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ChamberEy Summer 2009 (Web)
ChamberEy Summer 2009 (Web)
ChamberEy Summer 2009 (Web)
OF COMMERCE GUANGDONG
2009 SUMMER EDITION
BRITCHAMGD.COM
Due
Diligence ARTICLES BY
DELOITTE, EXPAT-CFO, MERCER, KPMG
Kelcroft E&M Limited & MORE!
CONTENTS CHAMBER EYE GUANGDONG
A DIFFERENT TOOLBOX FOR M&A DUE
10 DILIGENCE IN CHINA Guangdong Magazine
16
Pat Kwan
Office Administrator
Emelie Zou
Sales & Marketing Executive
Chris Chen
21
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MARKET www.britchamgd.com
Shenzen Sub-Chamber
Roof 314, 3/F
Chinese Overseas Scholars Venture Building
23
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Advertising Contacts
Josef Jelinek
EXAMINING THE FINANCIAL HEALTH OF YOUR
27
jj@inecko.com
LISTINGS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
NEW MEMBERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
EVENT PHOTOS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
3
SUPPLY CHAIN VISIBILITY:
ILLUMINATING HIDDEN LINKS IN ASIAN SUPPLY CHAINS
Manufacturers in Asian emerging markets often meet the supply requirements BY JIM RIDGWICK
of their international customers through an interlinked network of sister op-
erations, business partners, subcontractors or even the sub-contractors of their
subcontractors. In many cases the buyer is not even aware that this trading
relationship is happening. This is particularly commonplace when buyers
seek a one-stop source of supply outside of the limits of their chosen supplier’s
capacity or competence.
Trading companies that make global sources accessible to compa- some key global sourcing risks, it also allows capture of further ben-
nies who are buying abroad also add uncertainty to supply chains. efits from companies’ Asian supply base.
If they were to share information about the manufacturer, it opens
doors for buyers to purchase directly, thereby removing their role
and margin from the transaction. What are the benefits of illuminating these hidden
links?
Suppliers that subcontract or trade without notifying the buyer or
having trading companies that protect their commercial position by Open and transparent relationships with the trader helps ensure
hiding the identity of the suppliers are both accepted business prac- that quality requirements have been met. Quality managers in the
tices in many industries in Asia. buying organisation can speak directly with those responsible for
production, thereby building accountability. They can also see first-
Many industries are so fragmented that, in order to meet the prod- hand evidence by visiting the factories to be reassured that produc-
uct range, volume or lead-time requirements, there may be no single tion workers and their managers understand, respect and adhere to
supplier that can produce the complete order. Furthermore, even the buyer’s quality and social responsibility requirements.
with rigorous supplier identification and screening processes the
most capable manufacturer may still be overlooked due to the lack The importance of nurturing direct relationships with Asian suppli-
of public domain information about them or due to extreme market ers should not be underestimated. It is impossible to build trust if
fragmentation (for example, there are 10,000 electronics and tele- the buyer and the manufacturer never actually meet and spend time
communications equipment manufacturers in China with revenues together to understand one another. By communicating through
over $800,000). the trading entity, messages can be miscommunicated or, at worst,
manipulated to meet the objectives of the trading entity.
Building direct relationships can also provide the foundation for ser-
vice improvement, joint product development, and cost and price
Global Sources Buyer reduction through value engineering. Suppliers in emerging econo-
mies are entrepreneurial and innovative; they are hungry to explore
such opportunities.
Trading Trading Whilst managing social and environmental compliance is possible
Company Manufacturer with suppliers that buyers know, it fails for those that are hidden. In
relying on the trading entity to conduct this due diligence the risk in-
creases exponentially. In a world with powerful global brands, con-
Source Manufacturers sumer expectations do not differentiate between product produced
(entity unknown) domestically or overseas; to them the entire supply chain is all one
brand, one company.
In Many Buying Relationships The True Source This further demonstrates that the only way to have total confi-
Manufacturer Is Unknown By The Buyer dence is to see the supplier’s conditions first hand or to use an in-
dependent trusted audit firm. To accomplish this, each part of the
supply chain must be known and visible.
From whichever channel a product is sourced, it is therefore critical
in low cost locales to know where and by whom the product is being
made. Increasing the visibility of the supply chain not only mitigates
EXTENSIVE MONITORING
35%
LITTLE MONITORING
16%
SOME MONITORING
49%
5
Finally, traders must understand the importance of buyer visibility
to all nodes in their supply chain, and therefore when they wish to
Percent Responding ‘Extremely Likely’ (6-7 On 7 Point Scale)
change the source manufacturer, they should notify the buyer and
gain their approval before any transition.
Overall 45% This should be documented into the supplier agreements and should
Reputation 67% be monitored by plant visits through the contract term.
Quality Of While maintaining these higher standards can lead to higher operat-
89%
Products/
Raw Materials 88% ing costs, it must be factored into the total cost model that informs
the sourcing decision, they need to be seen in a larger context.
87%
Cost
77%
Is this the end of the trading entity?
80%
Reliability
89% Even in supply relationships where the buyer works directly with
the source manufacturer, the role of the trading entity may not nec-
67% essarily become obsolete. As buyers aim for transparent trade rela-
Product Safety
77% tionships, the traders must continue to demonstrate and improve
their value proposition to earn their share of each transaction.
Fast Delivery 65%
Schedule 75%
52% At one extreme their role could be to introduce the buyer to the
Flexibility manufacturer then to step back. At the other extreme, day-to-day
45%
communication is through them, they receive all payment and are
Environmental 40% ultimately accountable for product quality and delivery. Buyers
Record 40% should carefully consider the role of the trading company in their
Asian sourcing.
Product
40%
Development
Capabilities 60% Having the trader as a point of escalation or as an intermediary
can be invaluable to
Working reach a particular out-
32%
Conditions/ come, for example, to
Labor Practices 31% Trading entities value proposition may
overcome the source
include:
manufacturer’s resis-
Product Design 32%
Capabilities
tance to a low mini- •Established network of capable proven
58%
mum order quantity manufacturers;
Corporate 24%
or to a new, unknown
Citizenship 21% customer. The trading •Capability and infrastructure to control
entity may have more quality or to consolidate, label, package, or
negotiating influence hold inventory;
D eve l o p e d M a r ke t E xe c u t i ve s as it is likely to be
trading with the man- •Export license/customs brokerage;
C h i n e s e E xe c u t i ve s
ufacturer on behalf
of other buying com- •English speaking, professional service
Source: Deloitte’s Global Manufacturing Industry Group ‘Innovation In experienced in meeting the needs of
Emerging Markets. 2008 Annual Study’ panies. Alternatively,
the trader could gain international buyers;
one-third said that such monitoring was extensive. concessions leverag- •Knowledge of local regulations or
ing personal connec- government relationships;
The survey showed that roughly 90 percent of executives said they tions (or “guanxi”
visit supplier facilities in emerging markets, with half saying these in China) through •Provide pricing stability;
visits occur more than once a year. Nearly all said that these inspec- drawing on the trust
tions looked at quality control processes, followed by facilities/ gained through their •Intermediary with the source
equipment, raw materials, and the skills of quality control person- entire business rela- manufacturer in issue resolution or
nel. Companies that are more successful with emerging market tionship. This may negotiations;
sourcing were more likely than others to assess the skills of manage- have a far greater ef-
rial employees and working conditions in their inspections, as well. fect than the influ- •Ability to deliver special projects such
ence a foreign buyer as, joint product development or quality
In all such site visit audits, it is important to cross-reference each could apply even with improvement programme, and/or
answer from the supplier by requesting and observing supporting local sourcing staff.
evidence. Evaluate their true capacity. Seek evidence that the target •Ability to develop and integrate new
product is actually being manufactured and that production covers suppliers into global supply chains.
