Due Diligence in China : Beyond the Checklists [1 ed.] 9781118469040, 9781118469064

Citation preview

Due Diligence in China

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Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Asia, and Australia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Corporate F&A series provides information, tools, and insights to corporate professionals responsible for issues affecting the profitability of their company, from accounting and finance to internal controls and performance management.

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Due Diligence in China Beyond the Checklists

KWEK PING YONG

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Cover image: © iStockphoto.com/Robert Churchill Cover design: Wiley Copyright © 2013 by John Wiley & Sons Singapore Pte. Ltd. Published by John Wiley & Sons Singapore Pte. Ltd. 1 Fusionopolis Walk, #07-01, Solaris South Tower, Singapore 138628 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons Singapore Pte. Ltd., 1 Fusionopolis Walk, #07-01, Solaris South Tower, Singapore 138628, tel: 65–6643–8000, fax: 65–6643– 8008, e-mail: [email protected]. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor the author shall be liable for any damages arising herefrom. Other Wiley Editorial Offices John Wiley & Sons, 111 River Street, Hoboken, NJ 07030, USA John Wiley & Sons, The Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, United Kingdom John Wiley & Sons (Canada) Ltd., 5353 Dundas Street West, Suite 400, Toronto, Ontario, M9B 6HB, Canada John Wiley & Sons Australia Ltd., 42 McDougall Street, Milton, Queensland 4064, Australia Wiley-VCH, Boschstrasse 12, D-69469 Weinheim, Germany Library of Congress Cataloging-in-Publication Data ISBN 978-1-118-46906-4 (Hardcover) ISBN 978-1-118-46904-0 (ePDF) ISBN 978-1-118-46905-7 (ePub) Typeset in 10/13 pt, Photina MT Std by MPS Ltd Printed in Singapore by C.O.S. Printers Pte Ltd 10 9 8 7 6 5 4 3 2 1

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To My Family For your unreserved support with my stay in China for so many years

To Kelvin Fu Joshua Lim For your talents and hard work

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Contents

Preface

xi

Acknowledgments

xv

Chapter 1: The Business Landscape in China Macro and Structural Domains Corruption in China Conducting Due Diligence in China versus Western Countries Conclusion Notes

Chapter 2: Due Diligence in China Due Diligence for Different Types of Deals Levels of Due Diligence Key Considerations Organization of Due Diligence Process The Due Diligence Team Independence of Vendor Due Diligence Reasons for Poor Due Diligence Reverse Takeovers Dispute between SEC and CSRC Conclusion Notes

Chapter 3: Financial Due Diligence Financial Due Diligence Checklist Conclusion Notes

1 2 6 26 30 31

33 36 48 56 59 63 64 68 73 75 77 78

81 82 139 140

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Chapter 4: Operational, Commercial, Legal, and Other Due Diligence Operational Due Diligence Commercial Due Diligence Legal Due Diligence Balanced Scorecard (BSC) How to Predict Bankruptcy—Altman Z Scores and Gearing Optional Checklists Conclusion Notes

144 167 169 178 185 186 193 194

Chapter 5: Beyond the Checklists: Founder and Management

195

Founder Management Root The Founder Background Check Guanxi (Relationship) Due Diligence on More Than One Founder Summary of Background Check: SWOPEST and Tri-Background Conclusion Notes

198 200 216 223 224 228 229

Chapter 6: Beyond the Checklists: Hard Facts Face-to-Face Meetings Proportion Check Site Visits Due Diligence Goes One Step Deeper: The Four Deadly A’s Conclusion Notes

Chapter 7: Implementing a Due Diligence Workflow Getting the Mind-Set Right Formulating the Due Diligence Strategy Forming a Team Starting the Due Diligence Process Conclusion Notes

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143

231 231 242 247 256 290 292

293 294 295 300 304 312 313

Chapter 8: Post Due Diligence and Case Studies

315

Preparing the Due Diligence Report Due Diligence Outcome Review Deal Structuring, Negotiation, and Deal Making

316 316 318

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Contents

Post-Acquisition Due Diligence Summary Models Final Case Studies Conclusion Notes

About the Website About the Author Index

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318 319 327 347 348

351 353

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Preface

C

O N D U C T I N G D U E D I L I G E N C E I S B OT H an art and a science. We argue that the due diligence process in China is more art, as there are more subtleties but less black-and-white, number-crunching processes. Due diligence checklists are frequently relied on by many legal, accounting, and financial institutions as a methodology to conduct due diligence in companies, these checklists typically cover the basic due diligence areas, and some firms may have refined the checklists based on their own in-house expertise and experience in the industry. Yet, judging from the number of financial blowups and fraud cases in China and around the world, one inadvertently comes to the conclusion that the due diligence checks conducted by these professional services accounting and fi nancial institutions are inadequate and have failed to uncover these spectacular financial disasters. To this end, the central position of this book is to argue that one must go beyond the due diligence checklists in order to attain a more comprehensive and more reliable assessment of the target company in China. Due Diligence in China: Beyond the Checklists is the fi rst book that goes beyond the scope of what most readers are familiar with in a typical checklist. Going beyond the checklists requires an in-depth understanding of the relationships between all the entities present in a typical Chinese company. This could run the gamut of personal, professional, political, and social relations between internal peoples/groups and external parties. This book utilizes real-life case studies that were developed specially for this book. These case studies are meant to provoke the readers to delve deeper into the intricacies of conducting due diligence in companies operating in China and also to provoke the readers to garner valuable lessons from the colorful history of companies and deals gone badly. The first chapter of this book, “The Business Landscape in China,” sets the stage for the rest of the book. In this chapter, we discuss the business landscape in China. Indeed, there are many books out there that attempt to describe this topic. However, this chapter is meant for readers who are relatively new to xi

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China and want to have a basic understanding of the basic business environment and the unique characteristics of doing business in China. A discussion of the business landscape of China includes the political, social, and cultural aspects that are often neglected when one considers doing business in China. Understanding the business landscape will provide readers with a good contextual understanding of why conducting due diligence in China needs to be deliberately and meticulously planned and why it is so critical prior to deal making to maximize the chances of success in the deal. In the second chapter, “Due Diligence in China,” we discuss the basic due diligence process in China. We also discuss the differences in the types of due diligence conducted. It is critical to understand that the nature of the due diligence will affect the type of due diligence conducted. There are significant differences between conducting due diligence on M&A transactions and on private equity investments, for example. We also identify the shortcomings of these checklists pertaining specifically to Chinese businesses, so as to provide readers with a good understanding that relying on checklists alone to conduct due diligence is not advisable, and could be also highly risky, as the results of the due diligence would not be an accurate reflection of the true state of any Chinese company. This chapter also includes a discussion of the differences of due diligence conducted in China versus the West. Readers will find that while the processes for due diligence are generally similar in different countries, there are significant differences in the approaches and mind-set that one must adopt in conducting due diligence in China especially, because of the differences in the business landscape and political system. In the third and fourth chapters, “Financial Due Diligence” and “Operational, Commercial, Legal, and Other Due Diligence,” we discuss the conventional due diligence checklists that are typically involved in deal making. There are many different types of checklists used by different service providers for different industries. These two chapters list items on the checklist that are most pertinent to conducting due diligence in China and what are the key things to look out for when going through the checklists. The fi fth and sixth chapters discuss in depth the ways to overcome the shortcomings of the conventional checklists—that is, how to go beyond the checklists in order to get a truer reflection of the state of the Chinese company. We will be introducing many different applications of these unconventional methods of due diligence and its impact on the company. The fundamental basis of a due diligence that goes beyond the checklists is to ensure that no stone is left unturned no matter how uncomfortable or awkward the process can be. However, this oversimplifies things. Readers, by now, should be asking the key

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question: Are there other stones that we did not know of in the first place? This is a fundamental question that any type of due diligence that goes beyond the checklists should ask and explore deeply. The fi fth chapter, “Beyond the Checklists: Founder and Management,” focuses on the conduct of due diligence on key executives of the company. This human due diligence is especially critical in China, as the founders and highlevel management wield enormous influence in the company. We also examine in detail the personal lives and relationships of the executives, which may turn out to be potential liabilities and risk factors to the company. The sixth chapter, “ Beyond the Checklists: Hard Facts,” lays out the importance of verifying the hard facts through face-to-face meetings, site visits, and proportion checks. These methods require investing a significant amount of resources, time, and experience to carry out. We also discuss about the four deadly A’s that one has to contend with during the due diligence process: Authorization and control; Abnormalities; Anti-corruption and bribery; and Accounting frauds and cheats. Lastly, we would introduce the Anti-Corruption Investigate Due Diligence (ACID) framework and show how it could be utilized to guide the process of doing due diligence that is beyond the checklist. The seventh chapter, “Implementing a Due Diligence Workflow,” features a useful practical guide for readers who may be conducting a fi rst-time due diligence exercise in China, or for readers who want to deepen and broaden their knowledge about the effective ways of doing due diligence in China from the planning stage and forming a team onwards. The eighth chapter, “Post Due Diligence and Case Studies,” deals with the tasks upon completion of the due diligence formal process—namely, the preparation of the due diligence report, conducting the post due diligence review, and, if the deal were to go through, the conducting of the post deal monitoring process. Additional case studies have been included to allow readers the opportunity to apply the methodologies introduced in going beyond the checklists and to compare and contrast both outcomes. Through this exercise, the readers will be able to better appreciate the comprehensiveness and detail required when conducting due diligence in China. Throughout the book, some terms are used interchangeably, for example, investors and acquirers, founders and entrepreneurs; they are in general referring to the buyer or the seller side of an acquisition or investment deal respectively. As usual, case studies used in this book are to demonstrate main points highlighted and discussed in the chapters. It is not a show of good or bad decision making, strategy, or management on the part of those parties involved.

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There is also no right or wrong “answers” to these cases. Furthermore, remember that one does not have the full insider information of the situation. They only serve as a trigger to the readers to think deeper into any similar scenario they may face, and as far as possible, the readers should try to apply the methodologies and models discussed in this book to these case studies and maybe go one step further, applying them to the readers’ own cases. A good due diligence needs to be highly customized according to the objectives and nature of the investment or acquisition. There are two Appendices on the companion website. In Appendix A, we have included due diligence checklists on financial, tax, operational, legal and environmental that could be used as guides for the due diligence process. In Appendix B, we have included proprietary tools and diagrams that go beyond the checklist (Appendix A) that readers could use to enhance their due diligence process. These tools and diagrams are only the skeletal framework and deliberately kept blank so that readers could utilise them as worksheets. In order to utilise these checklists, tools and diagrams effectively, readers must go through individual chapters to understand its context and how they could be applied for their own use. Lastly, readers can visit the author’s Website at http://www.ddinchina .com for the latest updates on the book, due diligence related information and to download the soft copies of the checklists, tools and diagrams. Likewise, the book’s companion Website is http://www.wiley.com/go/ddinchina, and the password is yong123.

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Acknowledgments

W

R I T I N G T H I S B O O K WA S M O R E difficult than I thought it would be, but I am really fortunate to have a group of very capable professionals and friends who helped me along the writing journey. Once again, I am most grateful and indebted to Kelvin Fu and Joshua Lim. This is the second book we have worked together on. They were both instrumental in getting this project sailing smoothly. Kelvin and Joshua helped me tremendously in the structure and content of this book and gave me invaluable suggestions and constructive comments during the writing and editing process. I know very well that they both have sacrificed lots of personal time for this book. In fact, the many methodologies and models used in this book were also the hard work and brain child of Kelvin and Joshua’s field work with me in China, when we went through the due diligence process of many Chinese companies in different cities and sectors. They were the ones who transposed many difficult and complicated due diligence processes into easy-to-understand yet rigorous models that we are still using today. Time has proven that our models worked so well that we do not have a single failure in our investment history in China. I dedicate this book wholeheartedly to these two extraordinary young friends of mine. I have an excellent research team who helped me in researching all of the case studies featured in this book. I am very thankful to Yeo Zhi Wei and Zhou Peng Hui, who have spent many sleepless nights discussing cases with me after our busy daily schedule in Shanghai or anywhere in the world when we were traveling together. They are both the most talented, energetic, and passionate young professionals we have in our office. Joshua Lim and Zhou Peng Hui will be living in Philadelphia and Boston respectively for the next few years. I wish them a good stay and enjoyable learning experience.

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Whenever I received drawings from Kenny Ng for the illustration of some major points in this book, I had a jolly good laugh. I noticed Kenny’s talent in drawing many years ago and I am so privileged and thankful for the bit of humor Kenny adds to this book. Thanks also go to Chen Heng Hui and Evan Foo for their assistance with the case studies, and James Guk for the nicely drawn diagrams and flowcharts. I thank Kelvin Koh for his warm hospitality when I was in Seoul writing the final part of the first manuscript for submission to my Wiley editor. I sincerely appreciate and felt the professionalism from the John Wiley & Sons team. This book would have been absolutely impossible without the support from Nick Wallwork and Nick Melchior. Gemma Rosey is the most helpful and greatest editor, who has guided me through the writing process and Chris Gage, has been so patient and thoughtful during the production stage. Thank you very much. To my family again, I sincerely thank them for letting me living in China for more than a decade. Without this experience in China and the long stay there, this book would not be possible.

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C HAPTER O N E

The Business Landscape in China

T

H I S C H A P T E R I S D E S I G N E D TO provide a broad overview of the

business landscape in China. Without a fundamental understanding of the key components that make up the business landscape, readers may find it hard to understand the intricacies of doing business in China and how it relates to the core topic of conducting due diligence in China. Conducting due diligence in China requires an intimate understanding of the business landscape in China and understanding how these various factors interact together to pose challenges. An in-depth due diligence is critical in helping potential buyers to identify the workings of a company and its strategy, and to uncover any hidden issues. In this chapter, we discuss the characteristics of Chinese political, business, and social landscapes and their relevance and impacts to the due diligence process. The three landscapes are inherently wide in scope and cannot easily be exhaustively covered as they are also dynamic and changing with the times. The purpose is to inform readers to pay attention to the context and unique circumstances that surround Chinese due diligence. The landscapes described may share some similarities with other regions or countries, but, seen as a whole, the Chinese characteristics of these landscapes are unique to China. First, we cover the macro and structural domains that include a discussion on the macroeconomic conditions and system of rules and laws in China. We 1

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also cover the level of corruption in China and the significant number of fraud cases that plague business dealings in China. Second, we cover company-specific issues such as the lack of internal controls of Chinese companies that have made it more susceptible to corruption, backroom dealings, and dubious related-party transactions. We would also discuss the current state of how Chinese businesses operate in general, which is to say that they rely heavily on manually intensive record keeping. Moreover, we discuss the cultural and social aspects of the Chinese businesses, which include the corporate culture and environment, the powerful influence of Chinese founders, and their peculiar characteristics that shape their own corporate landscapes. The aspects discussed in this section are merely snapshots and highlights of the highly complex business landscape in China. As such, readers may find many other peculiar aspects of doing business in China that may complicate the due diligence process that are not covered here. Nevertheless, the purpose of describing the business landscape in China is to provide readers with a contextual understanding and appreciation of the complexities of doing business in China. These insights will provide readers with a good background and allow them to understand and appreciate the importance of conducting a full diligence prior to any deal making in China.

MACRO AND STRUCTURAL DOMAINS This section covers selected macroeconomic conditions in China that have contributed to the challenges that one may encounter when doing due diligence in China. Some of these conditions, such as the systemic low-compensation schemes, may have exacerbated the level of corruption and fraud cases in China.

From Planned Economy to Market Economy China has advanced tremendously economically ever since Deng Xiaoping’s economic reform that began in 1978. That reform was accelerated by China’s accession into the World Trade Organization in 2001. Since then, China has been transitioning from a planned economy to a market economy (Figure 1.1). China’s economic growth has been so tremendous that it had surpassed Japan as the world’s second largest economy, and it is poised to surpass the United States by 2027, according to Jim O’Neill, the head of Goldman Sachs Asset Management.1

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Macro and Structural Domains

FIGURE 1.1

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3

The Transition from Planned to Market Economy in China

Source: Illustration by Kenny Ng.

China had been known as a cheap manufacturing haven among investors and businesses looking to leverage the country’s cheap factors of production, such as labor, and government policies. As China’s economy embarks onto the next stage of growth, since its identity as a manufacturing hub, it is gradually evolving into an economy that is more service centric and higher up in the supply chain. The Chinese government has embarked on deliberate measures in the form of strategic economic goal setting using the Five-Year Plans that outline its economic development initiatives. These Five-Year Plans serve as critical benchmarks that the Chinese government strives to achieve, and these changes present great opportunities to investors and businesses. China’s economic reforms and open-door policy has provided a conducive investment environment for business and investors. Foreign investments into the country were seen as an important source of injection of capital and technology to enable economic growth. China’s investment attraction strategy comprises the liberalization of trade with its key partners using free trade agreements (FTAs) to reduce supply chain costs and to enhance price competitiveness. In addition to the FTAs, China has signed various partnership agreements that seek to mirror the benefits of an FTA such as the Economic Cooperation Framework Agreement with Taiwan. As China increasingly moves closer to become a capitalistic society, there is a need to implement structural reforms to strengthen the foundations for a market-based economy. China’s economic growth had been propelled primarily

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through fi xed-asset investments. There is a prevailing recognition that China will have to rebalance its economy by shifting into a consumption-driven economy. However, the general consensus is that China will find it challenging to shift into this mode and will rely on investment spending, which it has heavily relied on for its rapid progress. China has sufficient resources to support this move into a consumption-based economy. According to Jefferies projections, consumption in China is expected to reach 73 percent of GDP by expenditure by 2025, up from 49 percent in 2012. In terms of GDP by output, tertiary industries (services) are projected to reach 67 percent of GDP, up from 44 percent in 2012. Secondary industries (manufacturing and construction) are expected to fall to 27 percent of GDP, down from 47 percent in 2012. China’s massive state-owned enterprises (SOEs) have dominated the economy since its economic reforms and the massive earnings have been crucial in funding China’s investment-led growth. The revenues from SOEs account for approximately half of China’s economy. Jefferies estimated that listed blue chip SOEs could pay out dividends of up to 35 percent. However, SOEs have only paid a portion of it, at around 5 to 10 percent. The large retention in earnings of the SOEs has led them to look for other sources of investments and even led to speculation in the real estate and stock markets. The Chinese government has started to look deeply into the reform of the SOE sector in order to curb excessive speculation and to redeploy capital into the other national objectives such as economic rebalancing and improvement of social welfare. Government revenues can be significantly increased if SOEs are forced to pay proper dividends, which could result in an additional 692 billion yuan ($111 billion). Apart from raising dividend payout ratios, China may embark on a privatization drive for SOEs or increase the public float.

Rising Income Inequality There is growing social tension and political risk in Chinese society. Chinese officials had not published the country’s Gini coefficient since 2000 when it was 0.412. A score of 0 would represent perfect equality; a score of 1 would mean one individual controlled 100 percent of income. The Gini coefficient measures income distribution on a scale of zero to one. A Gini index between 0.3 and 0.4 indicates a relatively reasonable income gap. A Gini index between 0.4 and 0.5 indicates a large income gap. The Chinese government has claimed that there is insufficient and inaccurate data on high-income groups, which may skew the results. China’s wealth gap raised concerns about China’s development path. The income gap between urban and rural areas,

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between communities, and the lack of a middle class are factors that could affect social stability. A growing divide between the haves and the have-nots has far-reaching implications for China’s future growth. In addition to the difficulties of narrowing income gaps, the Chinese government also has to contend with the immense task of creating sufficient jobs. In order to maintain the employment rate and to absorb the large numbers of people coming into the labor force, the Chinese government has targeted an economic growth rate of 8 percent. Chinese leaders have prioritized building a “harmonious society” to ease social and political tension. In January 2013, the chief of China’s National Bureau of Statistics revealed that China’s Gini coefficient stood at 0.474 in 2012, down from 0.477 in 2011. The peak was 0.491 in 2008. The large income disparity is a contributing factor to the large number of corruption and cheating cases in China.

Compensation Schemes in China Low civil service pay has been widely accepted as an important contributing factor for corruption. This is especially so in less developed nations. The assumption is that when salaries are low but expectations for service remains high, government officials may demand more compensation from informal or even illegal channels than what is officially sanctioned; hence, corruption arises.2 In China, civil servants refer to public employees in people’s governments, people’s congresses, people’s political consultative conferences, and courts at various levels. In recent years, the number of people in China’s civil service has grown fast. By the end of 2011, the total number of public servants had reached 7.02 million, according to Wang Jingqing, deputy head of the Organization Department of the Communist Party of China (CPC) Central Committee. The civil service in China is quite lowly paid as compared to more developed countries. Currently, the country’s civil servants receive a basic salary, bonuses, subsidies, and allowances. According to the National Bureau of Statistics (NBS), civil servants enjoyed, on average, an annual salary of 33,869 yuan ($5,435.97) in 2008, higher than the 29,758 yuan average earned by those working in state-owned enterprises and the national average of 28,359 yuan for all urban workers. In total, the regular pay received by civil servants, combined with their annual bonuses—which typically range from 21,000 to 40,000 yuan—costs the state between 404.26 billion and 537.67 billion yuan per year.3 Due to the relatively low official compensation scheme of civil servants and public officials, there is a higher propensity for officials to seek alternative forms

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of compensation in order to make up for their pay and to sustain their lifestyles. These additional forms of compensation could come from many sources, and it is not surprisingly that many officials have many unofficial sources of income other than their official salary from the government. Although there may be a higher propensity to accept bribes, this in no way suggests that all officials are corrupt or susceptible to these additional compensatory temptations. However, the critical thing is to acknowledge and accept that corruption and bribery is not uncommon in China. Seen in this context, the due diligence process will have to factor these facts of life into the calculation and process. As such, it should not be surprising that, during the due diligence process, there may be challenges and obstacles presented by officials who purposely put up roadblocks to slow down or inhibit the process.

CORRUPTION IN CHINA It is widely known that China suffers from widespread corruption. According to Transparency International’s Corruption Perception Index, China was ranked 80th out of 176 countries. China scored 39 out of a possible 100 points, behind countries like South Africa and Italy. Corruption cases extend across the private and public sector and it can come in many forms such as graft, bribery, embezzlement, backdoor deals, and many others. Corruption is not a new phenomenon in modern-day China. However, it has become more pervasive and lucrative as China transitioned from a planned economy to a market economy. The market liberalization reforms that were initiated by Deng Xiaoping created unprecedented lucrative opportunities for people to exploit and profit from them. Corruption becomes more entrenched as the private and public sectors increasingly intersect and business deals rely more heavily on the positive relationships developed with government bodies that wield significant authority in the approval process for projects and deals. That said, corruption is not unique to China. Indeed, there have been numerous corruption and fraud cases that have happened all over the world. As such, readers need to be mindful that this book was not written as a Chinabashing book. In order to put things into perspective, this section will also highlight some case studies of high-profile corruption and fraud cases that have happened around the world. In fact, the magnitudes of damages of these global cases were often many times larger than any fraudulent cases that have ever occurred in China to date.

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Corruption in China

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CASE STUDY 1.1: OLYMPUS FRAUD

M

ichael Woodford, then-Chief Executive Officer, of Olympus, sounded the alarm bells on the company in 2011 about the company’s accounting fraud. Olympus had falsified financial statements for two decades to hide over $1 billion in losses. It started in the early 1990s when Olympus created a special purpose vehicle to buy battered securities at market value after the company lost money due to the yen strength and the slowing economy. This scheme would gradually increase over time and become increasingly costly. Between 2006 and 2008, Olympus spent $733 million to buy three Japanese start-ups that had no relation to the company’s core business. The three firms were: 1. Humalabo, a producer of nutritional supplements 2. Altis, a waste disposal and recycling firm 3. News Chef Inc, a seller of microwave cookware and assetmanagement firm* The value of the firms were subsequently written down to just $187 million in 2009. According to internal documents and Cayman Islands records, the money spent on the acquisitions of these three firms were directed to Cayman Islands-based companies that were either dissolved or closed down shortly after receipt of the money. It was later revealed in 2008 that Olympus had paid a $687 million advisory fee on its $2.2 billion purchase of British company medical firm Gyrus. This meant that more than a third of the purchase price went to services rendered by a New York firm AXES and a Cayman Islands incorporated firm, AXAM. The advisory fees charged were astronomical figures compared to the 1 to 2 percent of fees charged of the purchase price. An independent PriceWaterhouseCoopers (PwC) report that Michael Woodword had commissioned revealed that the acquisitions had led to a combined loss of $1.2 billion of shareholders’ value. In addition, the report highlighted possible false accounting, financial assistance, and breaches of duties by the board. After Michael Woodford came on board in late 2011, he reported the suspicious fraudulent payments. Michael Woodford was subsequently fired on the basis that there were differences in management style as cited by the board of directors. However, Michael said that he was fired for challenging the board over irregular business practices. The Chairman, Kikukawa, resigned. Chan Ming Fon, a former Commerzbank AG and Societe Generale banker, had secretly helped Olympus to liquidate hundreds of millions of (Continued)

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(Continued) dollars of Olympus investments and then lied to auditors by certifying that the investments still existed over a period of six years. Subsequent due diligence revealed that out of the three start-ups that Olympus had invested in, Humalabo and Altis shared the same address. All three firms used the same auditor, Mioru Tanaka of accounting firm Rekorute, which already had been flagged as a problematic firm by a commercial rating service. In addition there was a potential red flag that would have been uncovered in a reputational due diligence check on members of the key management team. The former CEO of News Chef, Kenichi Nishumura, had been arrested on fraud charges in 2006 and convicted of violations of investment law in 2007. *“Advisers under Scrutiny over Olympus Payments,” Financial Times, November 9, 2011.

In China, becoming a senior government official might be seen as one of the easiest ways to get rich. The number of government officials that have been tried and prosecuted for corruption in China has become more widespread in recent years. One of the most high-ranking bureaucrats to be investigated so far is Li Chuncheng, the former deputy party secretary of Sichuan province, and an alternative member of the Central Committee, one of China’s highest-level state organizations. Li Chuncheng reportedly bribed his way to a senior post in the 1990s when he was an official in Heilongjiang province in northeast China. Moreover, as deputy party secretary in Sichuan, he reportedly sold lower-level government posts. It was also reported that Li was involved in a case involving Han Guizhi, who was a former deputy party secretary of Heilongjiang who received a suspended death sentence in 2005 for taking bribes in exchange for promoting officials.4 Caijing reported that the investigation into Li may be linked to businessman Dai Xiaoming, the chairman of the state-owned Chengdu Industry Investment Group who was taken away in August 2012 for an internal party investigation.5 Dai worked under Li while in various positions—as party secretary of Qingbaijiang district, director of the Chengdu Economic and Information Commission, and then as chairman of the Chengdu Industry Investment Group. From 2007–2012, over 660,000 government officials have been investigated for corruption of some sort, representing a significant percentage of all the party and state officials. There were many serious cases that involved phenomenal sums of money and officials at or above the ministerial level.6

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China’s top anticorruption watchdog, Chinese Communist Party Central Commission for Discipline Inspection (CCDI), reported in 2010 that 106,000 officials were found guilty of corruption in 2009, an increase of 2.5 percent from the year before. Moreover, the number of government officials caught embezzling more than 1 million yuan jumped by 19 percent over the year.7 In 2009, Cheng Tonghai, the former chairman of Chinese oil giant Sinopec, was convicted of illegally receiving 196 million yuan ($28.70 million) between 1999 and June 2007. Chen had helped others “seeking illegal interests” in company operations, land transfers, and contracts, according to the verdict from the Beijing No 2 Intermediate People’s Court. His sentence has been suspended for two years, which means it is likely to be commuted to life in prison.8 In 2010, the former head of the China National Nuclear Corporation, Kang Rixin, overseeing the country’s nuclear industry, was sentenced to life in prison for accepting bribes of 6.6 million yuan between 2004 and 2009.9 He was suspected of taking bribes from French nuclear power giant Areva to win a contract for a project in China’s southern Guangdong province. In November 2007, Areva announced an agreement to supply China with two third-generation nuclear reactors in a deal worth 8 billion euros ($11.9 billion at the time). Kang was a member of the 17th Central Committee of the Communist Party of China. He was stripped of his post and membership in the Chinese Communist Party for “serious violations of the law and discipline breaches” in December 2009.10 Chinese top leaders have also publicly stated that corruption is the biggest problem facing China and failure to stop it will also threaten the legitimacy and longevity of the Chinese Communist Party. At the 18th National Congress held in November 2012, then-President Hu Jintao stated that if the corruption issue was not well handled, it “could prove fatal to the party, and even cause the collapse of the party and the fall of the state.” He also affirmed the government’s strong position that anyone who broke the law would be brought to justice regardless of “whoever they are and whatever power or official positions they have.”11 The Chinese president, Xi Jinping, has vowed to crack down on both “tigers” and “flies”—powerful leaders and lowly bureaucrats—in his campaign against corruption and petty officialdom.12 In other words, all officials at all ranks were under scrutiny. In light of the numerous corruption cases and scandals exposed in the traditional and social media, the Chinese Communist Party is increasingly aware that its legitimacy is dependent to a large extent on its ability to stop corruption in order to regain the trust of the public especially in light of economic uncertainty and social conditions going forward.

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Indeed, China’s anticorruption campaign is still in the nascent stage, and it would take a long time to stem out all the corruption cases and root causes. However, there are positive signs that the Chinese Communist Party and its top leaders are serious about rooting out corruption and institutionalizing reform in response to the Chinese citizens increasing pressure on its top leaders to crack down on corruption.13 Despite the high number of prosecution of corruption cases in China in recent years, there is still a high level of corruption cases in China. Clearly, prosecution alone is not enough for fighting corruption as the roots of corruption need to be addressed. The critical aspect that needs to be addressed is the power structure of the system. In China, there is a blurring of lines between public and private sectors, as both are increasingly intertwined and dependent on each other for influence, power, and money. Large SOEs and banks have seemingly monopolistic power over the economy, which has stifled the business environment and made it more difficult for small and medium-sized enterprises to thrive. In addition, there is a general lack of control over government officials and their relatives in their personal capacities and their involvement in business activities that may be a conflict of interest. According to Shujie Yao, head of the School of Contemporary Chinese Studies at the University of Nottingham, “dealing with corruption in China will rely on the party’s ability and willingness to reform the political system so that power is not highly concentrated and controlled by one person or a group of people. In addition, any political group with common economic interests should be broken up by moving people around to different positions on a regular basis. The media should be allowed to investigate and freely criticize wrongdoing by party and state officials.”14 Apart from business deals, even other public institutions such as education, health care, and the media are plagued by this culture of rent-seeking behavior and corruption. It is not uncommon to find doctors expecting red packets of cash for performing operations or allowing patients to cut into the queue for consultation and operations. Doctors also sometimes prescribe expensive medication that the patient does not need. In this way, doctors are able to push and market expensive medications that pharmaceutical companies have provided to the hospitals for a percentage of the sales or they had informal agreements with the companies to receive side payments. Chinese hospitals generally charge very little for doctor consultations, and they make up a bulk of their revenue, up to 50 percent, by charging significant markups on medications from a range of 15 to 100 percent. Hence, in order to increase profits at their hospitals, doctors frequently overprescribe medicines. The pay for doctors in

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China is very low compared to developed countries. Doctors on average earn $1,000 a month, so many have to seek alternative sources of income by overprescribing medicines, especially the expensive ones, to patients. The doctors then split the profits with the hospitals. In order to put corruption in hospitals under control, government officials have initiated reforms to realign the incentive structures that have plagued hospitals. For a start, they have started to put in place pilot projects to raise consultation fees of doctors in order to increase their revenue contribution and increase pay to doctors in order to create less incentives for over prescription. Drugs prices are also targeted to be lower. For example, at the Beijing Friendship Hospital, a patient would now pay a minimum of 42 yuan ($6.60), versus the old fees of 5 to 14 yuan for a consultation with a doctor. A visit to a specialist now costs 100 yuan. Drug prices have dropped an average of 30 percent.15 Teachers Day in China, which falls on September 10, has in recent years been a lucrative time for teachers in China. In the past, Teachers Day in China was a day to show respect and appreciation to their teachers with greeting cards and small gifts. However, that tradition has evolved into an occasion for parents and students to lavish expensive gifts and red packets stuffed with cash on teachers. These gifts could range from a few hundred to thousands of yuan for middle-income families, and the wealthier families could give luxury goods such as branded watches and travel packages. The motivation behind the expensive gift giving by parents and students to teachers is to allow students to distinguish themselves in a school environment in which competition is cutthroat and to seek more attention and better grades in school. China’s one-child policy has also contributed to this phenomenon because parents put so much of their hopes and aspirations on their only child.16

U.S. Foreign Corrupt Practices Act The U.S. Foreign Corrupt Practices Act of 1977 (FCPA) forbids any person (whether individual or entity, public or private) from giving foreign officials anything of value to obtain or retain business. There is an exception for facilitation payments for routine governmental actions such as administrative processes, which would not have any influence over the decision outcome of the businesses. The Department of Justice, for private persons, and the Securities and Exchange Commission, for public issuers, are charged with enforcing this law.17 In essence, the FCPA makes it illegal to bribe foreign officials in return for a business advantage directly or indirectly through third-party intermediaries.

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Doing business in China poses significant risks that may violate the FCPA. The term foreign official refers not only to high-ranking government officials but also to employees of SOEs. This poses an issue in China as the major industries are dominated by SOEs. Moreover, the business culture in China relies to a large extent on building relationships and trust between partners. This is manifested outwardly as the giving of gifts and hosting of extravagant meals that are often used as means to demonstrate sincerity and a sign of mutual respect. The strong tradition of gift giving in China creates a high-risk environment. Several U.S. companies had publicly disclosed their own investigations into potential FCPA violations in China of their Chinese subsidiaries in the first half of 2012. Another issue is that doing business in China often leads to many interactions with government officials at all levels to seek their assistance, guidance, or approval. This level of interaction extends throughout the business process and begins at the business licensing and regulatory approval process in China. International Business Machines Corporation (IBM) On March 18, 2011, IBM Corporation—New York-based global information, technology, and services company—was charged by the SEC with the violation of the books and records and internal control provisions of the Foreign Corrupt Practices Act of 1977 (FCPA) as a result of the provision of improper cash payments, gifts, and travel and entertainment to government officials in South Korea and China. The SEC alleged that from at least 2004 to early 2009, employees of IBM (China) Investment Company Limited and IBM Global Services (China) Co. Ltd., both wholly owned IBM subsidiaries, engaged in a widespread practice of providing overseas trips, entertainment, and improper gifts to Chinese government officials. IBM paid a disgorgement of $5,300,000, $2,700,000 in prejudgment interest and a $2,000,000 civil penalty.18 SL Industries, Inc. On May 10, 2012, SL Industries, Inc.—a New Jersey-based designer, manufacturer, and marketer of power electronics, motion control, power protection, and other related products used in a variety of industries—disclosed that it was conducting an investigation to determine whether employees of its indirect wholly owned subsidiaries incorporated and operating exclusively in China, SL Xianghe Power Electronics Corporation, SL Shanghai Power Electronics Corporation, and SL Shanghai International Trading Corporation, operating

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in China “improperly provided gifts and entertainment to government officials” in violation of laws, including the FCPA. The company stated that “the preliminary estimate” of the amounts of the gifts and entertainment did not appear to be material. However, there can be no assurance that, after further inquiry, the actual amounts will not be in excess of what is currently estimated. It also disclosed that its outside counsel contacted the Justice Department and the SEC and agreed to cooperate fully with the agencies.19 Eli Lilly & Co. On December 20, 2012, Eli Lilly—an Illinois-based pharmaceutical company that discovers, develops, manufactures, and sells products in one business segment, pharmaceutical products—was charged by the SEC for violations of the FCPA for improper payments its subsidiaries made to foreign government officials to win millions of dollars of business in Russia, Brazil, China, and Poland. Lilly subsidiaries in Brazil, China, and Poland also made improper payments to government officials or third-party entities associated with government officials. Lilly agreed to pay more than $29 million to settle the SEC’s charges. Employees at Lilly’s subsidiary in China falsified expense reports in order to provide spa treatments, jewelry, and other improper gifts and cash payments to government-employed physicians.20

China’s Own FCPA On May 1, 2011, an amendment to China’s Criminal Law took effect after passage by the Standing Committee of China’s National People’s Congress on February 25, 2011. This amendment represents the first instance in which PRC law has prohibited PRC nationals and PRC companies from paying bribes to non-PRC government officials.21 The new law prohibits the act of giving “money or property” to any foreign government official or official of a public international organization to “obtain an improper commercial benefit.” The PRC Criminal Law applies to all PRC citizens, wherever located, all natural persons of any nationality within China, and all companies, enterprises, and institutions organized under PRC law, which generally includes, in addition to PRC domestic companies, Sino-foreign joint ventures, wholly foreign-owned enterprises (WFOEs), and representative offices. Thus, under the amendment, a joint venture between a PRC company and a non-PRC company organized under PRC law could be prosecuted for the payment of bribes to non-PRC government officials.

