The great China M&A roulette wheel – Due diligence, due diligence, due diligence: Part one

Posted by Reading Time: 5 minutes

China is seeing a huge increase in M&A activity, from increasingly diverse parts of the world. Led often by European businesses, who after all, share the same land mass as China (albeit one separated by a few deserts and a rather large mountain range) and have been pretty gung ho about China over the years. Mainly attracted, at least at first, by the lower wages as Western Europe became expensive, the development and inclusion of a cheaper labor pool from the former Soviet republics – some now EU members – has lead to the Europeans now coming to China seeking the Holy Grail: sales to China.

Buying an existing Chinese manufacturer who can be trained to make branded products is one way to go. Increasingly the Americans, traditionally more conservative (and separated by a not insignificant pool of water), are also moving in for the same reason. China’s market, as well as greater Asia’s, is opening up and creating new opportunities to sell branded products. It doesn’t hurt that the country provides a solid manufacturing base from which to conduct this. India meanwhile, faced with a demanding domestic consumer market but infrastructure problems in developing factories quickly enough to service it, has had to look into establishing factories in China to manufacture goods to send back home.

The past two issues of China Briefing have dealt with two of major topics – due diligence and financial reporting – when looking to buy a Chinese company. The January edition of the magazine will cover another important topic to consider: Can your China manager manage?

In the October issue, Chris Devonshire-Ellis wrote:

Over the 15 years of working with Dezan Shira & Associates in China, we have seen many cases of troubled investors with problems in our dealings with foreign investors in the country. Some of these, regrettably, have proved terminal and the venture had to close. Contrary to popular belief, lawyers and accountants do not want to see businesses with problems. At Dezan Shira, clients who are profitable and on-track with their investment are a far greater source of sustainable income than those with problems. It’s also true to say that of the many trouble shooting cases we’ve been involved in, 90% could have been avoided by the deployment of due diligence at the front end of the investment planning. That initial work upfront would have almost certainly have thrown up red flags that would have altered the destiny of the investment and made it far less prone to inherent problems.

It is an interesting position to take, stating as it does that problems over law and finance can effectively be mitigated against by proper planning. These are more the comments of a businessman than a lawyer on hourly billing rates. What is the most important step someone moving into China (or any market for that matter), due diligence.

Due diligence, due diligence, due diligence. The six D’s foreign investors must carry with them in a box of things to do that need to be crossed off their investment check list. Not to do so is largely negligent, and those problems later on that so many expatriates like to tell horror stories about can usually be avoided.

Instead of the usual “we got ripped off and it’s all the fault of the Chinese” diatribes that usually do the rounds, a lot of problems can often be attributed to the “arrogance of certain foreign investors” who fail to take the time needed to conduct a proper due diligence.

[There is] a devil-may-care attitude of many foreign investors and buyers in China who simply accept what they are told – and then get badly burnt. I recall a potential Western client who, when warned about conducting due diligence on his JV partner prior to signing contracts informed me, “I know all about international due diligence, I once set up a JV in Haiti so am familiar with what goes on.” Quite apart from the fact that Haitian law is completely different from Chinese law, not to mention the business culture, it was a classic example of ego getting in the way of homework. “I know what I’m doing.” That may be true. But if the Chinese know what they’re doing more than you do, and this is an away match on their soil, then you’d better get your knowledge base up to speed for local conditions. The potential client didn’t buy our due diligence services, and set up the JV himself. It went broke after a year. It was a clear case of investor arrogance – insisting he knew what he was doing despite having no China experience – that got this investor into trouble. Individual egos can interfere with due diligence requirements.

But impatience with egotistical foreign investors messing up China M&A or their joint ventures is only part of the story, the amoral nature of Chinese financial reporting also get taken to task:

A lack of moral fiber in Chinese society that makes fraud acceptable, particularly when it involves foreigners. The previous century of turbulence, civil strife and domestic persecution has lead to a mentality of taking what you can for yourself first, family second, and China third. Foreigners are still largely from outside the Great Wall and are fair game. In fact, the 20 years of foreign direct investment in China must, to some, have seemed like the world’s longest open season for big game hunting ever on record. Many Chinese are honest. It’s the ones that are not – and with 1.3 billion people, there are rather a lot of them – that you need to be aware of. I recall a German JV, whose senior management, impressed with the police escort from the airport, the ownership of a local five star hotel, and the ability to get documentation sorted, prevented any concept of due diligence taking place. “It’s simply not necessary with people like this” was the reply. Two years later, the same Chinese partner was in jail and the JV forced to buy back his 50 percent shareholding as the money invested in it had been stolen. That cost the German investors US$20 million more than they had intended and placed the JV in a position they are unlikely ever to recover their investment from. In looking at the case, it would have taken only two weeks homework to uncover the fact that the Chinese partners money just simply wasn’t really there”.

Guanxi, oft misunderstood and used as an excuse is also toucehd on: 

China’s regulatory system does not rely on guanxi and neither should you. Just because a local mayor gives you his blessing and says “I’ll look after you” does not mean you should not conduct your homework, and I must have met so many people who “confidentially” told me they were connected with the provincial governor. So what? Is he going to work on the factory shop floor?

True to point, it gets old hearing how many people have great guanxi as it is some sort of badge of honor, never realizing how dangerous, or downright useless the supposed guanxi is. There is a long history of foreign businessmen coming to China and getting taken for a ride by some provincial official, the whole time believing they have “found their man” in China. As Chris writes:

Government officials are often deployed as quasi salesmen, trying to get you to spend money in their city or province. They even have sales targets to meet. Having good relations is one thing, but you still need to do your homework. In the most cynical cases, officials themselves can even collude with local businessmen to defraud investors; especially over land use rights issues. When officials start to get involved, you definitely need to check out what is actually being offered to you.

Essentially what Chris is saying is that foreign investors and amoral Chinese partners are a duet made in hell, and places the burden of failure in ventures squarely at both doors.

The piece then goes on to outline the many aspects of due diligence – mainly legal administration work – that can be conducted to mitigate risk. The whole article (indeed the entire magazine) can be downloaded here if you are a China Briefing subscriber. If you’re not, but wish to read it, you still can, but you need to register as a subscriber first here. Don’t worry, it’s free.

As for the importance of due diligence, Chris is right, though it’s unusual to hear the faults of the foreign investor as much as the Chinese mentioned. Next week I’ll post his comments on Chinese financial reporting – it should prove interesting.