It is also wise to de-
the elements of the manufacturing process critical to quality and velop an exit strategy
not just assembly, finished goods testing or packaging.
Based on the recent phenomenal growth of exports from Asian Jim Ridgwick, Deloitte.
sources, if a trader with a sustainable value proposition is removed jridgwick@deloitte.co.uk
from one buying chain there are many other opportunities for them
to capture! In this fashion a trading company partner can become Jim is part of Deloitte’s Supply Chain practice. Over the last 3 years he
an element of continuous improvement in a global sourcing pro- led their Sourcing practice for China in Shanghai; he advises European
gram. and US leading companies on the design and successful implementation
of their Global Sourcing programmes. He is currently based in the UK.
In summary, an accepted practise amongst Asian suppliers is that
manufacturers will trade or subcontract to fulfil orders – in some
cases without the buyer’s knowledge – and trading companies will
protect their role in the transaction by concealing their manufactur-
ing sources. This leads to concealed nodes in global supply chains
that represent lost opportunity at best, and at worst a significant
risk to product quality and corporate brand equity. Through under-
standing the importance of full supply chain visibility and by ad-
dressing this point of exposure directly, tactics can be employed to
shine light on the hidden parts of Asian supply chains.
7
STARHOUSE 60 - GUANGZHOU
BY AJOY SAHU & CEDRIC MOREE
FROM RADDISSHMe
Over the past decade, there has been a big global push towards sus- artistic movement.Guangzhou has an opportunity to make a name
tainable and responsible development, leading many governments for itself as one of China’s leading cities for creative arts and busi-
and businesses to start considering their impact on the environ- nesses.
ment.
Give the young people spaces that will let their dreams and hopes
Already the major cities in China have worked hard to regenerate evolve as Guangzhou moves to a post-industrial era of aesthetic and
and promote old industrial areas, turning them into artistic and ethical regeneration.
cultural centres. Most notably, Beijing ‘798’ and Shanghai ‘Mo Gan
Shan’ have shown that these areas can give artists and other cre-
atives the chance to flourish.
Guangzhou is no different.
If you are a manufacturer in China and your ucts there may be significant environmental 7. Can you supply a list of Environmental
client starts asking you about your environ- impacts associated with their extraction, Issues arising from your activities, products or
mental performance what do you do, why production, transport, intermediate stor- services?
are they asking these questions and how are age and/or contracted out services, or ser- 8. Do you use any environmentally damaging
you supposed to respond? vices provided by JV partners. Although you Chemicals or Processes?
might like to conveniently ignore some of 9. Have you carried out any work to minimise
Pressure these your client will regard all environmen- their impact on the environment?
Global competition forces companies to tal impacts associated with your product or 10. Do you have an EMS (Environmental
form commercial alliances, suppliers with service as yours and so you have to be seen Management System) in place?
weak environmental performance can dam- to be managing them. 11. Do you intend to get it Certified?
age their business and business partners
want to minimise risk by working with lead- Control Your Response
ing companies. Clients will normally try to keep suppliers If you cannot answer these questions easily
under control by: then it’s about time you took some action.
Views • Use of contractual terms You could consider implementing an envi-
A “Clean” environmental image equates to • Establishing lists of preferred suppliers ronmental management system which will
efficient & innovative management, be- • Adhering to a consistent Purchasing Policy address these issues as illustrated below.
cause good environmental management re- • Use of supplier questionnaires and audits
quires waste minimisation and prevention • Applying bans to certain products/suppliers To achieve this you could ask your friendly
of pollution. Effective waste minimisation etc. neighbourhood consultant, but make sure
and pollution control maximises profit. you get an Environmental Consultant and
Information Management not a Quality guy who sees an opportunity
Customers in the supply chain cannot af- Your client will probably store supplier to earn a fast buck. Ask how they can dem-
ford to buy products which do not meet questionnaires and audit responses in a onstrate their environmental competence.
their environmental standards; would you database, allocate ratings re performance, If they shy away then you’ve asked the right
want to admit you bought supplies from rating suppliers re risk, visiting and inspect- question!
Union Carbide after their Bhopal incident or ing suspect responses! Where there is doubt
from Exxon after the Exxon Valdes disaster? they will seek to find alternative lower risk Alternatively you could look at the HK Gov-
suppliers or maybe even eliminate high risk ernment’s Environmental Protection De-
Like ISO 9001, large companies have adopt- suppliers altogether. partment’s web page to find some answers,
ed ISO14001 & are forcing their suppliers most of what you need is there in English
to follow their lead (witness HKSAR Gov- Questionnaire & Chinese. A good source of info is the In-
ernment who have certified most of their Typical questions you will be asked to an- stitute of Environmental Management and
Works’ departments and are now asking for swer are as follows: Assessment in the UK, (IEMA.net). Oth-
environmental management in their tender 1. Do you have an Environmental Policy? erwise go on an Environmental Awareness
specifications) 2. Who is ultimately responsible for Environ- course and start to learn about Environ-
mental Issues within your organisation? Give mental Management.
If your client is certified to ISO 14001 then name & position
they have requirements under clause 4.4.6 3. Can you provide a list of applicable Envi- Remember “Treat the earth well: it was
Operational Control to: ronmental Legislation, with which you have not given to you by your parents, it was
• Establish & maintain procedures related to to comply? loaned to you by your children”. (US In-
identifiable significant environmental aspects 4. Do you know what to do to comply with this digenous Rights Quote)
of goods and services used by the organization legislation?
• Communicate relevant procedures & require- 5. Do you have any Environmental Licences Dr Ian T Nicolson is founder of Enviro
ments to suppliers and contractors in place? Solutions(HK) Ltd. He can be contacted at
6. Have you ever been prosecuted for breach- MD@Enviro-Solutions.HK
Impacts es of environmental laws /regulations?
When purchasing raw materials or prod- ( give details, dates & outcome)
Management
Commitment
Do Aspects Act
Communication Customer
Check Satisfaction
9
A DIFFERENT TOOLBOX FOR M&A DUE
DILIGENCE IN CHINA
BY JAMES BOYLE AND MATTHEW WINTER
A Different Toolbox for M&A Due Diligence in China to send in a turnaround team to salvage residual value from a failing
operation that was ill-advised from the start.
If we accept that the goal of any diligence process is to understand After a sober review of these major issues, if the contemplated
the inner workings of the target business and that what the acquir- transaction still looks like the best strategy, you are ready to begin
ing party ultimately needs is a clear, valid and exhaustive portrayal the due diligence process in earnest.
of the company being scrutinized, then it is easy to understand why
a document-driven due diligence is inadequate in China. The corpo-
rate culture of local companies is not typically one that values trans- Target Search: Cast a Wide Net, Quickly Sharpen
parency, and serious analysis combining operations, finance and Your Focus
accounting is critical in order to arrive at meaningful numbers and
avoid investing in a mirage or a house of cards. The document review Once it is determined to proceed with a transaction, it is important
that would comprise the entirety of a due diligence in the West is to review all possible targets. Before revealing your intentions or
certainly an essential part of diligencing in China, but an acquirer making a commitment, it is crucial to learn all the players and their
that limits itself to mere examination of the paper trail will fall on its relative standings: many foreign firms take the easy route and pur-
face. The key to a powerful diligence in China is rigorous analysis and sue a venture with their current supplier or even the first firm they
fact-checking and cross-verification on site by a multidisciplinary find in their business. Tying up with a weak partner at this stage,
team. Only this kind of thorough, cross-functional approach will ad- however, not only threatens the success of the project—it can be a
equately equip decision-makers to ensure a successful transaction or potentially fatal blow for the parent itself.
avoid a costly mistake.