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Unlike the FCPA, however, the new Chinese law applies only to officials of governments and public international organizations and not to foreign political parties, officials of such parties, or candidates for political office.22 The amendment of the criminal law to cover foreign bribery is a step in the right direction. However, the ultimate effectiveness of the amendment in preventing overseas bribery will depend on interpretation and enforcement. This amendment will likely encourage the development of more ethical practices in Chinese companies that have been accused of engaging in corrupt practices overseas. In addition, this law has the potential to level the playing field that other foreign companies such as those from the United States have been subjected to in their own version of the FCPA.

Fraud Conducting due diligence is essential for any corporate deals done in any country. Although this book is focused on China, readers should note that the issues and challenges faced in the conduct of due diligence or the corporate scandals and frauds that are discussed in this book may apply to many other cases in the world. As such, this book should not be seen as a China-bashing book. Every country has its own peculiar set of factors from the corporate culture, historical and social influences, accounting and legal structures, and people that make each case unique—China is no exception. Indeed, there have been many corporate frauds that have happened out of China and in some cases the extent of fraud is appalling. Indeed, there have been many corporate frauds that have happened out of China and in some cases the extent of fraud is appalling. In order to illustrate this and to put things into perspective, this section will include a discussion of four case studies of large-scale corporate fraud that have happened around the globe and outside China. The case studies discussed are: 1. 2. 3. 4.

HealthSouth Parmalat Enron WorldCom

The prevalence of fraud cases that have been uncovered in China in recent years may lead observers to think that China is unique in this situation. However, fraud cases happen all over the world even in developed countries. That said, there is a still a high level of incidence of fraud cases in China. According to Kroll, the number of fraud cases that have affected companies

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in China has improved significantly, from 84 percent in 2011 to 65 percent in 2012. This number is still higher than the global average at 61 percent. The common areas of losses are: ■ ■ ■ ■ ■ ■

Vendor, supplier, or procurement fraud Information theft, loss, or attack Management of conflict of interest International financial fraud or theft Theft of physical assets or stock Corruption and bribery

Vendor, supplier, or procurement frauds occur when employees of a company receive favors in the form of direct and undisclosed payments to the employee from a vendor or supplier in exchange for preferential treatment. Some of the telltale signs include vendor or suppliers that restrict access to their accounting books and records. Even when these documents are made available, it would not be easy to identify any direct evidence of these transactions. For companies that have a large number of vendors or suppliers, it would be difficult to pinpoint which ones were engaging in kickback schemes. The lack of familiarity with the local market is one of the most common drivers of procurement fraud in China. It is not uncommon to find many family members and relatives working in the same company in China. In addition, there are likely to be transactions within the company involving many related parties, which also may involve confl icts of interest. Senior managers in the company may engage procurement fi rms run by family members and friends to obtain favorable rates and terms. High staff turnover ratios in Chinese companies also add to the woes of companies because it is not easy to control the amount of proprietary company information that can be shared with the new hires. Moreover, it is costly, time consuming, and impractical to run background checks on every single employee to ensure that there are no potential conflicts of interest or to check their true intentions. In order to mitigate the risks of procurement fraud, companies will need to build robust internal controls and reporting systems as well as to enhance information security protocols that restrict data sharing in order to reduce the risks of information theft. HealthSouth HealthSouth, which was then the largest provider of outpatient surgery, diagnostic, and rehabilitative healthcare services in the United States, was

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embroiled in extensive fraud that involved the overstatement of revenue numbers and other fraudulent figures. This was first disclosed in 2003. According to the SEC’s complaint released on March 19, 2003, it alleged that since 1999, at the insistence of HealthSouth Corp’s CEO, Richard Scrushy, HealthSouth systematically overstated its earnings by at least $1.4 billion in order to meet or exceed Wall Street earnings expectations. The false increases in earnings were matched by false increases in HealthSouth’s assets. By the third quarter of 2002, HealthSouth’s assets were overstated by at least $800 million, or approximately 10 percent. It was a systemic fraud that also implicated the workers down to the corporate office. Harvey Kelly, who was part of a team of experts brought in to investigate the corporate scandal, stated that HealthSouth’s fraud involved taking legitimate numbers from clinics and hospitals and mixing it together with bogus amounts at headquarters. Workers in the corporate office inflated financial figures and fed them into a computer program that created HealthSouth’s consolidated reports. The fake revenue generated was diverted into an account called “contractual adjustments” that would give the appearance that the company would collect more from patients than it really anticipated getting. In addition to this, there were numerous instances in which HealthSouth booked false income by overstating sales of technology and equity stakes in other companies. Parmalat Parmalat was the largest Italian food company and the fourth largest in Europe, controlling 50 percent of the Italian market in milk and milk-derivative products. However, it was subsequently discovered that Parmalat was engaged in financial fraud, its claimed liquidity of EU4 billion did not exist and it had lost billions of dollars in bonds invested into the company. This financial fraud was perpetuated by siphoning investor’s money into a network of international offshore entities that invested in billions of dollars’ worth of derivatives such as interest swaps. The elaborate financial scheme began to take shape as Parmalat had to cope with its overly aggressive but money-losing expansion plans that were fuelled by debt. This led to the company shifting into investments in derivatives and other exotic enterprises such as Parmatour, a tourism agency, and Parma, a local soccer club. These two enterprises did not produce profits and led to huge losses. It was estimated that Parmalat had lost EU2 billion.23 The financial fraud was exposed on December 8, 2004, when Parmalat defaulted on a EU150 million bond, which led to rumors spreading that

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Parmalat was in financial distress and had a liquidity crisis. That prompted auditors and banks to scrutinize company accounts. Some 38 percent of Parmalat’s assets were supposedly held in a $4.9 billion Bank of America account of a Parmalat subsidiary in the Cayman Islands. Parmalat stocks fell drastically. Bank of America announced on December 19, 2004, that an account with an alleged $4 billion in liquidity was falsified and the company was in fact bankrupt. Parmalat’s former fi nancial manager, Fausto Tonna, admitted that he had faked Bank of America documents to give the illusion of the false liquidity and that he had counterfeited Parmalat’s balance sheets in order to provide security for the bonds. In the ensuing investigation, Italian prosecutors say they’ve discovered that managers simply invented assets to offset as much as $16.2 billion in liabilities and falsified accounts over a 15-year period, forcing the $9.2 billion company into bankruptcy on December 27.24 Suddenly, it was discovered that its claimed liquidity of EU4 billion did not exist, and that EU8 million in bonds of investors’ money had evaporated as well. According to the charges, numerous shell companies were set up to generate fake profits for Parmalat and subsidiaries. In addition, Parmalat’s finance director, Fausto Tonna, has told interrogators that he participated in a “cut and paste” forgery, in which a document with Bank of America letterhead was scanned and then added to a document verifying a deposit account with that bank holding over $4.98 billion. The document was then passed through a fax machine several times in order to appear authentic.25 Parmalat is the largest bankruptcy in European history, representing 1.5 percent of Italian GNP—proportionally larger than the combined ratio of the Enron and WorldCom bankruptcies to the U.S. gross national product (GNP). Enron Enron Corporation, a U.S. energy-trading and utilities company based in Houston, Texas, was involved in one of the largest bankruptcy reorganization and attributed to be one of the biggest audit failures. Enron’s executives employed accounting practices that falsely inflated the company’s revenues, which, at the height of the scandal, made the firm become the seventh largest corporation in the United States. Once the fraud came to light, the company quickly unraveled and filed for Chapter 11 bankruptcy on December 2, 2001. As a result of the massive fraud at Enron, shareholders lost tens of billions of dollars. Many Enron executives, Enron’s accounting fi rm, and certain bank officials were indicted. Andrew Fastow, Enron’s now-imprisoned former finance chief, testified that many of the banks’ transactions were contrived, deceptive

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deals done solely to create the false appearance of profits and cash flow. Internal Enron documents and testimony of bank employees detailed how the banks engineered sham transactions to keep billions of dollars of debt off Enron’s balance sheet and create the illusion of increasing earnings and operating cash flow.26 WorldCom WorldCom, a U.S.-based telecom company was at one time the secondlargest long-distance phone company in the United States. It was one of the largest accounting scandals and led to the company fi ling for bankruptcy protection in 2002. As the telecommunications industry began to slow down in 1998, WorldCom’s stock began to decline. The CEO, Bernard Ebbers, was under financial pressure from various banks to cover margin calls on his WorldCom stock that were used to finance his other business endeavors. He had somehow managed to convince the board of directors to extend $400 million worth of corporate loans and guarantees to him.27 In addition to the dubious conditions under which the board of director acted to extend these corporate loans and guarantees, WorldCom had started to use shady accounting methods to mask the declining financial conditions of the company by declaring falsely financial growth and profitability in order to prop up the stock price of the company. WorldCom said its chief financial officer, Scott Sullivan, improperly booked expenses as investment in order to make the company look much healthier than it actually was. This fraud was perpetuated in two main ways: fi rst, through the underreporting of line costs by capitalizing these costs on the balance sheet rather than expensing them. This was accomplished by calling some ongoing costs, like network maintenance, capital expenditures—a move that let the company spread costs over several years, thus artificially improving cash flow and profits. Second, the company inflated revenues with bogus accounting entries. The company has admitted that its profits had been inflated by $3.8 billion between January 2001 and March 2002, to keep them in line with Wall Street expectations. WorldCom executives effectively fudged the company’s accounting numbers, inflating the company’s assets by around $12 billion dollars. The swift bankruptcy that followed led to massive losses for investors.28 The company founder and former CEO, Bernard Ebbers, was sentenced to 25 years in prison, and former CFO, Scott Sullivan, received a five-year jail

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sentence, which would have been longer had he not pleaded guilty and testified against Ebbers.

Company-Specific and Corporate Culture Issues Investors and foreigners often underestimate the difficulties and risks of doing business in China. Investors need to adopt a skeptical attitude and cautious mind-set when approaching doing business in China. Investors who are merely out to enter the market to profit in the short term and do not invest a sufficient amount of due diligence in the market and its potential partners will be doing themselves a disservice and are setting themselves up for potential failure. There are myriad issues that could plague Chinese companies. The traditional Chinese entrepreneur is focused on grabbing market share and growing its business while balancing the vast resources required to fund and support the expansion plans. See Figure 1.2 for an illustration on the Chinese entrepreneur’s delicate balancing act. One of the consequences is that the necessary corporate governance and internal control systems are not established adequately in the company, which exacerbates the challenges faced when conducting due diligence in China. Low Enforceability of Contracts in China In order to operate businesses effectively in China, one must be well versed in Chinese investment law and its implications. Even local Chinese citizens are skeptical when it comes to relying on the laws and regulations to protect their own rights. To that end, foreigners will fi nd it even more difficult to rely on

FIGURE 1.2 The Traditional Chinese Entrepreneur Only Focuses on Capturing Two Aspects—Market and Resources Source: Illustration by Kenny Ng.

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Chinese laws and regulations. Chinese contracts, for example, are written in general terms and differ from Western contracts, which specify explicit terms, conditions, and scenarios. In addition, the relatively unsophisticated system of laws and regulations are exacerbated by a poor enforcement system. Indeed, the only way to mitigate the risks of a poor regulatory system in the enforcement of rules and regulations is to conduct a thorough due diligence to minimize risks of disputes. China’s system of rules and laws are less sophisticated than those of the West. To add to that, China’s sheer size, decentralized and hierarchical government structure makes it difficult to implement and enforce rules and regulations. It is not uncommon to find instances in which the actions taken by the central, provincial, and local governments differ in terms of their interpretation of the laws and also the intensity of their enforcement actions.29 As a result, legal enforceability varies by region, location, and industry. Although Chinese laws are detailed and tight, Chinese contracts on the other hand are generally simple and vague. This provides room for the interpretation, implementation, and enforceability of the rules and regulations to the local officials, and also gives them significant discretionary power. As such, the room for maneuverability increases the temptation for local officials to abuse the system and to profit personally from the loopholes in the system. The legal protection of business interests in China remains relatively weak for a variety of political, sociocultural, institutional, and historical reasons. Chinese laws are generally not well enforced, in part due to “the long traditions of untrustworthy legal and government systems, lack of independent law enforcement, lack of independent law enforcement, the deficiency of supervision mechanisms, and the frequent unjustified law changes.”30 A study was conducted by the International Finance Corporation in 2012 that assessed the enforceability of contracts by assessing the efficiency of the judicial system by following the evolution of a commercial sale dispute over the quality of goods and tracking the time, cost, and number of procedures involved from the moment the plaintiff files the lawsuit until payment is received. According to the study, China was ranked 19 out of a total of 185 countries. It took 406 days from the filing of the dispute, trial, and judgment to its enforcement. The total cost, including attorney, court, and enforcement, amounted to 11 percent of the total claim.31 Lack of Internal Controls Establishing robust internal risk controls is critical in any company. However, in China, there is a general lack of internal control and audit efforts. Even if they

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are present, they are only rudimentary and initiated only to meet compliance requirements with little or no real benefit to the business. China has an evolving regulatory framework for internal control and audit. China has its own version of the Sarbanes Oxley Act (China SOX), otherwise known as the Basic Standard for Enterprise Internal Control. China SOX is a regulation adopted in China designed to improve risk management, and it was announced in June 2008 and sponsored by the Ministry of Finance, China Securities Regulatory Commission, the National Audit Office, China Banking Regulatory Commission, and China Insurance Regulatory Commission. China SOX was intended to impose stricter corporate governance, risk management, and control standards on domestically listed companies on the Shanghai and Shenzhen Stock Exchanges. Going forward, all listed companies are required to comply with China SOX, and nonlisted enterprises are also encouraged to adopt the standard as well. In accordance with the Basic Standard, a Chinese enterprise should:32 ■

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Include the five control elements when establishing and implementing effective internal control. Establish and implement internal control policies. Establish a suitable business management information technology (IT) system with embedded controls. Set clear policies on the rewards and disciplines relating to the proper implementation of internal controls. Effectiveness of internal control implementation should be treated as a key element of performance appraisals for departmental and staff levels. Perform self-assessment of the effectiveness of its internal control on a periodic basis and issue control self-assessment reports.

According to Professor Li Ruoshan of Fudan University, only 239 companies listed on the A-share market were willing to publicize reports on their internal control practices, a significant improvement from the 175 companies that were willing to do so in 2007. This is a small percentage as compared to the Shanghai and Shenzhen Stock Exchange, which have 954 and 1,539 listed companies, respectively. Even the companies that have publicized their internal control audit reports only reflect standard audit opinions with little information on their financial conditions or internal controls. To this end, there are still many problems and unclear aspects regarding the current internal control measures of Chinese companies.33

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Effective internal controls rely on two key elements: the separation of incompatible duties and job rotation within the company. They are fundamentally based on a robust check-and-balance system through a structure that is independent and free of potential conflicts of interest. Effective internal control measures must also be tailored to the individual company and the level of implementation of internal controls must be scaled according to the business processes. On that note, it is not uncommon to find that many Chinese companies have family members and relatives either directly or indirectly employed by the company. This is typically because the boss of the company often finds it difficult to find trusted partners and employees to take charge of key functions and departments in the company. Therefore, the easiest alternative is to employ a family member or relative to the position. In this regard, it is also easier to control the company and the boss will have a certain level of comfort as key functions of the business are still in family and relative hands. Clearly, this violates the principles behind effective internal controls of potential confl icts of interest and independence. The prevalence of family members and relatives within the company and in other businesses that the company has business relationships with is a significant risk factor in the management of internal control risks. This also typically accounts for a significant level of related-party transactions that occur in a Chinese company, which need to be carefully scrutinized for any potential risks in unfair dealings or fraud.

CASE STUDY 1.2: CHINA HONGXING

C

hina Hongxing Sports, Ltd. manufactures sporting goods in China. The company, along with its subsidiaries, is engaged in the business of designing, manufacturing, and selling a range of footwear, as well as the sale of a range of apparel and accessories. The company’s products are sold under its Erke brand name. According to a company press release dated February 25, 2011, China Hongxing Sports Limited announced that the company and its auditors, Ernst & Young, faced difficulties in the finalization of its audit of the group’s financial statements for the year ended 2010. It was reported that the financial irregularities include cash and bank balances, accounts receivable, accounts payable, and other expenses, which were uncovered during the audits of its subsidiary companies in China.

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Trading in the company’s shares has been suspended since February 28, 2011. This after the counter fell by almost 18 percent following a report by Ernst & Young over some financial irregularities. The company had appointed special auditor Ntan Corporate Advisory on March 1, 2011, to conduct an independent investigation into the company’s affairs after some financial irregularities were uncovered. The subsidiaries are Fujian Hongxing Erke Sports Goods and Quanzhou Hongrong Light Industry. It took more than a year for the report to be completed. In the special auditor’s report, it was highlighted that the group’s cash and bank balances as at December 31, 2010, were some 263 million yuan, and not 1.417 billion yuan as presented in the company’s initial accounts for fiscal year 2010. This is a shortfall of 1.154 billion yuan. Other key findings showed that China Hongxing’s key subsidiaries had incurred and made excess payments without the board’s approval. The report also stated that there were instances when key subsidiaries did not comply with established internal control procedures.

Takeaways Many Chinese companies have weak internal control systems that lead to the presence of many loopholes and breaches of corporate governance. The China Hongxing case is just one of the many cases in China where corporate executives have exploited the loopholes for their own personal gain. It is even more challenging for companies that have multiple subsidiaries to exert their control and influence over their corporate affairs if there are no control systems in place. Therefore, it is imperative that robust internal control systems be established and for trustworthy executives to maintain authority and supervisory oversight.

Lack of Systematic IT-Enabled Internal Control Processes The majority of the Chinese businesses, especially small-to-medium-sized enterprises, rely predominantly on manual paperwork to run the businesses. It is not uncommon to find that the company’s financial, human resources, and operational records are all input and kept manually. Even for businesses that utilize IT systems to keep the records, they are often primitive in nature and not extensive. Due to the large amount of manual and paper records, there is generally a lack of internal control processes to guide employees on business processes. Moreover, these records are more susceptible to being manipulated. The use of computerized management enterprise systems, such as enterprise resource planning and customer relationship management, will systematize

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internal processes. The benefits of using IT systems to structure the processes are that it allows for a detailed mapping and restructuring of management flows of the company and the ability to delegate specific functions to subordinates. These individual processes can be easily managed and controlled, which allows for the interconnection of decisions flows such that there are minimal grey areas that may pose risks to the business. Compared to the manual and cumbersome paperwork in the past, IT-enabled internal control systems allow for greater accessibility and clarity and make it easy to manage the business. These computerized records are also harder to manipulate, which reduces the risks of fraud. Chinese Corporate Culture Guanxi or relationships in China has been featured prominently as one of the most critical aspects of doing business in China. Conventional understanding of guanxi has been overemphasized as one that will be able to open pathways to all possibilities and be able to resolve all problems. However, guanxi can work both ways. Government officials in China may sometimes collude with local businessmen in business transactions. Government officials’ interest lies in attracting investments into their local jurisdictions and their promotion and standing is in large part linked to economic performance of their local jurisdictions. Moreover, there is the threat of personal gain when government officials receive kickbacks from companies. The potential for abuse of relationships between government and companies compels investors to be cautious whenever there is a strong government connection in the transaction. Chinese businesses typically have a hierarchical structure where the founder or CEO of the company wields de facto power over all the company’s executive decisions. Moreover, the Chinese business owners and founders are typically fi rst-generation entrepreneurs in their forties and fi fties who have benefited from economic reforms in China. As the fi rst-generation entrepreneurs, there is typically significant concentration of power in their hands. Their authority is rarely questioned or challenged by the employees in China’s corporate culture. This could be attributed to the Chinese culture of deference to authority as well as a fear to speak up for fear of being labeled as insubordination or being disloyal. This may then lead to repercussions such as being sacked by the company or reassigned to another department that pays lower wages and in a less influential position. As the fi rst-generation entrepreneur, the Chinese founder and business owner would typically own 100 percent of the company or be the largest shareholder. As the business continued to flourish and grow rapidly, the

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Corruption in China

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25

founders would be preoccupied with grabbing market share, developing new businesses, and securing resources. This rapid expansion has also left the business owner with little time to consider the need to build up internal controls systems and processes for the business. After all, as long as the company continues to grow and is profitable, there is no need to rock the boat (see Figure 1.3). Some Chinese business owners face another conundrum when they reach a plateau in their business when the business growth has been stagnant and they have run out of ideas on how to expand the business. For this group of Chinese business owners, the key for them is to generate ideas on how to improve their business through means such as improved marketing and branding, product innovation, and diversification. Due to the relatively short time that Chinese businesses have developed ever since the economic reforms started in the late 1970s, there is a general lack of understanding of business management skills and experience. Most of the entrepreneurs who are now running successful companies did not have the sophisticated management training that their Western counterparts may be exposed to. Instead, Chinese entrepreneurs have been focused

FIGURE 1.3 Founder of Company Overpromising on Company’s Growth Prospects Source: Illustration by Kenny Ng.

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The Business Landscape in China

primarily on two aspects of the business: (1) grabbing a bigger market share and (2) grabbing more resources to support the growth of the company. In addition to this, China’s education system during the economic reform period had been focused on developing professionals in engineering, science, and mathematics core subjects. As such, Chinese business owners generally do not have formal business training in core subjects such as fi nance, accounting, marketing, management, and taxes. Due diligence conducted in China typically entails higher risks because there is limited public record availability. For more stable jurisdictions, such as the United States, a routine due diligence screen will entail the checking of names against publicly available records. As there is limited public record availability, due diligence screenings will require significantly more time, effort, and costs in order to acquire information. The general lack of transparency in the company’s administrative processes can be attributed to the lack of professional management, as the majority of the companies were started by Chinese entrepreneurs who did not have formal management training or awareness of documentation, processes, and systems. The lack of transparency does not necessarily mean that fraud is being committed. However, the lack of transparency could lead to the existence of loopholes that increase the risks of account manipulation or fraud.

CONDUCTING DUE DILIGENCE IN CHINA VERSUS WESTERN COUNTRIES There are distinct differences between the conduct of due diligence in Western countries such as the United States and Europe and China. There are many reasons for this but they can largely be attributable to the differences in business landscape and stages of development and maturity of the countries. One of the biggest mistakes potential investors make when they conduct due diligence in China is relying solely on using their “Western” lenses and experiences to guide their due diligence process. In order to conduct due diligence in China, one must take a “Chinese” view in approaching the due diligence process. In China, investors are potentially faced with unfamiliarity with the business landscape, cultural and social differences, as well as potential language barriers. Table 1.1 provides a summary of the differences between Chinese and Western business landscapes. In China, investors have to contend with the lower quality and efficiency of business processes, fi nancial statements, infrastructure, and operations

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TABLE 1.1

Comparison between Chinese and Western Business Landscapes

Issue

China

Western

Education Background of Business Owners/Founders and Management

Less well educated in business core topics such as finance, marketing, accounting, and operations.

Better educated and exposed to business topics.

Company Record Keeping

Manual and paper records.

Computerized and systematic.

Internal Controls

Internal controls are weak.

Internal controls are present.

No computerized system to systematize business processes. Computerized systems that map out the business process and allows for easier management.

Using family members, relatives and friends to safe guard.

Corporate Culture

Cor porate culture is dependent on the culture set by the Chinese business owner and founder.

The Chinese business owner and founder wields ultimate power.

Board of directors are not independent and wield little influence.

State of Economy

Transition from planned economy to market economy.

Generally open and transparent.

Professional working environment.

System of checks and balances within the company.

Key management is accountable to the board of direc tors.

Market economy and capitalist.

Increasingly becoming more capitalistic.

Tendenc y for Corruption

Business environment and ways of doing business in China create temptations for taking kickbacks and corruption.

Business environment and landscape is less conducive for corruption due to the systems of checks and balances.

Compensation Schemes of Civil Servants

Low wages leads to tendenc y to seek alternative sources of income.

Adequately compensated as compared to China, which lowers the propensity for rent-seeking behavior.*

Enforceabilit y of Contracts

The enforceabilit y of contracts is generally weak and should not be relied upon.

Contracts are generally well enforced and business partners will adhere to the terms and conditions stipulated in the contracts.

Building a relationship and maintaining trust in the business partnership is paramount.

*Rent-seeking behavior is an attempt to obtain economic gain by manipulating the social or political environment without reciprocating any benefits back to society through wealth creation.

27

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The Business Landscape in China

setup of Chinese companies. The business processes may be convoluted and inefficient, which would lead to a tedious and time-consuming due diligence process. Many multinational companies are used to more developed markets in which the target company or partner’s corporate and financial information are well-documented, systematic, audited, and accessible. However, Chinese companies usually do not have systematic business processes and good documentation and filing systems. Therefore, one often faces challenges in getting Chinese companies to provide their complete and accurate information within a specific timeframe. Moreover, it would not be surprisingly to find that Chinese companies typically purposely leave out certain key information and deliberately do not record them on the books. The due diligence process typically starts with an investor approaching a company with a preprepared checklist. The target company proceeds to prepare the necessary documents according to the checklist and then submits them to the investor. However, investors should not rely solely on the responses and documentation prepared. In addition, it is not uncommon to find many Chinese companies that claim that the company did not possess such documents. Even worse, some documents could either be faked or dressed up in an attempt to paint a greener picture of the company’s performance than it really is. The due diligence checklist might seem overwhelming to the Chinese company especially if it is its first experience with international investors or companies. It is important for the people conducting due diligence to approach the Chinese company gradually and respectfully, so as not to scare the Chinese company. Some Chinese companies might also be wary of due diligence because of the amount of documentation and information required. This is because the due diligence process may appear to be a form of “witch-hunt” for fraud or for mistakes in the way the Chinese company had gone about doing business. To the Chinese shareholders and key management, the outcome of the process is uncertain and they would be wary of giving up too much information, as they would be suspicious of the intent of the investors. Moreover, they would not want to divulge all the company’s proprietary data and secrets to a process that has no certainty of outcome or success. The level of transparency in the financial information is generally lower than in developed markets. One often hears about multiple financial books that are kept by the company in order to avoid paying too much in tax. The financial statements are usually audited by a local accountancy firm or sometimes not even audited at all. The accounting standards used are the People’s Republic of China (PRC) GAAP. The level of auditing and accounting usually differs quite significantly and appear to be unreliable from a U.S. GAAP or IAS perspective.

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Conducting Due Diligence in China versus Western Countries

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Chinese companies rely largely on manual processes for their business accounting. Therefore, it is not unusual to encounter problems retrieving all necessary documents, and some may even be missing because of poor record keeping and filing by the company. As such, the time taken for due diligence is typically much longer for Chinese firms as compared to more developed markets. The Chinese companies also require extensive assistance in order to prepare the necessary documentation. Related-party transactions are extremely common in a Chinese company and they tend to be extended and complicated. The high prevalence of relatedparty transactions does not necessarily mean that the Chinese company is deliberately engaging in nefarious activities. Related-party transactions are not fully disclosed and this information can only be discovered through discussions with management or by interviewing the staff about the status of these companies. Liabilities are another key concern area. These contingent claims are not usually disclosed, and this poses a fairly high level of risk. To this end, it is critical that the investors need to explain carefully and in detail about the intents and workings of the due diligence process. Trust and rapport needs to be built between the parties involved so as to ensure a smooth process. It is important to explain in detail the individual items on the checklist and its importance in order for the deal to go through. As discussed earlier, many Chinese companies do not have good documentation, and when they are faced with a deluge of requests for information, it will take significant amount of time for the Chinese companies to prepare the necessary documentation. Another important source of information is for the due diligence team to speak directly to senior management on key questions about the company and other unwritten records that would otherwise not be uncovered. Apart from the formal meetings and interviews with management, another approach would be to conduct informal dialogues with management at all levels and selected rank-and-file staff to gain a better understanding of the dynamics of the corporate structure and culture. With the formal and informal interviews conducted, the due diligence team would then attempt to piece together a consistent story and compare that with the findings from the legal and financial advisors. In the developed markets, contracts are seen as an integral part of a company’s business that guides the corporate structure and relationships with its stakeholders such as governments, suppliers, customers, shareholders, boards of directors, and employees. These contracts are usually very detailed; therefore, they are heavily relied on in the conduct of business and

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The Business Landscape in China

any deviation from the contract will be subjected to litigation. In contrast, although the Chinese also have contracts between their stakeholders, these contracts are typically not as extensive as those of the companies in developed markets. These contracts usually only set out general terms and conditions and do not delve deeply into specific terms or recourse of actions in the event of a breach in contractual terms. This may seem baffl ing to investors who are more used to scrutinizing and relying on the contracts as a basis for the relationship. However, one must consider that Chinese contracts and business relationships are built on the foundation of trust between stakeholders. The fluidity in the business relationships between stakeholders may pose obstacles to investors who are not familiar with the way Chinese companies function. Indeed, it is precisely because of the differences in the way Chinese companies operate that investors must conduct due diligence that’s beyond the checklists.

CONCLUSION The business landscape in China is complex and poses significant challenges to the conduct of due diligence. The macroeconomic and structural conditions determine the environment in which one must contend with when operating in China. In addition to the macro factors that affect the business landscape in China, we also have to consider company specific and corporate culture in China. In general, there is a lack of internal control systems and the level of corporate governance is still quite poor because many Chinese firms are still helmed by firstgeneration entrepreneurs who may be so preoccupied with expanding market share and balancing resources that they have no time to look into the professionalization of the management of the company and strengthen the corporate governance framework. The prevalence of corruption and fraud cases in China suggests that one has to be extra careful when dealing with Chinese companies and individuals. Indeed, there are significant differences between the Western and Chinese business landscapes, and many people have either overlooked or underestimated their effects. In order to mitigate the risks of taking the due diligence process in China too lightly, one needs to understand these differences and their potential impacts on the company and individuals involved. To this end, conducting due diligence in China requires attaining a good understanding of these various factors in order to be well prepared, well informed, and to develop a better appreciation of the political, social, and cultural issues that occur in the process.

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Notes

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31

NOTES 1. “Jim O’Neill: China Could Overtake US Economy by 2027,” The Telegraph, November 19, 2011. 2. Ting Gong and Alfred M. Wu, “Does Increased Civil Service Pay Deter Corruption? Evidence from China,” Review of Public Personnel Administration 32 (June 2012): 192–204. 3. “Government Paying Big to Provide for Civil Servants,” Global Times, December 3, 2012. 4. “Li Chuncheng Graft Probe Linked to Chengdu Businessman,” South China Morning Post, December 6, 2012. 5. “Under-Secretary Cadre in Sichuan Province Investigated,” Caijing, December 5, 2012. 6. “Xi Jinping’s Anti-Corruption Crusade,” Risk Advisory, March 5, 2013. 7. “Corruption Up among China Government Officials,” BBC News, January 8, 2010. 8. “Corrupt Sinopec Ex-Chairman Convicted,” China Daily, July 16, 2009. 9. “China Nuclear Chief Latest Hit in Graft Crackdown,” AFP, August 7, 2009. 10. “Former China Nuclear Head Jailed for Life over Bribes,” BBC News, November 19, 2010. 11. “China’s Hu Jintao in Corruption Warning at Leadership Summit,” BBC News, November 8, 2012. 12. “Xi Jinping Vows to Fight ‘Tigers’ and ‘Flies’ in Anti-Corruption Drive,” Guardian, January 22, 2013. 13. “How Serious Is China on Corruption?” BBC News, January 28, 2013. 14. “Hello 2013: To Fight Corruption, China Must Fight the Cause of Corruption,” Financial Times, January 14, 2013. 15. “China Looks to Cure Hospital Corruption,” Bloomberg BusinessWeek, September 27, 2012. 16. “Expensive Gifts on Teachers’ Day in China Raise Question: Kindness or Bribery?” International Business Times, September 11, 2012. 17. “The Foreign Corrupt Practices Act in China: A Balancing Act for Business,” Westlaw Journal Government Contract, 26, no. 5, September 10, 2012. 18. “IBM to Pay $10 Million in Settled FCPA Enforcement Action,” U.S. SEC, Litigation Release No. 21889, March 18, 2011. 19. SL Industries Inc., Form 10-Q, May 10, 2012. 20. “SEC Charges Eli Lilly and Company with FCPA Violations,” Document 2012-273, December 20, 2012. 21. “China Amends Criminal Law to Cover Foreign Bribery” Covington & Burling LLP, March 1, 2011. 22. “China’s Own FCPA,” WilmerHale Publications, August 1, 2011. 23. “The Story Behind Parmalat’s Bankruptcy,” Executive Intelligence Review, January 16, 2004.

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24. “How Parmalat Went Sour,” Bloomberg Magazine, January 11, 2004. 25. “The Parmalat Scandal: Europe’s Ten-Billion Euro Black Hole,” World Socialist Web Site, January 6, 2004. 26. “The Enron Fraud,” Enronfraud.com. 27. “WorldCom Scandal: A Look Back at One of the Biggest Corporate Scandals in U.S. History, Yahoo! Voices, March 8, 2007. 28. “Disgraced WorldCom Faces Fraud Charges,” BBC, June 27, 2002. 29. “Avoiding FCPA Risk While Doing Business in China,” Deloitte, August 22, 2008. 30. Kevin Zheng Shou and Laura Poppo, “Exchange Hazards, Trust and Contracts in China: The Contingent Role of Legal Enforceability,” Journal of International Business Studies 41, no. 5 (2010): 861–881. 31. “Doing Business Project,” Website International Finance Corporation, 2012, http://www.doingbusiness.org. 32. “SOX Has Reached China,” PRLog (Press Release), July 28, 2009. 33. “Expert Diagnoses Internal Control of Chinese Companies,” Fudan Business Knowledge, April 2012.

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2

CHAPTER TWO

Due Diligence in China

D

U E D I L I G EN C E I S T H E A S S E S S M EN T of the benefits and liabilities

of a proposed investment by evaluating all imaginable aspects of the past, present, and future of the business. It requires an understanding of the business and the environment and to use that information to come to an accurate valuation and to build reliable and predictable financial models. It includes an investigative analysis of the financial, legal, and operating activities of an entity in connection with a proposed transaction that would result in a significant change in the ownership or the capital structure of the entity. The aim of due diligence is to identify problems within the business, particularly any issues that may give rise to unexpected liabilities in the future (as shown in Figure 2.1). A good due diligence must be unbiased and carried out by independent professionals. It should be conducted with a positive attitude and with the cooperation of the management. Management may pose road blocks to the due diligence team if there is no trust or rapport built with the due diligence team. There are many different types of due diligence processes, and the ones that are used depend on the intent of the due diligence, costs, the amount of time allowed for due diligence, the level of detail required for the due diligence, as well as the nature of the industry and business scope of the companies involved. In order to determine the scope of the due diligence, one needs to weigh and determine numerous factors. In addition, it is critical to understand the issues and the risk level involved. 33

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FIGURE 2.1

Due Diligence in China

Do Your Due Diligence Properly before Taking the Plunge

Source: Illustration by Kenny Ng.

The focus of this book is to provide readers with a thorough understanding of the due diligence process in China and its complexities. The discussion throughout the book will be targeted at highlighting the key aspects of due diligence that one must look out for in China. In addition, the discussion of due diligence aspects in China will focus on the perspective of a corporate buyer acquiring a target company. This could take the form of mergers and acquisitions or private equity deals. Within these two broad fields of corporate buyers, we will also highlight the key differences between them that would affect the level and extent of due diligence. Effective due diligence in China requires mutual respect and trust between the parties involved in the deal. The cover of this book was carefully chosen to reflect this notion of mutual respect and trust that creates a conducive environment for frank and open sharing of information. Due diligence will be much more difficult if the parties involved are suspicious and unfriendly toward each other. This hostile environment tends to create uncertainties and doubts about the other parties’ underlying intentions and motivations. Furthermore, this would lead to the deliberate hiding of information or spreading of misinformation that would ultimately derail the deal. A detailed due diligence checklist is important because it creates a structure and systematic way to guide the process. What is more critical is the actual planning and skillful execution of the due diligence checklist. The checklists cover important aspects of the business that should not be neglected. Generally, companies rely on checklists to go through the due diligence process and often,

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Due Diligence in China

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35

these checklists may not fully account for the intricacies and complexities involved in due diligence in China. As such, this book advocates an approach to due diligence that goes beyond the checklists, and that will be further elaborated in subsequent chapters. As shown in Figure 2.2, the fundamental idea behind this book is that, in order to conduct an effective due diligence in China, it is important to have a skillful execution of a detailed checklist combined with a beyond the checklist approach. With this combination, the chances of success in the deal will be greatly enhanced and the risks highly mitigated. There have been many cases of failed investments in China by multinational companies and investors that can be traced to lack of a thorough due diligence. The due diligence process needs to be integrated and deliberately planned for at the onset of the deal in order to provide sufficient time to uncover any red flags or potential problems that could arise. However, often, investors or companies downplay the importance and role of due diligence because of poor attitudes, complacency, or a plain lack of understanding of the business environment and culture of doing business in China. The results of the due diligence process more or less determines whether the buyer would want to take things further into the next step: negotiation of the deal. If that goes well, the buyer then continues to complete the deal and begins planning the post-completion work. For company mergers, it means the integration of two companies, and for private equity investments, it means the execution of the 100-day plan, which is a mix of operational improvement projects planned and designed by the private equity fi rms on the target company post investment. As Henry Kravis elegantly puts it, “Don’t congratulate us when we buy a company, congratulate us when we sell it.”1 That speaks volumes for the importance of the post-completion work after a completed merger or acquisition. Deal completion is only the

Detailed Checklists

Beyond Checklists

Effective China Due Diligence

FIGURE 2.2

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Effective China Due Diligence

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Due Diligence in China

beginning of an arduous task of integrating a business or managing a portfolio company, ensuring that the transaction is actually value accretive to the acquirer or profitable to the fi nancial investor upon sale later. To ensure that the buyer knows exactly what work is required, which improvement projects are needed, and which qualification is essential for the management, a thorough due diligence process should help in reducing risk and uncovering the important issues that have to be addressed during post completion.

