It has been over five years since we wrote the article “Ender into Senior Housing and Care Market in China”, at which time China had just introduced its 12th Five-Year Plan for the development of senior living industry. A lot of things—legislation, brands, product, supply and demand trend, among many others were unknowns to new entrants. Five years later, many operation brands, foreign and domestic, have emerged in the marketplace—some are doing pretty good and some are still struggling. Walking through the years, the market has evolved dramatically, and now it is a good time to have a recap.
The market status for foreign operators
There was a time foreign brands are struggling with whether or not they shall have Chinese partners to work with. To answer that really requires leveraging the mixture of various factors—specialty, team, capital, commitment to the local market etc., which usually will be putting together as a company’s business strategy of moving to the China market. However, many actually are more opportunistic. Partners being chosen to work with, locations being selected, or even core team members on board are not happening in a strategic way. Often times, it is just opportunities haven’t been emerged in other possible ways.
Over the times, the route into China has become clearer, thanks to a couple of pioneers from the U.S, Europe, Australia and Japan. Here is a summary of their attitudes towards a partnership. First, they are open for various types of cooperation with Chinese partners. Even for those who do insist on the WFOE (Wholly Foreign-owned Enterprises) investment form (or going solo putting in another term) are not resistant to have a Chinese partner to help then get access to real assets, capital, government relationship and other resources. Second, the market has been developing rapidly, in particular in the merger and acquisition spectrum. Nowadays, you can find a number of deals where Chinese companies buy equity or assets of overseas senior care communities, large companies buyout startup business, and big brands merge, just to name a few. Today’s solo could be tomorrow’s cooperation. Third, as is played in every business, joint venture is still a prevalent approach to pursue when a foreign investor enters into a nascent market. Admittedly, in many industries, JV could be fragile where the parties fail to find mutual ground to accommodate diversified views and accomplish different goals. But for now it could be more risky and costly haven’t a Chinese partner working together and navigating a lot of uncertainties at the first place.
In this context, the most frequent way operators adopted to expand their landscape has to be the execution of “Facility/Community Management Agreement” with Chinese owner, a business model that U.S. operators are very familiar with and feel comfortable to start with in the Chinese market. It is neither new things for other operators, foreign or domestics, as during the years it has become one of the highly welcomed cooperative models for many real estate developers and insurance companies in China.
Definition of Facility Management Agreement
The common definition of operation management is that manager is granted with full authority by owner and holds responsibilities and complete and full control and discretion in the operation, direction, management and supervision of a senior housing project. Operation management contract may vary in different context and forms due to particularity of different projects. It is particularly important to note for seasoned operators that typical Western-style contract terms in the Management Agreement have been developed in China to the extent that we cannot take it for granted that some well-accepted commercial terms in the U.S. context will also be working on the negotiation table with a Chinese partner.
Negotiating a management contract satisfactory to both the owner and manager is a work of art that requires patience and effort for all stakeholders. Closing a management deal is also a self-reflection journey to find out an operator’s bandwidth as well as reach a balance between the owner and itself. In a typical 30 to 40 pages’ management contract, there are lines both parties care about the most, failure to achieve mutual agreement of which may cause a negotiation broken.
Ten Basics for a Senior Care Community Management Agreement
1、Is due diligence necessary?
Many think it does not worth the time and cost to conduct a due diligence but actually it does. Simply because the negotiation of a Management Agreement is a time and money cost process for many foreign operators, it is extremely important to conduct a preliminary legal and commercial due diligence to exclude opportunities that don’t fit for the parties at the first place. When negotiation goes on, further due diligence regarding project information and owner’s track record on selected items recommended by an experienced counsel is necessary, as the result of which might affect major commercial terms in the Management Agreement.
2、What are signing parties of a Management Agreement?
A foreign operator can choose to set up a Wholly Foreign-owned Enterprise (“WFOE”) or Joint Venture (“JV“) to conduct business in China as a manager. Whether a Chinese partner holds stake in the management company could make a lot of difference for a manager in the bargaining power of such agreement.
Company incorporation procedure for foreign investor has been simplified in China in recent years, and usually there is no restriction to establish a senior care management, consulting or service company to sign and execute a Management Agreement. However, it is advisable to carefully choose business scope of the management company as that will have significant impact on a foreign investor’s capacity to conduct business in China.
3、What is common Fee Structure for the manager?