This master list should be built mostly from a market research or
survey point of view: search engines, B2B sites and other databases
Diligencing the Logic of the Transaction are a good way to get a general catalogue of who the players are.
Once all the players are known, a proper analysis can be made of the
Prior to spending considerable resources on putting together a relative strengths and weaknesses of each.
meaningful due diligence, it is imperative to ask ourselves some
major questions regarding the decision under consideration. What, With a comprehensive list in hand, you can now move to cross most
explicitly, do we hope to achieve by the transaction? What is the end of the firms off of it. Much of this will be easy to do, especially if the
game and what are the alternatives? Why is the deal better than a process is properly structured so as to conserve your resources for
greenfield operation or some other business arrangement? If the the main diligence effort. Many companies in China’s fragmented
transaction is to be a joint venture, are you merely paying tuition for market have no intrinsic value proposition and exist merely because
a formidable competitor? of local protectionism, some form of subsidy, or even a single re-
lationship. While this is certainly valuable for them, it limits their
It is also wise to explore all of the reasons why local management growth perspectives and is unlikely to be transferable to the new
recommends a certain approach in regard to a transaction. In our venture without tradeoffs that would be unacceptable to most out-
experience, many transactions in China are ego-driven and under- side investors. Depending on the industry and type of transaction,
taken to build the resume of local country management: often, there may be other obvious “deal-killers” that can be used to eas-
foreign-educated local managers will recommend actions merely to ily eliminate candidates at this stage. After this initial cull, you can
put an M&A feather in their hats, ultimately leaving the head office utilize simple SWOT analysis techniques to further pare down the
1. A typical staged due diligence would start with commercial DD/ market research, then move to operational DD, legal review, moving finally to accounting compliance review and financial DD.
11
to falsify its records, and good modeling will easily identify whether
the current ledgers are reasonable. During the modeling phase, it is Additional Checklist Items: China-Specific Consider-
important that the team make sure that the full costs are accrued. ations
This would include the costs incurred from verbal barter agree-
ments, off-balance sheet liabilities and the commitments associated
with government favors and relationships or “guanxi”. ABOUT THE AUTHORS
Only by mapping and then financially modeling the business using James Boyle,“Jay,” is the Managing Partner of Expat-CFO Services,
fraud and forensic techniques is it possible to confirm that the ac- a boutique financial consultancy providing transaction advisory
counting records are realistic. Letting the mapping process drive the for pre- and post-acquisition. He is fluent in Mandarin and has
interviews and your site visit is the quickest way to get up to speed lived and worked in China since 1996 in numerous financial roles
on a business and forensically test whether the information that is for industry.
in the accounting system is in line with what you see on the shop
floor. Matthew Winter is the Frontier Market Project Manger of Expat-
CFO Services. He speaks Mandarin, Uighur, Russian, Uzbek and
Arriving at a number: Business Valuation Turkish and has lived in Asia for 10 years.
For further info see http://www.expat-cfo.com or contact Jay at
While business valuation techniques employed at this stage are by jay.boyle@expat-cfo.com
no means unique to China, some special points are worthy of note.
First and foremost, the valuation under any method should be driv- © 2009, James Boyle; Expat-CFO Services LTD.All rights re-
en by the due diligence numbers themselves, including all the hid- served.
den and off-balance sheet costs.
For deals in which sales are highly uncertain and are dependent on Industry Classification: The PRC government classifies industries
one or a few major events, as: encouraged, neutral, discouraged, or forbidden. Policy dictates wheth-
including blockbuster R&D er and on which terms an industry can have outside investors.
Asset deals: The diligence projects and abstract, long-
exercise should dictate the type of term, strategic “we cannot Verbal agreements and hidden stakeholders: In the 90’s, verbal
deal that is feasible. In many cases afford not to establish a contracts became legally-binding, and there are often many people that
the risk of an equity deal is too beachhead in China” proj- are able to demand that it honor such agreements. It is also not uncom-
great, and an asset deal that allows ects, a valuation utilizing mon for local government officials to receive certain benefits from a firm
the acquirer to cherry-pick assets real option methodology that go unrecorded and for it to be expected that these services continue.
is a more viable solution. Note that may give a clearer picture
for an asset deal to be viable, your of the risk and opportunity. Shadow companies: This is when a JV partner sets up a mirror opera-
firm will need a registered legal en- tion following a transaction, especially if the foreign firm is a strategic in-
tity that is legally allowed to accept When using discounted vestor that upgrades knowhow. Management may open a second or third
the assets that will be transferred. cashflow methodology, shift, use company assets for an unrelated enterprise or run two payrolls
In some cases, assets are not trans- the discount rate must be through the company—one for the company itself and the other for the
ferrable at all under local law and, meticulously built-up by a shadow.
in any event, different taxes often party with China-specific
apply. micro- and macro-econom- Tax GAAP: Most private firms keep records in the old PRC GAAP, a mix-
ic acumen. One of the big- ture of cash and accrual methods currently referred to as tax GAAP. These
gest mistakes strategic buy- can severely misrepresent the company’s financial condition.
ers make is to determine that the discount rate is the same as their
company’s cost of capital. This is a very dangerous assumption as Land use right: In China, you cannot own land, but you can purchase
that rate, at best, does not reflect sovereign and currency risk. the land use right. It is mission-critical to confirm that the correct compa-
ny (not the parent or an affiliate) owns the land use right, that the right
As indicated above, use of sales and net assets multiples for the rel- has been transferred correctly and that the land is not zoned for farming
evant industry is one widely-accepted method in China. When using or something else.
multiples, it is useful to bear in mind that, if the existing market in
China is weak or non-existent relative to the comparables, then the Off-balance sheet liabilities: Off-balance sheet liabilities, such as
result will be an inflated number. unrecorded accounts payable and extra employees on payroll, are common
in China and can pose a problem.
Conclusion: Negotiating the Minefield
Contingent liabilities: It is important that all contracts are reviewed
While daunting, good China due diligence is rewarding, as it allows a by competent professionals knowledgeable in Chinese legal language.
company to snatch up bargains and back away from lemons—both Contracts can be very obtuse and interpreted differently by each party.
are abundant in Chinese M&A and PE deals. Having conducted It is best to err on the side of caution when identifying and quantifying
thoughtful analysis of the kind that the Chinese side might well these types of risk.
be unequipped to perform itself, quality diligence can be a source
of a powerful informational advantage. However, diligence of the
sort outlined here remains, above all, a necessary risk-mitigation
technique for an environment that lacks guarantees often taken for
granted in the West.