DUE DILIGENCE FOR DIFFERENT TYPES OF DEALS The level and extent of due diligence that needs to be done depends on the type of deal. We can broadly categories these into three types: minority, majority, and full buyout. In general, the due diligence process is tedious and time consuming for minority deals because there may not be full access to the company’s operations and financial information. Moreover, the acquirer will have to contend that, as a minority shareholder, there will be less management control and ability to influence the company. Due to this, it is critical that acquirers conduct a full due diligence on the company so as to ensure that the interests are aligned and that there are no hidden liabilities that may adversely impact the company. As illustrated in Figure 2.3, there exists an inverse relationship between process and intensity of a due diligence exercise—the less process driven the exercise is, the bigger the required intensity of the process. Less Process Driven Private Equity— Minority Stake

Corporate JV

Private Equity— Buyout Corporate M&A Investment Firms

More Process Driven

Customer/ Supplier

Pre-IPO

Intensity of Due Diligence Process

= time taken

FIGURE 2.3 Relationship between Process Driven and Intensity of Due Diligence

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Due Diligence for Different Types of Deals

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37

CASE STUDY 2.1: TEMASEK AND SIA’S PROPOSED MINORITY ACQUISITION OF CHINA EASTERN AIRLINES

S

ingapore Airlines and Temasek were looking to purchase a 26 percent stake of China Eastern Airlines in September 2007.2 China Eastern Airlines’ shareholders voted against the deal and failed to attain the required level of support from independent shareholders at the extraordinary general meeting conducted to consider the investment proposal. Of the minority shareholders, 78 percent opposed the sale of a 24 percent stake of China Eastern to Singapore Airlines and the state investment firm Temasek Holdings. They had offered 7.2 billion Hong Kong dollars (HK$), or $920 million, for the stake.3 The SIA investment then received approval from the Chinese government, including the State Assets Supervision and Administration Commission (SASAC). SASAC, an arm of the China State Council, China’s cabinet, controls the country’s big-three carriers. After that, China Eastern only needed final approval from its shareholders.4 Air China, with the backing of its parent China National Aviation Holding Company, had announced, prior to the commencement of the EGM, that it would make a higher counter that was at least 30 percent higher than the current SIA-Temasek offer. Air China (National Aviation Holding Co.) pledged to offer at least HK$5 a share for the stake in CEA—32 percent more than the Singapore bid of HK$3.80—should the Singapore Airlines deal be rejected.

Takeaways Minority acquisitions pose different challenges to the due diligence process. Due to the lack of management control in the post-acquisition phase, the acquirer will have to ensure that the business being acquired needs to be in line with its own interest and that the management, key executives, operations, and financial information are in order. Most of the time, the need for even more thorough due diligence on minority deals is often overlooked as the acquirer will not need to take up operational issues or to take over as key management. As such, the acquirer is dependent on the current management ’s execution abilities to deliver on growth. However, this lack of effective control is precisely why due diligence is important to uncover any potential issues and liabilities and then to plan ahead to see if there are any workarounds or solutions. Therefore, a full due diligence is required to conduct reputational and operational due diligence on the business. The focus will be on mapping the founder and key executives to determine their interests, relationships with government, clients, and suppliers as well as their execution abilities.

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Due Diligence in China

Private Equity and Mergers and Acquisition Due Diligence The key difference between private equity investments and corporate mergers and acquisitions (M&A) lies in the investment objectives, time frame, and methodologies. (See Table 2.1.) The objective of the private equity fi rm is to invest in a fi rm and then exit that investment at a significant premium in order to distribute the returns back to its limited partners (LPs). Corporate M&As are driven by the desire to gain more market share and revenue, to gain

TABLE 2.1 Differences ff between Private Equity Investments and Corporate Mergers and Acquisition Private Equity

Corporate

Strategy

Exit driven

Revenue, market-share driven and technology acquisition

Synergy

Synergy between portfolio companies but not necessarily required

Synergy is the most important reason

Integration

No integration

Integration is necessary – Culture differences – Redundancies

c02.indd 38

Due Diligence

Very extensive and intensive due to lower risk tolerance

Comparatively less extensive and intensive due to higher risk tolerance

Adding Value

Important consideration

Integration

Choices

Many choices for potential deals

Less choices for targets

Stake

Minority, majority, or buy out

Majority

Valuation

Get bargain & discount

Paying for market shares and synergies

Psychological

Walk away anytime

May be under pressure to make deals

Frequency

Frequent

Not as frequent

Exit

Exit within 2 to 10 years

Integrated

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Due Diligence for Different Types of Deals

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39

new product lines or business, and to acquire companies that have synergy with the company. Depending on the investment strategy of the private equity firm, synergy among its portfolio companies may or may not be a key consideration in its decision to invest in the company. There is generally no need to integrate the companies that it had invested in with one another because the portfolio companies are generally able to function independently. In addition to this, private equity fi rms can typically avoid having to deal with the integration of company cultural differences, and corporate redundancies are common in corporate M&As since there is no need to integrate the company’s business operations. To this end, the due diligence process conducted by a private equity fi rm and a corporate fi rm on a potential investment can differ quite significantly. In general, the due diligence process of a private equity fi rm is very extensive and intensive because the tolerance for risk in a private equity fi rm is generally quite low as compared to a corporate fi rm. The latter has many business units that can potentially make up for the fi rm’s inadequacies and may, therefore, be willing to bear the risk of acquiring the fi rm. Therefore, the corporate fi rm will have to identify potential synergies with its own business units and the potential fi rm to be acquired and then adjust its risk tolerance accordingly in its due diligence process. In order for private equity firms to extract a high investment return from its investments, they will need to add significant value to the companies so that it becomes more valuable. Corporate M&As, on the other hand, are focused on the integration of the newly acquired company with its own company. The choice of investment for the private equity firm is only limited by its investment strategy, whereas the choice of investment in corporate M&As are restricted because corporates have to identify firms that are typically in similar industries and businesses. Depending on the nature of the deal by private equity players or for merger and acquisitions, the level of due diligence will vary. Minority, majority, and full buyout deals will affect the intensity of the due diligence required. Minority acquisitions are perhaps the most complicated as the corporate suitor would not have management control over the target company. As such, the corporate suitor must have sufficient assurance that the target company is healthy and acting in good faith. This assurance can come only from a full due diligence to verify the target company’s corporate and financial information. However, it gets complicated for minority deals as the level of access provided to the corporate suitor would be much less. As such, there will be difficulties to gain full

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Due Diligence in China

access to the target company’s documentation, customers, suppliers, executives, and operations. For the majority and full buyout acquisitions, the level of due diligence required will need to be extensive because the management control will be transferred to the acquirer. This also means that the acquirer will have to inherit the target company’s obligations and liabilities. Without a full due diligence, it may not be possible to uncover these hidden or obscure liabilities that may pose significant costs to the company in the future.

Pre-IPO Due Diligence Pre-IPO due diligence is primarily concerned with following the pre-IPO checklist issued by the securities regulators and exchanges. (See Figure 2.4.) Each entity has its own set of checklist criteria but they are generally focused on the documentation and financial information of the company. As such, there is unlikely to be extensive checks on the operations of the target company or in-depth checks on its key customers and suppliers. For instance, the listing process of a Chinese company, particularly on overseas stock exchanges, is a very process-driven, checking-the-box exercise. Stock exchanges are regulated by a regulatory body, such as the Securities Exchange Commission (SEC) in the United States. Their role is to ensure that companies listed on the U.S. stock exchanges adhere to the IPO requirements, which often is a set of criteria and disclosure standards that the company has to meet before it goes public. Although the securities regulators around the world

FIGURE 2.4

Pre-IPO Due Diligence Is Very Much a Process-Driven Exercise

Source: Illustration by Kenny Ng.

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have put in place very high standards of listing requirements, there are always blind corners and potholes that are often unavoidable. There are many drivers that accentuate these shortcomings, including the following: ■

■

■

■

Stock exchanges have incentives to encourage companies to list on their board. Although attaining IPO requires a very rigorous due diligence exercise, it does not take into consideration cultural differences between companies from different countries; the due diligence checklist is a standard one that does not customize to companies from different geographic regions. Vendors are very familiar with the listing criteria, and they understand the process and know how to help the company get around certain hurdles. Vendors’ interests are aligned with the company, and, therefore, they might engage in “window-dressing” for the company to meet requirements.

All in all, investors should simply not take the foot off the pedal when they evaluate a public company. Quite the contrary, more due care should be taken when seeking a minority investment in a public company because there could be many hidden risks in a listed company that were uncovered during the listing process. This applies to any public companies, and even more so for foreign companies, that is, Chinese companies on U.S., London, and German stock exchanges.

CASE STUDY 2.2: HONTEX INTERNATIONAL HOLDINGS

O

n June 20, 2012, the Court of First Instance (in proceedings brought by the Securities and Futures Commission [SFC]) ordered Hontex International Holdings Company Ltd (Hontex) to make a repurchase offer to about 7,700 investors who had subscribed for Hontex shares in the initial public offering in December 2009 or purchased shares in the secondary market during the three months after its shares were listed (by then the present action was taken by the SFC).5 Hontex will pay HK$1.03 billion, or HK$2.06 per share, to buy back all the shares owned by the 7,700 small shareholders, who either subscribed for the IPO or bought after the listing. The offer is equal to its last trading price. (Continued)

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(Continued) In June, a Hong Kong court ordered the company to refund money to small shareholders after the Securities and Futures Commission alleged it had provided misleading information by overstating its profit and turnover figures in its listing prospectus in 2009. The move marks the first time the regulator has sought compensation for investors. Hontex, founded and chaired by Taiwanese Shao Ten-po, runs a factory in Fujian. It listed on Christmas Eve of 2009, but the SFC suspended it from trading in March 2010, meaning it traded for only 64 days. The Court ordered Hontex to pay a total sum of HK$1.03 billion (HK$832,244,497 of which had previously been frozen by the Court upon the SFC’s application). The orders were the first of their kind made under section 213 of the Securities and Futures Ordinance (SFO). The orders were made by agreement between the SFC and Hontex 12 days into the trial. Essentially, Hontex acknowledged, for the purpose of the civil proceedings, that the following information in the prospectus was materially false and misleading:6 ■

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The amounts stated in the IPO prospectus with respect to its turnover for the three years before its listing from 2006 to 2008. The value of its cash and cash equivalents for the years ended December 31, 2007, 2008, and June 30, 2009.

The SFC alleged that the overstatements in the turnover and cash positions were as much as RMB974 million and RMB204 million, respectively. Although Hontex did not agree to the extent of overstatements alleged by the SFC, their acknowledgment amounted to an admission of the contravention of section 298 of the SFO. This, in itself, enabled the SFC to seek the present order through the power given under section 213 of the SFO, to compensate the investors. In April 2012, the SFC revoked the license of Mega Capital (Asia) Company Limited (the sponsor, sole book runner, and lead manager in Hontex’s listing) to advise on corporate finance and fined it a record amount of HK$42 million for failing to discharge its sponsor ’s duties in relation to the listing application. The SFC found that Mega Capital had failed in the following duties as sponsor:

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Mega Capital was also found to be in breach of the sponsor ’s undertaking and to have filed an untrue declaration with the Stock Exchange of Hong Kong. Earlier this month, the SFC also revoked the license of Mr. Hong Hui Lung, a former managing director of Mega Capital, to act as a representative and the approval for him to act as a responsible officer. Hong was found to have breached the following duties as a sponsor, principal, and responsible officer: 1. Refusal to accept responsibilities 2. Failure to supervise Hong was also found to be in breach of the sponsor’s undertaking and to have filed an untrue declaration with the Stock Exchange of Hong Kong.

Takeaways This case marked the first revocation of an IPO sponsor ’s license to advise on corporate finance for due diligence failings.7 It represents the importance that the SFC places on the sponsor to conduct their own due diligence work in a responsible and comprehensive manner. Going forward, there will be greater regulatory scrutiny of sponsors and the integrity of the listing process. This also puts onus of the verification of financial statements, corporate background, and the establishment of internal controls and corporate standards on to the sponsors. In sum, sponsors will have to bear greater responsibility for their due diligence work prior to the IPO process.

China’s 10-Step Process for IPO The China Securities Regulatory Commission (CSRC) is a ministry-level unit directly under the State Council that regulates China’s securities and futures markets with an aim to ensure their orderly and legitimate operation. The CSRC is responsible for the approval process for any Chinese IPO. CSRC controls new listings by placing each applicant under an intensive and elaborate listing process in which the financial conditions of each IPO applicant is investigated and analyzed thoroughly. The listing process is overlooked by CSRC’s Public Offering Review Committee (PORC), which is the ultimate approving authority for listing. In addition to the PORC’s appointed staff of seven people, an additional four people would be assigned to each IPO applicant: two review staffers and two directors.

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The roles of the Public Offering Review Committee are:8 ■

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To examine and verify whether the application for share issuance meets the conditions for public share issuance. To examine and verify relevant documents and opinion papers presented by such securities intermediaries as the sponsors, accounting firms, law fi rms, and asset appraisal institutions as well as those presented by relevant personnel for the share issuance. To examine and verify the preliminary audit reports issued by relevant functional departments of the CSRC, and propose examination and verification opinions on the share issuance according to law.

According to Caixin, a single CSRC official could stand to gain an illegal payoff in the range of 300,000 to 500,000 yuan per IPO applicant. A single PORC member can review up to 50 companies in a normal year. This would amount to close to 10 million yuan a year for a single corrupt CSRC official.9 There are a number of ways that an IPO applicant could expedite its application process by pursuing rent-seeking CSRC officials and offering them various measures to satisfy their desires. For IPO applicants that do not have access to CSRC officials, one option would be to engage intermediaries to arrange for get-togethers at expensive restaurants and similar venues. Caixin also reported this agent could stand to gain more than 100,000 yuan to setup a get-together meeting. CSRC had established a 10-step process for IPO listing, outlined in Figure 2.5. Two public-offering department staff members are assigned to an IPO applicant to look into legal and accounting issues as part of the preliminary review. Once the screening has been completed and passed, the preliminary review staff members would engage the public offering department’s directors to discuss the eligibility and qualification of the company. This is followed by the compilation of follow-up questions for the company. In the next step, a meeting is called for the company executives and underwriters for a presentation on the company and a question and answer session related to the company’s fi ling application. The company will then have to formally reply to the follow-up questions in writing or to fulfi ll any request for materials and information from the preliminary review staff members. If the company answers the questions and fulfills the requests for materials and information satisfactorily and on time, the company will be allowed to release a preliminary announcement of its listing intentions on the CSRC

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1. Company registers and files IPO application.

2. Preliminary reviews of IPO documents led by two Public Offering Department staff members and two directors. 3. Meetings between company officials and the designated staff members and directors for clarifications, questions, and answers.

4. Submission of written answers to questions posed by department.

5. Preliminary announcement of company’s stock market intentions to IPO.

6. Preliminary hearing attended by seven Public Offering Review Committee members, two application reviewers, and two directors.

7. A formal hearing is conducted.

8. All relevant documents are sealed and closed to public access.

9. A so-called “significant events report” mechanism.

10. CSRC announces decision.

FIGURE 2.5 Ten Step Process for Chinese IPO by CSRC

website. Once the preliminary announcement has been made, it is effectively an invitation for public scrutiny of the company. The next step marks an important step in the whole listing process where all the key decision members—the seven members from PORC and the four preliminary staff members—are involved in the preliminary hearing. The PORC members will scrutinize the legal and accounting reports prepared by the public offering department’s staff and clarify any doubts if any. After the hearing has concluded, all the documents and minutes of meeting are stamped and the decision would be made on whether the company has passed this stage of the listing process. At this stage, the listing process moves into a “significant events report” phase during which the legal and financial intermediaries are obliged to inform

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CSRC if there are any information or impending events that may significantly impact the company’s operations and commercial viability. This period also allows for the company and intermediaries to make any amendments to the company’s listing prospectus if required. After this “significant events report” phase, the last step in the process is to wait for CSRC’s official approval for the IPO to proceed. Although the company that has reached this stage is technically ready for the IPO, the company will still be dependent on CSRC’s balancing of other factors, such as market conditions and economic policies at that juncture.

CASE STUDY 2.3: AMBOW EDUCATION

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mbow Education Holding Ltd. is a national provider of educational and career enhancement services in China. The company operates K–12 schools, tutoring centers, colleges, and career enhancement centers. On June 11, 2012, Glancy Binkow & Goldberg LLP announced a class action lawsuit against Ambow Education Holding Ltd.10 The lawsuit alleged that throughout the class period the defendants made false and/ or misleading statements, as well as failed to disclose material adverse facts about Ambow’s business, operations, and prospects. Specifically, the complaint alleged that the defendants made false and/or misleading statements and/or failed to disclose: ■

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That certain of the company’s distributors did not have an adequate history of timely payment. That, as such, the collection of resulting receivables from these distributors was not reasonably assured. That, as a result, the company was improperly recognizing revenue on sales to these distributors. That the company was improperly accounting for certain business acquisitions. That, as a result of the foregoing, the company’s financial results were misstated during the class period. That the company lacked adequate internal and financial controls. That, as a result of the other points, the company’s financial results were materially false and misleading at all relevant times.

On April 30, 2012, Ambow unexpectedly announced that it would be unable to file its Annual Report on Form 20-F with the SEC for the 2011 fiscal year in a timely manner. Thereafter, on May 16, 2012, Ambow disclosed that the company was further delaying the filing of its 2011 Annual Report and that the company had identified certain preliminary

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adjustments to its previously issued 2011 unaudited financial statements. According to the company, Ambow expected, among others (1) to change its revenue recognition method with respect to sales to certain distributors, leading to the reversal of between $13.5 million (85 million yuan) and $15.1 million (95 million yuan) of revenue previously recognized in 2011; (2) to make a bad debt provision of between $2.1 million (13 million yuan) and $2.4 million (15 million yuan); and (3) to increase its depreciation and other expenses by between $0.5 million (3 million yuan) and $0.6 million (3.5 million yuan). As a result of this news, the company’s shares declined $0.99 per share, or 17.55 percent, to close on May 16, 2012, at $4.65 per share, on unusually heavy volume, and further declined $0.30 per share, or 6.45 percent, to close on May 17, 2012, at $4.35 per share, also on unusually heavy volume. Even after Ambow faced several class action lawsuits in 2012, it was not the end because the company faced fresh charges that it had manipulated its accounts prior to its initial public offering. According to a complaint filed on February 19, 2013, in federal court in Los Angeles, investors had sued Beijing-based Ambow Education for propping up its revenue just prior to its initial public offering in the United States. The complaint alleged that, in 2008, Ambow had paid Changsha Study School, also known as Changsha Tutoring, to borrow its name and revenue for the public listing.11 On November 15, 2008, Ambow Sihua acquired the 100 percent equity interest in Changsha Tutoring, an entity engaged in providing after-school tutoring services for junior high and high school students in Changsha. The group believes the acquisition of Changsha Tutoring is an integral piece of the group’s strategy to increase its market share in providing after-school tutoring services in China. Changsha Tutoring was incorporated on June 1, 1984, and acquired on November 15, 2008, by Ambow at a purchase price of 52,282 yuan with 34,506 yuan in goodwill.12 “The cash for the purchase was secretly returned to Ambow in the form of fake software sales,” according to the complaint, which cites statements from a member of the Changsha owner ’s family and “reputable Chinese media” articles.

About Ambow Education Holding Ambow Education Holding Ltd. (NYSE: AMBO) is a leading national provider of educational and career enhancement services in China, offering high-quality individualized services and products. Ambow has two business divisions: “Better Schools,” which includes K–12 schools and tutoring centers; and “Better Jobs,” which includes colleges and career enhancement centers. With its extensive network of regional service hubs complemented by a dynamic proprietary learning platform and distributors, Ambow provides its services and products to students in 30 out of the 31 provinces and autonomous regions within China.

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LEVELS OF DUE DILIGENCE There are different levels of due diligence that are appropriate for different situations and needs, shown in Figure 2.6.

Initial Due Diligence The initial due diligence is normally used when there is only a small transaction or short-term business relationship to be established. Initial due diligence would typically start gathering a team to go through the publicly available information. The simplest form of due diligence is to retrieve a copy of the company’s business license, which will include the following information: ■ ■ ■ ■ ■ ■

The legal representative of the company The name and address of the company The amount of registered capital that is also their limited liability The type of company The business scope The date it was established and the period of its business license

After retrieving the business license, the due diligence team will need to verify that the information from the business license coincides with what they already know and what the company has been telling them. A further step would be to verify this information with the State Administration of Industry and Commerce (SAIC), which is responsible for the overall administration of industry and commerce in China. The local branches of SAIC would have the

Initial Due Diligence

Advanced Due Diligence

Full Due Diligence

FIGURE 2.6

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business registration and licensing records of businesses registered in their locality. The status of the registered capital of the company can be checked by requesting a capital verification report through an audit firm or certified public accounting (CPA) fi rms. Upon verification, capital verification institution shall issue a report on capital verification, together with the capital verification certification materials. The initial due diligence will also include an industry sector analysis and financial analysis. However, these analyses are not going to be comprehensive due to the lack of resources, time, and money paid to carry out.

Advanced Due Diligence After the initial due diligence stage, if there are potential risks that have been identified with the potential business partner or if there are external factors that may affect the partnership such as the area of operations, jurisdictions, or industry, a more in-depth due diligence will need to be conducted. In the advanced due diligence stage, the corporate buyer would have received company-specific information and the full set of fi nancial statements after signing off on the nondisclosure agreement. The documents are typically organized and can be browsed through either an electronic or physical data room. At this stage, a site visit to the target company may not be required. This advanced due diligence stage will need to delve deeper into the company and management’s history, reputation, personal, and professional backgrounds. In addition, this stage of due diligence will need to review sources of information in the native language of the company using a plethora of private and public sources. In the context of China, this has to be done at the local, regional, and state levels because there are many governing bodies that may have overlap of departments and authorities. Due to the relative lack of accessibility of obtaining records in China, the due diligence team will need to do on-site research in order to uncover any existing or potential risks that the business or management may face due to its activities. In order to determine the company or management’s business practices and character, the due diligence team will need to rely on investigators on the ground to conduct checks.

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CASE STUDY 2.4: CELESTIAL NUTRIFOODS

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elestial Nutrifoods, a soy products maker based in Daqing, Heilongjiang province, was listed in Singapore in 2004 as having raised $20 million. ■

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2005—Raised $47 million through two placements (Templeton Asset Manager took up $13.3 million for a 5 percent stake) 2006—Raised $234 million through convertible bond

When the global financial crisis hit in 2009, the company’s shares dropped significantly and there was increased risks that the convertible bondholders would opt for payment in cash rather than shares when it was due in June 2009. Despite these financial risks, the company surprisingly did not conserve cash. Instead, it stepped up its capital expenditures throughout 2008 and the early part of 2009, which were claimed to finance a massive soybean industries zone that included a biodiesel plant. ■

2Q2008: Spent 53 million yuan

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3Q2008: Spent 440 million yuan

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4Q2008: Spent 750 million yuan

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1Q2009: Spent 123 million yuan

Celestial Nutrifoods had a cash position of 1.75 billion yuan at end 1Q2008 but by the end of the capital expenditure spree, it ended up with a net debt position of RMB 570 million yuan at 1Q2008. In addition, the company had planned to seek alternative financing when the convertible bonds were due in 2009. However, this was not possible due to the poor economic climate and the company defaulted on its convertible bonds. This series of events reflects the poor cash management and planning of the management. Moreover, it also shows that the management was either oblivious to the risks looming or they were outright depleting the company of its cash reserves for other purposes, which has resulted in the firm’s insolvency. FTI Consulting, a Florida-based company, has been retained by BlackRock, which holds more than 60 percent of Celestial’s convertible bonds. FTI Consulting will lead the liquidation of Celestrial Nutrifoods. FTI Consulting discovered from the Daqing Administration of Industry and Commerce that the ownership of the main China-based units of Celestial—Daqing Sun Moon Star, Daqing Celestial Sun Moon Star Protein, and Daqing Weitian Energy—had been transferred between August and December 2010. FTI Consulting also faced roadblocks when their investigations at the records office were abruptly cut short after

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a day and told that the files were “closed to public inspection.” Court documents in Singapore revealed that FTI Consulting also suspected that there was collusion between the key management of Celestial Nutrifoods and local government officials in Daqing and Harbin, Heilongjiang’s provincial capital.13 Investigations revealed that Ming Dequan, the executive chairman of Celestial Nutrifoods, had other interests that may have taken up his time or distracted him. Ming was building a media company in Beijing that produced films and TV dramas. The company, called Beijing Tian Yuan Xin Yu Co, a music production company, released a feature film called A Tale of Two Donkeys14 at the Tokyo International Film Festival. This company also released a single called “Moon and Stars” that was written by Ming Dequan. The company also produced a song “You Do Not Want to Leave” that was written by Ming Dequan and performed by Huang Ho-Shiang.15 His media ventures also included organizing concerts within China and abroad. Ming produced a concert in Vienna that was performed at the Musikverein on March 14, 2011. Ming’s other ventures include a hotel in Daqing called the Daqing Manhaway Hotel.

Takeaways A thorough due diligence needs to be conducted on key management and their links to the government and also into their personal lives. Ming Dequan’s additional interests outside the business suggested that he would have to spend significant amount of time and capital to fund his other expenses. Ming’s media ventures coincided with critical periods in the company when it was facing financial difficulties and stepping up capital investments. An astute investor that had diligently looked carefully into Ming’s background would have revealed his divergent interests and he would have been more cautious when dealing with this company.

About Celestial Nutrifoods Celestial NutriFoods Limited is an investment holding company. The company is engaged in the manufacture and sale of soybean-based food products. The company operates in three segments: health food and beverages products, industrial proteins products, and biofuel products. Its products include health foods and beverages, soy protein isolate, soy functional protein, biochemical feedstuff, lecithin, soybean oil, and biodiesel. Its subsidiaries include Celestial (Singapore) NutriFoods Pte. Ltd., Clear Faith Holdings Ltd., Max Dragon Investments Ltd., and Giant Fortune Group Limited.16

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Full Due Diligence A full due diligence is necessary to make major business decisions in which the risks and financial commitments are much larger. In addition to the significant amount of capital and resources at stake, a large part of these business tie-ups, especially in the case of mergers and acquisitions or private equity investments, are dependent on the growth projections and potential synergies of the parties involved. As such, there is a higher level of uncertainty, as these expectations and projections are unproven and hypothetical. Moreover, there is a tendency for management to oversell the synergies and profit but also downplay the potential risks or deal breakers. To this end, a full due diligence is necessary to enhance the success of the deal.

CASE STUDY 2.5: HENGDELI

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engdeli Holdings is one of the largest retailers of watch brands with an extensive sales network in mainland China, Hong Kong, and Taiwan. Swatch Group owns 9.1 percent of Hengdeli and LVMH Moet Hennessy Louis Vuitton SA (MC), whose brands include Fendi, holds 5.9 percent.17 Hengdeli was suspected to be in financial difficulties and running into operational problems. Next Magazine published an article about Hengdeli on January 30, 2013, and raised seven key concerns: 1. Some of the store outlets were either nonexistent or not branded as company stores. 2. There was negative operating cash flow between 2006–2008 and 2010 despite being profitable. 3. The company had lost key distribution licenses and exclusive rights for brands like Omega, Rado, Bucherer, Audemars Piguet, Fendi, and Dior. 4. The company raised US$350 million of senior notes despite holding 3.4 billion yuan in cash as of June 30, 2012. 5. The company has invested in a bond of 259 millon yuan with an interest rate of 13 percent. 6. The company made three short-term loans amounting to 720 millon yuan at an interest rate of 11–18 percent. 7. The chairman has pledged its shares to Swatch for a three-year US$100 million loan for his private business. In response, the company issued a statement that operations are “normal, healthy and stable” and it “has maintained good partnerships with numerous worldwide renowned watch suppliers.”

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There are clearly corporate governance issues in the company that are posing as an overhang over the company. In 2011 the company’s chairman, Zhang Yuping, took a personal loan of US$100 million from Swatch, secured against 500 million of his Hengdeli shares. Also in 2011, Hengdeli lent unnamed third parties US$115 million—the equivalent of about 16 percent of equity.18

Takeaways Although the verdict on Hengdeli’s actual financial and operational position are still uncertain at the moment of print, there are lessons to be learned from this episode at Hengdeli. There are clear red flags when the chairman pledged his shares for a loan for his private business. This puts the company at risk for an unrelated business.

About Hengdeli Holdings Limited Hengdeli Holdings Limited is the world’s largest retailer of renowned international watch brands. The group’s strategic shareholders include the world’s largest watch manufacturer and distributor—the Swatch Group and global luxury giant the LVMH Group. Hengdeli owns an extensive retail network that includes Elegant (for luxury watches), Prime Time (for middleto high-end watches), TEMPTATION (for high-end fashion watches), and various other brand boutiques. As of June 30, 2010, Hengdeli had an extensive sales network of 302 retail outlets in mainland China, Hong Kong, and Taiwan, from which it distributes over 50 deluxe international watch brands. Across its entire wholesale operations, Hengdeli serves approximately 300 customers in over 50 cities in the PRC. As an integral part of its retail business, Hengdeli offers world-class customer care, including professional after-sales services to customers in China, Hong Kong, and Taiwan. Hengdeli’s ancillary production company also provides strong support for its principal business operations. Hengdeli maintains close relationships with numerous internationally renowned branded watch suppliers, including the Swatch Group, the LVMH Group, the Richemont Group, and the Rolex Group. Hengdeli also distributes many internationally elite watch brands, mostly on an exclusive basis.19

A full due diligence will entail the extensive use of accounting, legal counsels, investigators, journalists, and industry experts to conduct an in-depth and insightful investigations into prospective deals. A major focus of a full due diligence will entail the mapping out of business relationships of the firm as well as the personal relationships of management and key personnel. A typical process will start with looking at the supplier and customer databases and then mapping out the relationships to the firm or to key personnel in order to identify

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any related-party transactions or risks. This will also include a comprehensive background check on the suppliers and customers, their operating histories, and any unreported liabilities. A full due diligence will also include conducting an in-depth study of the company’s operations in order to validate the company’s existing operations and then assess the ability and capability of the company to sustain or grow its operations according to its own projections. Any material facts, unrecorded or understated financial liabilities or risks, will be investigated and its impacts to the business will be reported in the due diligence report. The various issues raised will be used as inputs to conduct an independent valuation of the business in order to inform the due diligence team of the viability of the deal. If there are critical issues that cannot be resolved or risks that cannot be mitigated, this may lead to the restructuring, repricing of the deal, or, in the worst case, no deal.

CASE STUDY 2.6: CHINA’S FOOD SCANDALS

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he food and beverage industry in China has faced several food safety issues and scandals in recent years. (See Figure 2.7.) Any uncovering or suspected food safety breaches will cause significant damage to the company’s brand and affect the company adversely as customers may shun the food and beverage outlets. Most of the safety breaches could be traced to the key suppliers of the company. As such, it is critical to conduct extensive due diligence on the supply chain of a food and beverage company.

FIGURE 2.7 Food Scandals and China F&B Have Become Almost Synonymous Source: Illustration by Kenny Ng.

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Liuhe Group, a large poultry supplier to fast-food chains, was embroiled in a food scandal and suspected to have used excessive amounts of antibiotics.20 According to the China Central CTV report in late 2012, some of KFC’s suppliers in Shandong had put illegal drugs in chicken feed to make the birds gain weight faster. The program claimed, “chicken farms had lights turned on around the clock to make the birds eat nonstop and grow faster, with a chicken growing from 30 grams to 3.5 kg in just 40 days. Farmers had given at least 18 kinds of antibiotics to chickens so that they would not become ill.” There were also reported cases of farmers fabricating records about how the chickens were raised before shipping them to the Yum! Brands logistics center in Shanghai.21 The Shanghai Food and Drug Administration conducted further tests and found the level of antibiotics and steroids in Yum!’s current batch of KFC chicken supply to be safe. However, there was a suspicious level of an antiviral drug in one of the eight samples tested.22 Yum! China discovered that certain batches of chicken supplies did indeed contain excessive amount of antibiotics. Subsequently, Yum! conducted more extensive checks and on-the-ground visits to the Liuhe factories to determine the extent of the problem. The sample testing at the factories indicated that the safety breaches had been rectified. CCTV identified Liuhe Group and Yingtai Food Group as suppliers of chicken to KFC and McDonalds.23 In addition to the poultry antibiotics food scandal, Yum! China also faced a damaging food safety issue when it was discovered that Sudan red dye no. 1, a type of carcinogenic coloring, was found in the seasoning of the New Orleans roast chicken wings and chicken burgers. Investigations revealed that the seasonings that were contaminated with the dye were from the Guangzhou-based Tianyang Food Co. Yum! China had also responded that as a result of the incident, all contaminated ingredients from KFC outlets and marketing centers would be disposed of in accordance with the waste-treating standards. At the same time, the production of all the substitute ingredients has been completed. In addition, the substitutes have been sent to the special institutions recognized by China for measurement in an all-round way, ensuring that the related seasonings contain no elements of Sudan Red 1.24

Takeaways The spate of food scandals in China highlight the importance of conducting a full due diligence in China when there are significant financial commitments and resources involved. A full diligence would require an in-depth study of the company ’s entire operations, inclusive of the whole supply chain. In the context of Yum! China, these food safety breaches could have been avoided if there was a concerted effort to conduct regular and thorough due diligence on their suppliers.

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KEY CONSIDERATIONS Prior to any due diligence exercise, it is critical to ask five basic questions about the deal. 1. What are the motivations for the deal? 2. What are we really after in this deal? 3. What are the potential synergies that can be extracted or liabilities that will be incurred? 4. How much are we willing to pay for the target? 5. What are the deal breakers in this deal?

Motivations for the Deal Identifying and understanding the motivations for the deal is a crucial first step in planning the due diligence process. These motivations can originate from the idiosyncratic factors such as the pride or desires from the key management to a corporate desire to acquire new growth markets, diversify the business, protect its own market share, or consolidate the supply chain. Sometimes, the deal could be motivated by a case of management getting deal fever and rushing to complete a deal. This will mean that the time afforded to conduct a thorough due diligence is significantly reduced. On the other hand, a diligent acquirer will approach a target with a well-prepared due diligence process and strategy. Sufficient time will be accorded to cover not just the standard due diligence checklist but also to look beyond the checklists into factors such as understanding the founder and relationships, supply-chain due diligence, and operational due diligence. Before the start of the due diligence process, it is also critical to identify which are the elements that may have vested interests in seeing the deal succeed. For example, the key executives pushing for the deal may be motivated by the need to legitimize their own corporate standing within the company in getting a deal done regardless of the economics of the deal or operational liabilities that the company may incur down the road. These executives may impede the due diligence process by shortening the time taken for a due diligence to rush the deal for approval.

Identify the Specific Element Wanted in the Deal The corporate profile and background of a target company will be shaped by its public image and reputation of the business community. These perceptions are derived from what is publicly known about the company and this provides

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a frame for the potential acquirer. However, this public image may not be a good and accurate representation of the true state of the company. As such, a due diligence process needs to challenge and breakdown this public image into an unbiased analysis of the target, the industry, and their strengths and weaknesses. With this proprietary view and understanding of the target company, the acquirer will be able to run scenario tests on the deal to see if it would fit the deal’s strategic logic. Breaking down the various components of the deal would encompass looking at several key aspects and conducting a more thorough due diligence. First, the customer base of the target company should be mapped out to understand the market size, the growth rate with a breakdown of the product and services, and the geography spread of the customer base. This will provide a good overview of the core customer segment, its profitability, its potential growth rate, and the weakness of the target company’s customer base. This due diligence should not rely solely on the target company’s financial numbers and data. Instead, the potential acquirer should build its own customer base map and the target company’s key strengths and weaknesses, and then rely on its own analysis to determine the customer segments to see how well the target company has captured these markets. Doing its own analysis will provide the potential acquirer additional insights about how the target company is currently performing and how it should reposition itself to capture bigger margins and markets. Second, the due diligence should include mapping out the competitive landscape of the industry. This will entail comparing the target company with its peers in the industry in the same geographic region and product segment. A comprehensive set of benchmarks mapping out the key components of the target company should be developed. This will allow the potential acquirer to benchmark the target company and to determine whether the target is cost competitive and/or product competitive. Looking at the cost competitiveness of the company includes looking at how well the company has managed its supply chain to extract the maximum value for every dollar spent. In addition, the cost economics of the deal should look at the degree of cost rationalization that would be possible when integrating business units and leveraging shared services. This benchmarking exercise will allow the acquirer to determine the target company’s competitive advantages or disadvantages. Competitive advantages that have been identified should be built on and sustained, whereas disadvantages or weaknesses will need to be addressed. In the due diligence process, possible solutions to these weaknesses or ways to overcome them

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should be thought through, because those solutions would also affect the outcome of the deal. Third, the competitive advantages and capabilities of the target company should be mapped out. This will provide the acquirer with a good understanding of what exactly it is buying and what the core competencies of the company are that are valuable. These capabilities could be wide ranging and encompass the management expertise, operational expertise, technology, supply chain management, market share, and potential growth.

