediary to connect landlords and renters. The company's business model and strategy is, for all intents and purposes, identical to Danke's, including the target demographic of young office workers in big cities, the co-living space format (see Part 1) the supposed heavy reliance on technology, and most importantly, the use of three-way rent loan financing with partner banks.

Qingke had its IPO on NASDAQ in November 2019 (two months before Danke's IPO) as the first Chinese long term rental company ever to go public. The company grew from 912 units in Shanghai at the end of December 2012 to 91,234 units across six major cities in China at the end of 2018. Prior to its IPO, Qingke had received funding from a number of institutional investors with the most notable being Morgan Stanley Private Equity Asia, whose managing director stated that Qingke was their first investment in China's long term rental market and that they were "confident in Qingke's leadership team" and believed that "Qingke will remain a high-growth industry leader domestically and expand its footprint overseas" (please refer here).

Like Danke, Qingke relied heavily on upfront payments from rent loans to expand, with 65.2% of the company's units being financed through rent financing as of mid-2019. Typically, loan proceeds of up to 24 months' worth of rent would be made available upfront, with Qingke paying a security deposit of no more than 5% of the loan value. Qingke explicitly writes in its prospectus that it "encourage[s] tenants to prepay [rent] and have used the prepayments to finance [its] operation and expansion", with the proceeds from rent loans specifically going to capital expenditure for new apartments.

By early 2020, news started surfacing of Qingke defaulting on rent payments to landlords and contractors as the company was involved in numerous lawsuits. Given Qingke's increasing financial difficulties, China Construction Bank, one of Qingke's largest debtholders and partner financial institution, engaged in an agreement for Jianrong Rental, a long term rental company owned by the Bank, to accept a transfer of 25,375 rental units from Qingke over a period of six months from April to September 2020. This move was funded by local governments who wanted to avoid the same sort of unrest as the events that unfolded in front of Danke's head office. The transfer had an effect of reducing Qingke's total amount of rent loans outstanding from a previously recorded level of RMB756.7 million in September 2019 to RMB54.5 million in September 2020. Qingke also continued to serve as a service provider to its transferred units and benefited from servicing fees.

Since May 2020, financial institutions suspended providing new rent loans to Qingke's tenants. Qingke continued to struggle with cash flow issues and engaged in borrowing agreements with Shanghai Huarui Bank to obtain liquidity injections over the course of the subsequent months, although the company continued to march on with its aggressive expansion and acquired an additional 72,200 units in July across various cities in China. After making continual changes to its rental portfolio, Qingke had 81,624 rental units across almost 20 cities in September 2020, while at the same time continuing to borrow money to cover for operating expenses.

In 2020, Qingke reported a net loss of RMB1.5 billion and a working capital deficit of RMB1.76 billion. The company also reported its first positive operating cash flow last year, primarily driven by a large increase in Prepaid Rent and Deposit (presumably from the 72,200 new units acquired in July 2020), as well as increases in Accounts Payable and Accrued Expenses and Other Current Liabilities. We don't think the positive operating cash flows are sustainable since the prepaid rent and deposit are one-off inflows, whereas the increases in the latter two accounts reflect deferred expenses. Qingke also had large negative investing and financing outflows, while the company's ending cash and restricted cash balance was a meagre RMB31.7 million.

The auditor to the Qingke's annual report states that the company's significant working capital deficiency and significant losses, in addition to the fact that the company needs to raise additional funds to meet its obligations and sustain operations, raise substantial doubt about Qingke's ability to continue as a going concern.

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Explore the Danke Series

Part 1: Company Overview

Part 2: Analysis of the Collapse

Part 3: Recap, Reflection, and Lessons Learnt

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