A response to both these observations can be found in “Poorly Made Aware of these dynamics, Western retailers increasingly use outside
in China” by Paul Midler, a fluent Chinese speaker who in 2001 testing laboratories for Chinese products. But this too, Mr Midler
moved to China to work as a consultant to the growing numbers of writes, is more form than function, since the tests are by their very
Western companies now replacing factories in Europe and America nature more limited than the ways to circumvent them. The process
with subcontracting relationships in the emerging industrial zone resembles the hunt for performance enhancements used by ath-
surrounding Guangzhou. It was the perfect period to arrive. The letes, where a few get caught but the cleverer ones stay ahead by us-
normal problems of starting a business, such as getting clients or ing products not yet on the prohibited list.
providing a value proposition, do not hinder Mr Midler, who had the
benefit of being in the right place at the right time. It would be unfair, of course, to see all Chinese companies in this
light. A few are gaining international recognition for quality, but in
Not only did he quickly, and seemingly effortlessly, find customers, contrast, say, to Japan or America, this recognition comes at a cost
they were delighted with what they found in China. Factories will do to the firms themselves because it is accompanied by unpopular
anything to please. Prices are famously low and production cycles scrutiny and compliance. This odd situation became apparent when
short. His clients returned from their initial trips to China stunned Mr Midler witnessed large, modern Chinese factories outsourcing
by how quickly factories became proficient and puzzled by how work to smaller, grittier, facilities even though this meant forgoing
much could be done so well, so fast, so cheaply. They were right to the production benefits from economies of scale. The tiny outfits
wonder. were in a much better position to skirt environmental controls and
safety standards for products and workers.
Most of Mr Midler’s work is coping with what he calls “quality fade”
as the Chinese factories transform what were, in fact, profitless con- The obvious way to clean up this mess—and to know whether it is
tracts into lucrative relationships. The production cycle he sees is really as pervasive as this book suggests—is through broader disclo-
the opposite of the theoretical model of continuous improvement. sure, but by whom? The Chinese press is sometimes revealing but
After resolving teething problems and making products that match typically controlled, as are foreign reporters. Many production prob-
specifications, innovation inside the factory turns to cutting costs, lems are well-known within local manufacturing circles, Mr Midler
often in ways that range from unsavoury to dangerous. Packaging is says, but collusion is rampant and there are no rewards in China for
cheapened, chemical formulations altered, sanitary standards cur- whistle-blowing. Most of the people in Mr Midler’s position would
tailed, and on and on, in a series of continual product debasements. not dream of disclosing what they see and many testing laborato-
ries protect their reputation by hiding, rather than revealing, what
In a further effort to create a margin, clients from countries with they test. As a result, if Mr Midler’s perceptions are true, the pri-
strong intellectual-property protection and innovative products are mary source of discovery will come in the worst possible way—by
given favourable pricing on manufacturing, but only because the consumers who buy Chinese products, only to discover their flaws
factory can then directly sell knock-offs to buyers in other countries themselves.
where patents and trademarks are ignored. It is, Mr Midler says, a
kind of factory arbitrage. From the print edition of The Economist 16th May 2009 @
The Economist Newspaper Limited, London (2009)
The first line of defence against compromised products are the fac-
tory’s clients, the importers. The moment they begin suspecting a
13
COMMERCIAL DUE DILIGENCE - AN ESSENTIAL
TOOL FOR EVERY TRANSACTION IN CHINA
As a whole, FIE expansion via M&A has increased substantially over the past three BY STEFAN KRACHT
years. This is partly due to consolidation in many industries and also because increas-
ingly, growth via acquisition is proving to be a faster and sometimes better method
to tap the China market. Against the background of lower transaction prices and
increased opportunities in China, we advise clients to continue this strategy in a more
focused manner.
In our work with GMs, Business Unit Leaders, Strategy Heads and • Confirms basic interest on both sides and further strengthens the
CFOs, two reasons arise for failed acquisitions: lack of information partnership with the target
and failure to build relationships. Negotiations often break down in • Optimises buyer’s tactics and negotiation power
the early stages when decision-makers of both parties fail to agree • Reduces transaction risk and limits liabilities
on basic issues such as business plan feasibility and valuation meth- • Results in a practical and realistic plan for post-acquisition integra-
ods. This is because validating the deal rationale and building deep tion including agreement on complementarity and synergies
relationships during the financial and legal due diligences is impos-
sible. For which cases does CDD apply?
This approach is widely used in M&A both for strategic investments
Our clients confirm that the best way to achieve sufficient infor- by corporate and for financial investments by private equity. In ad-
mation and to build the necessary relationships is via discussions dition, many clients have engaged us to conduct such diligence when
within the target and with third-parties such as industry observers, making strategic supplier decisions.
suppliers and customers. The fast-changing environment both in-
side and outside of China is a further reason why commercial due How does it fit with other DD?
diligence has become essential. Finally, deals here are much more (Chart 1)
about creating mutually beneficial partnerships than about pure fi-
nancial transactions. How does it differ from FDD?
Due to the broad nature of commercial issues, a CDD often also in-
What is commercial due diligence (CDD)? cludes a basic legal and financial analysis. Below is an outline of the
CDD is a complete process of investigating a target in terms of its main differences:
strategic, commercial and organisational capabilities relative to its (Table 1)
market. It allows the buyer to gain a deep insight of the target’s busi-
ness model, success factors and competitive position in order to What are the successful deal ingredients in China and
validate future investments. Specifically, a CDD assesses the target’s how does CDD play a role?
commercial situation in three main respects:
• What drives growth in the target’s market? 1. Define deal breakers before beginning the CDD or negotiations,
• How is the target positioned and perceived to grow in its market? and be firm on them
• How will revenues and profits from the target’s core operations • This will clarify your thinking in terms of when to drop the deal.
support its ambitions? • In case you decide not to proceed, you can use your funds to invest in
alternatives.
Why does it pay off? As an example, for a specialty metal manufacturing client, the rela-
Our clients have found that such insight: tionship with local residents turned out to be a deal breaker since
the manufacturing process currently used by the target had a large tion.
negative influence on the local community. As an aside, this high- • Example: qualitative inputs from workers on assembly line, engineers
lighted how important win-win solutions between targets and lo- from QA and production departments are important facts to identify the
cals are. potential for cost optimisation.
2. Fix a schedule 5. Use the process to familiarise yourself with the relevant people
• Clear communication on the project schedule can convince Chinese own- • Get to understand the working style and personality of the decision
ers, who are often inexperienced, of your seriousness, and can assure that makers.
they will cooperate with the CDD team efficiently throughout the process • Better understand who the influencers are (including shareholders,
including interviews and data room set-up. management team, local government officials, relatives or partner com-
• This schedule should include key communication windows during the panies).
project in order to save time committed by the target.
• Such a timeline can also contribute to smoothing the process of internal As an example, we dealt with a Chinese entrepreneur who owned
approval, for example from a board of investors. 20 companies involving different types of businesses, using them to
evade tax and enable other ”flexible arrangements” between the en-
As an example, for most of our clients engaging in mid-market tities. The shareholders of the 20 companies were friends and rela-
transactions, a 3-4 week CDD is necessary in order to enable closing tives who had significant influence over the target even though they
within less than 6 months. Without clear communication and regu- had no direct investment relationship under the legal framework.
lar updates on the working schedule, the target may lose interest
throughout the process. In closing, carrying out a CDD is not only essential in providing in-
formation for successful transactions, but also highly beneficial to
3. Agree on rules the long-term post-acquisition relationship. By applying some or
• Legal documentation and repeated commitment of confidentiality is all of the elements mentioned above, you can ensure the success of
paramount since Chinese owners lack deal experience and the awareness both the buyer and seller.
of the importance of confidentiality.
• Explain the nature and reasoning of the investigation and highlight the
danger of manipulating information.