Identify Potential Synergies and Liabilities Potential synergies arising from the deal come in many forms and its value is often subjective. These potential synergies that range from cost to revenue types are often overestimated and the ability to achieve them is often underestimated. Synergies should be carefully mapped out for each component of the business, and they should be mapped for the acquirer in order to determine if these synergies are achievable or not and at what costs. First, the cost synergies typically come from the integration of business units to use shared services and to eliminate duplicate functions and business activities. These cost synergies can transcend the entire company but typically reside in the back office, research and development, service centers, and operational facilities. Second, the revenue synergies will involve looking at the sales channels and to identify cross-selling of products and services. In addition, the customer base should be leveraged to determine if there are complementary interests and relationships that will provide opportunities to push products and services.25

Establish the Value of the Target A thorough due diligence process is necessary to inform the valuation process. The target’s financial information and documents will need to be scrutinized in terms of their accuracy to paint a picture of the target company’s fundamental value. It is beyond the scope of this section to uncover the various valuation methodologies. However, the critical thing in this key consideration of the value of the target is to take careful consideration of the findings of the due diligence to inform the valuation process. Through the proprietary process of building up the target company’s customer, supplier, and competitive landscape, the acquirer will be able to have a good sense of the state of the company and how it measures against its peers in the industry. To this end, the acquirer will be

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able to better assess the business performance and decide on the appropriate multiple to pay for the business.

Identify Deal Breakers Deal breakers need to be identified early in the due diligence process. The most often cited deal breaker is the price of the deal, which is known as the walkaway price. The walk-away price is the maximum price that one is willing to pay after factoring in the findings from the due diligence process and negotiations. It is recommended that the walk-away price excludes the potential cost or revenue synergies identified in the due diligence process. This is because these synergies have not come into fruition and there is a high level of uncertainty about whether they could be achieved or not. That said, it is not uncommon for the deal negotiations to include discussion of the impacts of the synergies and to factor that into the price of the deal. Apart from price, other deal breakers may include the findings from the due diligence process. A good due diligence process may uncover potential liabilities and red flags of the target company. These findings should be carefully considered and deliberated to see if they pose further difficulties after the deal has been finalized. Other factors include the need for management control of the deal team.

ORGANIZATION OF DUE DILIGENCE PROCESS Understanding the interests of key players in the due diligence process is a critical step in building the trust necessary for a thorough due diligence process. The goal of the due diligence work should be to gain a level of comfort with respect to the property and its potential for any liability. The level of due diligence will vary according to the risk tolerance of the lenders.

Stages of Due Diligence There are five main stages in the deal process, as shown in Figure 2.8: 1. 2. 3. 4. 5.

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Deal sourcing Deal selection Deal structuring Investment/portfolio management Exit

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Deal Sourcing

Deal Selection

Initial Due Diligence Stage of Due Diligence

Screening

Deal Structuring

Advanced Due Diligence Qualifications

Investment/ Portfolio Management Full Due Diligence

Exit

Post P Due Diligence/Exit D

Beyond Checklist

FIGURE 2.8 Relationship between Stages of a Deal and Stages of Due Diligence

These stages of the deal can be mapped onto the various stages of the due diligence process. In the due diligence process, there are three broad key stages: 1. The screening stage 2. The qualification stage 3. Beyond the check list At the deal sourcing and selection stage, the level of due diligence required is typically not that comprehensive, and it will likely involve only an initial due diligence checklist to determine if the deal matches the corporate suitors screening criteria. The key executives in the firm, including the board of directors, determine these screening criteria. Screening criteria include financial numbers and ratios that have to match the corporate suitors’ predetermined financial logic and returns on investments, size of the target company and its market share. Also, its products and services or technology must match the corporate suitor’s growth plans and vision. As the deal passes the initial due diligence and screening checks, the intensity of the due diligence will be gradually stepped up to include an advanced due diligence check that will involve going through extensive due diligence checklists to verify the target company’s financial data, profile, market, and operations. At this stage, the aim of the due diligence is to uncover any inaccuracies in the corporate and financial information and to uncover any red flags or liabilities. The advanced due diligence stage aims to qualify the deal in order to pass it to the next stage: deal structuring. At the deal structuring stage, the intensity of the due diligence needs to be at maximum intensity to include a due diligence beyond the checklists. The findings from the full due diligence will provide insights on an appropriate deal structure and valuation to be used for the deal. If there are any serious red flags uncovered in the due diligence process, the target company must be prepared

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to address them fully to the corporate suitor. At this instance, it is critical to take a step back to take a macro view of all the findings from the due diligence process and to determine if the deal still matches the corporate suitors strategic logic and expectations.

Intensity of Due Diligence The intensity of the due diligence process is dependent on three key components: ■ ■ ■

Level of detail required Length of time available The costs of the due diligence

The corporate suitor determines the intensity of the due diligence required. This intensity need not be fi xed at the outset of the deal because it could be calibrated according to the pace of the deal execution. To represent this, we have developed a due diligence odometer shown in Figure 2.9. As the level of

Level of Detail/ Length of Time/Cost

Cost

Time

Detail

25%

50% 75% Due Diligence Odometer ometer 100%

0% Intensity of Due Diligence

FIGURE 2.9 The Due Diligence Odometer—Cost/Time/Detail versus Intensity of Due Diligence

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intensity of due diligence increases along the due diligence odometer, the level of detail, time, and costs will increase accordingly. Another way to understand the level of due diligence required for each deal is to look at the percentage of shares being acquired by the target company. In other words, one needs to look at whether the deal is a minority, majority, or full buyout deal. In order to illustrate this, we can use a diagram to represent the different factors at play. The y-axis in Figure 2.10 represents the level of management control in the company. As the percentage of shares acquired increases so does the level of management control in the company. A higher degree of manager control translates into a greater ability to implement changes in the company. To this end, we have labeled the top of the axis as Replaceability in the diagram to represent the ability of management to carry out changes in the company or to replace them. This replaceability factor can be applied to any form of assets in the company, including physical assets such as property and IT systems. It also covers the human-resource aspect such as the ability to replace the key management and executives of the company. The y axis of the diagram represents the level of cost, amount of time, and the level of details required for the due diligence process. As seen from the diagram, as the percentage of shares to be acquired in the target company increases, the less the cost, time taken, and detailed the due diligence will be. For example, in a buyout deal that is to acquire 100 percent shares of a company, the acquirer can take over the management control and take charge of the assets

Replaceability

Cash/Time/Details

s are sh ed f o ir % cqu a

Management Control

FIGURE 2.10

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and operation of the target company; hence the due diligence process can be less intense in many areas; in this case, the CEO or any top management can be replaced, making the background check on senior management less relevant; the IT systems can also be replaced, hence making any shortcomings of the current IT systems with the target company less vulnerable and a nonred-flag. A good example of buyout due diligence done in lightning speed will be that of JPMorgan Chase taking over the collapsed Bear Stearns within days.

THE DUE DILIGENCE TEAM A strong due diligence team comprises a team made up of seasoned executives who have strong operational experience and judgment that can “make good assumptions and quickly develop hypotheses that help them gauge the size of projected investments, the potential savings, the likely future operating model, and the risks.”26 The due diligence team will typically be made up of an eclectic team, comprising the team leader, industry experts, legal counsels, and investigators. The team leader is responsible for the planning, management, and execution of the entire due diligence assignment. He would typically be equipped with financial and operational skill sets that would allow him to analyze financial statements and projects on the required investments as well as to be familiar with the business model and supply chain of the business in order to identify critical areas that need to be investigated in depth. He will also need to possess strong interpersonal and negotiation skills in order to navigate any roadblocks that the company or its affiliates may erect during the due diligence process. The industry experts will complement the due diligence team by providing their expertise and insights into the company’s operations and then comparing it with industry players. With their deep knowledge of other industry players, they would be able to assess the credibility and feasibility of the business operations and projections. In addition, the team will be able to identify present and potential risks that would affect the company and to conduct a hypothesis test based on various scenarios in order to determine the impacts to the business. The legal counsels will be responsible for going through the legal documents of the company, such as the business registration, licenses, contracts with suppliers and customers, and other business relationships. The legal counsel will need to be well versed in the local laws. Investigators will be able to utilize their expertise to uncover any irregularities found during the due diligence and site visits. In addition, investigators will look into the reputations and background checks of key management, suppliers, customers, and business partners. Any suspicious findings or relationships will be investigated to see its potential impacts on the business.

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INDEPENDENCE OF VENDOR DUE DILIGENCE Careful due diligence has always been critical in China. Having experience certainly helps, but the importance of hiring an expert consultant is not to be overlooked. For example, the expert opinion of a geologist would have a greater weighting than the results of exploration reports provided for a potential investment into a shale gas project. Likewise, the financial due diligence report would take precedence over the management accounts provided by the company’s own accountants, and the professional legal advice given by both local and foreign law firms would give a more wholesome picture of the potential issues that may arise from a VIE structure that a particular Chinese company has adopted. These third-party experts, also known as vendors, already have a very systematic process in the due diligence approach given their profound experience in analyzing different Chinese companies in different industries. These vendors already have a due diligence checklist that they have been religiously using and that they have found much success with. However, investors should still be wary of the potential pitfalls arising from taking the opinions of these vendors at face value, without actually questioning the assumptions and taking into account certain intangible circumstances that may cloud the objectivity of a particular opinion. In the following sections, we will be discussing the limitations and issues of engaging vendors to conduct due diligence. Vendor due diligence is simply the due diligence that is commissioned by current owners of the business when preparing for its sale or investment. This is more commonly associated with virtual data rooms where the company, usually organized by the representing investment bank or broker, uploads all relevant materials on a secured data room to facilitate the due diligence process to be conducted by the buyer. Situations like this can be found in many different types of financing situations, including private companies planning to list, private companies looking to be sold, private equity’s portfolio companies raising additional funds, and so on. Investors should be wary of the due diligence reports provided by the seller. After all, it is designed to control the information given to the company and maintain the upper hand in negotiation afterwards. Often, vendor due diligence could be used as a tool for hiding the real problems of the company by clouding the reporting with trivial ones. Even if the investigation has been conducted by an independent organization of the highest reputation, the investor would not know what is going on behind the scenes during the briefing between seller and service provider. To mitigate possible risks of reading a report produced by a not-soindependent service provider, investors are highly recommended to conduct a

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due diligence on the vendors, or, in a worse and most inefficient scenario, to request a separate due diligence conducted by vendors appointed by the investors themselves. Of course, the latter alternative will mostly be greeted with resistance of some sort by the company, but sometimes, assessing the response may allow investors to form an opinion about the vendors’ tendencies to hide information. Conducting due diligence on the vendors is very similar to detective work. Vendor due diligence makes it more difficult for investors to form an opinion of the target company, and in some instances it is designed to do just that. Besides assessing the reputation of the firm that carried out the due diligence work, investors should meet the firm(s) that produced the reports, and investors ought to be very suspicious if this is not permitted by the seller (extremely common in China). The entire investigative process should be approached with skepticism and probe, and investors often have to read between the lines to identify oddities in the due diligence report or in the conversation with the seller and vendor. Figure 2.11 illustrates several questions to guide the vendor due diligence process, listed here: 1. The number of drafts produced for the final due diligence report often gives clues about how much client interference there was in the drafting process. As much as possible, ask the vendor for the reasons for redrafting and also for the actual content that has been changed.

• More drafts more suspicious!

• If so, reasons? • Disagreement in wordings? • Disagreement in content?

• Content of the redrafts

Number of drafts

Any outstanding bills?

Impressions of the target?

Off-therecord comments?

• Watch for body language • Avoidance of questions

FIGURE 2.11

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• Any skepticism? • Concerns?

Questions for Vendor

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2. Determine whether the vendor has been paid in full or if there is an outstanding bill. It could be a disagreement in the wording or content of the final report. 3. Ask for the vendor’s impression of the target company. Take note of the length of work relationship and also watch for body language; sometimes vendors may avoid certain questions entirely or beat around the bush. 4. Taking it to the next step, investors could always assure the vendor that the conversation would be kept off record. Advisers are typically paranoid about legal implications, and it is sometimes important to indirectly remind them of that. Although it is widely understood that the enforceability of law is notoriously difficult in China, advisers themselves have an image to uphold and “rice bowl” to keep. To reinforce their opinions on the reliability of the vendors, investors could also track the previous deals done by the vendor and speak to investors whom the vendors have crossed paths with. Be mindful that, at the end of the day, vendors are only engaged to perform due diligence based on the historical information and situation of the company. Even if they were required to express an opinion about the future of the target company, these vendors are limited by the information they have (only historical information) that may not necessarily be indicative of the future of the company.

CASE STUDY 2.7: MAMTEK INTERNATIONAL IN CHINA

B

ruce Cole, David Ho, and Ho’s partner founded Mamtek International and registered it in Hong Kong to become a global supplier of sucralose. Sucralose is a stripped down, chemically altered sugar molecule that was in high demand worldwide for artificial sweeteners that had high profit margins. In 2007, Mamtek rented a small facility to research the production of sucralose and began to build a larger factory capable of producing commercial quantities in 2008. However, when construction was completed in 2009, the local Wuyishan government had revoked Mamtek ’s license because the sucralose product could cause environmental problems if its waste products were dumped untreated in the rivers. This would negatively impact the tourism industry.27

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This setback in China was purportedly what led Bruce Cole to look for a manufacturing base in the United States. The rationale behind the establishment of a manufacturing plant in the United States was to capitalize on the “Made in the USA” label, which would fetch higher profit margins in the marketplace. Moreover, Bruce Cole had claimed that he had secured customers for Mamtek ’s production for the first three years, thereby lowering the risks of the business. Mamtek ’s law firm provided blueprints of the manufacturing plant in Fujian and a purchase contract from a Chinese pharmaceutical plant. Mamtek ’s intellectual property was valued at US$50 million by an appraisal firm. In July 2010, Moberly’s city officials had given approval for US$39 million worth of municipal bonds for Mamtek to set up a state-of-the-art facility to manufacture its Sweet-O brand of sucralose. This plant would also create employment for about 600 people. As it turned out, Mamtek defaulted on the first payment of the principal of the bond of US$3.2 million in August 2011. Subsequently, by October 2011, Mamtek was broke and the city had defaulted on its bonds. The sucralose plant was never completed. Investigations revealed that Mamtek ’s business dealings were exaggerated. Although Mamtek had many customers, there was only one contract to purchase the U.S. made sucralose. Mamtek ’s supposed joint venture Zhucheng Haotian Pharmaceutical to set up in Moberly did not materialize. It was later revealed that Bruce Cole was facing tremendous financial problems. He had defaulted on the US$3.7 million mortgage on his Beverly Hills home, an unpaid American Express bill of US$135,000, and a personal unpaid loan of US$250,000 to a previous investor.

Takeaways The level of due diligence required for Chinese companies should never be underestimated. In a post-mortem investigation of the business transaction, it was revealed that Moberly had trusted the expertise of Mamtek ’s own counsel, the appraisal firm, and the bond underwriters, Morgan Keegan. Morgan Keegan, in turn, said its due diligence was focused on Moberly’s finance and it relied on Moberly and the state’s Economic Development Department to verify Mamtek ’s financial conditions. In other words, the various entities involved had been overly confident and assumed that each entity had done its own due diligence. Clearly, this seemed to be presumptuous and a case of passing the buck. 28 There was scant due diligence conducted on the actual company, Mamtek International, and its operations in China. In addition, there were no checks on the reputation and financial position of key personnel involved in this transaction. A thorough due diligence would have revealed many red flags that would have led Moberly to be cautious and skeptical of this deal.

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REASONS FOR POOR DUE DILIGENCE There are many reasons that companies make mistakes during the due diligence process. The focus of due diligence is typically on the legal and financial aspects of the deal, whereas the other aspects of the deal, such as the corporate culture, integration issues, and other risks, are given less attention. Potential sources of failure during the due diligence process should be identified early in order to plan for ways to resolve them. In addition to going through the due diligence checklists, deal makers must be mindful of the dynamics of the due diligence team and process that may affect the outcome of the due diligence process. An effective due diligence requires gathering a competent due diligence team and various service providers to support the process. It also involves the balancing of resources and competing interests among the deal makers and service providers. In this section, we will discuss some of the common factors that contribute to poor due diligence work.

Selection of Service Providers The selection of the due diligence team and service providers is critical to the deal. Many firms hire third-party service providers in order to have an independent due diligence process. Although it is necessary to have an independent team to conduct due diligence, there are also many other considerations in the selection of the service provider. First, the service providers must possess the necessary knowledge, experience, and connections to operate in China. This will entail the service provider understanding how doing business in China works, appreciating the business landscape, and having expertise in the industry sector of the target company. Often, poor due diligence arises because there is lack of knowledge and experience in the operating environment. As such, the due diligence will be poorly executed and only touch on the very superficial and basic levels. Although there may a reasonable level of comfort in dealing with vendors, suppliers, or companies that have some reputation and recognition in the industry, one must not be complacent in thinking that this entity would be clear of any risks of fraud or problems. Instead, potential suitors should also look at every new entity as a fresh candidate that requires, at a minimum, a due diligence and screening check.

Lack of Resources The lack of resources in terms of budget and time are often cited as the reasons for the lack of a thorough due diligence. Conducting a full due diligence

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will be costly because it involves extensive on-site checks and resources to carry out. Many corporate suitors opt for the easy way out and choose to save money on the due diligence process; instead of due diligence, they rely on blind faith and trust of the target company’s management and fi nancial data. However, what many corporate suitors fail to recognize is that saving on the due diligence process may result in even more costly expenditures or write-offs in the future. In addition, without a full due diligence, there is a high element of uncertainty and risks involved as the corporate suitor would have to shoulder the consequences of its decisions. In the worst-case scenario, there could be outright fraud conducted on the target company’s end that would only come to light only after the deal has concluded. The cost for conducting due diligence depends on the extent of due diligence required. Companies will need to balance the costs of conducting a due diligence versus the possibilities of long-term losses, should there be any corporate surprises that may negate all the supposed benefits of the deal. Companies that have to form partnerships and build relationships with third parties often feel overwhelmed if there is a need to conduct a due diligence on every single one of them. The large volume of due diligence assignments may deter companies as they would be costly and time consuming to carry out. However, there are advanced due diligence techniques that can quickly screen a high volume of deals efficiently. If there are limited resources, companies should prioritize the due diligence conducted to key vendors and relationships.

Rushing the Deal Sufficient time must be allowed for the due diligence process. Often, the key executives of the corporate suitor may be motivated by other factors and be blinded by deal fever to close the deal quickly regardless of the deal findings. This could also be attributed to the underestimation of the complexities of the deal. Deals should never be rushed. Sufficient time must be allowed for due diligence in order to gain the assurance that the deal was done in good faith and that the corporate information provided were reliable. Allocating sufficient time to do an in-depth due diligence is also likely to give the due diligence team sufficient time to mobilize resources to uncover and investigate any red flags. This would help reduce any surprises that may crop up in the future. Once the due diligence is completed, the management should take time to go through the report in detail and deliberate before making any decision. In order to pressure deal makers to complete the deal quickly, fraudsters would create a false sense of urgency so as to reduce the time allowed for due diligence.

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Poor Planning A good due diligence will entail detailed planning of the entire process. This should include a comprehensive schedule that includes site visits, interviews with management, employees, customers, and suppliers, and surprise checks on operations and the supply chain. Extensive due diligence checks may involve the need to ask probing questions to the target and conduct in-depth background checks on the target and its related parties. This may have the unintended consequence of sending a signal to the target that there is still an absence of trust underlying the relationship. This may harm the relationship going forward. However, this tendency to be overly emphatic to the target’s consideration needs to be managed. There is nothing to be worried about if the target is confident that there are no hidden skeletons in the closet. In fact, the target should welcome the due diligence checks in order to give assurance to the deal team.

Overdependence on Checklists Checklists provide a guide to the due diligence process and they are necessary to help focus the due diligence team. However, relying solely on the checklists to conduct due diligence is not sufficient, especially in countries in which there are many other factors to consider. Therefore, the due diligence process needs to go beyond the checklists to uncover reputational and operational due diligence issues that cannot easily be covered under a checklist. Moreover, target companies that have something to hide or are engaged in shady operations will not be easily uncovered through the standard due diligence checklists.

Poor Risk Mitigation Managers often underestimate the risks involved when engaging a new vendor, supplier, or partner, regardless of its size or perceived insignificance. Therefore, it is always prudent to do a due diligence on any new potential partners. Companies frequently have in place a basic level of internal controls that include the segregation of duties and other checks and balances for corporate compliance and internal audits. These internal controls would be relied on to conduct the first level of screening process and, if required, to do a deeper level of due diligence. However, these internal control systems may not be comprehensive enough to delve deep into the background, reputation, and relationships of the entity.

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Poor Alignment of Interests It is important to align the interests of all the elements of the due diligence team, including the advisors and service providers. The compensation structure for advisors is typically tied to the successful completion of the deal. As such, advisors would push for the deals to be closed and as a result may impose conditions to encourage such an outcome by rushing the deal completion and playing up the notion that the target company was being pursued by competitors. This may lead the corporate suitor to be pressured into rushing the due diligence process and rushing to complete the deal. Due diligence may be a long, drawn-out process that may entail delays in the deal execution. In highly competitive environments, the due diligence process may cause a competitor to offer quicker execution and completion of the deal without the need to subject itself to screening checks. Conducting a deal without due diligence would add to the risks of the deal, and management will need to balance the need to mitigate risks versus the need to stave off competition going forward. Trust advisors and referrals lend a sense of credibility to the deal. However, one must not be over-reliant on the referral source. To this end, it is still important for the deal team to conduct a basic due diligence on the deal. By promoting and marking a particular deal as one that is exclusive to the deal team, promoters are deliberately trying to create an illusion that the deal is proprietary and that the deal team is the only one that has access to the company’s proprietary information and should, therefore, be assured of the deal’s integrity.

CASE STUDY 2.8: ASAHI GROUP ’S ACQUISITION OF INDEPENDENT LIQUOR

A

sahi acquired Independent Liquor, an Australasian drinks group, for NZ$1.5 billion (US$1.3 billion). Independent Liquor was founded in 1987 and a maker and distributor of a range of alcoholic drinks, including Carlsberg beer, Whyte & Mackay Scotch whisky, Seagers gin, and Vladivar vodka.29 Independent Liquor, which specializes in ready-to-drink (RTD) alcoholic beverages and premixed hard-liquor drinks, posted revenues of (Continued)

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(Continued) NZ$414.4 million last year but still took a loss of NZ$22.7 million. It relies on Australia for 60 percent of its sales and was hit hard by a 70 percent tax hike on premixed alcoholic drinks in April 2008. Asahi has sued Unitas and PEP for providing false information about Independent Liquor’s finances and about their involvement in “misleading and deceptive conduct by inflating independent Liquor’s earnings ahead of its takeover.” According to a statement issued by Atsushi Katsuki, managing director of Asahi’s Australian unit, Asahi had “conducted due diligence thoroughly and in good faith and relied on the figures provided to us.” Asahi has also sued to recover NZ$1.5 million of NZ$16.5 million in management fees paid to Pacific Equity and Unitas and also sued directors at Pacific Equity, Unitas, and Independent Liquor claiming they breached their duties.30 Unitas Capital and Pacific Equity Partners jointly acquired Independent Liquor for NZ$1.2 billion in 2006 and currently own an equal stake of 43.9 percent each. A further 11.75 percent is held by Lynne Erceg, widow of the company’s founder, who stands to make NZ$179 million from the sale. Since their investment in 2006, the private equity firms have worked with Independent Liquor’s management to successfully build the business and increase revenues, despite challenges when the Australian government unexpectedly raised the excise tax rate in Australia in April 2008.31 The private equity firms secured a 1.5 times return on their original NZ$1.2 billion investment made in 2006. The Japanese firm’s Australian subsidiary plans to buy all outstanding shares in Flavoured Beverages Group, Independent Liquor ’s parent. The transaction values the company at 13 times Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Kirin’s A$3.3 billion buyout of Australia’s Lion Nathan in 2009 was valued at 12.5 times EBITDA, while SABMiller is offering $10 billion, also at 12.5 times EBITDA, for Foster’s.32 Independent Liquor had sales of NZ$414 million and EBITDA of about NZ$95 million according to a calculation based on the company’s 2010 accounts filed with New Zealand’s companies’ registry. The company had a comprehensive loss of NZ$95 million that year, and NZ$104 million the previous year. Based on an earnings forecast of NZ$124.6 million to NZ$125 million in the 12 months to September 30, 2011, cited in the statement of claim, Asahi paid about 12.2 times EBITDA for the company, compared to a median of 8.8 times EBITDA in nine alcoholic-drinks takeovers worth more than $1 billion in the previous three years, according to data compiled by Bloomberg.33 Advisors to PEP and Unitas were UBS as financial advisers and Clayton Utz as legal advisors. Advisors to Asahi were Nomura and Rothschild as financial advisers and Freehills as legal advisers.

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About Unitas Capital Unitas Capital is one of the most experienced dedicated regional private equity firms in Asia, with US$4 billion in capital commitments under management as of December 31, 2010. Since 1999, Unitas has advised on investments exceeding US$2.3 billion into 28 companies. Unitas targets control investments in market-leading industrial, branded consumer and retail companies with strong cash-generative business models, barriers to entry, and differentiated product capabilities. Unitas has a successful track record of investing in growth-oriented global businesses, in particular those with a large market in Asia but headquarters based outside the region.

About Pacific Equity Partners Pacific Equity Partners (PEP) is a leading Australasian private equity firm focusing on buyouts and late-stage expansion capital in Australia and New Zealand. The firm has a long track record of investing in and growing businesses, with significant experience in the consumer goods sector. Examples include SCA Hygiene Australasia (tissue and personal care products), Tegel (chickens), Griffin’s (biscuits, including Gingernuts and MallowPuffs), and Frucor (V energy drink). PEP currently has eight other portfolio investments, spanning sectors such as finance, energy, administration services, and entertainment.

REVERSE TAKEOVERS Reverse mergers, otherwise known as reverse takeovers, were a way for a private company to be listed on the stock market by acquiring the majority of shares in a largely dormant but still SEC-registered company. This would result in the private company essentially purchasing the public company’s shell to be listed. This is often accompanied by the acquisition of the private company’s assets and disposal of the existing public company’s assets. Chinese companies have used the reverse mergers as a short cut to the U.S. market. The company will then be renamed and a new stock ticker will be issued. The reverse merger strategy of getting listed reduced the time taken and streamlined the process taken for private companies to get listed on the capital markets. In addition, the level of due diligence conducted is minimal because there is no need to for an underwriter. This lack of scrutiny and transparency has contributed to the increased number of fraud cases involving Chinese reverse-merger companies.34 In addition, the SEC has a limited jurisdiction over these companies, and it cannot subpoena documents and people from the

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Chinese companies. To this end, the United States has limited scope to enforce any decisions made in the United States resulting in a more brazen attitude by these unscrupulous fi rms. According to the Public Company Accounting Oversight Board, the U.S. audit-industry regulator, there are more than 120 Chinese companies that have delisted from the U.S. stock exchanges or are no longer actively filing the necessary SEC reports.35 In addition to the civil cases brought against Chinese firms, the SEC has also expanded its scope to include the actions of key players in the United States who played a role in bringing these Chinese firms to the U.S. capital markets. Rodman & Renshaw, a boutique capital advisory firm based in New York, was one of the most aggressive fi rms that pushed for investment in Chinese companies. Its investment conferences were lavish and were known to feature prominent speakers.36 According to ABC News, out of 40 Chinese companies that presented at the 2010 Rodman & Renshaw conference, 20 of them have since lost their listing on U.S. exchanges, and another 10 are trading at or below $1 per share.

CASE STUDY 2.9: PUDA COAL

T

he company traded on the New York Stock Exchange from 2009 to August 2011, when trading halted on word that Puda’s chairman, Ming Zhao, had secretly transferred control of the company’s sole source of revenue to himself and turned Puda into an empty-shell company before selling shares to the public. Shares of Puda stock dropped from a high of $17 to pennies and cost investors hundreds of millions of dollars, according to an SEC civil fraud complaint filed last year. According to the SEC complaint, Zhao took over Puda’s 90 percent stake in Chinese coal mining company Shanxi Puda Coal Group Co. Ltd. in September 2009, just weeks before Puda announced that Shanxi had received a highly lucrative government deal. Zhao later transferred almost half the coal business to a fund controlled by Citic Group. The coal business was Puda’s main corporate asset.37 In the middle of 2010, Zhao turned around and sold 49 percent of this same unit to Citic’s private equity arm in exchange for shares of Citic trust, while pledging the remaining 51 percent to Citic to secure a 2.5 billion yuan loan. Former Puda Chief Executive Liping Zhu had forged a letter falsely saying that Citic Group claimed no interest in the coal business despite

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knowing that the coal business had been transferred to Citic and Citic was selling the interest in Shanxi Coal to Chinese investors at the same time.

Takeaways There was a complete lack of internal control that allowed Chairman Zhao to first steal the company of its most prized corporate asset, the coal business, and sold half the company and pocketed the sales proceeds. The other half of the company had been sold to Citic Group. In addition to the fraud perpetuated by the chairman and chief executive, the service providers involved with Puda were partly responsible for the lapses. Its auditor, Moore Stephens, and legal counsel, Sheaman & Sterline, had quit in the scandal’s aftermath. The underwriters like Brean Murray and Macquarie Capital, which were responsible for Puda’s secondary offerings, were also partly responsible for assisting in Puda to raise money even though it was a mere shell company without its Chinese subsidiary.

About Puda Coal Puda Coal, Inc. (Puda) is a supplier of high-grade metallurgical coking coal to the industrial sector in the People’s Republic of China. Its processed coking coal is primarily purchased by coke and steel producers for the purpose of making the coke required for the steel manufacturing process. Puda’s operations are conducted by Shanxi Puda Coal Group Co., Ltd. (Shanxi Coal), which it controls through 90 percent indirect equity ownership. Puda cleans raw coking coal sourced from third-party coal mines primarily located in Liulin County, Shanxi Province, and markets the cleaned coking coal to coke and steel makers. Its primary geographic markets include Shanxi Province, Inner Mongolia Autonomous Region, Hebei Province, Beijing, and Tianjin, China. It purchases raw coal from a diversified pool of local coal mines in Shanxi Province.

DISPUTE BETWEEN SEC AND CSRC The U.S. Securities and Exchange Commission (SEC) and China Securities Regulatory Commission (CSRC) have been embroiled in a dispute concerning the access and inspection of Chinese companies’ audit papers. This dispute was sparked when there were a number of fraud cases concerning Chinese companies listed on the U.S. stock exchanges, which compelled the SEC to

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take proactive actions to clamp down and prevent any fraud cases or irregular accounting. The SEC had sued the Chinese affi liates of the top five accounting fi rms for violating the Sarbanes-Oxley and the Securities and Exchange Act for refusing to produce audit work papers related to the U.S.-listed Chinese companies under SEC ’s purview. These fi rms were Deloitte Touche Tohmatsu CPAs, Ernst & Young Hua Ming, KPMG Huazhen, Pricewaterhouse Coopers Zhong Tian CPAs, and BDO China Dahua. According to court fi lings, the SEC had argued that Chinese auditing fi rms must share audit documents from China for U.S. issuers under SEC investigations However, Chinese law bars the sharing of these audit documents. Moreover, the Chinese government had the position that it would be a violation of national sovereignty to allow any foreign regulators to oversee domestic companies regardless of their listing destinations. In response, the SEC had argued that CSRC was a signatory to the International Organization of Securities Commission’s Multilateral Memorandum of Understanding Concerning Consultation and Exchange, which obliged it to share audit documents internationally.38 Caught in the middle of this long-standing dispute between both regulators, the Chinese affiliates of the accounting firms face tough decisions because obliging the SEC’s request to handover audit documents would be seen as violating Chinese laws, which would almost certainly lead to the Chinese affiliates’ exit from China, risks of losing their valuable licenses in China, and access to an important and growing market. The SEC had struggled to take any action against a string of accounting scandals at China-based companies in 2010 and 2011 because it was hampered by difficulties in obtaining evidence such as audit work papers that were kept in China. The auditors had not turned over all the related documents claiming that the SEC’s request confl ict with Chinese laws. An attempt to reach a diplomatic solution with the China Securities Regulatory Commission (CSRC) had failed. This led to the reopening of the case and to a separate charge in the administrative court that the Chinese arms of the audit fi rms had refused to turn over work papers that were related to the securities violations. On March 4, 2013, a federal judge, Magistrate Judge Deborah Robinson, stated that the U.S. SEC could move forward with its attempt to force Deloitte Touche Tohmatsu CPA Ltd. to comply with a subpoena related to a fraud investigation into Longtop Financial Technologies Ltd.39

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CASE STUDY 2.10: KEYUAN PETRO CHEMICALS

K

eyuan Petrochemicals Inc. had been suspended by Nasdaq since October 2011 and subsequently delisted in April 2012. Keyuan Petrochemicals had agreed to pay $1 million to settle securities fraud charges after the Securities and Exchange Commission had accused the company of failing to disclose to investors related-party transactions involving its chief executive and others. These related-party transactions included transactions between management-controlled entities or their family members that took place on May 2010 to January 2011 during the company’s first year trading in the United States. They involved purchases of raw materials, loan guarantees, and short-term cash transfers.40 In addition, the company was accused of maintaining an off-balance sheet account to pay bonuses to senior officers and fund other expenses. These other expenses included making cash and noncash gifts to Chinese government officials, according to a complaint filed in federal court in Washington. The account also allegedly funded travel, entertainment, and an apartment rental for Chief Executive Officer Chunfeng Tao. Anchun Li, the former finance chief of Keyuan Petrochemicals, agreed to pay a related $25,000 penalty. Neither Keyuan Petrochemical nor Li admitted or denied the charges.41

About Keyuan Petrochemicals, Inc. Keyuan Petrochemicals, Inc., established in 2007 and operating through its wholly owned subsidiary, Keyuan Plastics, Co. Ltd., is located in Ningbo, China, and is a leading independent manufacturer and supplier of various petrochemical products. Having commenced production in October 2010, Keyuan’s operations include an annual petrochemical manufacturing design capacity of 720,000 metric tonnes for a variety of petrochemical products, with facilities for the storage and loading of raw materials and finished goods, and a technology that supports the manufacturing process with low raw material costs and high utilization and yields.42

CONCLUSION In this chapter, we have discussed the broad conditions necessary in order to carry out effective due diligence in China. The intensity and level of due diligence required depends to a large extent on the type of deal structure and

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motivations for carrying out the deal. There are distinct differences between the due diligence work involved in a private equity deal versus a mergers-andacquisition deal. Effective due diligence requires proper planning and execution. This starts with the forming of a competent and experience due diligence team and to engage professional service providers that can provide independent advice to guide the due diligence process. With the establishment of the due diligence team, the key considerations behind the deal must be identified in order to assess the level of potential risks and conflicts of interest that may disrupt the deal. Lastly, we highlighted the reverse takeovers of Chinese companies prevalent during the economic boom from 2005–2007 that saw a flood of sponsors that took advantage of the lax regulatory scrutiny and supervision as well as euphoria of investor interest in Chinese companies. Increasingly, the regulators have stepped up their checks on these reverse takeovers to ensure that they meet corporate governance standards and are operating with integrity. The regulators have also started to apply pressure and to hold sponsors and service providers responsible for the IPO listings that are under their watch. All in all, the bottom line is that due diligence in China requires a deliberate and concerted effort in order for it to ensure that deal makers do not unwittingly make costly mistakes.

NOTES 1. “Henry Kravis Interview, Financier and Investor,” Academy of Achievement, February 12, 1991. 2. “SIA, China Eastern Airlines Announce Atrategic Tie-Up,” Channel News Asia, September 2, 2007. 3. “China Eastern Shareholders Thwart Singapore Airlines’ Ambitions,” New York Times, January 8, 2008. 4. “Turbulence in the Skies: The On-going Saga of China Eastern Airline, Air China and Singapore Airlines,” Knowledge@Wharton. 5. “Hontex International Investors Agree on HK$1b Refund,” South China Morning Post, August 21, 2012. 6. “Unprecedented order by the Court against Hontex International Holdings Company Ltd for a HK$1.03 Billion Buy-Back Offer for False and Misleading Information in Prospectus,” Deacons, June 2012. 7. Herbert Smith, “SFC Imposed First Revocation of IPO Sponsor’s Licence to Advise on Corporate Finance for Due Diligence Failings,” Association of Corporate Counsel, April 30, 2012.