Management services are usually defined at different stages of project development: pre-opening consulting and technical support, operation management as of facility opening, support on the property sales (often seen in multi-stage and mixed-used developments), and other services such as day care and home care services (optional). Accordingly, fees can be charged in forms of consultancy fee, base fees, incentive fees, brand use fees, etc. There are benchmarks from the Western market we can refer to as to how much those fees can be charged. For example, base fees usually vary from 3 to 6 percent of gross revenue, and incentive fees can be determined by earning result of the community. However, when the facility management model is transformed and evolved in China, those references from other countries have become less reliable for operators as market performance is hard to project but operation cost in a new market is usually higher than that in developed markets—therefore, it is also common to agree on a minimum monthly fee in case the calculated base fees result in short of its expenses.
Accounting rules specific to gross revenue, net income and cash flow is also important to be clearly defined if any of the fees are calculated based on these factors.
4、Is the royalty fee for using the operator’s brand common to charge?
It is not common in Facility Management Agreement because a manager’s reputation and expertise have been reflected in the fee structure at above point 3. However, in a multi-stage development project, the owner/developer will be willing to discuss a brand use fee if part of the project is for sale and the operator’s brand and participation in the sales and marketing activities (usually together with manager’s service available to the homeowners) is expected to make a great contribution to the project value. In those cases, brand use fees generally represent a fixed percentage of the sales price of real property, mostly like what branded residence under hotel groups will charge but usually lower than the benchmark in a hotel business.
5、Manager’s autonomy vs. owner’s appropriate supervision in daily operations
In the fight of decision making of daily operation issues, manager definitely seeks complete and full control and discretion over the operation without intervention of the owner; however, the owner wants to make sure it will not assume the operational risks as a result of manager’s wrongdoing, and the manager will make proper and good use of its money.
A lot of practices in the hospitality industry can be transformed in this respect as fights alike have been taking place and addressed in China for over a decade. Participation of an owner’s representative in daily operation can be carefully designed. It can be very useful to coordinate tons of matters in day-to-day operations. It is also common for a manager to hold firm position to make decisions on expenditure within approved budget, prepare and execute marketing and sales plans, recruit and train employees, draft and implement residency policy and documentations, etc.
In a multi-stage project development, a manager may only participate in a portion of community management job. In that case, other consultants, service providers or stakeholders may be involved. It is of great importance for the manager to define clearly of its duty and authority of management in order to avoid intervention by third parties, or in some instances being blamed for the failure of a project not attribute to it.
6、What performance test clause usually provides?
Performance text clause usually entitles an owner a right to elect an early termination in the event the community is under-performed. This requires a lot of elaboration as the pricing model, market projection, project cost has a lot to do with the metrics of performance. With less confidence and experience in the Chinese local market than in their home countries, managers are very cautious in choosing earning-based or expense-based tests formula. More often, performance test is as easy as simply based upon the occupancy rate.
7、Who will recruit and employ operation team?
While in the hotel industry it has been well accepted that an owner’s entity which operate a hotel will employ all operational staffs but the senior ones (e.g. hotel General Manager) usually report to the manager, practice in the senior care industry is a bit different that many of the senior level employees are employed by the manager, and owner may only reimburse part of the HR cost.
From the manager’s perspective, it is a highly professional business that senior operation and marketing people need to be retained by themselves to protect their knowhow and avoid the risk of losing control over project. Burden to have more HR cost will usually reflect on the fee arrangement so eventually it aims to be shared by the owner.
8、Typical terms of a Management Agreement and where early termination can apply
It is typically between 10 to 20 years. Sometime in an agreement with a relatively short term, a manager will have a renewal right if certain conditions are met. Early termination usually applies when managers fail to pass the performance tests during a certain period of time. Occasionally, manager will ask for a right to cure a failure by paying remedies to the owner in order to continue with the facility management.
9、How operational risks are allocated between the owner and manager？
A manager has a duty of care to fulfill its diligence in day-to-day operations. However, while operational risk in the senior care business is high, a manager usually will only agree to hold the liabilities arising from its misconduct or wrongdoing under severe circumstances, and a manager’s liability to reimburse the owner is only on top of what the premium owner can firstly acquire from a liability insurance policy. Apart from these, ordinary risks arise in the course of daily operations are usually born by owner.
10、Is exclusivity clause common for a manager to agree?
Exclusivity is not common in a pure management agreement. But in some circumstances, owner might request an exclusive cooperation in specific region (territorial or radius restrictions) while the owner has a pipeline to develop multiple senior care communities in targeted region and seek cooperation with the same manager. Situation may be different if the owner has an equity interest in the manager’s corporation, as in those cases need to restrict competition becomes mutual interest for both to consider. Having that said, it is not common for the manager to charge an exclusive fee.