• Assure the mutual benefit of conducting CDD as it provides an ideal Stefan Kracht is Executive Director of Fidu-
platform to confirm post-acquisition synergies and potential operational cia’s China Consulting Practice. Established
changes. in 1982, Fiducia Management Consultants
provide a wide range of services to assist inter-
As an example, a local target was heavily influenced after talking national companies in implementing, expand-
with their competitors who were also conducting negotiations with ing or optimising their business activities in
our client. Without repeated reminders of confidentiality, this talk China and Hong Kong. He can be contacted at
amongst targets could have created complications for all the clients’ skracht@fiducia-china.com.
projects at once.
15
TECHNICAL DUE DILIGENCE
In today’s challenging business environment organisations are increasingly exposed BY JOHN A. HERBERT
to complex, interconnected risks; if you are planning a Joint Venture, merger, or an
acquisition it is essential that you employ the services of a reliable TDD partner to
provide Technical Due Diligence assessments.
What is Technical Due Diligence finance, legal and related regulatory matters and usually examined
a limited range of risk exposures, critical engineering related risk,
What is Technical Due Diligence (TDD) and how does it differ from many of them deal breakers were overlooked.
other types of Due Diligence? It’s the independent examination of
the science and technology within a potential asset, from an en- Whether we like it or not society is becoming more litigious, and ex-
gineering perspective. Whether your deal is for real estate, wind posing your stakeholders and shareholders to a critical risk is simply
farms, hotel management, buildings, or an industrial facility sector, not an option these days if you want to stay in business. Increasingly
Technical Due Diligence has a vital role. It’s important to note that individuals are being singled out, and made publicly accountable for
it’s not a substitute for other forms of Due Diligence, rather it’s an failing to demonstrate adequate risk management. It all rests on the
essential part of the whole Due Diligence family. cornerstone - credible risk management. Technical Due Diligence
ensures that your decisions are well-informed.
An assessment tries to identify:
i) potential liabilities Technical risk exposures are the most important for immediate op-
ii) risks erations. You would like to know whether your operations manager
iii) deficiencies associated with the technical aspect of a project will require US$1 million spend to improve energy efficiency, and
iv) added value opportunities comply with current codes before your acquisition, not after it. A
good TDD firm will not only highlight and assess those risks before
Anyone can walk on to a site and say whether or not a standby the transaction, but also stand ready to rollout solutions for each
generator is fitted, but you’ll need an engineering expert to decide deficiency uncovered.
whether the genset is serviceable or whether it has suffered from
deferred maintenance. Will you need to replace it next week? Does
it have the potential to be converted to use alternative fuel? Can it Carbon Risk
be converted for use in a cogeneration plant? These are engineering
questions that Technical Due Diligence assessments try to address. We can no longer ignore Climate change, and it’s implications for
business. Governments around the world are busy implementing
Let’s take an example, imagine you plan to acquire an existing in- different types of carbon taxation schemes which will impact facil-
dustrial biofuel facility, financially it may appear to be an attractive ity operations. Australia and the USA amongst others are mulling
proposition. However, your legal adviser cannot assess the techni- schemes to cap emissions at a building level. The risk is real, and an
cal side of the coin. What is the condition of the existing mixing imperative for the future, but often overlooked.
and treatment plant, is it state of the art technology? Any deferred
maintenance noted? Any code violations that require immediate Depending on the business sector, the total cost of energy is nor-
repair? One engineering deficiency could cause serious operational mally the first or second largest cost centre. Imagine acquiring a
headaches. Call for a Technical Due Diligence assessment to fill that facility only to find aged steam boilers suffer from low energy effi-
information gap early in the process. ciency. A smart assessment could look past the pile of rust, and help
clients identify opportunities to upgrade, lower fuel costs, and even
In the good old days, not so long ago in fact, Due Diligence involved monetise carbon credits. During one assessment we found a very
2) Fieldwork -- Just because a turbine is spinning today does not A Technical Due Diligence assessment is essentially the creation of a
mean it will spin for the next thirty years. A TDD inspector will methodical step by step shopping list of technical risks, coupled with
walkthrough the site to check all major items of plant and equip- matched solutions deliberately designed to avoid the unexpected.
ment, check the monitoring system, and identify any deferred
maintenance, all of which would have risk and cost implications for
future operations. Another point often overlooked is the availability John Herbert is Managing Director at Kelcroft E&M Limited, an envi-
of spare parts. Without adequate spares bespoke equipment could ronmental consultancy he founded in 1999. John has more than twenty
be just one breakdown away from complete replacement. five years international engineering experience gained on three conti-
nents in commercial, healthcare, hospitality, and industrial sectors. He
3) Value -- Identifying opportunities for improvement. For example can be contacted at john@kelcroft.com.hk
an inspector can identify potential energy efficiency improvements
or carbon management opportunities.
For a Hong Kong Pension scheme to qualify under ‘QROPS’ legislation certain conditions must be met. To explore
your eligibility call David Bojan on 25118337 or e-mail drb@hfs.com.hk to request a free newsletter or to arrange a
meeting.
Horwath Financial Services Ltd
2004 Central Plaza, 18 Harbour Road, Wanchai Hong Kong
Tel: (852) 2511 8337 Fax: (852) 2137 9190 Email: info@hfs.com.hk Website: www.hfs.com.hk
17
LEGAL DUE DILIGENCE
Doing your legal due diligence in China is just like making a regular visit to the doctor. BY JAMES ZENG AND JAMES
Not long ago, companies doing regular legal compliance audits were unheard of in China, ROWLAND
although the reason for maintaining high legal standards is generally well-understood.
Now, in light of increasing regulation and safety concerns, the need for private enforce-
ment of legal compliance standards is more pressing than ever. Like taking a regular
medical check-up, the need to keep operations legal can be addressed using due diligence
strategies more familiar in the world of M&A.
Requiring the target to voluntarily provide documents and infor- The target is a Chinese company drawing water for its
mation responsive to the DD checklist makes the most efficient operations from a municipal water source. A shareholder
use of information already in the target’s possession. A preliminary wants to know if a permit is required for this activity to be legal.
Published laws say that a permit is required. However, the
review of this information by the requesting party’s legal advisors target has never obtained a permit and its Chairman insists that
or in-house counsel is done to identify any obvious deficiencies in none is needed - what is going on?
the target’s responses as well as any legal compliance issues that are
already apparent. Has the water resources bureau officially waived the permit
requirement?
Sometimes the target’s initial responses demonstrate a lack of un-
Do the target’s good relations with the bureau mean that it
derstanding of or a failure to cooperate fully with the due diligence will be able to obtain a permit without penalty or delay in the
investigation. This can be because the target is not sophisticated future?
enough to know what the investigators are looking for, for instance
if it is evidence of a permit or authorization that the target was not Several calls placed to technical staff in the local water resources
aware the law required, or reports in a format which the target is not bureau confirm that a permit is required, legally. A discussion
capable of producing. with the target’s operational staff reveals that the question of
permits is always dealt with between the Chairman and the
Sometimes foreign investors are required, by the laws of their home Chief of the Bureau. The Bureau Chief is known to have no
understanding of applicable law. Independent enquiries permit
jurisdiction, to meet a very high standard of diligence but the Chi- this complicated situation to be understood and will pave the
nese target insists that certain material information is confidential way for a reasonably skillful and diligent response, if remedial
or company private property and cannot be the subject of any in- action is needed.
vestigation. These situations are common and can be addressed if
patience is used and good channels of communication have already
been established by the party initiating the due diligence or its pro- TEXT BOX 2
fessional advisors. tary materials, against the target’s own responses and against any
responses provided by relevant authorities noting whether they are
In addition to supplying information, it is usually necessary for due written, verbal, formal or informal.
diligence investigators to obtain a copy of the target’s business li-
cense (if it is a company) and a power of attorney or other relevant
19
tions have been asked and answered by the target, or other investi-
A ROUTINE COMPLIANCE AUDIT
gations conducted.