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8. China Securities Regulatory Commission Website, www.csrc.gov.cn. 9. “Finding IPO Alley,” Caixin, March 4, 2013. 10. “Glancy Binkow & Goldberg LLP Announces Class Action Lawsuit Against Ambow Education Holding Ltd.,” Press Release from Business Wire, June 11, 2012. 11. “Ambow Education Investors Pursue Lawsuit as Shares Plunge,” Bloomberg News, February 28, 2013 12. Ambow Education IPO Prospectus. 13. “Liquidators Move in on ‘Tunnelled’ Celestial, Aiming to Draw Attention of China Authorities,” The Edge Singapore, June 25, 2012. 14. “A Tale of Two Monkeys,” Internet Movie Database. 15. “Ming Dequan Production Concert Moon and Stars,” Ban Dao Xin Wen, March 15, 2011. 16. “Company Profile on Celestial Nutrifoods,” Reuters, May 14, 2013. 17. “Hengdeli Declines after Report Some Watch Licenses Lost,” Bloomberg News, January 31, 2013. 18. “Governance Is Hengdeli’s Watch Word,” Wall Street Journal, January 30, 2013. 19. “A Strategic Partnership Leads to New Growth Opportunities for Bulgari Watches in the Chinese Market,” Hengdeli, Press Release, November 24, 2010. 20. “Yum! Brands—Food Safety in Asia: A Case Study,” Macquarie Equities Research, January 21, 2013. 21. “CCTV Report Says KFC Chickens Are Being Fattened with Illegal Drugs,” South China Morning Post, December 19, 2012. 22. “China Chicken Suppliers Dropped before Probe Announced: KFC Parent,” Reuters, January 9, 2013. 23. “Chinese Animal-Feed Billionaire Takes Hit On KFC Food Safety Scare,” Forbes, December 20, 2012. 24. “KFC Publishes Investigation Results of Sudan Dye,” People’s Daily Online, March 30, 2005. 25. “When to Walk Away From a Deal,” Harvard Business Review, April 2004. 26. “Merger Deal Breakers: When Operational Due Diligence Exposes Risk,” Journal of Business Study 29, no. 3 (2008): 27. 27. “A Missouri Town’s Sweet Dreams Turns Sour,” Bloomberg Businessweek, January 5, 2012 28. “Blame Is Spread Wide on Mamtek,” St. Louis Post-Dispatch, December 4, 2011. 29. “Asahi in $1.3bn Independent Liquor Deal,” Financial Times, August 18, 2011. 30. “Asahi Sues Buyout Firms Over 2011 Independent Takeover,” Bloomberg News, February 14, 2013. 31. “Asahi to Acquire Independent Liquor from Unitas Capital and Pacific Equity Partners,” Press Release Unitas Capital, August 18, 2011. 32. “PEP, Unitas Exit Independent Liquor to Asahi,” Asian Venture Capital Journal, August 24, 2011.

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33. Asahi Sues Buyout Firms Over 2011 Independent Takeover,” Bloomberg News, February 14, 2013. 34. “A Guide to Managing the China Reverse Merger Fallout,” Ernst & Young, June 2011. 35. “Rare Victory for U.S. Investor in Chinese Reverse Merger Company,” China Realtime Report, January 23, 2013. 36. “China Fraud Accusations: Wesley Clark’s Ex-Firm Faces Questions,” ABC Go News, January 23, 2013. 37. “Puda Coal Executives Stole Company Assets, SEC Alleges in Suit,” Bloomberg Businessweek, February 24, 2012. “Chinese Giant Falls Short,” International Trader —Asia, Barrons, October 15, 2011. 38. “US Regulator Sues ‘Top Five’ CPA Firms,” The Corporate Treasurer, December 2012/January 2013. 39. “U.S. Can Pursue China Documents from Deloitte: Federal Judge,” Reuters, March 4, 2013. 40. “Keyuan Petrochemicals Settles SEC Suit over Secret Fund,” Bloomberg News, March 1, 2013. 41. “China-Based Keyuan Settles SEC Accounting Charges,” Reuters, February 28, 2013. 42. “Keyuan Petrochemicals Inc. Corporate Update,” March 1, 2013.

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3

C HAPTER THREE

Financial Due Diligence

T

H E F O L L O W I N G T W O C H A P T E R S P R O V I D E the readers with

a comprehensive overview of the most crucial stage in any acquisition or merger process in China. The due diligence checklist, although commonly described as monotonous and time consuming, forms an important foundation for the buyer to understand the intricacies of the seller’s business as well as to raise any red flags that require further digging beyond the conventions. For the largest of companies that routinely conduct due diligence on numerous potential acquisitions annually or for the largest of private equity funds that meticulously flip every stone in hundreds and thousands of companies, this process can be daunting; no two deals are ever exactly the same. It is important that readers think critically about customizing and shaping each due diligence exercise that is better suited for a particular industry, company, and purpose. The due diligence checklist consists of two parts, namely the compulsory and optional checklists. Compulsory checklists include the types of due diligence that one cannot miss in the evaluation of every transaction. Optional checklists are not to be taken lightly either; depending on the uniqueness of the industry of the target company, optional checklists are aimed at uncovering the blind spots of a transaction.

81

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This chapter focuses on one of the most crucial components of compulsory checklists: financial due diligence. Readers would find that it is impossible to discuss a single aspect of due diligence independently without delving into the others. In the next two chapters, you will find that the items in the compulsory checklists are closely intertwined and, hence, investors have to ensure that third-party consultants work closely with one another to achieve better results. Compulsory Checklists 1. Financial 2. Operational 3. Commercial 4. Legal and Intellectual Property 5. Balanced Scorecard 6. Predicting bankruptcy—Altman Z scores

FINANCIAL DUE DILIGENCE CHECKLIST Financial due diligence is often the most important and rigorous part of the entire due diligence process. With the exception of a few larger companies, the books and records of many Chinese private companies are usually not accurately kept or well maintained. It is a very common practice to keep a second, third, or even a fourth set of books (for banks, equity investors, tax bureau, and for themselves). These companies are very accustomed to being asked for all the different sets of books and it is very important for the investor to send an experienced accounting team on site to conduct thorough checks and review actual results. Depending on the situation and the understanding of the management’s character, it often helps to carry a skeptical mind in conducting financial due diligence. Often, when one finds the financial numbers too good to be true, that is usually the case. Contrary to popular belief, accounting is not science. Accounts are subject to a number of judgments, such as valuation of stock and depreciation policies, which both can make significant differences to reported profitability. Accounts will also contain a number of one-time profits or expenses, which distort the profitability of the business. Therefore, they have to be appropriately treated. In fact, buyers should never rely on auditors to be responsible for preparing audited financial statements and assuming that they would be fully liable for

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not producing the accounts with due care and skill. In addition, engaging in a lawsuit with the auditor is counterproductive and erodes the time and resources of the buyer. As a result, there is a lot more to financial due diligence than examining the audited accounts or scrutinizing the information systems. Buyers should not scrimp on the due diligence process because it would only expose the buyer to myriad issues that come after the acquisition. It also pays to remember that reporting accountants or in-house accountants are going to spend a great deal of time with the target company and, therefore, they can be an extremely good source of nonfi nancial information about the target. Nonfinancial and beyond-the-checklist information will be further elaborated in the next chapter.

Major Differences between China and Developed Countries The quality of financial statements and business processes in China are lower than what Western investors are used to. Moreover, the fi nancial accounts frequently contain errors that first need to be corrected. It is not surprising to find several important documents missing, thus resulting in an increased risk and a longer process. Table 3.1 lists the major differences between Chinese and developed countries’ financial due diligence processes. In general, financial reporting and systems are still evolving in China and it is not surprising to find nonqualified personnel overseeing the accounting process, especially in smaller private companies. Finance departments of target companies are usually the first area of concern for financial investors (private equity). Due to the inherent culture of Chinese firms to keep the accounts close to their hearts—that is, accounts are usually managed by family members or people who the founders can trust but who are not necessary qualified— investors would typically first rebuild the finance department once they have invested.

The Approach After selecting a competent professional service provider to lead the financial due diligence process, investors have to understand the importance of adopting the right approach to maximize the effectiveness of the process (Figure 3.1). The following subsections describes the important objectives at each phase of the due diligence exercise that investors could work together on with the professional firms.

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TABLE 3.1 Financial Due Diligence: Developed Countries versus China Items

Developed Countries

China

Level of competency in producing management accounts

High

Low, be wary of occasional mistakes

Level of transparency in financial information

High

Low, if any

Duration of due diligence

1–8 weeks

4–12+ weeks

Preparation time required

Minimal

May require assistance

Basis of financial statements

U.S. GAAP or IAS

PRC GAAP

Audited financial statements

Usually reliable

Typically not reliable; especially if done by a smaller, local CPA firm

Extent of related-party transactions

Varies; typically disclosed

Often extensive; inadequately disclosed

Disclosure of contingent liabilities

Usually transparent

High risk area and rarely disclosed

Computerized accounting systems

Typical

Slow evolving; large dependence on manual processes

Reliability of representations and warranties

Normally reliable

Untested

Enforceability of indemnifi- Strong and backed by cation claims courts

Untested; enforceability is usually weak

Source: Stephan Haagmans, “Due Diligence Factors of Success in China,” Ernst & Young, 2011.

Preparation Financial due diligence typically starts with a review of the audited financial reports—if the accounts are not audited, then the process would begin with the review of the management accounts. This process could be done before entering the site, and it helps to obtain all the different sets of the accounting books that the company keeps. In most cases, financial due diligence is carried out by firms of accountants. There are no firm rules about this, but typically this team is drawn from the auditors who have already a good understanding of the company’s business and

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Preparation 1. Reviewing of audited accounts 2. Selecting the team

Entering of Site Post Work 1. Interview of key management team 1. Production of reports, beginning with analysis of numbers commerical operations 2. Post due diligence 2. Interview of finance discussion — other team nonfinancial observations 3. Review of financial 3. Follow-up discussions information provided

FIGURE 3.1 The Approach

strategy. However, it might be worthwhile to consider including independent advisors who have strong industry experience and solid finance backgrounds to add another perspective into the process. This experienced professional, who should be very familiar with Chinese firms, could be someone either from the investor or another third-party consultant. It is important to emphasize again that the aim of a fi nancial due diligence is not to verify results. This is already done by the auditors, and due diligence actually seeks to explain the results, that is, understanding why numbers are what they are. It begins with information supplied by the company and supports this by interviewing key members of the management team. Speaking to the auditors themselves is also important as to understand their opinion on the risks and issues of the target company from the auditor’s standpoint. This is really more of a “soft” process as compared to an actual audit, and it is more of an investigative work to be done on the Chinese company. Entering the Site Financial due diligence work relies heavily on the target company for information and especially on interviews with its management team. The team has to plan and work in conjunction with the target company to arrange to meet the people and gather the data they require. It is, therefore, vital that the due diligence team supply the target company with a detailed list

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of the required information needed and people they wished to meet, which is why the process will usually kick off with an information request (see Appendix A on the DDIC Companion Website). The due diligence team will start with their interview program. The first port of call is usually to speak to the operational people to understand the company’s commercial operations and strategy. These people include the individual department heads—procurement, manufacturing, sales, quality assurance, and so on. A basic understanding of the company’s history, operations, and strategy is required before diving deep into the financials. This would give the team ample information about what to look out for during the interview with the fi nance team later. This can also be accompanied by visits to the plant, procurement sites, and sales distributors to supplement the due diligence team’s understanding of the company’s operations. The team would then interview the finance team to understand the various processes and how the finance team integrates its work with the rest of the company. The due diligence team would be most interested in the various internal controls and whether there is ample separation of duties, especially when it comes to the management of cash transfers. The team would also examine the reporting systems and how information flows to the top. This work includes taking a closer look into the accounting information systems utilized and whether the top management has access to the periodic financial reporting of the company. Finally, it would be the gathering of information for the analysis. Target companies are supposed to provide all the requested supporting data of its audited or management accounts. This is to give comfort to the investors of the authenticity of the numbers and at the same time is a very informative process that could possibly expose the target company’s intention to cheat (to be discussed later). Post Work The next step would be the review of all the information gathered from the target company, including financials, director’s reports, business plans, budgets, forecasts and records of the meetings with the top management, and so on. The heart of the work would be numbers crunching, financial analyses, and assembling a report that summarizes the key risks and issues of the company. This process could definitely be done off site, and it is worthwhile to conduct meetings with the entire team to go through the findings of the work together. Inconsistencies in the information provided by different

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.

managers during meetings are often uncovered during these group discussions, giving clues about which aspect of the business or financials require a deeper look. At the end of it, do remember that this process is only limited to what the company wants the investor to see. The target company’s management could already be trained to tell a similar story, and the suppliers and distributors they introduce to the investors are probably the ones whom the company has better relationships with. The entire process is usually window dressed and it requires looking beyond the checklists to really discover what the real picture of the company is. Examples and cases will be provided in the following sections to illustrate examples of investments gone wrong due to a lack of depth of due diligence. Chapter 5 will go deeper into the areas mentioned in this chapter that are beyond the typical due diligence checklists.

Information Collection Process Most of the private equity investments in China deal with small and medium enterprises (SMEs) that do not have audited accounts or that have their audits done by weak local accounting firms (usually unheard of). In these instances, financial due diligence must encompass information gathering and initial verification of financial information (similar to an audit) on top of the actual due diligence work. Information gathering in Chinese companies is particularly tricky, but the process will give the investor a good idea of the character of the founders. Information gathering can be a long and arduous process. Resistance can be found at the top and middle management’s level. This could be due to a variety of reasons, but an investor can use that resistance as a measure of management’s competence and information transparency. Usually, after the information request has been made to the top management, the middle management should provide the investor promptly with all the information. The top management is responsible for educating its finance team about the purpose of the due diligence and get them excited enough to be spending more time outside of their daily work to organize and compile data for the investor. There are a few telltale signs that investors can be watchful of during this process, listed in Table 3.2. Resistance usually comes in three forms: transparency of data, promptness of information flow, and the format of the data provided. For instances in which the company does not cooperate with the information gathering process during the due diligence process, it could either mean incompetence in the financial

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TABLE 3.2

Financial Due Diligence

Tell-Tale ll l Signs ffor Investors

Positive

Negative

Level of detail: High and transparent about information

Level of detail: Low and did not adhere to the information request

Information provided very promptly and does not require much coaxing

Information flow is slow and requires a lot of follow-up and prompting

Financials are given in a very convenient format (Microsoft Excel)

Company purposely makes the process very inconvenient and refuses to provide data in soft copy

reporting process or serious issues with the management’s integrity or intention to hide or to buy time to window dress the accounts.

Sales Verification of the quality of top-line sales numbers is one of the most critical and difficult tasks for Chinese companies. Revenue is one of the most commonly manipulated areas of fraud discovered in Chinese firms, including the accounting scams of U.S.-listed Chinese companies. Investors should spend more resources and time to detect possible overstatement of sales. There are typically three common forms of sales manipulation: 1. Fictitious customers 2. Related-party sales 3. Channel stuffing Fictitious Customers Booking revenue from customers and transactions that did not happen still is a common mean of inflating sales for Chinese companies. This could happen with forged supporting documents, including sales contracts, VAT receipts, bill of materials sent for production, warehouse registry, and so on. It could be a highly elaborated and coordinated system that could be uncovered only over time through field checks and close scrutiny of the financial numbers. Chinese companies are not new to producing fictitious sales, and a good example is the case of Yin Guang Xia that occurred more than a decade ago.

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CASE STUDY 3.1: YIN GUANG XIA (YGX)

T

he history of Guangxia (Yinchuan) Industry Co. can be traced to Ningxia, a relatively dry, desert-like province located in Northwest China. The predecessor of the firm, Shenzhen Guangxia Culture Industrial Co. (SGCI), was founded by a playwright named Chen Chuan. Born in 1939, Chen in his early years was one of the main playwrights for the Yinchuan Drama Company. The company was registered in Shenzhen and held shares in companies engaged in floppy disk production and manufacturing of visual equipment supplies. During the period of 1993–19941 SGCI underwent a few episodes of business restructuring and M&A before being registered as Guangxia (Yinchuan) Industry Co. on January 28, 1994, with a primary focus on floppy disk production. The company underwent a successful initial public offering (IPO) on June 17, 1994, and was the first company to be listed from the Ningxia Province. After the IPO, the people who would form the core management team of YGX began to gather around Chen, including the Chairman Zhang Jisheng, who was concurrently the director of the Office of Science and Technology of the Ningxia Autonomous Region, and the future CEO, Li Youqiang, a former director of an arts and crafts factory in Tianjin. At the same time, Baojie Ltd., the largest wholly owned subsidiary of Guangxia was established in Tianjin. Li subsequently took over operations of Baojie Ltd. However, the performance of YGX did not improve substantially after the listing. The opening share price was 1.64 yuan but soon dropped below its face value to 0.98 yuan. Due to intense competition in the floppy disk markets during 1995–1997, profit margins shrank drastically and YGX’s operations took a heavy hit. The production of every floppy disk lost the company US$0.02. The management team then made a decision in 1996 to diversify into other areas of business, including toothpaste, cement, real estate, wine, and herbal cultivation, and by 2000 it had more than 40 other subsidiaries across different industries and regions, including Tianjin, Beijing, Wuhan, and so on. One of the most successful strategic decisions by the management team was the involvement of YGX with the “Great West China Development,” a policy adopted by the central government to boost the less-developed western regions. The policy aims to develop infrastructure to promote foreign investment and education, and to increase efforts for ecological protection (including reforestation). YGX reoriented itself in 1995, having some prior experience in herbal cultivation, to combating desertification2 and ecological programs. On a train ride to Beijing, Chen met Wu Anqi, the director of the Water Technology Department in Ningxia (Continued)

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(Continued) Autonomous Region, who had spent some time researching how to combat desertification in the region. An initiative was set up to develop 1200mu (also known as Chinese acre; 1 mu equates to 666.7 square meters) of desert near Yinchuan but was abandoned due to insufficient funding. Chen was interested after hearing from Wu and decided to invest in the endeavor. Guangxia (Yinchuan) Natural Development Co. was set up with 80 percent of the equity contributed by YGX and 20 percent by the Water Technology Department. The company began in Yinchuan and developed more than 20,000mu of desert land, planting mainly ephedra and other species of herbs. The firm invested more than 400 million yuan into the project, raising a shelterbelt 187 kilometers long, and after five years controlled more than 60,000 Chinese hectares (4,000ha) of sandy land, which became green oases3 and grape vineyards. This subsequently set the model for many other enterprises to follow. The central government publicly recognized YGX’s efforts, and the media started to promote YGX as one of the pioneering corporations in modernizing Chinese medicine and its role in ecoagricultural industrialization. The company also invested into supercritical carbon dioxide (ScCO2) technology,4 purchasing three 500-liter ScCO2 assembly lines through a German company, C Illies and Co., to expand operations in the herbal extraction industry. This resulted in YGX having one of the larger herbal extraction capacities in the Chinese market, and the goal was to become the largest player in the herbal extraction industry in China. However, even though YGX was active in the ecological scene, the diversified business did not take off, and the company trudged along for a few years. The breakthrough came in late 1998 when the Tianjin subsidiary of YGX, Tianjin Guangxia,5 received an order from a German company, Fidelity Trading GmbH, for more than US$32 million worth of herbalextraction products produced in YGX’s ScCO2 facilities every year. These included egg yolk lecithin,6 cassia essential oil,7 cassia oleoresin,8 ginger essential oil,9 and ginger oleoresin. This order was close to 85 percent of the total revenue for YGX in 1998. Li Youqiang subsequently announced in June 1999 that the total value of the first shipment was US$33.5 million, generating profits of over US$8 million. This was about 76 percent of the total net profits for YGX in 1999.10 This piece of news seemed to have been the light at the end of the tunnel after years of research and lackluster demand of herbal extraction products. The single order from Fidelity validated the reorientation of operations by the management team, and the stock market subsequently caught onto the festive mood as well. From December 30, 1999, to April 19, 2000, YGX’s stock price surged to 35.83 yuan from 13.97 yuan, reaching 37.99 yuan on December 29, 2001, a close to threefold increase in less than a year. The earnings per share (EPS) also increased from about 0.510 yuan

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to more than 0.827 yuan, growing more than 40 percent, and the profit margins increased to 60 percent.11 YGX’s performance made it one of the top performers in the Shenzhen Exchange and the company was soon unofficially termed the “2000’s most bullish stock”12 in China. Asiaweek magazine also ranked the company eighth in China’s top 100 listed company charts in 2000.13 The company signed another contract, worth 110 million Deutche Marks, with Fidelity on January 14, 2000, and in March 2001, YGX announced that they were predicting EPS to rise from 1.92 yuan to 2.98 yuan on the back of a new contract with Fidelity worth 520 million Deutche Marks, approximately 2 billion yuan. The contract states that, each year, YGX would supply Fidelity with US$242 million of products, including 157.5 tons of natural caffeine, 150 tons of cassia oleoresin, 160 tons of ginger essential oil, 160 tons of ginger oleoresin, 9,000 tons of decaffeinated tea leaves, 24 tons of tea polyphenols, 30 tons of ginkgo keto esters, 10 tons of Puerarin, and other herbal extractions. YGX also acquired three additional 1,500-liter ScCO2 assembly lines and three 3,500-liter ScCO2 assembly lines in order to increase production capability in line with the new contract. This made YGX one of the biggest players in the herbal extraction industry, capturing close to 80 percent of market share.

6/28/1996

9/30/1997

11/30/1998

1/28/2000

The Stock Chart of YGX from 1995 to 2000

Fraud Exposed The real story of YGX’s meteoric growth was exposed in 2000 initially by a research analyst from the Stock Exchange Executive Council (SEEC), an (Continued)

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(Continued) organization established to improve the efficiency of the securities market in mainland China. The analyst, Pu Shaoping, first became suspicious because the price of YGX’s stock rose every single year since 1994, which is rare even in a bullish market. The fact that profits also rose more than 200 percent in 2000 and profit margins rose to 80 percent were suspicious as well because YGX’s competitors were doing comparatively far worse. The research led to the publication of an article by two Caijing (which is a subsidiary of SEEC) journalists titled “The YGX Trap” on August 2, 2001, alleging the various frauds that YGX had engaged in. The stock was suspended shortly, and on August 3, 2001, the China Securities Regulatory Commission (CSRC) sent out a team of 20 people to investigate the case. After the stock was unsuspended, the share price dropped consecutively every single day for 15 day,s from 30.79 yuan to 6.59 yuan, causing a nearly 6.8 billion yuan loss of shareholder value.

Overview of the Frauds Committed According to the final statement published by CSRC, YGX overstated profits of up to 77.1 million yuan from 1998 to 2001, 17.7 million yuan in 1999, 56.7 million yuan in 2000, and 0.89 million yuan in the first half of 2001. 700 600 500

Profits (fabricated), million RMB

400

Profits (actual), million RMB

300 200 100 0 −100

1999

2000

2001

−200 First half

Overstatement of Profit

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The overstatement of profit took place via a few means of fabrication (Lin, 2006): 1. Invoices a. Raw material purchase b. Production c. Sales and exports d. VAT 2. Sales contracts 3. Export bill of entry 4. Revenue fraud From the court trial of YGX, one learns of the extent to which YGX engaged in fraudulent overstatement of revenue. The fraud began with the CFO of YGX, Ding Gongmin, making a call to the CFO of Tianjin Guangxia, Dong Bo, in November 1999 to increase the EPS of the stock to 0.8 yuan. Dong Bo then did the math and found out the amount of profit required to achieve this target, and subsequently fabricated the sales, production, raw material, and sales contracts to support the fictional profit. This implies that the entire operational process of the company, starting with purchases from the supplier to sales to the customers, is likely to have a degree of fraudulence. The fraud begins with the fabrication of invoices for raw material purchases. Dong Bo invented a few suppliers of raw material,14 including egg yolk powder, ginger, cassia, and illegally purchased forged invoices, remittance receipts, and bank transfer receipts from the black market. These forged documents were then used to fabricate a web of realistic transactions between YGX and these imaginary suppliers, including bank transfers to and from these suppliers. The next step was to fabricate records of sales. Dong Bo forged four separate exports documents worth 56 million Deutche Marks, and in order to make the entire process more convincing, told the then-CEO of Tianjin Guangxia Extraction Ltd, Yan Jindai, to invent production records for the exported products. Yan Jindai instructed the workers under his charge to forge the storage records of raw materials and worker attendance records, and transfer orders of goods from one storage location to another. Finally, with all the previous documentations laying the foundation for the fraud, Dong Bo created export sales of 238.9 million yuan and publicly declared profits of 127.7 million yuan in 1999. Tianjin customs declarations were also forged to support the fabricated amount of exports by YGX to Fidelity. (Continued)

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(Continued) Creative accounting processes were also employed in order to further support the revenue and profit falsifications. In order to have dividends in May 2001, Li Youqiang took a 150 million yuan loan from Shanghai JinErDun (high-interest lender) with the pretext of asset purchase. This amount of money was then transferred to Tianjin Heyuan Co Ltd., which is one of the main sales representatives of YGX, and subsequently transferred back to Tianjin Guangxia as product receivables—among which 1.25 million yuan is booked as profits for the year. This only illustrates some of the accounting frauds that YGX engaged in. The degree of fraud that has taken place permeates many aspects of YGX’s operations, not being localized to only one stage in the company’s operations. It is interesting to think about what the role of the accounting firm was in auditing the reports of the company

Audit Firm Zhongtianqin (ZTQ) was formed in July 2000 from the merger of two audit firms, Tianqin and Zhongtian, becoming the largest domestic audit firm in China. Tianqin and Zhongtian were previously state-owned audit firms, and the merger was carried out in order to compete with the international accounting firms that were moving into China. After the merger, they had more than 300 employees and 100 registered accountants and were serving over 60 companies within China. There were two perspectives to ZTQ’s audit with YGX. A minority believes that ZTQ was in collusion with the firm, taking an active role in the entire fraud process. The other camp, the vast majority, believes ZTQ was not actively colluding with YGX, but rather did not do a sufficiently thorough job and was to a large part misled by YGX. Generally, it is believed that it was largely due to ZTQ’s ineptness rather than active participation in fraud that allowed YGX to get away with fraud for more than six years. In order to perform a proper audit on the firm, a fundamental understanding of the business is generally required, especially with firms with high-tech operations. This is especially important because one could then attempt to verify the financial statements or figures presented with the business model of the company. For instance, understanding the cost and volume of raw materials required would be especially useful for auditing a company in the herbal extraction industry. However, this sort of understanding is hard to come by, especially for an accounting firm that deals with companies in many different industries with different business

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models. The frequent high-technology and complex operational disclosures by YGX also, in a sense, deterred the ZTQ accountants from attempting to understand the company better. This resulted in the complete reliance of financial statements that were provided by YGX, instead of questioning how the numbers came about and the business model behind the financials presented. Hence one of the reasons that YGX was able to engage in fraud to this extent is an insufficient understanding of YGX’s business model by the ZTQ accountants. Having engaged in combating desertification in the late 1990s, YGX formed good relationships with the Ningxia government as well as some officials within the central government. This resulted in Li frequently meeting government officials and politicians, most of which were televised and promoted by the media. To ZTQ and most people, this created an image that YGX had the approval of the central government in its operations and business model. ZTQ hence logically assumed that there was minimal risk that the company could engage in any form of fraud, as the central government would surely not endorse a company that engaged in fraudulent activities. Unfortunately, this turned out to be a false assumption. Table 3.3 below shows the very suspicious-looking financial numbers audited by government-owned auditors. Formed by Chinese Government

Zhongtian Accounting

Tianqin Accounting

Merger 2000

ZhongTianQin (ZTQ)

Supported by Chinese government to compete with big foreign accounting firms in China

Most renowned auditing firm in Shenzhen

300 EmpIoyees

100 registered accountants

Serving over 60 companies

US$7m annually, y ranked fifth nationally

The Merger of Two Government-Owned Accounting Firms (Continued)

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(Continued) TABLE 3.3 Extract from the Annual Reports of Yin Guang Xia RMB (‘000)

2000

1999

1998

1997

Cash and bank

555,000

302,723

24,633

47,664

Accounts receivable

544,195

348,482

294,954

242,254

Revenue

908,988

526,038

606,285

324,317

Costs

325,648

303,359

338,934

191,646

64%

42%

44%

41%

Gross profits

Takeaways from the YGX Case Study Among other problems, YGX’s case gives a good illustration of the common issues to be watchful of during the verification of sales process. The lessons to be learned from this case study can be summed up in the following: ■

Auditors’ reliability

■

Verification of export sales

■

Verification of sales customer

■

Matching of sales to raw materials purchased.

Auditors’ Reliability This case speaks volumes on reliability of auditors’ reports, especially the ones produced by local accounting firms. Although Chinese accounting firms have improved by leaps and bounds since a decade ago, one still cannot forget the lessons to be learned from the infamous Enron incident. It is important for investors to also assess the relationship between the target company and the auditing firms, especially that of the auditing partner and the firm’s top management. Chinese executives would usually put in extra effort to establish good relationships with the audit partner and try to “buy them over” in any way possible. Typically, the closer the relationship between them, the higher is the risk of collusion between the auditors and the target company. To reiterate, the importance of making sense of the numbers produced by the auditors could have avoided getting involved in an accounting fraud. Also, the investor should always question numbers and trends that look too good to be true by always keeping a skeptical mind in reviewing auditing reports, and it would not be difficult to realize that this company

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was growing out of proportions—cash balance ballooning, revenue numbers growing at a rate faster than three or four times the country’s rate of growth, and the mere fact that gross profits could still be improving. It was either that the company had produced a miracle drug that was impacting the entire world’s population or the numbers were simply falsified. In YGX’s case, the license of the accounting firm Zhongtianqin Accounting was later revoked by the Ministry of Finance (MOF)—similar to that of Arthur Andersen’s collapse after the Enron incident. Accounting firms now are more careful, but it does not rule out history repeating itself. Chinese firms today have learned to become more complex, and the following examples will illustrate how firms are now able to get around auditors and investors in a more elaborate manner. Verification of Export Sales One of the many ways that Chinese firms can play with the numbers is to manipulate the export sales. Although invoices (pronounced as “Fapiao” in Mandarin) for domestic sales are to be provided by the tax authority for VAT purposes, invoices for export sales can be produced by the entity—if the entity has applied for an export license and is exempt from VAT. This means that there is more room for manipulation for exports as compared to domestic sales, since firms can simply fake sales vouchers and orders for overseas sales. This does not mean that it is impossible to verify export sales. In fact, it was by uncovering the fake customs documents that it was confirmed that YGX was faking its export sales to Germany. As more and more suspicions were raised about YGX’s operations, the CPA from ZTQ in charge of the YGX case, Liu Jiarong, attempted to reassure the reporters about YGX’s dealings with Fidelity by providing customs records, documentation, and financial notes of the export and sales overseas to Germany. Liu claimed that these documents were provided by YGX and the accounting firm did not directly liaise with the customs office to verify the authenticity of the documents. Armed with these documents, the reporters approached the Tianjin customs office for verification. The documents are typically done in triplicate, with copies kept by the both YGX and Fidelity and the other to be kept by the customs office for record purposes. In this case, the reporters submitted the documents’ reference numbers to the Tianjin East Port customs office, through which YGX has conducted operations. However, two months later, it was confirmed that the reference numbers were nonexistent. Tianjin East Port customs office also issued a statement stating that the total amount of exports by YGX in 1999 was US$4.82 million, which was less than one-sixth the amount (US$33.5 million) declared by Chen in June (Continued)

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(Continued) 1999 on the shipment to Fidelity. The customs office further clarified that most of the shipment, instead of herbal extracts and related products, was actually toothpaste and linseed oil. This creates an interesting perspective—that firms would normally avoid providing fraudulent documents or giving false information to government or state agencies. For instance, they would be unwilling to declare a higher amount of revenue to the CSRC so as to avoid paying more tax. They may also be wary of providing false information to the government because the repercussions could be much more serious. For this reason, the investor should always obtain company ’s government filings (e.g., customs documents for exports) from the relevant authorities in order to verify the authenticity of the company’s claimed revenues or finances. However, it may sometimes be difficult to obtain these documents from the government, especially for private companies, since these government agencies have no incentive to do extra work to aid the investor in the due diligence process. Unless circumstances are in your favor—that is, there was public pressure in YGX’s case to find out the real state of the company or the investor knew someone influential in the relevant authorities—it is typically a long, complicated process. Verification of Sales Customers No financial due diligence can be completed without ascertaining the existence of the target ’s top sales customers. Depending on budget and situation, investors should try to conduct checks on as many sales customers as possible, beginning with the most significant. Since Fidelity Trading Company is the largest customer of YGX, a closer look into this company would have found cracks in the amazing growth story of YGX. According to a YGX publication issued to its shareholders in March 2001, Fidelity is a famous long-standing trading company in Germany. After all, it was the subsidiary of C Illies and Co., an engineering and trading house for the export of investment goods based in Germany, and it had a history of more than 160 years, specializing in trading food and pharmaceutical raw materials. Indeed, C Illies and Co. was a company with a long operating history and the ScCO2 assembly lines manufactured by ThyssenKrupp Uhde were purchased from C Illies and Co. However, questions were raised about whether Fidelity was a subsidiary of C Illies and Co. Investigations into this matter proved inconclusive. Caijing reporters approached C Illies and Co. a few times to inquire about the identity of Fidelity, but the company’s representative was unusually tight-lipped about it. Investigations were carried out to verify the

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identity of Fidelity, and finally it was revealed that Fidelity was a company with business relations with C Illies and Co, but was not a subsidiary of the company. Still unsatisfied, reporters then took further steps to get to the bottom of the matter. The reporters decided to engage the assistance of the Chinese embassy in Germany to find out more about Fidelity. Industrial and Commercial Bank of China (ICBC) also did their research on Fidelity via a local branch office in Germany and a concerted effort between these two parties yielded results; Fidelity was established in Hamburg in 1990 with a registered capital of EU51,129.19. The contact person was Kiaus Landry and the company primarily focuses on machinery. Usually, registered capital of about EU50,000 for trading companies are not uncommon, but it was unrealistic to think that the company was engaged in contracts worth more than 6.0 billion yuan. Based on the results of this investigation, one of YGX’s loans from ICBC was then disrupted. YGX took on a 200 million yuan loan on December 29, 1999, from ICBC with the repayment timeframe falling between 1999 and October 28, 2001, but the bank terminated the loan early in May 2001. Subsequently all loan requests to ICBC were also rejected. These revelations would have surfaced if a thorough due diligence was done on YGX’s customers, and especially so since the entire company’s growth was attributed to this one customer. These would certainly have raised suspicions about the existence of the customer and, hence, raised important questions about the validity of YGX’s business growth and operations. Matching of Sales with Raw Material Purchases Sales revenue has to be supported by raw material purchases that are reasonable and authentic. This is especially relevant for YGX’s business operations and product mix, requiring larger amounts of raw material to extract from in order to produce the essential oils or concentrated products at the end. During the due diligence process, the investor can deduce the reasonableness of the business performance simply by looking at the amount of raw material that is purchased or utilized by the company. For example, YGX claimed to have exported more than 50 tons of yolk lecithin to Germany in 2000. This amount of product actually requires more than 1000 tons of raw egg yolk powder, but in actual fact, YGX only has two producers of raw egg yolk powder based in Shenyang and Xi’an. The combined sale of raw egg yolk powder from these suppliers to YGX was less than 30 tons, thus sending strong suspicions that the sales are fabricated. Besides doing a reasonableness test on the raw materials, it is also important to verify the authenticity of tax invoices and receipts of raw material purchase by contacting the suppliers directly. Calling up or doing a surprise visit to the top ten suppliers would ensure that the suppliers (Continued)

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(Continued) do exist, or, in other cases, whether the supplier’s factory or warehouse size would be able to produce and store the amount as stated in the sales voucher. In addition to that, it would be helpful to understand whether the transactions are made in cash, to understand the amount of internal control risks (discussed later) inherent in the company.

Related-Party Sales Fictitious sales transactions were a tactic often used in the past to falsely inflate sales and boost earnings. After the Ministry of Finance revoked the license of Zhongtianqin Accounting as a result of the YGX’s saga, other auditing firms have tightened their verification process to ensure that fictitious sales transactions do not occur under their watch. As the Chinese saying goes, “Policy imposed on the higher level would eventually be counter measured by people from below.” Chinese firms have since evolved and have slowly moved toward using a more subtle and difficult-to-detect approach to inflate earnings, namely related-party sales. Related-party transactions are very common in Chinese firms and if one is not careful, it is fairly easy to fall into the trap. A more recent case—Guangdong Xindadi Biotechnology Co., Ltd—illustrates how related-party transactions can be used to inflate sales.

