Acquisition in China: How to scope financial due diligence

  

By Ronald Kung - 
Corporate Finance

 

 

 

The world is "buying" China, - this is what newspapers and magazines keep reporting. While we keep hearing news about private equities and corporates acquiring Chinese companies, people may not know how much effort has gone into a typical transaction. China could be, among all the countries in the world, the place where takeover transactions take the longest time to complete. A significant portion of the total time will be spent after the due diligence exercise.

Due diligence is a process every serious investor requires, and investing in China would definitely require serious due diligence to be carried out. Many enterprises, especially private ones, tend to have a lot of issues which may not have been experienced previously by western investors. Some of these issues could be deal breakers, others could be issues which the buyers would need to resolve before they could exit or integrate with their own businesses. Good due diligence should help them avoid buying a "lemon".

When it comes to financial due diligence, there are a number of common issues which are likely to be found in many, if not all, Chinese Privately Owned Enterprises (POEs). Here are some which you may have already come across:
 

1.

To many sophisticated western buyers, a set of tidy financial statements would be a basic requirement. But in the acquisition of many POEs, this is not something to be taken for granted. Many POEs may not prepare a tidy set of financial statements. In fact, it is not uncommon for them to have two sets of financial statements, one for tax reporting purposes and another one for the use of the owner.

The first priority of every financial due diligence exercise is to find a set of financial statements, that provide an accurate financial position for the target. Western buyers may be surprised that the proforma financial statements themselves could be the major deliverable or even become a deal breaker. In the preliminary discussion phase, buyers can use the figures provided by the target in arriving at the heads of terms. Only after the financial due diligence has been carried out will they find out exactly what they are buying. When buyers are devising the scope of a financial due diligence exercise, the crucial step is not the IFRS reconciliation or the sales and costs analysis. The first thing a buyer should request is: 'Show me the true financial status of the target'. People often overlook the basics, but when it comes to acquiring a Chinese POE, it is essential to start at this level.

   

2.

A second question buyers always ask is about tax. China may not have the most complicated tax system in the world, but tax issues identified in a financial due diligence exercise could be of great concern to most buyers. From Enterprise Income Tax to Social Insurance, it would be strange to see a local Chinese POE fully reporting or paying all of its tax liabilities. This is no secret. Trade buyers tend to avoid being liable for this non-compliance by insisting on an asset deal. Whether a mere purchase of assets can fully avoid liability depends on what kind of assets they are buying. But in most cases, an asset deal not only minimises the exposure of the buyer to the tax liabilities of the target, it minimises the tax liabilities of the buyer in the deal itself.

Sometimes financial buyers may have no choice but to have a share deal if they want to make an exit in a short period of time. In this case, they need both a good tax adviser and a good lawyer. They need to fairly estimate the amount of possible tax exposure, and they need to know the consequence of non-compliance. More importantly, financial buyers should seek protection by ways of warranties or conditions precedent in the S&P agreement.

In terms of deal breakers, ultimately, price will, in a ranking of deal breakers, be in the top three, if not number one. Most of the issues identified in financial due diligence can be resolved by price adjustments. Even when trade buyers purchase targets to run instead of sell, they can still deal with the financial issues if the price can be adjusted downwards. Pricing is a result of the negotiation skills of the buyers. The findings of a financial due diligence exercise may help buyers to substantiate a request to lower the price.

Obviously, pricing is always the result of demand and supply, and not necessarily of scientific calculation. Recent years have seen a lot of money chasing the same pool of Chinese companies. And given that the M&A rules in China restrict certain industries which could otherwise become targets for foreign investors, the number of quality companies which can be taken over are limited. As a result, even a mediocre target may come with an expensive price tag.

What drives up the price is the mentality of business owners. They know very well that foreign investors want to acquire Chinese companies because China will be the fastest growing economy in the world for at least the next few years. Not only do Chinese business owners not want to sell their businesses cheap, they do not want to sell their businesses at all. They have confidence that they can run their businesses in a profitable manner, and they don't see the involvement of foreign investors as necessarily creating synergy.

As an acquisition in China is often not a happy task, the carrying out financial due diligence should not add inconvenience. A due diligence exercise should focus on the key areas and critical deal issues which buyers would need to know quickly in order to decide whether they want to go ahead. This will ensure that buyers don't waste time and effort on deals that cannot be completed.

In many cases, scope creeps. The scope set out at the beginning of the financial due diligence process may not cover the major deal issues and the team is then required to shift its focus into areas which may not have been anticipated in the first place. It requires an experienced team and frequent discussion with buyers to re-focus the direction of financial due diligence. An old fashioned financial due diligence exercise which lists out all the breakdowns and explanations of individual items on the financial statements would not provide much relevant insight for buyers. Analysis in various ways, comparison to the market and counterparts, and identification of the key drivers are more useful to buyers in a deal assessment.

Setting out the scope for a due diligence team is definitely less exciting than negotiating with the target. But when it comes to acquisition in China, buyers may want to spend double their usual time sitting down or having conference calls with their advisers, to set a realistic scope.

ronald.kung@gthk.com.hk
 

 

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