The shareholders in a Chinese food processing company want to
do routine due diligence on local operations. A legal advisor to Often, after the preliminary DD report is submitted, some items re-
the shareholders makes an enquiry at the local environmental quire no further analysis or elaboration and the party commission-
authority presenting herself as “a potential business partner”. ing the DD may instruct its investigators to focus their enquiries on
Similar enquiries are made at the local trade registry where the a more limited number of issues perceived to be of key importance.
investigator’s Chinese ID card is sufficient to obtain a full extract
of the company’s record. But why go to the effort of conducting The final due diligence report is often voluminous because its read-
due diligence anonymously when relations with the target are ers may be relying on its contents in order to reach a final decision,
friendly? whether that is a decision to purchase an individual asset, to proceed
with an IPO or to commit resources to taking corrective action (or
The target of a due diligence investigation will often see not) in the case of a legal compliance audit.
itself as fully compliant as long as it is trading without any
complaint from local authorities. Lawyers engaged to conduct One of the most important objectives of due diligence is to identify
due diligence will form an independent view and owe a duty to the potentially harmful aspects of an operation in time to prevent
the shareholders who instructed them to disclose any non- harm to the investors. However, the primary objective, whether it is
compliance that is identified after reasonable enquiry, whether a typical M&A investigation, pre-IPO due diligence or a routine legal
the target is trading without complaint from the authorities or compliance audit, is to gather information that leads to an objective
not. and intelligent assessment of the operation overall. All businesses
have good and bad aspects - the point is identifying the bad aspects
TEXT BOX 3
while their impact is still within your control.
This preliminary information enables the investigators to iden-
tify issues and suggest items to be added to any supplemental DD James Zeng is a partner and James Rowland a consultant at King &
checklist. In an M&A or IPO scenario, all of these suggestions are Wood PRC Lawyers in Guangzhou, a Beijing based Chinese Corporate
contained in the preliminary DD report. The preliminary DD report law firm. They can be contacted at james.zeng@kingandwood.com and
normally does not contain detailed legal analysis of any issues iden- james.rowland@kingandwood.com respectively
tified – it is just a documentary record of the investigation. More
detailed analysis can then be requested and provided in a final DD
report which is produced after several rounds of supplemental ques-
For many investors, China still offers strong growth potential and corporate governance, but more complex risks need to be identified
many attractive M&A targets. Global funds and strategic investors and due diligence needs to keep up.
continue to allocate capital, even if the sense of urgency is not as
high as it was one or two years ago. Due diligence needs to be more substantive in terms of underlying
issues and understanding key trends and indicators. That means it
However, with buyers becoming more cautious, negotiations are needs to be more than simply a snapshot of a moment in time. It
more protracted and companies have more time to devote to due can also aim to develop a more in-depth understanding as to why
diligence. In a recent Asia Pacific survey conducted by KPMG, 64 margins have declined or risen over time, or how the target has per-
percent of respondents said that due diligence was taking slightly formed relative to its competitors.
longer on average since the onset of the financial crisis. Over 70
percent of respondents said they had become more cautious about Buyers, particularly with a US focus and in large or buy-out situa-
making acquisitions and, consequently, over 60 percent believed tions, are additionally demanding investigations into potentially
due diligence was becoming more detailed.2 improper financial transactions, as a result of an increasing focus
on implications from the Foreign Corrupt Practices Act. Any issues
The downturn brings an extra dimension to the challenges of con- uncovered can affect the valuation to a greater extent in a bear mar-
ducting M&A. The old horror stories about companies having mul- ket environment and also impact the buyer’s and seller’s reputations
tiple sets of books do not reflect the reality of M&A in China today. and their ability to conduct future business.
Over the past decade, companies have grown dramatically and their
financial profiles have become increasingly complex. Many compa- Cash flows and working capital, and in some cases where financing
nies have become more transparent in their financial reporting and is still being raised, the ability to service debt, are naturally receiving
21
VALUE
300 50,000
261 45,000
250
40,000
35,000
200
NUMBER OF DEALS
150 25,000
137
116 20,000
100
15,000
10,000
50
5,000
VALUE volume
Source: MERGERMARKET value(usd m)
greater attention in the current climate. Vendors or borrowers need ers will have to come to terms with the shortage of funding options
to invest time and resources to these aspects within their finance and the new market reality. At the same time, due diligence will have
function, while acquirers will look to this as an area in which they an important role to play in restoring confidence to the market, by
can implement change and realise greater value. When acquiring a helping support the completion of good-quality deals that allow ac-
distressed asset, the general approach to due diligence may not alter, quirers to realise their strategic objectives and create lasting value.
but there are greater timeframe pressures. This means that the due
diligence process needs to be well-planned, to anticipate next steps Warren Philips is a Partner in KPMG China’s advisory practice.
and identify potential shortfalls in information or other hurdles. He can be contacted at warren.phillips@kpmg.com.hk
Apart from taking more time to assess a deal, there is also an in-
creasing focus on the identification and mitigation of post-deal is-
sues. When the global economy was expanding and financing was
readily available, the risk of overpaying for a deal was mitigated by
the likelihood that strong economic growth would add to sharehold-
er value over a relatively short period of time. This is no longer the
case.
This is particularly relevant to HR professionals since they are re- ing points or the purchase price
sponsible for the integration of “people”-related issues such as the • Uncover and understand the information that will influence inte-
integration of compensation and benefits programs, workforce re- gration and transaction strategy decisions
structuring, labor contracts/agreements and their administration,
and the management of issues such as leadership, organizational We’ll now consider how due diligence plays an important role over
culture, and employment practices. However, HR professionals the various stages of a deal, then address what can and should be
are not usually provided access to the vital information surround- changed from an HR perspective to obtain better results.
ing these “people” or “human capital” issues until late into the M&A
process. They are often not included in the early stage discussions Stages of the deal
and due diligence with their counterparts in functional areas such
as accounting and finance, operations, and legal. In many cases, Mercer broadly categorizes the M&A transaction process into three
“people” issues are not valued as highly as financial/legal issues and stages: 1) Pre-deal, 2) Doing the deal, and 3) Post-deal.
HR teams may lack credibility as a contributing strategic member of
the executive deal team.
PRE-DEAL
Managing the due diligence process effectively can yield more im-
pactful and faster results from an integration standpoint. While a
smooth transition is an important goal, it should also be accompa-
Strategy And Planning
nied by a speedy close of the transaction, in order for the organiza-
tions affected to begin to realize the full value of the deal as quickly
as possible. Figure 1 illustrates this point.
• Business logic – Why is the transaction being done and what needs
to occur for it to be considered a success?
• Price paid – What is the economic baseline and what improve-
ments in post-transaction performance are expected in order to pay POST-DEAL
any premium in price?