CASE STUDY 3.2: GUANGDONG XINDADI BIOTECHNOLOGY CO. LTD. (GXB)

G

XB was established in 2004 and located in Pingyuan County, Guangdong Province. It was founded by married couple, Mr. Huang Yunjiang and Mrs. Ling Meilan, and together they hold about 65 percent of the total company’s shares. The company is a national high-tech enterprise involved in the cultivation, processing, research and development, and sales of tea-oil Camellia. GXB prides itself as having strong research

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and development capabilities and has established long-term and close cooperative relationships with reputable institutions including State Forestry Administration’s Camellia Research and Development Center, South China Agricultural University, Zhongshan University, South China University of Technology, and Guangdong Academy. As a national hightech enterprise, the company enjoys preferential tax treatment. The company currently has two industrial bases in Guangdong and Jiangxi Provinces; both are tea-oil Camellia resource-rich areas. Camellia can be utilized to develop tea oil products, such as refined tea oil, skincare products, organic fertilizer, detergent powder, soap, and biological pesticides. The company claimed to be on the forefront of developing tea oil-related products and expects to develop more functional uses of Camellia to be commercialized in China. (See Table 3.4.) GXB has enjoyed very strong revenue growth in the past three years (2009– 2011). The company’s revenue growth is mainly driven by the sales growth of tea oil, tea meal, and tea-oil-related washing products. GXB also sells organic fertilizers and tea-oil seedlings as supplementary products. According to the prospectus, customers are mainly split into direct sales, which are the sales to retailers and wholesalers, and sales to distributors. (See Table 3.5.) GXB’s top customer is a natural person. (See table 3.6 below.) According to the prospectus, the top 10 customers make up about 30

TABLE 3.4 Financial Snapshot (audited by BDO) RMB ‘000

2011

2010

2009

106,155

76,638

42,839

Growth (%)

38%

79%

—

COGS

64,029

47,386

24,361

Net profit

31,532

21,530

13,908

Revenue

TABLE 3.5 Sales Channel Split15 Sales Channel

2011

2010

2009

Direct sales (%)

64.1

71.7

73.9

Distributor sales (%)

35.9

28.3

26.1

(Continued)

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(Continued) TABLE 3.6 Top 10 Customers (2011)16 Amount (RMB ’mn)

% of Total Sale

Related Party?

Mr. Lin Shao Qing

8.1

6.5%

No

2

Changsha Xianshanyuan Co.

6.5

5.3%

No

3

Beijing Hefeng Dadi Trading

4.1

3.3%

No

4

Changsha Wuhehongjing Co.

3.8

3.1%

No

5

Meizhou Mantuoshenlushan Co.

3.3

2.7%

No

6

Meizhou Weishun Gongmao

3.1

2.5%

No

7

Meizhou Shikangzhiji Co.

2.4

1.9%

No

8

Meizhou Zhilian Co.

2.1

1.7%

No

9

Pingyuan Xianlin Department

2.0

1.6%

No

10

Pingxiang City Hengnong Co.

1.6

1.3%

No

36.9

29.9%

—

Rank

Customer

1

Total

percent of the company’s total sales, and none of them are related in any ways to the company’s management. (See Table 3.6.) The company officially submitted its application to CSRC for an IPO on the Shenzhen ChiNEXT in April 2012. Its application was later approved by CSRC on May 18, 2012, but as soon as all the listing information was made public and the prospectus was freely circulated, there came myriad attacks from the media. On July 12, 2012, as a result of the media reports questioning the authenticity of the company ’s business, CSRC decided to block GXB’s supposed listing process. All the related service providers were requested to provide answers to the accusations set out by the Chinese media, and CSRC also launched its own investigation probe into this company and its service providers. Nanjing Securities,

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BDO accounting firm, and Beijing Lawyers Co. were summoned to the investigations of GXB. So what really did the Chinese media find?

Top Ten Customers The media began the investigation with the most obvious suspicion—who really is this biggest customer of GXB? Why is he a natural person and is he really not related to the company? Mr. Lin Shaoqing has been topping the biggest customer charts for three years consecutively and has contributed to 14.8 million yuan of sales from 2009 to 2011. This begged the question of why a natural person, instead of a company, is placed as the company’s top customer. A few reporters went to investigate on the matter and it was revealed that Mr. Lin was the legal representative of a company called Guangdong Aoqingnong Farming Products Company, whose main operations were the sales of tea meal and biscuits. This company is also based in the same city as GXB, and more suspicions were raised when the search of the actual person was futile. The media did not stop there and went on to look up the other top customers on the list, leading to another interesting revelation. The three companies that ranked, second, sixth, and tenth in 2011 all had one thing in common—they shared the same legal representative and sponsor, Mr. Huang Gang. It could be a coincidence that these could be different people sharing the exact same name and surname, but the former assumption would actually signify two risks: (1) This person could possibly be a related party to the company or (2) there was a customer concentration risk. Later evidence suggested that the actual person behind these three companies was actually Ms. Huang Xianxian, who is the founder ’s relative. It was the fifth largest customer that gave the strongest suspicions of being a related party. According to the prospectus, Meizhou Mantuoshenlushan (Mantuo) Company contributed to 2.7 percent of the company’s total sales (3.3 million yuan), and a natural person called Zou Qiong was supposedly the legal representative and sponsor of the company. The media’s investigation proved otherwise. According to the public records of the local administration and industry commerce, Mantuo has been deregistered as a company before in 2010, when it was formerly owned by another individual named Ms. Huang Shuangyan. This company was mysteriously brought to live again in June 2010 in which the new owner is now Ms. Zhou Qiong. The reporters decided to pay Ms. Zhou and the company a visit on the May 26, 2012. (Continued)

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(Continued) Upon arriving at the registered business address, the reporter found out that the shop was located in a very secluded corner in Meizhou City, where there seemed to be little human traffic. The shop was about 100 square meters in size, and the reporter was greeted by a lady with the name of Ms. Zhou Qiong. Through a conversation with Ms. Zhou, the reporter found out that she did not actually own the shop and that the shop was experiencing increasing competition and declining sales, which is not aligned with what was stated in the prospectus. According to Ms. Zhou, the shop’s revenue has been declining for the past two years and has only made around 2 million yuan in 2011. The prospectus, however, stated that the particular shop made 3.3 million yuan and 2 million yuan in 2011 and 2010, respectively, suggesting very strong growth that contradicted Ms. Zhou’s claims. Below is a short conversation excerpt between the reporter (“R”) and Ms. Zhou (“Z”):17 R: How long has your shop been operating? Z: A long time, for at least six, seven years. But I was only transferred here two years ago. R: So it was operated by Xindadi before it was transferred to you? Z: I am not sure who was operating this shop before me but it was transferred to me from an individual, not a company. R: A shop as big as yours, how much can you make a year in terms of sales? Z: Situation is a bit different from the past, when we were the only shop selling this product (tea oil), we could make millions a year. But now with so many competitors, we now make much less than before (Ms. Zhou later mentioned that they made around 2 million yuan in 2011). R: Why not you leave me your contact number, perhaps we could cooperate next time? Z: Oh, this is unnecessary. Further, I don’t make the decisions around here. R: You mean you are not solely responsible for your own shop? Z: Yes, it’s my husband who actually calls the shot (Ms. Zhou said smilingly). The reporter took further steps to find out who was actually behind this shop that GXB claims to have no relations with. It was later revealed that there were compelling reasons to suggest that Ms. Huang Shuangyan, who is the founder’s niece, owned the shop. The reporter also managed to locate Mr. Huang Huanguang’s (the founder’s brother’s) wife, who then claimed that Ms. Zhou Qiong was actually an employee of GXB. All the evidence gathered seemed to suggest that there were suspicious dealings

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among many of the top 10 customers that the company claimed to have no relationships with. There was a very possible case of fictitious, related-party transactions to boost the company’s profits and growth in order to meet the requirement of the listing on ChiNEXT. Through a concerted effort to uncover GXB’s related transactions, the local Chinese media has found that 10 out of the 22 largest sales customers were linked to GXB’s management, including GXB’s company secretary Mr. Zhao Gang, the company’s CPA Mr. Zhao Heyu, and relatives of the founder Mr. Huang Yunjiang.

What Were the Other Accusations Toward GXB? Not only was GXB being accused of possibly having related-party transactions; the other media reports also stated three other potential issues with the company.18 GXB’s past three years’ gross margins for the tea-oil business amounted to 61, 44, and 36 percent, respectively. But upon closer look, the stipulated costs incurred are far below the required amount to even purchase enough raw materials (tea seeds) to process. The company’s tea meal utilized for the production of the organic fertilizer product was far below the industry standard of 45 percent. The company only used 2.54 and 1.28 percent in 2011 and 2010, respectively. Mr. Zhao Heyu, the company’s certified public accountant, is also serving as the CEO of Da Ang Investment Group, GXB’s third biggest shareholder. There is a major conflict of interest that also infringed the Chinese accounting law that restricts CPA members to be both the accountant and shareholder of any company. As such, GXB is currently under investigation by the CSRC, and it might implicate its listing plans. There are many lessons to be learned from GXB’s case and it also gives proof to the mere fact that an investor cannot rely only on the third-party service providers to ensure that the company is clean of any form of fraudulent activities. As mentioned earlier, an investor has to understand that service providers may lose objectivity in their judgment especially when they are compensated based on the success of their work, in this case, an IPO of GXB. Listing a company is merely a check-the-box exercise and, thus, cannot be taken at face value. The potential investor has to look beyond the numbers and representations to form his own opinion of the target company.

Takeaways We have learned from the GXB about the dangers of related-party transactions. For GXB, it is still unclear whether the company has really (Continued)

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(Continued) committed any frauds or fictitious transactions, but the relatedness of its top few customers should be something to worry about. If financial due diligence is only limited to time spent at the company, interviewing the management and reviewing the financial numbers, instances like the preceding case will occur and it will be too late when the truth is uncovered later. Related-party transaction is one of the most important aspects to be watchful of, as the company could be engaged in a “sales from the left to the right hand,” which does not involve any actual exchange of money or goods. In some complex fraud schemes, there could be actual exchange of goods and money (bank transfers) that make it harder to detect. The GXB’s case also sends a strong reminder to always question and look beyond the numbers. During the due diligence process, always remember to keep a skeptical and investigative mind and a “guilty until proven innocence” attitude toward target companies. Below are some of the methods that can be utilized to uncover related-party, fictitious transactions. These methods will be further elaborated in the next chapter when looking beyond the checklists. ■ ■

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Check bank accounts to verify actual money transactions Utilize local AIC public database to identify the company’s sponsor and trace the history of the companies (distributors) Conduct field checks Interview other industry players to ascertain the reputation of the founder and company

Channel Stuffing There have been many signs that point to the fact that many industries in China are overproducing and facing severe channel-stuffing issues. The increasing build-up of unsold goods cluttering shop floors, clogging car dealerships, and filling factory warehouses are all signs of unsold products. An investor should be wary of these signs and it is important to note the following telltale signs of channel stuffing: ■ ■

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Customer base is distributor heavy. There is evidence of maximizing sales during the end of each fi nancial reporting period (e.g., end-June or end-December). Seasonality of sales do not match that of peers in the industry. High sales return. High accounts receivable to sales ratio.

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Revenue recognition policy recognizes sales when products are sold to the distributor, not end consumer. The industry is prone to channel stuffing.

In the event that the target company has a distributor-heavy customer base, especially when the company deals with hundreds of distributors, it sometimes is very convenient to push its products to these distributors and recognize sales. For example, if a company has 500 distributors, stuffing a miniscule volume to each distributor would not have as much impact to each distributor as to itself. This, however, would have long-term implications like increasing accounts receivable, writing bad debt, growing sales return, cannibalizing future sales, and so on. Channel stuffing can sometimes be evidenced from the sales pattern over the year. In order to meet certain sales and profit targets, one can usually find an unusual spike in sales just before a financial reporting date, that is, midyear end or year end. The investor should always obtain detailed sales numbers to analyze— daily sales would be ideal. That would facilitate analyses of sales pattern, and also give clue about which distributor the company usually sells to in order to boost sales, because that would give the biggest lead to a related-party transaction. High sales return and increasing accounts receivable to sales ratio might be signs of channel stuffing. One should also scrutinize the revenue recognition policy as stated in the sales contract with various distributors and investigate the reasons of the sales return. There are also many industries in China that are more prone to channel stuffing. The machinery industry is one that is prone to revenue manipulation. The next example illustrates the problems faced by Caterpillar, one of the largest manufacturers of earthmoving equipment in the world, in its recent acquisition in China.

CASE STUDY 3.3: CATERPILLAR—ERA ACCOUNTING SCANDAL

C

aterpillar closed the acquisition of ERA Mining Machinery Ltd. on June 4, 2012, for a total amount of US$ 813 million.19 Even before the party balloons could settle and before Caterpillar could actually start benefiting from the acquisition, cracks had begun to show. Five months after the completion of the deal, Caterpillar came clean and said that it noticed discrepancies between the inventory in ERA’s records and the (Continued)

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(Continued) physical count of equipment in November 2012. Caterpillar then initiated an investigation that revealed years’ worth of incorrect cost allocations that allowed profits to be overstated. The probe results included improper revenue recognition practices that boosted sales.20 Another two months later, Caterpillar confirmed, on January 18, 2013, that it would write down the value of ERA investment by $580 million, which is a whopping 71 percent off from its initial acquisition amount. The company also said the noncash goodwill impairment charge would be 87 cents per share, in the fourth quarter of 2012. The blame was directed at the subsidiary of ERA, Zhengzhou Siwei Mechanical and Electrical Manufacturing Co. (“Siwei”), where Caterpillar claimed that Siwei’s managers have coordinated and deliberately contrived this entire accounting scheme. It came as a shock to the industry, and many began to wonder how a multinational Goliath like Caterpillar could also fall prey to typical accounting frauds. (See Table 3.7.)

History of ERA Mining Machinery Ltd. ERA is a Chinese maker of mine-safety equipment. Its subsidiary, Siwei, specializes in making roof-support equipment for underground coal mines TABLE 3.7 Transactions Advisors for the Caterpillar—ERA Acquisition21 Advisor Specialty

Caterpillar

ERA Mining Machinery

Financial

Citigroup Global Markets The Blackstone Group Asia Ltd. Partners Capital International Ltd. Quam Capital Ltd. Platinum Securities Co. Ltd.

Auditors

PricewaterhouseCoopers

RSM Nelson Wheeler Hong Kong Registrars Ltd.

Financial due diligence

Ernst and Young—overall lead Deloitte—working capital due diligence

Legal

Freshfields Bruckhaus Deringer Conyers Dill & Pearman

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DLA Piper Orrick, Herriongton & Sutcliffe LLP

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and heavy hydraulic lifts used inside mine shafts to reduce the chance of collapse. Prior to the announced acquisition, ERA was a listed company on Hong Kong’s Growth Enterprise Market. It was 46 percent owned by Mining Machinery, a company that, in turn, is held by chairman Emory Williams (33 percent) and 67 percent by James Edward Thompson III.22 ERA obtained its listing in 2010, through a maneuver called a reverse takeover (RTO), according to ERA’s regulatory filings. It bought out a defunct distributor of Hollywood DVDs called ERA Information and Entertainment Ltd., and the Hong Kong RTO allowed it to bypass regulatory hurdles involved in an IPO.23 Tracing back to its roots, ERA was initially founded by a Chinese coal tycoon, Li Rubo, and Emory Williams Jr., the son of the renowned former Sears executive. Williams was a Beijing-based American entrepreneur and a former chairman of the American Chamber of Commerce of China. Williams holds an MBA from Kellogg Graduate School of Management and he is also a co-founder of another Hong Kong-listed mining machinery company, International Mining Machinery. Williams and Li met each other through business dealings involved with concrete products in China. Li, a U.S.-trained coal engineer, bought into Siwei, a unit of ERA, in 2002 with a few other investors. Li later brought in Williams as an investor and also to help run the company. Williams eventually gained majority control of the company in 2007. ERA prospered under the control of Williams and Li, and achieved 130 million yuan24 (US$20.6 million) of net profits in 2009. Around the time of listing in 2010, Williams and Li sold majority of their shares to James E. Thompson III, the son of James E. Thompson, chairman of HK-listed Crown Worldwide Group, for a reported sum of US$38.5 million. Li and his partners exited fully before the IPO due to their preference of not holding a publicly traded entity in Hong Kong and because of other considerations. This was how the pre-IPO shareholding ended with Williams and Thompson being the major shareholders.

Transaction and Aftermath Caterpillar, the world’s biggest maker of earthmoving equipment, has strengthened its presence in the mining machinery market by acquiring ERA for $813 million in June 2012. This acquisition builds on Caterpillar ’s $7.6 billion purchase of Bucyrus International in late 2010, transforming the company into the world’s biggest supplier of large mining equipment.25 The purchase of ERA was supposed to open the road into China, a region that Caterpillar has been desperate to enter. Right after the transaction, the company said the deal “underscores Caterpillar ’s long-term commitment to continue to invest in China in order to support the growing (Continued)

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(Continued) base of Chinese customers.” This deal was also supposed to give extra boost to Caterpillar in its rat race with rival Joy Global, a U.S. miningequipment maker, to take up market share in China’s mining industry. Earlier, Joy Global also purchased another Chinese maker of mining equipment called International Mining Machinery Holdings (IMM).26 A member of the Caterpillar board during the course of the Siwei deal told Reuters the board was distracted at the time by a larger transaction and paid relatively little attention to the Siwei acquisition. On the condition of anonymity, the board member quoted that the deal came as a complete surprise, and it was presented to the board as a straightforward transaction. He also mentioned that the deal should be investigated further and that the driving force behind the deal was Ed Rapp, former Caterpillar CFO who now serves as group president with responsibility for China, among other operations. Rapp was said to have presented the deal and pushed for its completion. 27 As a result of the accounting shake-up in ERA, Caterpillar said it removed several senior managers at Siwei and installed a new executive team. “The actions carried out by these individuals are offensive and completely unacceptable. This conduct does not represent, in any way, shape or form, the way Caterpillar does business or how we expect our employees to work, which is spelled out in Caterpillar’s worldwide code of conduct,” Caterpillar Chief Executive Douglas Oberhelman said in a statement.28 The effectiveness of the new executive team to revive ERA and bring it out of its ashes is yet to be seen, but the lesson of the ERA would definitely stay with Caterpillar for a long time to come. It also serves as a stern warning to the rest of the multinational companies (MNCs) intending to expand to China not to underestimate the due diligence process in China.

Lesson Learned—Revenue Recognition Issue of ERA Parsing the background of the Caterpillar–ERA incident suggested a few accounting problems, including the most pronounced channel-stuffing problem that resulted from improper revenue recognition. Although Western standards of revenue recognition require signed contracts and black-and-white supporting documents, Chinese tend to apply the revenue recognition rules with considerably more flexibility and leeway. Verifying sales could get even more complex if the company is involved with overseas transactions and finished goods are pushed to overseas warehouses, because then the due diligence exercise would sometimes become more expensive and time consuming. In these instances, investors normally would resort to the cheaper alternatives, like phone-call verification instead of physical checks.

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Premature and unsupported revenue recognition is a persistent problem in China and especially rampant in industries like machinery. Zoomlion was another heavy manufacturer that was allegedly channel stuffing and booking fictitious sales in China, reportedly in late 2012. Typically, bosses of big companies of similar industries are closely linked, usually through Chinese trade and industry associations, and it would not be surprising if they exchanged notes on managing sales numbers.

Other Lessons of ERA Deals as big as acquiring ERA often leave many wondering what really went wrong and how would a giant MNC miss out on the fundamental accounting problems of ERA. Indeed, this case earmarked the troubles faced by foreign firms in their acquisition or M&A activities in China, no matter how big they are. Caterpillar was very eager to gain entry into the heavy machinery industry in China and, coupled with the fact that ERA was a listed company on the Hong Kong Growth Enterprise Market, Caterpillar may have underestimated the due diligence process. As mentioned in the case, there were several other activities happening concurrently that may have clouded the board of directors’ judgment and diverted their attention from the ERA acquisition. Perhaps the management had let down its guard since ERA had already passed the regulatory hurdles stipulated by the stock exchange. Maybe the big four accounting firms in charge of the due diligence were given little resources (i.e., budget, time) to complete the process properly. Or one could also question whether the due diligence is really that robust and rigorous? All in all, skimping on due diligence processes could lead to disastrous effects. Perhaps if more time and budget were given to have the proper checks of the company the crisis could have been averted and the write down of hundreds of millions of dollars avoided. The difference of an additional month or the allocation of a million dollars more on the due diligence might have done the trick.

Remedies for Channel Stuffing The easiest way to counter channel stuffing is to increase sales verification efforts on two fronts: 1. Increase sample size 2. Check the sales of the end customer, not the distributor Increasing the sample size of checks on the sales customers would definitely lower risk, but in China it is even more important to check on the actual

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Food processing company

Distributors

Restaurants

Hotels

Supermarkets

FIGURE 3.2 An Example of a Typical Sales Distribution Model in China

sales to the end consumer. Figure 3.2 illustrates the typical sales distribution model adopted in China. Many Chinese companies rely on distributors in different parts of China to distribute their products to end consumers, which could be in marketplaces, in supermarkets, or directly to customers. Companies usually prefer to just deal with the distributors rather than directly with the end consumer because dealing with customers strains their resources and time, and largely because of cultural and language differences in different parts of China, which creates the strong need for local distributors who knows the place and people well. As a result, it is always difficult to track the sales and to whom the company’s product is sold, and that creates the opportunity for the company to be in cahoots with distributors to stuff sales into their channel. Therefore, it is only meaningful if more attention were paid on the actual sales to the direct customers instead of these middlemen. Together with the auditing team, the investor should conduct sample tests on the actual sales of these direct customers to the fi nal consumer. This usually requires the assistance of the target company to help coordinate with these distributors, and it is very important to let them know the purposes of these checks. This exercise is very crucial but it is also a very tedious task and requires the distributors to provide the sales information on the target company’s products. If the request to visit the top 20 to 30 percent of the distributors were rejected by the company without providing logical reasons, it should be seen as a big red flag. In addition, this exercise also presents the opportunity for the investors to receive feedback from these end consumers to understand the positioning or popularity of the target company’s products.

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Others There are other common ways of manipulating sales, but these are considered the ones that are unique to a few industries only. They include: ■

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Recognizing revenue from property sales before the related risks and rewards have been transferred to buyers. Recognizing revenue but not the related cost of sales. Record sales in other payables to avoid tax payments.

Cost of Sales The typical weakness of Chinese firms with non-audited accounts is the poor allocation of cost. Businesses might record irrelevant items in the cost of goods sold like fixed asset costs or forget to include the social-welfare costs into the direct labor costs. Discrepancy in Cost of Sales Tracking the cost of sales is important in ascertaining sales. One should be suspicious if sales and costs of sales do not match, especially if there were a large discrepancy in cost per unit sales between two fiscal years. Table 3.8 shows the big jump in one of Xindadi’s business segments gross margins. Going back to the Xindadi’s case study, one of the issues that surfaced was the irregularity in the company’s per-unit cost of sales for one of its product segments. According to the prospectus, the company enjoyed tremendous gross margin improvements for its organic fertilizer. On fi rst glance, it seemed that the company was performing well. But a closer look into the industry peers showed that there are severe discrepancies in the reported raw material costs of Xindadi as compared to all its peers. Except in very rare circumstances, it is very unlikely any one company, with no obvious scale or relationship advantage, can procure materials at a steeper discount than its industry peer companies. It was very possible in this case that Xindadi was involved in fraudulent transactions or improper costs allocation, which was not picked up by the auditors.

TABLE 3.8 Guangdong Xindadi's Business Segment Gross Margins29

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Organic Fertilizer

2010

2011

Gross margins

25.1%

41.9%

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Dependency on a Few Suppliers Since the majority of the costs of sales come from raw materials, investors should be concerned if the company is only dependent on a few suppliers. Investors should be aware of any predeal sales with these core suppliers and if there is the possibility that suppliers take advantage of change of ownership to increase prices. Investors should definitely not forget to understand and meet with the company’s top suppliers to have a better understanding of their relationships with the company and determine any risks of working with them in the future. Incorrect Capitalization of Losses In new business lines or segments, or in first-time operation of new production lines, it is not unusual for companies to experience significant losses due to overoptimistic sales forecasts and underestimation of costs of sales. Because it would have a big impact on the profit and loss statements, sometimes companies might choose to capitalize those losses in the balance sheet under accounts like deferred assets. This, of course, is an act of window dressing and improper treatment of losses that should be corrected. Investors should reclassify and treat this capitalization under the cost of sales. Labor Costs Kept Artificially Low Similar to the concerns of suppliers, investors should also be made aware of the predeal promises made with the company’s employees about pay increases or bonuses that the buyer has to honor. Investors must also take note of the company’s compliance with the Social Insurance Law, which entails the cost of five “insurances” plus the housing fund (Τ㤗̈́㖨) for each employee. The scope of mandatory welfare in China could mean rather significant cost burden for the employers to make contributions in full to the employees. In addition, migrant workers may also face issues withdrawing the pension payment in the future if they were to move back to their hometown for retirement. Due to the effect of the “hukou” system and administrative reasons, the pension disbursements are usually done in the city in which the company has paid for and it cannot be transferred to other cities, that is, the employees’ hometown. As a result, Chinese companies sometimes enter into temporary employment contracts with its migrant workers so as to go around this Social Insurance Law. This allows the company to save on the pension costs and employees are usually more receptive to such plans because they would be getting more cash as opposed to pension money. Of course, this practice could lead to complications and legal problems, especially when the

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company is seeking exit. Investors have to resolve this issue and ensure that the founder pays off this social welfare liability before the investment or acquisition is completed.

Expenses In many cases, businesses will book non-deductible expenses in operating expenses account. These could include the following: ■

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■

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Interest paid between business units of nonbank enterprises or relatedparty borrowing that does not meet the debt to equity ratio rules Rental and royalties paid between business units of an enterprise Sponsorship expenses Dividends and returns on equity investments Donations that do not fulfill prescribed requirements Unapproved provisions like allowances for asset impairment and risk reserves Fixed asset costs and other expenses not related to production or business operations Penalties and surcharges relating to income tax payments

Generally, there are specified limits to the deductibility of advertisement, entertainment, union and employment welfare, donations, commissions and handling costs, and so on. Investors should look out for anomalies in the operating expense accounts and always should compare the individual percentage to sales with peer companies. Following is a summary of the financials30 of a Shanghai-based solar company, Chaori Solar (see Table 3.9). This company has been in the center of a Chinese media controversy for having successfully listed on the Shenzhen ChiNEXT Exchange in October 2011, despite having questionable financial numbers. Chaori Solar is a manufacturer

TABLE 3.9 Chaori Solar Financials Millions (yuan)

2010

2009

2008

Revenue

2,687

1,318

1,270

Gross margins

27.5%

31.1%

13.1%

9.5%

14.7%

7.5%

Net margins

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of solar cells and panels and is headquartered in Yangwang District, Shanghai. As reflected on the company’s audited reports, the company enjoyed phenomenal growth from 2008 to 2010, which also coincides with the period in which the company was applying for its listing. Based on Chinese media reports, the biggest suspect was the doubling in the gross and net margins from 2008 to 2009. This happened during a time that the global solar industry had a glut, when solar panels were severely oversupplied, and the global demand was weak. Solar prices were at a two-year low and it was only in the last quarter of 2009 that the demand and prices increased marginally with the announcement of government subsidies from key markets like Europe and China. As a result, both the local—and overseas—listed Chinese solar companies only managed to achieve an average of 15 percent gross margins. Those listed fi rms that only produced solar panels, the fi nal stage of the solar value chain where there is the least differentiation in technology and thus margin, only managed an average of 10 percent gross margins. In addition, Chaori Solar is not an SOE, nor is it a leader in this industry. Its peer companies have much larger revenues and market capitalization, have operations running at high economies of scale, and have very established sales channel and branding. For Chaori Solar to be operating at much higher margins than these peer companies under the aforementioned conditions raised many doubts among investors at large. On January 23, 2013, Reuters reported that the government of Shanghai Fengxian district persuaded Chaori Solar’s banks to defer claims for overdue loans worth 380 million yuan, indicating that the company could be in financial distress. If the government did not step in to rescue the company, or if in the near future Chaori Solar misses another interest payment, the company could very well become the fi rst to have defaulted on a Chinese bond. Further, there have also been rumors about Ni Kailu (company’s chairman and founder) attempting to flee to the United States and Europe in December 2012, but the rumors were dispelled when he came back in early 2013. In a nutshell, costs and expenses always have to make sense and be comparable to peer companies within a reasonable range. An effective analysis of the reasonableness of the expenses also requires an integration with commercial due diligence (covered later) in order to understand the macro conditions. In the preceding example, the movements of the company’s overall margins should have mirrored the rise and fall of the market’s solar spot prices. Any significant discrepancies should have been investigated and verified.

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Working Capital: Accounts Receivable Accounts receivable is a crucial component of working capital because it tells a story of sales quality, and also where auditors and investors look to pick up information of possible frauds discussed in the previous “sales” section. Investors should be mindful of high receivables-to-sales ratios and large amounts of bad debt written off historically. Traces of possible related-party transactions and channel stuffing can be found in the breakdown of the accounts receivable aging analysis. Investors should verify the identity of sales customers who have unusually large receivable accounts or have long overdue payments. Any links or relationship found between these customers and the founder should be an automatic red flag and worthy of deeper investigation. Many businesses in China have the weakness of not being able to formulate the aging analysis properly, and this is usually due to poor communication between the sales and accounting department or it could very well be an intentional act to hide evidences of channel stuffi ng and fictitious relatedparty transactions. In the event of the former, investors have to conduct a more stringent check on the sales customers and defi nitely have to make it a high priority in the post-acquisition plan to straighten out the reporting systems between the sales and accounting department. Depending on the volume of transactions, it would be wise to install and integrate these two departments into the accounting information system in order to better manage the accounts receivable. All in all, Chinese companies typically have weak systems to monitor and manage accounts receivable, meaning that there is usually a significant amount of cash underutilized that could be put to better use. Installing account information systems would be very helpful to help the Chinese company better manage their clients and prompt them to remind clients for payment. Working Capital: Inventory Inventory is a crucial element of working capital that one cannot ignore. Poor management of inventory could lead to piling of unnecessary cash that could otherwise be used more efficiently in other parts of the business. Naturally, investors should always understand why there is an exceptionally high inventory value. High inventory values are usually to maintain healthy inventory reserves in anticipation of customer sales orders as well as maintaining the company’s employees, keeping them working and busy.

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Since the finished goods inventory can be easily converted to cash when the sales are completed, it is very important that investors do a very thorough check of the physical inventory prior to the acquisition. In the Caterpillar case study mentioned earlier, Caterpillar suffered partly due to a lack of due diligence on the physical inventory that ERA mining claimed to have had, but it was discovered that there was a possibility of fraud with regard to the reporting of actual inventory value. For industries like heavy machinery where inventory could mean millions of dollars per unit, investors must ensure that the auditors or the accountants conduct a thorough and extensive stock-take process. Further, it must ensure that more senior accountants are tasked to lead this exercise. The inventory manager, usually a more senior person, may use his or her seniority to bully accountants and dissuade them from conducting a large sample test during the stock-take process. This could be made worse if the accountants tasked to conduct the stock take are young and inexperienced accountants who have no experience handling such situations. It is usually considered rude in the Chinese culture for a younger Chinese person to question a senior person, and this could be mitigated by tasking more senior accountants to handle the job. On the other hand, if the Chinese inventory manager seemed awkward or resistant to having the accountants check its warehouse inventory, it sends a rather negative signal about the integrity of the target company. Working Capital: Accounts Payable Accounts payable is about the management of suppliers and how much leeway is given to them in terms of credit days. The breakdown of account payables gives investors clarity on the supplier mix of the company and whether there exist a strong dependence on any particular supplier. Similar to checks of customers, verification of the existence of the company’s top suppliers is a good measure of whether the company’s revenue is supported by actual purchases of raw materials. For industries that rely heavily on cash transactions, investors have to be careful about whether adequate internal controls are in place to prevent fictitious invoices and embezzlement by accounts payable personnel. It is very common for the accounts payable personnel to be also doubling up as the person in charge of sending payment invoices as well as the cashier. Segregation of duties is usually weak for Chinese private companies, and it is an area that requires more attention and improvement.

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Cash Checking the company’s cash balance is often a straightforward process in the West but it could prove to be an arduous task otherwise in China. Experienced auditors in China typically do not rely on bank confirmation letters received from the local bank, because there have been countless cases of frauds regarding forging of bank confirmation letters. Due to the ease with which the companies could forge bank confirmation letters, Chinese auditors have learned to request the bank confirmation letters to be sent to them directly instead of going via the company. In other cases in which there are high suspicions of the cash balance, auditors would arrange for a visit to the bank (without the knowledge of the company) to retrieve the bank confi rmation letter. Investors and auditors should actually take this chance to interview the company’s account manager. This process allows investors to understand the relationship between the company (usually the finance manager) and the bank officer. Corruption in bank officers is not uncommon and clues could be picked up during the meeting or if resistance is met when requesting for further details regarding the company’s cash balances. Based on precedent cases, investors and auditors are now more vigilant about verifying the cash balances of the company’s corporate account. Unfortunately, even if the bank balance is actually confirmed, there could still be room for manipulation. In order to make up for the shortfall between the actual account numbers and the real balance in the bank, several companies have gone to the extent of actually borrowing money illegally from unregistered high-interest loan providers for a short period of time (days or weeks) solely for the purpose of passing the bank confirmation test. Usually after the auditors have checked the bank accounts, the money plus interest is returned to these illegal lenders. Therefore, it is important to request the recent (3–12 months or more in determining the possibility of a multiyear, deliberate accounting fraud) cash transaction records, so that big cash transactions could be picked up and questioned. The following list summarizes some of the countermeasures to prevent receiving fake bank balances: ■

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Bank confi rmation to be sent directly to the auditors instead of via the company. Interviewing the account manager of the bank and look out for possible signs of collusion and fraud. Requesting past transaction history and being wary of unusually large cash transactions in the period leading up to the bank confirmation date.

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Other Payables and Other Receivables These two accounts are where Chinese companies would dump all other payables and receivables that are not classified in other accounts—in other words, investors must tread carefully and scrutinize the unusual items in these two accounts. Other payables may include large accruals like underpaid social security obligations, withholding taxes for dividend payments, and provision for litigation—all of which should be settled before an actual investment or acquisition can be made. Other receivables may include prepayments to suppliers, loans to directors and shareholders, receivables of by-products, and other offsetting items. Similarly, investors should check the commercial viability and the purpose of offering prepayments to suppliers and loans to directors and shareholders. Typically, investors would look to clean up this account either by reallocating the resources or to help restructure some of the prepayment/loan contract with the suppliers as part of their 100-day plan. This process is typically integrated with the operational due diligence and the post-investment value creation initiatives.

Fixed Tangible and Intangible Assets Chinese companies could get creative when it comes to the treatment of fi xed assets. Since the fixed assets number is directly related to the company’s position to raise bank financing, this amount could be overstated. On the other hand, there could be instances of fraud in which the company could be intentionally hiding assets and understating them. Investors should bear in mind that the typical accounting tricks you might find in a Chinese companies are not new to the notorious Western examples such as Worldcom.31 Very few Chinese companies have the sophistication like that of the large multinationals, and investors just have to adjust their mind-sets and not fall prey to simple frauds that they themselves believed no longer existed. Similar to determination of sales revenue, analyzing the assets number requires a healthy amount of skepticism, stringent physical stock take, and scrutiny of legal contracts,32 especially on large-ticket items. There are mainly three common weaknesses that investors may find in conducting due diligence on Chinese companies’ fixed assets: 1. Incorrect depreciation of fixed assets—especially the intangible assets such as land-use rights and goodwill.

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TABLE 3.10 Minimum Useful Lives for Various Assets33 Asset

Years

Building and structures

20

Aircraft, trains, vessels, machinery, equipment, and other production plants

10

Appliances, tools, furniture, and other assets related to production and business operations

5

Means of transport other than aircraft, trains, and vessels

4

Electronic equipment

3

Productive biological assets in the nature of trees

10

Productive biological assets in the nature of livestock

3

Acquired software (subject to approval)

2

2. Self-established fixed assets that are not included appropriately in the fixed assets account. 3. Failure to post the “Fixed Asset” label correctly and failure to conduct periodic physical counting. Depreciation of tangible assets is computed on a straight-line basis and Table 3.10 illustrates the minimum useful lives for different asset class. The table is a guide of the minimum useful lives adopted in Chinese GAAP for different types of assets in China. Intangible assets, including intellectual property and land-use rights, are amortized over the contractual term. The concept of land-use rights in China is very different from the West, and the most distinctive feature of the land tenure system in China is that ownership of land is independent of the right to use land. In China, ownership of land is only divided into two types: (1) state-owned land and (2) collectively owned land. Under the Land Administration Law,34 any entity or individual that needs to use land for construction must apply for the use of the state land. Several rules must be complied with before construction can begin legally on land: 1. Only the state land may be directly used for commercial projects such as real estate development.

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2. Only after the collective land is requisitioned, that is, converted to state land, may it be used for commercial project development. 3. If arable land is used to construct commercial projects, the enterprise must undergo proper approval and examination procedures with the local government agencies for the conversion of the land from agricultural to construction/commercial use. In practice, foreign invested firms or domestic firms can acquire land use rights in three ways: leasehold, allocation, or grant. From a legal perspective, land grant is the most preferred and secured type of land use rights. 1. Land leasehold is the least desired method and also discouraged by the government in acquiring leasehold land-use rights. 2. Allocated land-use rights are issued to a company by the government, and it is imperative that investors note that the termination date is not fixed, that is, the government retains the right to terminate the rights any time. Land allocation land-use rights are typically acquired at no cost or, under certain situations, by only covering the resettlement and infrastructure costs. In this method, any development on the land would only benefit the government and not the company. 3. Land grants are the most secured of the three types of land-use rights. With this certificate, under the investors’ company or joint venture’s name, the owner can use it to raise loans in China (land grant as security). Land user enters into a contract with the government and pays the land grant premium in exchange for the land-use rights for a fixed period of time. By this agreement, the company (either foreign or domestic) has the right to sell, lease, or mortgage the land-use right to other land users. Therefore, depending on the specific purpose and use, land (under the assumption that it is a land grant) could amortize over a period of 40 to 70 years.35 Besides checking for forged land-use right certificates, investors also have to be careful of legality of the land-use rights—for example, whether the company has built a factory over the land that was demarcated specifically as agricultural land and has not gone through the proper procedures to have it requisitioned as state land. The BYD Auto Company case study is a brief illustration of how a publicly listed automaker from Shenzhen ran into troubles with the laws for disregarding the land tenure system in China.

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CASE STUDY 3.4: BYD AUTO COMPANY

B

YD Auto is a Chinese automobile manufacturer based in Shenzhen, Guangdong Province. The firm was established in 2003 and is part of the rechargeable battery company BYD Company. The company does not only focus on manufacturing the typical sedan car, but it has also been on the forefront of Chinese electric vehicle technology—rolling out many different versions of its own electric vehicles. This company came into the limelight in late 2008 when Warren Buffett publicly endorsed the company and spent $230 million in buying up a 10 percent stake in BYD Auto’s parent, BYD Company. In October 2010, BYD Company resurfaced into the spotlight, this time for the wrong reason, over a violation of land use in China. The company signed a contract earlier in July 2009 with Xi’an City, Shaanxi Province, to build a car plant with annual capacity of 200,000 units and to expand an engine plant in the high-tech district. Halfway into the construction of the car factory, the company was asked to cease after it was discovered to be infringing the Land Administrative Laws for its intent to build industrial buildings on arable land. China’s Ministry of Land and Resources fined BYD2.9 million yuan (about US$435,000) and confiscated seven buildings that were constructed on arable land that were not meant for commercial or industrial use. This came at a time when the amount of land used illegally had escalated to new heights, growing more than 14 percent in the first half of 2010. It was perceived that BYD was, unfortunately, made an example of and used as a deterrence to the business world as the Chinese government took a hard stand on their own laws forbidding illegal use of arable land. This poor publicity came as a blow for BYD, as they were already underperforming in the China’s auto industry that year when its growth dwarfed that of its industry peers. The company was also forced to shelve its dual-listing plans on the A-share market aimed at that same year as well.

Aftermath After paying the penalties and seeing the shutdown of the factories, BYD applied for the rezoning of the land from agriculture use to industrial use. About seven months after the saga, the Chinese officials approved of the rezoning of 86 acres (out of the 112 acres in the original plan) into industrial use. BYD managed to win the bid for the land through an auction and thereafter announced the restart of its construction plans and the recruitment of 70,000 employees from Xi-an City. (Continued)

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(Continued)

Takeaways It is very common for Chinese companies to start construction before securing government approvals regarding land-use rights and that could very well have been the case for BYD. Investors need to understand that a major source of income for the local governments come from the sales of land-use rights. Since the demand for industrial and commercial land usually surpasses that of arable land, there is always pressure on the local government to meet the needs of this demand and bring in more income. It is thus imperative that investors scrutinize the land-use contracts for target companies to ensure that they already have obtained the necessary land permits to operate. Even though the target company has never been faulted for illegal land use for operations in the past years, the entry of foreign investors into Chinese firms may very well raise the local and central authorities’ attention to scrutinize the transaction. The China Ministry of Land and Resources has been increasingly clamping down on illegal use of lands by domestic companies, including golf courses, housing developments, and mines. Harsh punishments have also been imposed, such as tearing down of unapproved buildings, issuing fines, and even sentencing company officials for up to four years in prison.

Accounting Information Systems More often than not, small and medium-sized Chinese business would not have the luxury of installing a fully integrated enterprise resource planning (ERP) system to help monitor its business performance. Chinese SMEs normally would rely on manual data entry and compiling the numbers on an Excel worksheet. As such, they would not have access to first-time information about the financials and usually have to rely on intuition and estimation before the monthly, quarterly, or the company accountants sometimes compile even semi-annual reports of financial performance. This is a common problem faced in Chinese firms and also an area in which investors could help improve the target company. Certainly, accounting systems would only be economical if the company grows to a certain size and the back office work to key in every transaction becomes increasingly tedious. It is also more meaningful to install accounting information systems (AIS) in a company if it deals with many moving parts; for example, the company deals with a large group of suppliers and distributors, and tracking payments and collections becomes more and more difficult manually.

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Installing AIS into the invested company can help the investor better manage and monitor the company. Assuming that it is properly installed and the staff is adequately trained, it could be a powerful tool to constantly keep track of the sales and working capital management of the target company. If the company already has AIS installed, it would be helpful to know which system it is using and whether it has the necessary modules to ensure oversight over the company’s operation. Investors should always request access to the company’s AIS to allow offline monitoring. Having access to the AIS is sometimes considered equivalent to acquiring very sensitive information about the company, and investors should also be suspicious if the request to access is rejected. Further discussion about the IT systems will be touched on in the operational due diligence section.

Tax Issues and Preferential Tax Policies toward Hi-Tech Enterprises Tax due diligence is best carried out by a tax expert. In a typical financial due diligence exercise, the accounting fi rm will usually engage its Chinese tax experts to scrutinize the company’s tax affairs. It is an open secret that Chinese firms have a reputation of dodging tax payments. It is not uncommon for Chinese companies to have a separate accounting book prepared for the sole purpose of misleading the tax authorities. This is especially prevalent in industries like food and beverage, where transactions are mainly in cash and the majority of customers do not ask for sales vouchers or receipts ( fapiao, in Mandarin). Therefore, it becomes extremely challenging for tax authorities to verify sales and collect the correct tax payments. It is imperative that the shortfall of tax payments to the tax authorities has to be settled before an acquisition. It usually entails the company’s sponsor (usually the founder or the shareholders) settling the shortfall and an additional fine to the tax authorities. This payment should be borne by the founders and not the company, or in the case of the latter, the additional costs should be taken into account in determining the target company’s valuation. In order to stimulate more research and technology-related projects, the Chinese government offers special tax incentives for firms that qualify for such treatments. The principal incentives include a 15 percent preferential tax rate applicable to new high-technology enterprises and a 50 percent super deduction for qualifying research and development expenditures. There are also other geographically based incentives focused on new high-technology enterprises that include tax holidays and tax levied at a rate lower than 15 percent.36

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Needless to say, these tax breaks mean a great deal to the Chinese companies and it could possibly save the companies millions of dollars in taxes paid each year. It is not uncommon for many of the companies to go the extra mile to attain the “new high-technology enterprise” status. Sometimes, investors may find target companies that may have attained the tax break status from the tax bureau but have not technically met the requirements. For example, in the previous Xindadi case example, the company’s annual research and development expenditure was well below the requirement of at least 5 percent of total sales, and yet the company was still using the lower tax rates (15 percent) in their income statement. Going back again to the Xindadi case study, Table 3.11 displays the percentage of research and development costs as a percentage to sales from 2009 to 2011. Not only must the investor be wary of the obvious infringement of the tax laws of the target companies, they must also verify the classification of costs under the research and development expenditures. As mentioned earlier, in order to qualify for the tax incentives, many companies may allocate nonresearch costs under that account. This problem could potentially jeopardize a deal if the wrong classification of the costs were to be discovered by tax authorities in the future.

Other Local Policies The Chinese government has demarcated many zones around the peripherals of big (fi rst- and second-tiered) cities as economic zones (or high-technology parks) to attract businesses and investors to set up their plants and factories, so as to draw the population away from the city centers and ease off the pressures of rising costs and escalating housing prices. In order to attract companies and investors, the local government bureau of investments in those areas have the authority to sell their land at deeply discounted prices and offer many other incentive policies like cheaper taxes, free office space, and local government grants/subsidies. Since these local government bureaus are essentially

TABLE 3.11

Guangdong Xindadi's Sales and R&D Numbers37

Items (’mn RMB)

FY2011

FY2010

FY2009

R&D expenditure

2.36

2.12

2.81

106.15

76.63

42.84

2.22%

2.76%

6.56%

Total revenue R&D as a % to sales

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competing with other zones and cities, they sometime can offer very attractive policies to businesses and investors alike. Especially for policies like cheaper land and lower enterprise taxes, the government is essentially promising that they will return the difference in the quoted (as stipulated by the local government) and final negotiated (lower) price in terms of government grants over the next year or so. When dealing with such arrangements, investors have to be wary of these contracts and have to understand that the company is not actually paying a lower price, but that the initial quoted price would still have to be paid and the local government is committing to cash payable of the agreed lower price to the company in the future. This affects the cash-flow forecasting of the company and in worse cases, might be bad debts that would be written off in the future.

Internal Controls Systems In June 2008, China issued its own framework of Basic Standard for Enterprise Internal Control38 (C-Sox) that was formulated after the Sarbanes Oxley act in order to impose requirements for management, assessment of internal controls, and opinion on the effectiveness of company’s internal controls for the Chinese listed companies. Ever since the implementation of C-Sox, local and foreign investors alike criticized the efforts for the “form over substance” quality— firms only met the requirements without actually benefiting the business. This is understandable given the relatively young guidelines and that China’s regulatory framework for internal control is fast evolving. If listed firms are seen as having questionable internal controls in place, needless to say Chinese private firms have a long way to go. Assessing the target company’s internal control systems should also be one of priority of the financial due diligence. The focus should be on the business processes that typically do not have many supporting documents such as sales vouchers or receipts ( fapiao). The agriculture industry, for example, is one industry in China that transacts heavily in cash and generally does not involve issuance of fapiao. For example, when a rice-processing company procures paddy rice from farmers, these farmers accept only cash. Sometimes, you will fi nd third-party brokers in centralized locations selling the grain or paddy on behalf of the farmers. These brokers make the procurement process much more convenient, albeit at a slight premium. Figure 3.3 lists the typical internal control issues with Chinese agricultural companies at the sales and procurement level.

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Procurement

• Farmers typically do not have bank accounts and most of times would only accept cash. • Farmers cannot issue fapiao.

Sales

• Sales are primary to distributors who wants to avoid paying tax and hence do not like fapiao. • Cash preferred over bank transfers.

FIGURE 3.3 Internal Control for Chinese Agricultural Companies

Kickbacks are extremely common in China, and when it comes to procurement, kickbacks between the seller and the procurement officer are often hard to trace and almost inevitable. This is made worse by the fact that transactions in China are largely in cash. In the preceding agricultural example, the only transactional evidence that farmers and third-party brokers can produce are sales vouchers. Farmers could provide a photocopy of their identification card and thumbprint as additional proof of sales, but, in reality, it is extremely difficult to trace and verify. Sales vouchers, unlike the official fapiao issued by the tax bureau, can be manipulated because they do not contain tax-payment obligations that the official fapiao has. Although sales vouchers obviously lack reliability, investors typically rely on other methods to better manage the company’s internal controls. Sales to distributors also face similar problems because distributors usually deal with cash and typically avoid accepting fapiao for tax reasons. It is an inherent problem that would take time to evolve and change. In such situations, investors should formalize this process as much as possible, beginning with enforcing a strict adherence to bank transfers instead of cash transaction. As much as possible, investors should request the distributors to set up a bank account or investors could even offer to help them set one up. Figure 3.4 illustrates the current weak internal controls in the procurement and sales process, what can be done by investors to bring them up to an acceptable level, and also the most ideal situation, which might be virtually impossible to implement now in certain industries in China. Usually, most of the important positions in the company are held by a close network of the founder’s family and friends. This may work in the pre-investment

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Current situation

1. Purchasing from individuals

Procurement

2. Cash transactions

3. Sales voucher only

1. Selling to individuals and distribution companies

Sales

2. Predominantly cash transactions

3. Distributors do not accept fapiao

FIGURE 3.4

Acceptable scenario

Ideal Scenario

1. Purchasing from a mix of individuals and brokers

1. Purchasing only from established corporations that consolidates individual’s raw material

2. Cash for individuals; bank transfer for brokers

2. Only bank transfers

3. Sales voucher only

3. Fapiao issued for every transaction

1. Selling only to established distribution companies

1. Selling only to established distribution companies

2. Only bank transfers

2. Only bank transfers

3. Distributors do not accept fapiao

3. Fapiao issued for every transaction

Unacceptable, Acceptable, and Ideal Scenarios of Internal Controls

129

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context, but as a potential investor, this arrangement is unacceptable. Systems and processes have to be installed and duties and responsibilities have to be well segregated. To install new people in charge of what the predecessors have been doing for the past years is likely to be met with resistance. However, these are necessary reforms and changes that will have to be communicated to the founders and this education process can be challenging. In the case of a private equity minority investment, founders may see this request as distrust in the business relationship and will feel that their egos and control over the company are in jeopardy. Investors will have to explain the purpose thoroughly and convince the founders that better internal controls and corporate governance could fetch a higher valuation later in the event of a listing. Rotation of employees within the department (or even cross departments) could be another way to improve internal controls and prevent the occurrence of kickbacks and thefts. When installing systems and processes, close monitoring of staff members is necessary to ensure their adherence to those systems. Consider, for example, the selection of a supplier for a certain raw material. Three legitimate quotations from three independent suppliers should be necessary to ensure price competitiveness and service comparisons to select the cheapest and most reliable one. Internal controls in China are still in their nascent stage and difficult to implement. The onus is on the investor and the service provider to identify the weaknesses, propose mitigating measures, and educate the founders on change and reform.

Important Points to Note Financial due diligence work streams are typically focused on building a historical fact base, particularly about regulatory and compliance with auditing standards. They often provide “buyer-beware” advice, often with much information but with little prioritization of risks, and are backward-looking by nature. Although these work streams can provide a context with which the future performance can be evaluated, it would be a grave mistake for an investor to not see beyond the information provided and assess which could be potential landmines. Further, every due diligence has to be customized and catered to a specific industry and company. Every company is unique and it often requires the investor to tweak and customize each process for each fi rm. Depending on the situation, priorities should be set differently so as to capture and uncover the risks adequately for each individual company.

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In addition, fi nancial due diligence cannot be done independently from the rest. As mentioned in numerous examples earlier, fi nancial due diligence has to be integrated together with the others, including legal, commercial, and operational due diligence. Investors have to ensure that advisers for the fi nancial due diligence also work together with the rest of the advisers and even consult the other advisers on matters out of their expertise. For example, they could engage lawyers to review the contracts, operational experts to verify the reasonableness of the sales and costs numbers, and industry experts with the commercial side of business to determine whether the forecasted numbers are reliable. Only through a multipronged approach can the fi nancial due diligence be wholesome and exhaustive.

CASE STUDY 3.5: WANFU SHENG KE HOLDING COMPANY

W

anfu Shengke (Wanfu) is a listed agricultural company that focuses on rice processing and distribution. The company also invests heavily in the development of the by-products, including rice starch sugar, rice protein powder, and rice bran oil. Wanfu is situated in Changde City, Hunan Province, which lies on a major Japonica rice belt in China. The company achieved its successful initial public offering on the Shenzhen ChiNEXT exchange in September 2011, issuing 17 million new shares and raising 425 million yuan of IPO money (net proceeds of 395 million yuan after deducting listing fees). After less than one year of listing on September 14, 2012, the company received a formal file inspection request from the Wuhan province securities regulatory commission (local SRC) on a suspected case of fraud. On October 25, 2012, Wanfu released an “Important notice regarding supplementary information and adjustments to the 2012 halfyear audited numbers,” admitting to numerous counts of frauds and misrepresentation of its financial statements. The news sent shockwaves into the investor community at large, and at the same time delivered a stern wake-up call to all stakeholders involved, including the CSRC and the company’s lawyers, auditors, financial advisers, and suppliers and customers who colluded with Wanfu to help make it all happen. The company ’s stock plunged and, within a few trading days, was ordered by the CSRC to stop trading. To date, Wanfu is facing a very high risk of delisting, even bankruptcy. Did the company commit fraud? (Continued)

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(Continued) TABLE 3.12 Comparison of Audited Numbers, Reported Fictitious Numbers, and Actual Numbers (2008–2010)39 2008–2011 accumulated (RMB, million) Revenue

Audited

Fictitious (approximate)

% of Fictitious

1,543

740

48%

Operating profit

187

180

96%

Net profit *

181

160

88%

*Of the RMB 20 million of actual profits attributable to the company, approximately 10 million yuan came from the government grants (booked as non-operating income)

Wanfu orchestrated an elaborate scheme that somehow managed to dodge the radar (or perhaps even with the knowledge) of the local auditors, Zhonglei CPA firm, for a prolonged period of time. In summary, Wanfu has committed the following offenses: 1. Over the period from 2008 to 2011, it created fictitious sales totaling 740 million yuan. 2. Subsequently, it over-reported operating and net profit by 180 million yuan and 160 million yuan, respectively. 3. It created a false construction in progress account totaling 80.4 million yuan. 4. It created a fake prepayment account of 44.7 million yuan. The founders have squandered away quite substantially the IPO net proceeds partly to maintain an elaborate scheme of buying and selling products to themselves. (See Table 3.12.)

Fictitious Sales It is clear from these figures Wanfu has taken the audacity of book-cooking to new heights, and, if one is not careful, history will repeat itself. A sales breakdown analysis by both the Chinese media and research analysts revealed the following: ■

■

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Sales to the company ’s top customers, which were previously verified by the auditors to be completely independent, were largely fictitious. Regional sales situation, which estimated half of sales in Guangdong province, 70 percent of sales in Hunan, nearly 100 percent in Hubei,

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and about 80 percent of sales in other provinces, were fictitious and unsubstantiated. ■

The fictitious sales were executed in the following manner: Wanfu first procures paddy rice from independent grain brokers (who buys and consolidates paddy from farmers), and then, impersonating farmers, sells back the rice to the independent grain brokers. Through this cycle of buying and selling back grain to the brokers, Wanfu was able to produce actual sales vouchers and goods receipt documents to verify their cost of goods sold, but, in actual fact, is only dealing with the same batch of paddy rice. Given the long shelf life of rice, usually more than 24 months, Wanfu was able to repeat this process many times over, and hence this fraud was difficult even for the auditors to track and uncover. Independent rice brokers buy and consolidate rice from farmers

Wanfu impersonates as farmers and resells paddy rice to the rice broker

Sell it to rice processors like Wanfu

Wanfu books the receipt and the cost of goods

Illustration of Wanfu’s Scheme of Buying and Selling Paddy Rice with Independent Third-Party Rice Brokers ■

To make the audit process even more challenging and riskier, the stocktaking process on the paddy rice inventory is very difficult. Rice processors typically would stack up the paddy rice in a warehouse like a hill, and it requires either a very good estimation or the tedious task of weighing it. Therefore, quantifying the actual inventory value of the raw materials is almost impossible. At the end of 2010, the company reported inventory values of 190 million yuan, which meant that the company had approximately 20,000 to 30,000 tons of paddy rice in its warehouse. (Continued)

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(Continued)

Fake Construction in Progress and Prepayment Account The following question then was where and how the company found the cash to execute this fraud? According to the company report Notice on disclosure of material issues and adjustments of Wanfu in December 2012, Wanfu disclosed a major adjustment on the construction-in-progress account. The company has overbooked an amount totaling 80.4 million yuan of construction in progress after it was discovered that the company did not actually spend this money on developing fixed assets. At the same time, Wanfu also adjusted down its prepayment amount from 146 million yuan to 101 million yuan, signifying another 45 million of prepayment account booking without actual proof and evidence. If one would to take a closer look at the method in which Wanfu withdraws cash to create fictitious sales, it becomes clear that the company is doing it via the creation of phony construction in progress and prepayment accounts. The cash is then used to buy its own products and repeat the procurement process as described earlier. The corresponding journal entries could be deduced as shown in Table 3.13. TABLE 3.13 Journal Entries for the Construction in Progress and Prepayment Account Adjustments40 Debit

Credit

Cash withdrawal from CIP 1

Construction in progress

80 million yuan

Cash

80 million yuan

Cash withdrawal from Prepayment 2

Prepayment

45 million yuan

Cash

45 million yuan

Purchasing of own products 3

Cash

x million yuan

Revenue

x million yuan

Carrying over of cost 4

Cost of goods sold

y million yuan

Inventory

y million yuan

Putting it together 5

CIP and prepayment Inventory and earnings

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125 million yuan 125 million yuan

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Operational Inconsistencies There were several operational inconsistencies that also gave clues that Wanfu was involved in fraudulent activities. Most notably was the contradiction between the timing of the production lines coming online and the sales of the corresponding products. 1. As noted in the prospectus, the company’s first premium grain processing line only became active in December 2008, but within the short period of one month (or less), the processing line already managed a very impressive sales volume of 5,364 tons of processed premium rice for financial year 2008. 2. The company’s second premium grain processing line became active in December 2009. According to the reports in 2009, the company achieved a total sales volume of 17,800 tons, up from 5,364 tons last year. 3. One of the by-products of the grain processing company was the cornstarch sugar, which the company used solely for the production of barley sugar. Similar to the premium rice processing line 1, the barley sugar processing line only became active in December 2008, but the company already booked sales of more than 42,000 tons of barley sugar in 2008. 4. Another by-product, rice bran oil, faced similar questions. Wanfu rice bran oil processing line became active in late 2008, but that did not stop the company from producing and selling a total of 9,742 tons of rice bran oil and reaping in revenues of more than 13 million yuan. What was more puzzling was that Wanfu sold significantly less rice bran oil in 2009 and 2010 (1,574 and 2,577 tons, respectively) when it really should be the opposite. 5. Overall, one of the most blatant inconsistencies lies in the breakdown of the core and by-products of the business. Based on the 2010 figures from the prospectus, Wanfu has processed a total of 165,100 tons of paddy rice to give the following breakdown of end products: a. 49,800 tons of processed rice (core product—primary processing) b. 70,000 tons of rice starch sugar (by-product—secondary processing) c. 10,000 tons of rice protein powder (by-product—secondary processing) d. 20,600 tons of rice bran (by-product—secondary processing) The fact that the by-product, rice starch sugar, was produced in larger quantities than the core rice product made little sense and the strategy (Continued)

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(Continued) TABLE 3.14

Overview of the Timeline

December 2010

Wanfu submitted its first IPO application, hoping to catch the year-end window

January 2011

CSRC began the question-and-answer process

March–July 2011

CSRC and Wanfu exchanged several rounds of questions and answers

July 2011

CSRC approves of Wanfu IPO application

September 2011

Wanfu issued 17 million new shares and raised 425 million yuan of gross proceeds and successfully listed on Shenzhen ChiNEXT exchange

September 2012

Wanfu received a formal investigation request from the local SRC—Wanfu was in the center of an accounting fraud suspect

September 2012

Local SRC launched its 17 person investigative team onsite

October 2012

Wanfu released its first Notice on disclosure of material issues and adjustments of Wanfu Shengke in October 2012 2 and admitted to fraud and wrongdoing

March 2013

Wanfu released second Notice on disclosure of material issues and adjustments of Wanfu Shengke in March 2013

was difficult to fathom. Rice starch sugar was a lower margined product that is produced from the rice rejects (broken rice) at the primary processing of the rice grain. By producing more than the actual rice itself, rice starch sugar by-product is actually cannibalizing Wanfu’s core finished product, or the processing lines had very low rice yield rate, resulting in more product rejection rates. Either way spells trouble for the company, and this should be enough of a telltale sign that the company might be involved in dishonesty and misrepresentation. See Table 3.14.

Takeaways The extent with which Wanfu has orchestrated this massive fraud as a listed company probably appalled many foreign investors intending to enter China. The truth is, unfortunately, that Wanfu definitely is not alone

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in this and there could very be many other listed companies lurking in the shadows, awaiting their judgment day. That is not to scare investors away from investing in this gargantuan market but, rather, to expose investors to the most extreme case studies to learn from the mistakes made by their predecessors. Chinese companies are well aware that if they had only created the fraud on the accounting books without integration with the rest of the operations (suppliers, customers, etc.), it would be easily uncovered by the accountants. In order to fool the accountants, brokers, and other service providers, companies like Wanfu had to start from the root of the business (i.e., the suppliers providing the raw materials) and work its way to the final end consumers. It is an elaborate scheme that is difficult to execute the other way round—starting on the accounting books and then working its way to look for the supply chain to support the lie. This is how frauds in China have evolved and become increasingly elusive to the public eye. Thus, it is necessary that investors always wear the investigative hat when evaluating and conducting due diligence on companies. Pursuant to the Wanfu example, what follows are several aspects that investors must not overlook when conducting their financial and operational due diligence. Verification of Company’s Relationship with Suppliers and Customers Covered in the earlier sections, it is critical to ascertain if there are any relationships between the company and its suppliers and customers in the value chain. This has to be an extensive exercise and any clues from the interaction with these supposedly independent third-party stakeholders should be investigated at greater lengths. Internal controls of the company are also important clues about whether pricing policies are fair and whether the supplier selection processed is unbiased. If the target company is found to be spot clean, it does not hurt to dig another level into the suppliers’ and customers’ customers to ensure that the company is not hiding its interests at below ground level. Verification of Bank Transactions—Paying More Attention to the Transferor or Transferee Identity Third-party service providers have now evolved and are typically extremely careful when it comes to the due diligence of the bank statements. Due to the rampant cases of bank statement frauds, auditors have learned how to tackle the cash verification process. Not only should investors ensure that the cash verification is properly overseen; they should also pay extra attention to the bank transactions as another method to verify the (Continued)

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(Continued) actual cash inflow and outflow. However, this should not stop at simply matching the actual cash inflow and outflow of the company. Rather, there must be follow-up to verify the identity of the person or company at the other end of the transaction. Consider, for example, that a big cash inflow transfer is booked from one of the target company’s customers. The transferor’s details should match with the actual customer (e.g., ABC Distribution Company should appear as the transferor’s name, not some other personal account). Auditors may at certain times overlook this detail, thus allowing the company to use its own personal accounts to simulate fictitious cash transfers, when the company is actually just transferring the money from its left to its right pocket. Verifying the Existence of Big Ticket Fixed Assets and Construction in Progress Wanfu created fictitious construction-in-progress and fixed-asset accounts in order for the founders to legally withdraw cash that allowed them to commit the other parts of the fraud scheme. This speaks volumes about the importance of physically verifying the fixed assets whose amount is very substantial. Investors should also always ensure that the value amount of a certain asset is reasonable and logical—any irregularities with the asset value and the actual physical appearance of the assets should be examined very seriously. Not only has it been a method used by Chinese companies to possibly embezzle publicly raised money, but Chinese firms have also inflated asset number to fool the local banks into issuing the companies more bank debts. Investors should always engage professionals to help ascertain the reasonableness of the reported asset value. Inherent Risks of Certain Industries in China The Wanfu example should give investors a good sense of the inherent risks of the agricultural industry in China. This industry undoubtedly possesses one of the highest potential for growth and development, but it also contains a lot of risks, especially because cash makes up most of the transactions (particularly with the individual farmers). It is not surprising at all to find that the distributors and suppliers in the entire value chain do not issue or accept fapiaos due to tax reasons. This is peculiar to agricultural companies, and it makes it especially challenging for foreign investors to verify sales of the target companies, much less to even implement internal control systems in them. In the near future, this industry will evolve and will become more structured and legally acceptable, but until then, foreign investors should be especially careful with investing in those industries in China that have a higher risk profile.

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Company’s Operations Must Make Sense Wanfu’s key operational metrics provided in the prospectus were very suspicious and the numbers did not seem reasonable. Investors should not rely on the service providers to identify these irregularities and ask the right questions. Rather, they should assume a more active role in understanding why the company is operating in a different way from other peer companies. Operational due diligence covered in the later sections will discuss in depth how to approach the due diligence from an operating perspective.

Lessons Learned To date, Wanfu’s case is still pending investigation, and this company could very well make history in becoming the first company on the Chinese stock exchange to be delisted. As stressed earlier, being a listed company does not automatically mean the company is free of risk. This example also sends a stern reminder that if this company, one that has reported more than 90 percent of fictitious profits, can pass the gatekeeping of the Chinese securities regulator, it probably could also pass the test of the overseas regulator who has little or limited understanding of Chinese businesses. In an ideal situation, a securities regulator improves its oversight significantly in the future and unscrupulous service providers are eventually weeded out, Chinese stocks would be deemed to be much less risky than they have been in the past. Until then, as foreign investors evaluating investment deals in China, listed company or not, investors can never really take their feet off the pedal in the due diligence process.

CONCLUSION In short, financial due diligence is the need to understand the accounting issues and the underlying profit and getting the assurance that the balance sheet is relatively clean and that profit and loss statements have not been overly manipulated outside the legal framework. Using the actual case studies to substantiate the possible different frauds and tricks that Chinese companies have pulled off in the past, investors should note that Chinese companies have slowly evolved and may already have devised a more sophisticated scheme to fool investors. Proportion check is a method that can be used to ensure the authenticity of accounting and financial figures, and it will be introduced in Chapter 6 to guide investors in early detection of accounting tricks and potential frauds.

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As mentioned from the beginning, financial due diligence cannot be carried out alone without the support of the operational, commercial, and legal due diligences. In the next chapter, investors will learn more about the intricacies in China when conducting the other due diligences in the compulsory and optional checklists.

NOTES 1. Juan Fu, “The Analysis of YGX Scandal,” Corporation Research, August 8, 2005: 254. 2. Desertification that resulted in environmental deterioration and land degradation was a serious environmental and socioeconomic problem in China and the rest of the world. It was mainly caused by excessive human activities (e.g., engineering construction of residential areas, oil fields, etc.) and natural factors (e.g., wind erosion). One way of combating desertification was to adopt reasonable land use, for example, reversing sandy desertified land for more effective farming or grassing. 3. Influence of the Convention to Combat Desertification on Forestry in China, FAO. 4. Supercritical carbon dioxide (ScCO2) is used as the extraction solvent for creation of essential oils and other herbal distillates. 5. Renamed from Baojie Ltd on December 31, 1997. 6. In the pharmaceutical industry, it acts as a wetting, stabilizing agent and a choline enrichment carrier, helps in emulsifications and encapsulation, and is a good dispersing agent. It can be used in the manufacture of intravenous fat infusions and for therapeutic use. 7. Cassia oil had many medicinal uses and was popular in aromatherapy. It was an ingredient in Tiger Balm, a soothing herbal balm. 8. Flavor and fragrance agents have a spicy odor and flavor. 9. Used in the treatment of fractures, rheumatism, arthritis, bruising, carbuncles, nausea, hangovers, travel and sea sickness, colds and flu, catarrh, congestion, coughs, sinusitis, sores on the skin, sore throat, diarrhea, colic, cramps, chills, and fever. 10. YGX Annual Reports, 1999–2000. 11. YGX Annual Report, 2000. 12. YGX was coined with the term “㊑͕⚠ଫ᷊⠱” (2000’s most bullish stock) by finance.ifeng.com 13. Asiaweek Magazine, 2000. 14. Beijing Ruijie Commerce Ltd, Beijing Jintong Commerce Ltd, Beijing Dongfeng Practical Technology Research Centre.

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Notes

15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31.

32. 33. 34. 35.

36. 37. 38. 39. 40.

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Ibid. Xindadi Prospectus. Daily Finance News, June 28, 2012. China Finance Net, July 16, 2012. Data from Capital IQ. Debbie Cai and Bob Tita, “Caterpillar Finds Accounting Misconduct at Chinese Unit,” Wall Street Journal, January 18, 2013. Data from Capital IQ. Russell Flannery (Forbes Shanghai Bureau Chief), “Caterpillar Takeover Would Create Fortune for ERA Shareholders” Forbes, November 13, 2011. James T. Areddy, “Caterpillar Unit in Scandal Has Unusual Roots,” Wall Street Journal, January 20, 2013. Data from Capital IQ. Hal Weitzman, “Caterpillar to Buy China Mining Machinery Group,” Financial Times, November 11, 2011. Coincidentally, IMM was also co-founded by Emory Williams. Ernest Scheyder, “Caterpillar Writes Off Most of China Deal after Fraud,” Reuters, January 19, 2013. Debbie Cai and Bob Tita “Caterpillar Finds Accounting Misconduct.” Xindadi’s prospectus. Company’s annual report 2010. An infamous accounting fraud by one of the largest telecommunications companies that involved capitalizing of operating expenses and artificially inflating assets. Will be elaborated in the next section: legal due diligence. 2011 Worldwide Corporate Tax Guide: China, Ernst and Young. Article 43. 40 years for business, tourism or recreational; 50 years for educational, scientific, technological, health, sports use or industrial use; 70 years for residential use. Taxation and Investment in China 2012, Deloitte and Touche. Xindadi’s prospectus. See Appendix A on the DDIC Companion Website for the C-Sox guidelines. Figures from Wanfu prospectus and “Notice on Disclosure of Material Issues of Wanfu Shengke Company,” March 1, 2013. Derived from Notice on Disclosure of Material Issues and Adjustments of Wanfu Shengke in October 2012.

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4

C HAPTER F O U R

Operational, Commercial, Legal, and Other Due Diligence

F

O L LO W I N G F R O M C H A P T E R 3 , this chapter will focus on the rest

of the components of due diligence in the compulsory checklists as well as the ones in the optional checklists. In China’s context, conducting financial due diligence without also physically verifying the company’s operations would be as good as digging your own grave. Not keeping in touch with the country’s commercial and legal developments could also result in huge write-downs in investments in the future. Other aspects of the business such as bankruptcy prediction, environmental issues, corporate cultures, and human resources are also important to the success of investments in China. Readers have to be reminded to seek professional help in leading the different types of due diligence mentioned in this chapter. The role of consultants cannot be bypassed because they have the experience and local knowledge to utilize different approaches, based on each unique situation, to achieve the best results. Having said that, after considering the different opinions of the professional consultants, investors are still required to form their own independent opinions and decide whether the risks are acceptable enough to proceed.

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Revisiting the compulsory checklists: 1. 2. 3. 4. 5. 6.

Financial Operational Commercial Legal and intellectual property Balanced scorecard Predicting bankruptcy—Altman Z scores

OPERATIONAL DUE DILIGENCE Operational due diligence is a very important process when examining Chinese companies and serves largely to: ■

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Ascertain production capabilities—revolving around the “Don’t tell me, show me” core tenet. Conduct reasonableness check with the financial numbers. Identify any obvious weaknesses in the operations that could affect future performance.

The purpose of this process is to prevent any big surprises after an acquisition or investment, and it is often crucial as an important gatekeeper to verify management’s claims and the financial numbers. It also gives investors a very clear idea of how the company works, which translates into a smoother transition and integration of operations in the case of trade buyers. Operational due diligence should be a much customized process catering to different industries, companies, company size, and geographic regions. Depending on the resources of the investor, this due diligence exercise could involve external consultants who are extremely experienced in that particular technical process flows. For trade investors, it is important to engage its operations manager to be very involved in this process. There are four important categories to consider when conducting operational due diligence in China and they can be summarized into four major aspects—Management and Employees, Information Technology Systems, Business Operations, and Supply Chain Management. (See Figure 4.1.) Besides assessing the current situation of each of the individual four components, investors always have to keep in mind to determine the future potential and underlying risks. This process is paramount in determining which aspects of the business require further work, especially in the process of laying out the 100-day plan.1

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Management and Employees

Supply Chain Management

MIBS

IT Systems

Business Operations

FIGURE 4.1

Illustration of MIBS

Management and Employees Operational due diligence is never complete without a good understanding of the management and employees driving the company. They are the ones essentially running the business and in charge of the day-to-day operations. Starting from the top management to the employees making the product, investors should attempt to appraise as many people as possible, based on the availability of resources for this due diligence exercise. Competency of the management team is measured not only by the historical track records of the company, but also by an assessment based on intangible aspects that can only be measured over time. These intangible aspects, including motivation of employees, management of the corporate culture, setting proper reporting lines, and so on, are very important gauges to determine the potential of the management to drive future growth and profitability of the company. Therefore, the process is a forward-looking one. Mapping Out Management Structure and Key Responsibilities During the data-collection process when interviewing the company’s senior management team, investors should always map out the key responsibilities

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of each of the senior managers and also learn how many employees he or she is managing. Doing so will provide useful information about whether these managers are overextended or underutilized. If a certain manager appears to be overly influential or in control of a very critical aspect of the business—for example, having relationships with most if not all of the sales customers—then the potential acquirer may want to look into mitigating risks and delegating that responsibility to other managers. In addition, mapping out management structure and responsibilities would also give a clue about whether the company is well managed and professional. It is in the Chinese culture to have businesses and corporations heavily centered around one key person, usually the founder. This can be likened to the king or emperor where the other senior managers do not have much autonomy when it comes to setting directions or goals and sometimes the founder even intentionally recruits people who are less resistant and easier to manage. There are substantial risks in this structure, and acquirers or investors may typically have to revamp the management team to improve overall governance and efficiency. The investor may also consider applying for key man insurance, a concept that is relatively unknown in China, for the founder. Making Sense of the Corporate Culture Organizational behavior and corporate culture are also important aspects of a Chinese company. Investors should not stop at interviewing current managers but also look up former managers who have departed the company recently. Fact finding from disgruntled employees is often very informative and insightful. These people would be able to provide a candid portrayal of the corporate culture and hidden risks within the management team. Labor disputes are common in China and it is a result of the general business climate in China. Chinese employees understand very well that labor laws and the government are still largely inadequate in protecting an individual’s rights when it comes to labor disputes. The labor situation in China is very different from developed countries’ in which cases of long overdue salary payments and dishonoring contracts are rampant. Employees do not have any avenue of seeking redress other than turning to the most rudimentary method of protest and demonstrations. These actions often attract media attention and cases would be publicly known, especially in the cities where the company is based. Investors should thoroughly understand the corporate culture of the company by poring through media reports or simply through conversations with the locals. High turnover rates, unmotivated employees, and poor public

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perception of the company are often strong signs of a company’s poor corporate culture. Competence of the Employees Competence of employees is of absolute importance to the company, and it definitely requires in-depth assessment. Investors have to ensure that the target company has a strong core team of employees, and the first and most basic step is to scrutinize the employees’ previous employment to determine whether they are fit. Next, investors could assess the average employee turnover, average training hours, and also watching employees at work. Employee competence is an integral component of the balanced scorecard (explained later), and the lack of it could indicate a weakness in the long-term growth and sustainability of the company. Also, the competence of the employees could also be affected by the leadership of the middle management, who pave the way for the learning and growth culture in the company.