• Integration – How is the strategy to merge or acquire translated Immediate And
into real value? Extended Integration
Due diligence is intended to uncover the answers to these three
questions. It prevents organizations from overlooking key issues
and can significantly improve the chances of the deal’s success. Spe- The “Pre-deal” stage of an M&A transaction is where the acquiring
cifically, due diligence is performed to: or merging companies define business strategy and transaction
criteria. Companies will develop a high level understanding of the
• Discover issues that could be “red flags” or “deal breakers” target company and potential transaction, which may include deter-
• Find and investigate material issues that might affect the negotiat- mining the:
23
CROSSOVER
POINT
VALUE
VALUE CREATION
VALUE DESTRUCTION
TIME
This stage typically ends with an agreement to move forward to the 1. the parties still can get out of the deal;
more formal and rigorous “Doing the Deal” stage. 2. the parties still can affect the price; and
3. the parties have the ability to plan the integration to get the max-
The second stage is typically conducted, at first, at a high level with imum value out of the deal in the shortest timeframe.
In certain countries in Asia (e.g. Hong Kong, Taiwan, and Financial statements (according to
Korea), companies are required to make payments upon country-specific GAAP and U.S.
TERMINATION retirement or involuntary resignation, and sometimes GAAP accounting standards)
INDEMNITIES voluntary resignation as well. Companies must therefore
Analysis of cash flows relating to
establish accounting reserves for such potential payments.
such programs
25
This stage typically ends with the negotiation of final terms and con- significant impact on integration, including the broader “people” is-
ditions into a formal agreement that addresses all of the relevant sues. Figure 2 provides examples of several critical HR areas that
information regarding the deal. should be examined as part of the due diligence process, but that are
often overlooked.
The closing of the transaction marks the beginning of the final “Post-
deal” stage. Typically, the closing is consummated by the signing of (3) Move HR due diligence to earlier stages. In addition to it be-
a Sales and Purchase Agreement (SPA) or a Definitive Merger Agree- ing crucial to involve HR professionals earlier in the M&A process,
ment (DMA). Theoretically, this stage should reflect the execution it is also important to begin collecting the relevant data early. This
of the integration plan with no further due diligence required. How- will expedite the M&A process with regards to HR due diligence, and
ever, as mentioned earlier, as not all information will be available or contribute to a smoother integration.
disclosed earlier in the process, it may be prudent for the buyer to
conduct further due diligence to confirm assumptions made earlier,
with appropriate adjustments made to integration plans. Conclusion
What is due diligence More importantly, in a deal where the investor is buying an equity
interest in the target business (i.e. equity deals), as he will be inherit-
Due diligence is a coherent and focused review exercise carried out ing the liabilities, the investor will want to identify the material his-
by the investor to evaluate the target business and ultimately maxi- torical potential risks and exposures which have not been reflected
mize the return on a deal. Among the family of due diligence ac- in the reported financial statements.
tivities, financial due diligence is often considered one of the most
important areas to cover mainly because it can provide the required Even in an asset deal (a deal where the buyer only acquires the assets
information and solid basis for a proper valuation and estimation of of the target business instead of buying the shares), although the in-
investment return. vestor will not inherit the historical liabilities and risks, as the seller
will likely walk away post-deal, enforcing warranties and indemni-
Some investors underestimate the importance of due diligence, ties agreed in the SPA may not be possible in practice, therefore a
whilst others rely only on a statutory audit report in lieu of a proper financial due diligence before the purchase will help the investor un-
financial due diligence. Financial due diligence is fundamentally dif- derstand what he is in for.
ferent from an audit and should not be confused with one. A statu-
tory audit seeks to verify whether the financial statements give a In the event that an investor only acquires a minority stake, it may
true and fair view under the specific accounting standards, governed be difficult to obtain quality information post deal, therefore car-
by the auditing standard. Whereas a financial due diligence is tai- rying out a proper financial due diligence upfront is important to
lored to the investors needs and looks to explain the financial num- understand the risks and exposure of the target business and seek
bers in order to understand the entity’s financial performance and appropriate protection. This is particularly important if the target’s
highlight potential deal breakers and other critical issues that the operation covers numerous countries and jurisdictions. In this case,
investor needs to pay attention to. This will then allow the inves- the target’s performance may not be transparent and potential
tor to ascertain whether the perceived potential realizable values of transfer pricing issues and related party transactions will often ex-
the target actually exit, what kinds of risks and exposures they may ist.
have to face and to formulate an appropriate pricing and negotia-
tion strategy. Owing to the complexity of doing a deal, rushing to close a deal with
insufficient understanding of the target will easily lead to failure in
The key objectives of a due diligence are therefore to maximize the realizing the value of the deal. Carrying out a proper due diligence in
return on a deal, focusing on issues impacting the deal valuation and a professional manner is considered vital.
pricing, deal structure and approach, terms and conditions required
in the Sale and Purchase Agreement (“SPA”), the potential synergies
generated or exposure inherited, and any other post deal operation- The scope of financial due diligence
al and management concerns. These issues should not be restricted
to the risks and exposure but may also include opportunities and It is up to the investor to determine the scope of the financial due
potential upside one may get from the deal. diligence, but it will normally be based on how the deal is priced, its
structure, complexity, the target business operations, and the nego-
tiation process.
Importance of financial due diligence
Pricing may be based on a multiple of earnings, turnover or net as-
Reported financial information does not always present a true set value etc, the results of the financial due diligence will be used
picture of the company, especially in countries like China, where to determine the valuation of the deal. Based on the results of a
maintaining two sets of books is common practice. Manipulated financial due diligence, the most appropriate deal structure may be
accounting records will distort reported financial statements, num- determined, based on mitigating risks, facilitating cash repatriation
bers are either deflated or inflated to minimize tax liabilities or ob- and exiting the deal at a future date.
tain funding that would otherwise be out of reach. Due diligence
will look to uncover these irregularities and hence assist the investor Financial due diligence will also help uncover potential defects of
in whether to go ahead with the investment and pricing. land, property title and unpaid liabilities in property deals, employ-
ee related liabilities in State-Owned Enterprises (“SOE”), standalone
27
cost issues in carving out the target operation from a larger group; (1) Many Chinese companies adopt cash accounting and recognise
and loan book quality and credit underwriting control weaknesses revenue and cost based on actual cash receipt and payment, which is
in bank deals. not compliant with the accrual principle in accounting. The reported
financial performance of a company may change significantly if the
Due diligence should be carried out by investors to examine the inappropriate revenue and cost recognition practice is rectified.
value perceived in the target or created in the deal and to identify
any potential risks in doing a deal. However, often sellers will try to (2) The financial statements of most Chinese private companies are
dictate the process and restrict the flow of information, meaning it often tax driven. External books often understate sales and contain
will be up to the buyer to formulate appropriate negotiation strate- invalid costs with a view to minimizing tax liabilities. The practice
gies to ensure a due diligence appropriate to his needs. not only distorts the true profitability of the target business but also
gives rise to significant tax exposure.
A typical scope of financial due diligence will often include the ex-
amination of the integrity of the financial information, assessment (3) Significant related party transactions are common in many Chi-
of the quality of historical earnings, the sustainability of the profit- nese companies, normally because of non-rationalized or informal
ability, working capital and cash flow trends and the quality of the group structure, or for obtaining financing beyond the facility’s lim-
target’s assets. Results will facilitate the investor’s ability to evaluate it, or to cover up the ultimate ownership of the entity. If the target
his financial modeling and valuation, which will include reviewing company is an SOE, related party transactions may occur under the
the projection of future performance and assessment of potential instruction of local government , perhaps to provide financial sup-
synergies benefited from the deal. port to other companies to avoid redundancy, or to provide cross
guarantees. Owing to their non commercial basis, these related par-
ty transactions may not only distort the profitability of the target
Typical common issues identified in financial due dili- business, but also give rise to potential contingent liabilities (such as
gence guarantees) and carve out issues (i.e. separating the target business
from the seller’s group activities). If a company is over reliant on the
The issues identified in financial due diligence may vary from target support from related parties, significant costs may be required for
to target depending on the type of the target (private companies vs it to operate on a standalone basis. Potential competition / threats
SOE) and the deal structure (asset deal vs equity deal). In China, the from related parties may also exist post transaction.
typical issues are often inappropriate revenue and cost recognition,
tax exposure due to two sets of books, distortion under significant (4) Off book transactions are common practices in China. As men-
related party transactions, off book transactions, non compliance tioned before, many private companies may not record certain sales
with regulatory requirements and poor reporting quality with lim- transactions and manipulate the cost of sales and expenses in order
ited transparency. The following is a summary of the common issues to present a “reasonable” profit margin with understated sales. The
identified in financial due diligence. actual cash inflow from off book sales transactions will usually be
handled and deposited in the owners’ personal bank accounts. The
Value
Standalone
Other
Costs
Upside
Other
Downside
Synergies
NEGOTIATION
RANGE
FOR
Improvement
in Profit
(6) One of the key concerns for many foreign investors doing deals
in China is the poor quality of financial information and integrity
issues of the management team. As mentioned before, practices
such as inappropriate revenue and cost recognition, off book trans-
80
60
% of respondents
40
20
0
Liability Quality of Matters Profit Post deal Commercial
Black-Holes Management affecting deal sustainability issues viability
Control price & terms
PricewaterhouseCoopers
29
THE BRITISH CONSULATE-
GENERAL GUANGZHOU
September
6-8 UKTI mission to China International Optoelectronic Exposition (CIOE) Shenzhen Kevin Liang
8-12 UK mission to China International Fair for Investment & Trade (CIFIT) Xiamen Vivian Zheng TBC
UK Food event Cities in Guangdong Jessie Zhang TBC
October
The British Consulate-General Guangzhou’s Trade & Investment team supports British businesses entering the Chinese market through
missions, seminars, trade shows, research and ongoing advice. They also foster positive bilateral trade and investment conditions through
their contacts with the Chinese Government.
The G20 meeting in London in April saw constructive agreement, on “Sustainable Cities” and “Regional Cities” initiatives also play to UK
the part of the UK and China amongst others, that protectionism, industry strengths in climate change/low carbon, and aim to assist
although viewed as a tempting prospect for some countries, would the Chinese government with policy implementation for sustain-
offer “false” short-term hope. This would simply result in a lack of able regional economic development in the Central, Western and
international competition in the domestic industry, with the result North East regions of China. Additionally, we continue to alert UK
of restricting the ability to export to such markets. Inevitably this business to other cities outside the main centres within China where
would have a particularly adverse impact on trading nations such as opportunities for cooperation with local companies exist.
the UK and China who rely on the openness of other markets.
These are only some of the initiatives being realised to contribute
The current situation offers an opportunity for countries to review to a continued and flourishing trade and investment relationship
their positions on Doha and attach a higher priority to concluding between the UK and China. This is in addition to the existing UK
the round. Clearly such a scenario would reduce the length of time government support, through UKTI and our partner organisation,
various countries’ economies spend in low, zero or negative growth the China Britain Business Council, provided to UK companies with
as a result of the current crisis. an interest in China.
It is all the more encouraging to tell you that in the midst of this By the time this edition of the publication appears, the UK will
global economic downturn, the UK and China continue to focus on have hosted the UK-China Economic & Financial Dialogue taking
the importance of strengthening our trade and investment relation- place in May 2009 and preparations for the Joint Economic Trade
ship. Commission annual meeting will be well underway. Both are well-
established government-to-government mechanisms to take stock
We have seen high level visits in both directions so far this year to of our bilateral relationship with a view to deepening those ties for
build on strengthening the trade and investment relationship to the the benefit of both countries.
mutual benefit of both countries. Of particular note was the visit of
Premier Wen Jiabao to the UK at the beginning of February 2009. In conclusion, I am keen to remind you of my UKTI colleagues based
During this visit, Prime Minister Gordon Brown and Premier Wen locally within the British Consulate-General in Guangzhou as well
Jiabao jointly reconfirmed the bilateral trade target of US$60 billion as the CBBC in Shenzhen. They stand ready to assist you as appro-
by 2010. Premier Wen’s visit was closely followed by a visit to the priate in your business endeavours and will be more than happy to
UK by Commerce Minister Chen Deming later that same month. He hear from you.
was accompanied by a trade delegation of 150 Chinese companies
keen to identify cooperative opportunities with UK counterparts. A Contact +86 20 8314 3000 or
number of activities were planned during the visit, bringing the Chi- guangzhou.commercial@fco.gov.uk
nese and UK businesses together, which resulted in contracts valued
at US$2.2 billion being signed. UK Trade & Investment (UKTI) is
following up with a number of interested UK companies. David Brown is Deputy Head of China Markets Unit, UK Trade & Invest-
ment. He can be contacted at david.brown@ukti.gsi.gov.uk
Further emphasis has been placed by our respective governments
on identifying linkages that play to our respective needs and
strengths. This has been backed up by implementation of a num-
ber of initiatives to realise those ambitions. For example, “China
Tomorrow”, launched in March 2009, aims to rapidly identify and
introduce 50 UK companies with particularly innovative products
or services to China/Chinese institutions with the hope that mu-
tually beneficial commercial relationships can be established. The
31
UK-GUANGDONG COOPERATION
ON CLIMATE CHANGE
Ed Miliband, Secretary of State for Energy and Climate Change, visited BY TIM HANSON
Guangzhou in early May as part of a China-wide programme to deepen United
Kingdom-China co-operation on climate change ahead of important interna-
tional negotiations in Copenhagen in December this year.
The primary focus of his visit to Guangdong, China’s export manu- Governor Huang said he welcomed the support that the UK is
facturing base and largest Provincial economy, was to promote low providing to China and shared Mr Miliband’s wish for greater co-
carbon economic development and to explore new opportunities for operation. He spoke of the challenges that climate change posed
UK-Guangdong co-operation on these issues. for the world and of the importance that Guangdong attached to
building a resource efficient, environmentally friendly, low carbon
His visit programme included high-level exchanges with Guangdong society. Some of the measures already being undertaken in the Prov-
Governor Huang Huahua, a keynote speech at a business luncheon ince included industrial restructuring, greater use of clean energy,
at the Grand Hyatt Hotel, a press conference and a fact-finding visit reforestation, the promotion of energy efficiency technologies and
to the Guangzhou Paper Mill, one of China’s Top 1000 Energy Con- processes and public awareness.
suming Enterprises that is successfully meeting national energy ef-
ficiency targets. In his speech to business leaders, including members of the British
Chamber of Commerce Guangdong, Mr Miliband further outlined
the need for action by the business community and spoke of the op-
portunities that arise from a global shift to a low carbon society.
“The actions that you take will affect the world. Business in China
has the chance to inspire other countries and to show leadership
that will be followed around the world” Mr Miliband said. “I wanted
to meet businesses in Guangdong because tackling climate change
is not just the right thing to do, it is the profitable thing to do. The
low carbon economy presents huge opportunities for businesses”.
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33
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35