Information Technology Systems It is no surprise that most Chinese companies lack strong IT systems to support their business processes. This is understandable because many Chinese entrepreneurs do not know or don’t have the exposure to such systems, nor do they understand the convenience that it could possibly bring to the corporation. Most Chinese entrepreneurs probably started their businesses with the most traditional bookkeeping using a pen and paper, but as the business scales and they find themselves increasingly busy, they realize they do not having the luxury of time to deal with the accounting and administrative side of the business. This could hamper the timely installation of IT systems like enterprise resource planning to help them with monitoring and strategizing the business going forward. For Chinese companies that do have IT systems, either partially or fully integrated, the onus is on the investor to uncover what the shortcomings and weaknesses of its implementation are. Having strong systems will provide more transparency, governance, and accountability for investors, hence the importance of due diligence on IT systems as part of the operational due diligence. Advisory services of the reputed accounting firms should be engaged to assist with this process. These institutions could lead the due diligence process and could also support the target companies in the post-investment implementation of IT systems. According to the Accounting Law of the People’s Republic of China, Regulation on Using Computerized Accounting System, the National Standard of Data Interface of Accounting Software, as well as the provincial

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and municipal level requirements of the accounting system, the use of software has to meet the following criteria:2 ■ ■

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Software should have a Chinese version. Chart of Accounts should conform to PRC accounting regulations and described in Chinese. Reports generated by the system should be capable of being printed in a standard format stipulated by the authority. For banks and insurers, the software should conform to China Banking Regulatory Commission and China Insurance Regulatory Commission regulations on Chart of Accounts printing format and information security. The system should be capable of exporting electronic data files in standard format stipulated in the National Standard of Data interface of Accounting Software. The computerized accounting system should register with the local financial bureau, which reviews the exported electronic data files and sample accounting documents to ensure compliance with relevant regulations.

Because there are just so many registered (many dormant) companies in China, it is virtually impossible to enforce the above requirements on every registered Chinese company. The regulations also differ from city to city, where lower-tiered cities may not have the budget, resources, or technical skills to ensure that this requirement is met for all companies. When conducting IT due diligence, either together with professional help or alone, investors should be focused around three phases, namely business requirement analysis, implementation analysis, and documentation analysis. (See Figure 4.2.) This process typically is conducted in tandem with the financial due diligence and conducted on site at the company’s headquarters for ease of communication with the staff. 1. Business requirement analysis The initial process would be an in-depth understanding of the company’s operations to identify mapping relationship between each

Business requirement analysis

FIGURE 4.2

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Implementation analysis

Documentation analysis

Three Phases of IT System Due Diligence

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of the business functions (procurement, processing, sales, for example). This would provide the investor with an understanding of the financial requirement of the company and which aspects of the business would require reporting and inputs into an IT system. 2. Implementation analysis The next step is to assess the effectiveness of the implementation of the systems. According to the financial inputs as identified in the previous process analysis, investors need to ensure that all pressure points are covered adequately and that the reporting of the different business functions, including procurement orders, sales orders, and inventory management, are effectively integrated into the information technology system. At this stage, investors need to have a good understanding of the software used, the sufficiency of the modules, and whether the computer systems in the company are updated enough to support the rigor and robustness of the software. Further, investors should conduct point-to-point testing of the software and ask the employees to demonstrate how they would typically use the software. Whether the company is actually using the systems effectively could also be evidenced from the competence of the employees using this software. Chinese companies typically only have the most basic functions and modules installed in their accounting software (sales orders and costs), whereas the rest of the inputs (inventory, assets, etc.) are still manually keyed into an Excel sheet separate from the data in the software. Investors need to table down the weaknesses and shortfalls during this due diligence process that require improvement postinvestment. Other components include the general security of the software; investors need to know who has access to this system besides the top management and finance team. 3. Documentation analysis The final step is the analysis on the output of the systems by reviewing the final product, the management reports produced by the system, and ascertain whether these reports are effectively communicated to management. If the management team does not rely on this software at all, it could mean that management installed the software only for the sake of managing investors and meeting regulatory requirements. This is dangerous because it might signify that the numbers provided to the investors may be cooked and that the accuracy of the financials is likely to be questionable.

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Business Operations This aspect of the operational due diligence process covers a large spectrum of issues and is probably the most crucial in China’s context. 1. Product development capability Measuring a company’s ability to constantly innovate and develop profit-making products into the market is not an easy feat. The importance of this process varies across industries: the ability of a fashion company like Septwolves to constantly design and produce trendy apparels is more crucial than a beverage company like Jiaduobao, which has already a highly successful, decades-old herbal tea drink. This process is best conducted with industry experts’ opinion to achieve better results, but investors have to understand that what a target company has done successfully in the past does not necessary mean that they will be as successful now or in the future. Nevertheless, looking at a company’s foundation and groundwork of product innovation would give clues about whether the company: ■ Possesses the infrastructure for product research and development. ■ Strives for a culture of continual product enhancement and innovation. ■ Keeps up to date with the developments among its competitors. The answers about whether the company is doing all three of these points could be picked up along the way, through interviewing the management team, observing the company’s operations, and reviewing the capital expenditure numbers specifically for research and development. Sometimes it could be as simple as observing what the founders and management team do for hobbies. A person’s passion about his or her own business can be very infectious, and likewise, a person’s lack of propensity to stay focus could be picked up from the corporate culture of the company, attitude of its management team, and distractions that the founders may have—for example, investments in assets that are not related to the core business. 2. Industrial capability As the name suggests, this aspect is only relevant for companies that have industrial activities. The effectiveness of the industrial capability of the company usually lies in the experience of the management team— whether they have had the experience managing an industrial plant before. Efficiency, employee safety, and environmental friendliness are the three key important aspects an investor should look for in a target company.

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a. Efficiency Efficiency can be measured by operational benchmarking against peer companies, especially those of the foreign companies that have attained high efficiency rates in their companies. Efficiency is largely affected by: ■ The equipment utilized for production ■ The factory layout ■ The training of the employees Investors should focus on asking questions about whether the equipment can support the sales of the plants. Chinese founders typically would estimate their factory’s production capacity based on unreasonable and overly optimistic estimates in order to make the company more marketable. For instance, the Chinese founder may claim that his or her factory has a certain production capacity based on 365 days and 24 hours operations. In other cases, the founder might make claims on production capacity based on a particular factory equipment, which is usually the most costly or most prominent, but conveniently omit the information about the bottleneck being at another less prominent process. Investors should definitely conduct their own due diligence on each of the processes in order to ascertain the actual production capacity of the plant. Factory layout is another important feature of the efficiency of the plant that investors cannot ignore. Chinese management oftentimes fails to plan ahead when it boils down to strategizing on the allocation of space for the production processes. As the plant scales, and in the interest of fulfi lling sales orders on time, Chinese management often choose the easy way out and place their new equipment in the first available empty space they find in the factory. This leads to a great reduction in plant efficiency. Last but not least, the significance of employee training is once again emphasized as a crucial component in achieving high efficiency. Investors have to understand how the company manages transfer of knowledge and training between the employees and how well the middle managers are managing the training of the employees. b. Employee safety Needless to say, employee safety has to be ensured at the target company. Chinese companies with records of poor employee safety can lose their business licenses overnight if the government

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or relevant regulatory agencies decide to make an example out of the company. That is why many Chinese companies in the past have taken great pains to hide employees’ accidents and mishaps that happened during work. In industries like mining, due to the extremely poor records of employee safety all across China, the State Administration of Work Safety (SAWS) was established to regulate the risk of occupational safety in China. For the mining industry, this meant that all coal mines in China had to adhere to strict regulations of employee safety. Many mines have been ordered to cease production after incidents of worker’s deaths or injuries as a result. c. Environmental friendliness Ensuring the plant is environmentally friendly is of utmost importance largely because of the consequences that an investor might face in the future if the regulatory agency has discovered discrepancies. This aspect of the operational due diligence is further elaborated in the environmental due diligence under the “Optional Checklist” section later. In a nutshell, in order to help investors better identify weaknesses and issues with the industrial operations of a target company, mapping out diagram workflows could prove very useful. After having a clear perspective and picture of the entire industrial operations, investors can then focus on the following: ■ Develop a comprehensive inventory of what could go wrong. ■ Build processes and protocols to mitigate the risks. ■ Develop systematic steps to reduce the risks. 3. Sales and marketing capability One of the key functions of a corporation is its ability to sell and market its products and services. Building on the traditional 4 P’s of marketing, namely product, price, place, and promotion, the fifth P, people, is identified as an equally important part of this exercise as well. (See Figure 4.3.) Below is a discussion on the important areas investors should be mindful of during the evaluation of the 5 P’s of a target company’s sales and marketing capability: i. People Measuring and identifying the strength and risks of people in the 5 Ps can be summarized by the following: ■ Qualifications and track record of the sales people. ■ Concentration of customer relationships. ■ Recruitment plan in the future.

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Promotion

Place

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People

Price

Product

FIGURE 4.3

The 5 P’s in the Producer-Oriented Model

Qualifications and sales track record of the sales personnel could indicate whether they have the aptitude to sell, although in certain cases that might not be entirely reliable. For example, a sales manager at Microsoft may not be suitable to lead a sales team of another smaller IT company with an unheard brand of products. Selling a lesser-known brand requires a very different skill set and tactic as compared to selling a well-known brand product. Although the sales executive might have an excellent track record at Microsoft, he or she may not be used to selling without the backing of a global brand and, as a result, may struggle at the new post. On the other hand, a sales executive from an established corporation may help a relatively younger brand and company formulate its customer service and strengthen the company’s after-sales service quality. Finally, it is the ability of the management team (or in this case, the sales vice president) to identify and effectively allocate its human resources in the roles that best exploit their talents. Concentration of customers’ relationships could be a risk that investors should target to understand. Typically, the Chinese founders are the company’s top sales person and have most of the customer’s relationships in their control. This could be a doubleedged sword. Chinese founders often use the customers’ relationships they possess as a bargaining chip during disagreements and disputes with their investors (typically financial investors such as private equity funds). Even when holding majority stakes in the target company, investors often have to give in to company founders as a result

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of their threats to take these customers away from the company. The result of this is a great deal of inefficiency in implementing measures and setting strategic directions for the invested company. Finally, the recruitment plan going forward is critical in measuring the company’s success in growing its business. Investors should place high emphasis on strategizing this going forward and aim to recruit the best sales people in the industry. This includes restructuring the compensation plan for the sales people and encouraging the founders and management to diversify customer relationship concentration risks. ii. Product Chinese management needs to be able to effectively articulate who their products and services are targeted at and why customers would continue buying in the future. They need to show a very good understanding of the consumer and why the company’s certain product mix would work in the near future. One can often tell whether the management team is close to the market and their customers by listening to their sales strategy in each geographic region. If the management team is unable to clearly explain the differences in customer habits in different locations, it could either be signaling that the sales people have a lot of control of the accounts or that sales could be cooked. After all, the best way to verify sales is really to witness the actual sentiments on the ground. If the company sells consumer products, investors have to actually visit the retailers or specialty stores to gauge the traffic flow and whether there are actual purchases being made. If the company provides a service, the best way is to interview the key clients to gather their feedback. In summary, the management team needs to have an in-depth understanding of the following matters with regard to their product or service: ■ Consumer habits and trends in different geographic regions ■ Attributes of the product or service that consumers are buying ■ Differentiation versus the competitors ■ Future strategy iii. Price Adopting an appropriate pricing strategy is extremely critical in China. Especially for the consumer industry, Chinese tend to be more price sensitive than they are loyal to brandings. If companies are positioned as high-end, premium producers, investors need to have a clear understanding of why the consumers are willing to pay a

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premium to the market price. Markets in China move so quickly that it is very unlikely that any companies, without a clear technological or brand advantage, can enjoy a premium for a prolonged period of time. Investors need to be wary of buying into companies in this category, and they will have to spend extra time understanding the market dynamics of that particular industry. iv. Place Investors have to understand the reason for the company’s choice of specific locations to carry out its sales and marketing. There are several ways to enter a market: controlling the sales customers remotely, licensing the product to local distributors, or setting up a sales office and hiring local sales personnel. Depending on the product demand and the stage of market development, investors have to ascertain the economic feasibility of the method chosen. In addition, it is always helpful to always turn and look at how the main competitors select the place and method of market entry. Their methods may not be the most appropriate, but there might always be things to learn and adopt. v. Promotion The company’s management team has to be clear on their choice of marketing: Where and when do they intend to carry out the marketing plan to achieve the best results? In the case of Chinese consumers, traditional marketing like TV and radio is still an effective way to reach out to the masses. The younger and more Internet-savvy generation is also growing rapidly and that could be another cheaper alternative of advertisement for the company. 4. Corporate strategic plans Formulation of a company’s strategic plans is an important exercise on which investors should be prepared to spend a good amount of time, with the company’s management. Similar to how the Chinese government set industry growth targets, Chinese management typically would start with a big growth target, say, 25 percent net profit growth, and expect their middle management to figure out among themselves what is required of the individual departments to attain this growth. In an ideal situation where the management is strong and there is ample communication between each department, this target might be attainable. Investors should also observe how this information is trickled down to the middle management and how each department coordinates with one another to work toward the common goal.

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On the other hand, and usually the case for many companies, middle management find themselves too caught up with the daily operations that they often neglect the interdepartment communication that is crucial for this task. As a result, targets are usually neglected and it may seem as though the company’s management did not have control over this process to begin with. At this juncture, investors should work with each of the individual departments to zoom into each of the department’s current resources and the future expansion plan to work out the feasibility of the targets. In essence, the investors have to convert the top-down approach as adopted in most Chinese firms to a bottom-up approach, which is more scientific and lays out very clearly what each department has to achieve. The bottom-up approach is also the fundamental method in which financial forecasts (financial model) are formulated. Through this process, investors would also gain a better understanding of how targets are set in the company and whether the targets are reasonable. See Figure 4.4 for the illustration of the top-down versus the bottomup approach. 5. Governmental relationships Governmental relationships in China are probably more important than they are in the West. With a good relationship with the government, companies could possibly have access to a number of benefits, including: ■ Government-bridged relationships with local banks—access to credit ■ Expedited administrative process ■ Access to governmental aid in sourcing for sales orders, grants, connection with other influential businessmen, and so on Although having strong governmental ties could be positive for the company, it could sometimes act as a double-edged sword. Investors need to be wary of companies that have relationships with government that are too close for comfort. Government officials have a strong incentive to promote their home-grown entrepreneurs so as to boost the local economy and employment, but investors should be worried if the company is doing special favors for the individual government officials in order to gain certain advantages over its competitors illegally. Especially in the current political climate, in which the Chinese Communist Party is taking a serious stand on clamping down on corruption at all levels (with particular focus on its government officials), the last thing investors would want in the future is to run into trouble with the central government. A delicate balance has to be reached between entrepreneurs and

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Top-Down Approach

FirmSpecific

Annual growth target: 25%

Bottom-up approach better substantiates growth, and follows the logic for financial modeling.

Typical Chinese management’s corporate strategy

Base case: 20% profit growth Bull case: 30% profit growth

T START

Allocation of growth:

Sales order increases:

Product A – 25% | Location A – 20% Product B – 25% | Location B – 20% Product C – 25% | Location C – 20%

Product A – 15% | Location A – 25% Product B – 35% | Location B – 15% Product C – 25% | Location C – 25%

Factors of Production:

Allocation to Factors of Production:

T START

Resources Production Capacity 25%↑ Production Line Workers 25%↑ Sales Personnel 25%↑

r FactorSpecific

FIGURE 4.4

Capacity for factors of production in a top-down approach is based on annual target rather than the actual capacity.

Preferred model investors should pursue

Resources Production Capacity 30%↑ Production Line Workers 20%↑ Sales Personnel 25%↑

Bottom-Up Approach

Top-Down Approach versus Bottom-Up Approach

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government, and it is required for investors to have a clear picture of that. The pitfalls of having too close a relationship with the government are discussed at lengths in the next chapter. 6. Integration issues In the event of a company merger or trade sales, the acquirer should have a very detailed understanding of the possible conflicts both companies (acquirer and acquired) might have during the course of integration. Differences in cultures, computer systems, reporting systems, management structures, and so forth should be listed as areas to be looked into. Acquirers need to also assess the overall integration resources required, such as costs, time, and manpower, so that a more informed decision could be made about whether the acquisition should be made.

Supply-Chain Management Investors often forget that supply-chain management contributes to the largest operation cost of the business, because it includes purchasing, inventory, warehousing, transportation, and information technology to effectively manage the complex supply-chain entity. Due diligence should be conducted on the supply-chain management independently as a vital component, although several aspects of it, for instance, the calculation of cash conversion cycle (average receivables days, average payable days and average inventory days), are already covered in the fi nancial due diligence. Supply-chain management impacts market position and differentiation, strategy implementation, and responsiveness to market changes. Investors have to look beyond just checking supplier’s invoices, goods transportation contracts, and warehouse operations. It should be a holistic evaluation targeted to understand areas of risk and opportunity for improvement to help support the deal hypothesis. Below are the eight different aspects of the supply-chain management due diligence that should be included: 1. 2. 3. 4. 5. 6. 7. 8.

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Sourcing Procurement Inventory analysis Quality Customer service Logistics Outsourcing Identification of risks and forecasting accuracy

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1. Sourcing The first step is to evaluate a company’s sourcing process. A business would not be sustainable without an effective ability to source for raw materials, components, and subassemblies. It is critical to ensure that the target company has a robust sourcing process, with sufficient resources allocated to support internal operations. Chinese companies that are more established typically are sometimes too contented with the status quo, and they do not allocate enough resources (largely manpower) to actively seek additional suppliers. Investors would then have to table down this risk and ensure that the company does not rely heavily on only a few large suppliers. If the company has an established sourcing team available, investors would then have to understand the competence of the team. Questions should be centered on how the team identifies suppliers and assesses the potential vendors. The sourcing team should also be visiting the suppliers’ plant regularly in order to keep tabs and be watchful of any red flags that the physical operations might give. Last but not least, the sourcing team needs to have the ability to work and source out of their comfort zone in different provinces and cities. 2. Procurement As mentioned in the previous chapter under financial due diligence, procurement falls under the big umbrella of company’s internal control. In this process stage, investors need to be wary of any signs of corrupt practices and kickbacks that procurement officers may possibly receive. At this stage of the due diligence, procurement from suppliers related to the company’s management or employees should be identified and scrutinized. Related-party transactions are strongly discouraged and investors should try to mitigate this risk and seek an alternative arrangement that would make transactions more transparent. Ensuring that the target company has a strong procurement system is one of the most important aspects of the supply management due diligence exercise. Investors should understand and seek to witness for themselves how procurement officers operate, especially on matters like price setting, proposal process, and relationship with the suppliers’ sales team. Target companies should have strong internal control systems in place to reduce the internal control risks; one way would be to make sure of a rigorous and highly customized accounting information system software that links with the other aspects of the business.

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3. Inventory management analysis Effectiveness of inventory management determines how much money is tied up as goods sitting in the inventory warehouse. This also includes in-transit inventories, especially when dealing with international sourcing and procurement. Inventory management is very seldom incorporated into the information technology systems in Chinese companies; therefore, Chinese management typically has very little oversight on that. As long as there is still space in the warehouse, management would seldom focus on inventory as a possible area for improvement. 4. Quality control Quality control is critical to every business. It has to be implemented at every stage of the supply chain, beginning from the procurement process. The target company needs to understand the impact of quality, have know-how to measure the effectiveness of the quality control, and also understand how to improve upon it in the future. Ensuring that systems are in place would avoid disastrous interruption to operations and irreparable damage to branding. Many Chinese companies have quality-control departments only for the sake of meeting regulatory requirements. Employees of that department are often taken from different departments and do not actually function as dedicated quality-control personnel. Investors have to ensure that the target company is serious about quality control and has sufficient resources allocated to it. 5. Customer service The quality of the target company’s after-sales customer service can be a differentiating factor from the target company’s peer companies. By providing reliable and responsible post-sales actions the company could easily gain consumers’ respect and thereby increase overall market share. Besides after-sales services, companies ought to have an internal system that tracks whether sales deliveries are made in a timely manner to the customers, whether multiple shipments are made for each customer order, and whether there are lost sales resulting from stock outs. The customer-service function should be evaluated both internally and externally: The company should have internal systems to track the goods delivery and external complaints and feedback from the customers should be treated very seriously. As for internal control systems, investors

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typically would be required to set up a tracking system to actively evaluate the sales delivery made to the sales customers. 6. Logistics China is a very competitive marketplace in which a robust logistics strategy and process can create unique competitive advantages. This could range from integrating a just-in-time delivery system with a third-party logistics partner to investing in an independent fleet of transport vehicles, if it made economic sense. Investors have to understand the balance between risks and costs in evaluating the choice of logistic options for a particular company. 7. Outsourcing If the company is using outsourcing companies to produce or provide products and services, it is required of the investors to analyze how these providers perform, overall and individually. This includes physical visits to the outsourcing companies to ensure that such outsourcing arrangements are authentic and that investors could physically see the company’s product in production. 8. Identification of risks and forecasting accuracy People, process, and technology are the three key components of supply-chain management. Weaknesses of the three components in each and every stage of the supply chain must be identified and reduced to give investors clarity about areas in which there are inefficiencies and areas of improvement for post-investment work. For each of the risks, investors have to seek the reasons for the shortfalls and determine whether it is a systemic risk (caused by the management) or something that could be easily corrected. Outsourcing of certain production and services could result in increased lead times for replenishing inventory and meeting sales orders deadlines. Additional lead time makes forecasting accuracy more challenging and increases the possibility of failing to send products on time. For products with short life cycles, the impact is enlarged because it may even lead to increased cost inefficiencies. Investors must identify factors that may decrease the forecasting accuracy of the supply chain and plan the corresponding mitigation steps going forward. Below is an excerpt of an operational due diligence report that was produced after a site visit at a target manufacturing company.

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CASE STUDY 4.1: FINDINGS OF ABC BATTERY MANUFACTURING COMPANY3

A

BC battery production processes consisted of a total of 10 steps, spreading across three floors and eight different working departments. The processes included the mixing of raw materials, to coating, laminating, drying, and packaging. The management claimed that the plant is running at a production capacity of 500,000 watts per day and will ramp up to 800,000 watts per day with the addition of a new production line. After the site visit today, three key production processes have been identified to be crucial to the entire manufacturing process. Three key battery production processes: 1. Spread Coating Machines ■

■ ■

■

Most complicated process that requires the longest time to install and calibrate. Most expensive machines, costing more than 5 million yuan per line. According to the department manager, each of the lines (total of six lines) processes about 5,000 watts per hour, and with two shifts of 8 hours, the department operates 16 hours a day and approximately 285 days a year. That equates to approximately 480,000 watts per day and 136.8 million watts per year. At the time of visit, one of the lines was down but was left idle with no troubleshooting or repairs being done, according to the department manager. The problem was being investigated and would usually take a few hours to get it back online. Check and determine the company’s repair capability.

2. Pressing Roll Machine ■

■

■

■

■

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Less complex machines (two sets) but both machines have been running for seven years with no parts replacement and minimal maintenance or repair. The company recently purchased a new pressing roll machine, but due to limited space on the department floor, the machine has been placed on the ground floor. Each of the old machines is running at 10,000 watts per hour, and the new machine can operate up to 18,000 watts per hour. This translates into about 608,000 watts per day and 173.8 million watts per year. According to the manager, the company is using a foreign brand of machines that are more durable than the local brands. Check on the brand of machines and determine the typical lifespan of the machine.

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3. Cutting Machine ■ ■

■

■

■

■

Current bottleneck of the entire production process. Four sets of the newly ordered machines are faulty and have been returned to the supplier. The current six sets of machines only can support up to 250,000 watts per day, considering 16 hours of production time. Department manager claimed that this department was running 24/7 to support the overall capacity—if true, it would only support up to 375,000 watts per day of production capacity. Hence, the plant is essentially running at approximately 375,000 watts per day, or just over 100 million watts per year of capacity. Consider the increase in depreciation of the current six sets of equipment and possible increase in down time for maintenance and repair of the cutting machines. Check if this department is really running 24/7. Workers’ productivity is usually very low at midnight.

Plant Observations ■

■

■

■

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Plant is only running at 75 percent or less of the claimed production capacity, due to bottleneck found in the cutting-process department. Reorganization of the process flow required: Due to a late expansion, the new set of pressing roll machine had to be placed on the ground floor instead of the third floor where the other machines are. This resulted in a break in continuity of the manufacturing process. Workers have to carry the half-finished goods down two floors and carry back up again after the pressing process is done. Hence, there is a great decline in productivity and efficiency. Expansion plans: After probing into the details of the expansion plans it was found that the new production line that management was going to add was only the spread coating machines. In actual fact, the company would need to invest another 15 million yuan of capital expenditure to bring up the capacity of the cutting and press rolling machines to match the increase in production capacity for the spread coating machines. Scalability of this production plant: The plant ’s floor space seemed to be fully occupied and has very limited expansion room. According to management, they will be expanding the factory space at another location. Scalability of the plant is limited and site visit to the new plant is required.

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CASE STUDY 4.2: FOLLOW-UP OF ANALYSIS OF THE OPERATIONAL DUE DILIGENCE OF YIN GUANG XIA Production Capability After verifying the customers and suppliers, it would be crucial to also understand the business operations of the target company; whether its production capability could realistically support the amount of goods that it claims it produces. Therefore, it is important to also obtain a professional or industry perspective on the production capability of a company, especially if the production process is technologically intensive and not easily understood. According to YGX’s disclosure of the contract signed on January 19, 2000, the US$200 million worth of exports to Fidelity includes at least 100 tons of yolk lecithin, 160 tons of ginger essential oil, and so on. Similarly, the 1999 contract of US$30 million already includes 50 tons of yolk lecithin and 80 tons of ginger essential oil. However, according to an expert ’s view on the ScCO2 extraction technology, it is highly improbable that three sets of 500 liters ScCO2 assembly lines could have an annual production of more than 20 to 30 tons of egg yolk lecithin, even if it was operating 24 hours per day, 7 days a week, 365 days a year. These murmurings, although not officially sanctioned, created a cloud of suspicion over YGX’s operations. In order to defend against these allegations, CEO Li Youqiang held a press conference, in March 2001, telling reporters that YGX managed to obtain special technology that increased the speed of the extraction process. With reference to extraction of egg yolk powder, he mentioned that YGX’s facilities could shorten the extraction time from 10 hours to only 3 hours, and recently were able to shorten the process to just 30 minutes. With the implementation of new observational systems, they would further be able to reduce the time taken for the extraction process to complete it by a few more minutes. Furthermore, the efficiency of the extraction process also increased, being able to obtain more than 97 percent concentration of yolk lecithin from the raw material instead of the traditional concentration rate of 35 percent. Added to this was a fourgroup rotational shift, which meant production was going on 24/7. When questioned about the source of this technology, Li replied with a story. He claims he was drinking with a German engineer, who then got drunk and gave away to Li a set of top-secret blueprints he was carrying at that time for improving the efficiency of ScCO2 technology. When Li integrated that technology into the existing production lines, the result shocked even the Germans, and the German engineer was subsequently fired.

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Reporters tried to verify the story with industry experts, and approached Professor Yang Jichu from Tsinghua University, from the chemical engineering faculty. Professor Yang is one of the foremost researchers in the ScCO2 extraction technology and has been working with both industry and academic professionals on the technology for more than 20 years. She is also heralded as the “living dictionary” on the subject by fellow academics. She responded derisively to YGX’s claims, stating that the advanced technology that Li claims does not exist and the blueprint that Li was referring to was simply a basic explanation sheet of ScCO2 technology. Even with the purchase of another three sets of 3,500-liter assembly lines, it is still highly unlikely that production capability could match up to the amount of products claimed to be sold to Fidelity. According to reports by YGX, the main purpose of the new assembly lines would be for extraction of tea leaves, producing 157.5 tons of natural caffeine, 24 tons of tea-polyphenols, 9,000 tons of decaffeinated tea, and so on. This would first require more than 27,000 tons of tea leaves, and separate calculations from Dr. Yang and Dr. Xu Anping from Beijing University of Technology showed that even if production was to take place 24/7, only 6,000 to 7,000 tons of tea leaves could be processed.

Production and Utilities Bills An aspect that one could always check to gauge the production of a factory is the utilities bill. It may be possible to fabricate receipts and invoices of goods purchased or sold, but it is much harder to fake the utilities bill, especially for a continuous period of time. If the factory claims to be in production every day, one could ask for the electricity bill for the past three years. Should there be huge discrepancies between months, or large differences compared to other factories undergoing a similar production process, one could certainly feel that something may not be as it seems. In YGX’s case, taking a look at the electricity bill should send off many warning signals. The extraction process typically requires extremely high pressure, which should put a huge demand on electricity. Yet the electricity bill for the company in 1999 was relatively low. After the new contract was obtained in 2000, the electricity bill instead of increasing actually decreased from 1999 to 2000. Evidently something is wrong here that should certainly be questioned further. Similarly, since YGX is engaging in massive contracts with a German counterparty, the phone bill should reflect that accordingly. These are just a few aspects that investors could think about investigating in order to ascertain the company’s claims with regard to production. A simple brainstorming session could easily yield many different things that could be checked on. (Continued )

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(Continued )

Existence of Facilities According to interviews conducted by Caijing with academics, including Dr. Yang and Dr. Xu, some products that YGX claims to sell to Fidelity cannot be extracted via ScCO2 technology. One of the main limitations of ScCO2 technology is that only products that are liposoluble (also known as nonpolar) can effectively undergo the extraction process, and they usually have to be combined with other technologies in order to obtain a more concentrated product. YGX claims that their production facilities are able to increase the purity of the final product from a typical 35 percent to up to 97 percent. However, experts claim that it is highly unlikely that the product could attain a purity of more than 30 percent with ScCO2 technology alone. A large amount of ethanol postprocessing is also required for further separation of the concentrate, and it is believed that YGX lacks these production facilities. The contract between YGX and Fidelity also includes items such as tea extracts, products that are hydrosoluble (or polar), which cannot be extracted via ScCO2 technology. Other products such as gingko bibola extracts, Puerarin, and others are also extremely difficult to extract with YGX’s production facilities. In 1997, the Nanyang City (Henan Province) government invested about 20 million yuan into extraction of gingko extracts, and converted thousands of hectares of land to gingko plantations, but the project was a failure.

Product Price and Competitors Another question to ask is: “How are YGX’s competitors doing?” Admittedly, the herbal extraction industry is typically technology intensive, but YGX disclosed that the extraction equipment and technology was purchased from ThyssenKrupp Uhde, and records show that there were two other companies who also purchased the ScCO2 assembly lines. YGX purchased three 500-liter assembly lines in 1999, whereas Xi’an Jiade Co purchased two 500-liter assembly lines. Another company, Guangzhou Southern Flour Co., purchased a smaller 250-liter assembly line in 1995. However, Jiade Co had tremendous difficulty in attaining profitable operations. In fact, Zhang Jishen, the Jiangsu DRC vice-chairman mentioned to reporters in July 2000 that the ScCO2 assembly lines in Xi’an Jiade were idle. The price at which Fidelity purchased the products from YGX was also very much higher than the average market price. For instance, YGX’s price for ginger essential oil was approximately 2,800–3,600 yuan per kg, whereas on November 17, 2000, the market price (CIF London 4) was

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approximately US$100 (~827 yuan) per kg. Xi’an Jiade Co’s research also showed that the international price at that time was only about 600–800 per kg, whereas Beijing Xinlong Biology and Technology Co., the first company in China to utilize ScCO2 extraction technology, was only able to set the price at a maximum of 1,000–1,200 yuan per kg for small batches of the product. See Appendix B on the DDIC Companion Website for a list of prices that Fidelity agreed to purchase the products.

COMMERCIAL DUE DILIGENCE Financial, operational, and legal due diligence focuses on verifying and explaining the target company’s past performance, whereas commercial due diligence focuses particularly on the estimation of the company’s future performance. Commercial due diligence is an exercise that stretches from pure market research at one end to high-level strategy consulting at the other. Conducting a macro due diligence in this case might be more applicable to financial investors rather than strategic investors. Before targeting a company to invest, strategic investors like multinational companies should already have a clear picture of the macro landscape in which the target company is operating, and as a result may skip this process all together. This section, however, could still be extremely important for a non-financial investor, acting as a supplementary exercise ensuring that all the boxes are checked and no stones are left unturned. The Kraft-Cadbury split after barely 18 months of its merger was an example of the miscalculated implications of the macro conditions that preceded it, forcing management to split the fast-growing global snack business from the North American grocery business, which was slowing the former down. There are many frameworks and tools that can be used to guide the commercial due diligence process. Two frameworks—industry outlook and PEST analysis—will be outlined to provide readers with a brief introduction on their application to the commercial due diligence process.

Industry Outlook An analysis into the current state of the industry and its outlook will provide a macro overview of the industry dynamics and trends that may affect the company. There are four main components that could be analyzed (see Figure 4.5). First, the economic cycle and environment must be assessed to determine if it is conducive for the company operations. Different industries have

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Industry Outlook Economic Cycle

Is the economic environment favorable for the company?

Valuation

Are valuations attractive in the market?

Size and Growth w

Is the market set to grow in the future?

Drivers

FIGURE 4.5

What are the drivers in the market?

Four Main Components for Analysis

peaked at different economic cycles and sometimes investing in a company that is at the wrong end of the economic cycle will have disastrous consequences. Second, the valuation of the company should be compared against the industry average. This is typically measured in various fi nancial ratios such as the price-earnings multiples, book value per share, and many others. Knowing the valuation comparison allows the dealmakers to determine whether they are under- or overpaying for the particular company. Third, an industry analysis will have to consider the potential size and growth of the industry in the future and what effects those will have on the company. An industry that is growing will provide opportunities for the company to grow. That said, a company would still need to get its implementation strategy planned and executed well in order to reap economic benefits. Last, an analysis into the growth drivers for the market will provide a deeper understanding of the trends affecting the industry and how the company should best position itself to take advantage of these drivers.

PEST Analysis The PEST (Political, Economic, Social, and Technological) model is a basic model that investors can use to identify the various forces that can affect a business. There are four main forces: political, economic, social, and technological forces (see Figure 4.6). Political forces refer to the pressures and opportunities brought by changes of the government and public attitudes toward the industry; changes in political

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Political Forces

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169

Economic Forces

Business

Social Forces

FIGURE 4.6

Technological Forces

PEST Model

institutions; and the direction of political processes, legal issues, and the overall regulatory climate. Economic forces refer to a society’s economic structures and such variables as the stock exchange, interest and inflation rates, the nation’s economic policies and performance, exchange rates, and so on. These variables affect different industries differently. Social refers to cultural attitudes, ethical beliefs, shared values, level of differentiation in lifestyle, demographics, education levels, and so on. Observing social factors helps organizations maintain their reputation among stakeholders. Technological refers to changes in technology that can alter the fi rm’s competitive position. Industries merge, new strategic groups emerge, current products improve, and the cost of production gets reduced by process innovation. Managerial innovation is part of the technology scan.

LEGAL DUE DILIGENCE Legal due diligence forms the core of the entire due diligence program and many of the specific legal issues are already covered in the previous sections. The objectives of this chapter are to help investors set the correct attitude before the exercise, and to highlight the common pitfalls during the due diligence of the different aspects of the business.

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FIGURE 4.7 Without the Proper Understanding, Lengthy Legal Due Diligence Reports Can Be Meaningless Source: Illustration by Kenny Ng.

As explained in the fi nancial due diligence section, it is doubly important that the legal due diligence process is fully integrated with the other due diligence processes, and focus is placed on the commercial implications of the findings. This is to say that it is imperative that the legal advisors should work closely with the other due diligence professionals to ensure all bases are covered. All in all, investors should never underestimate this process and the underlying risks behind each issue brought up by the lawyers. It is a rigorous process and investors should never take their feet off the pedal and let the lawyers “auto-pilot.” (See Figure 4.7.)

Setting the Right Attitude and Mentality Legal due diligence can be a daunting task in China especially when information is not readily available and the culture itself is one that shields outsiders—in this case, the investors—from the inner circle of “trust.” Unraveling the truths and the past of the Chinese founders and management requires reading between the lines and piecing many clues together. This process requires investors to tune in to the correct attitude and mentality—more importantly, the four golden rules as stated next—in order to be more effective in identifying all the risks pertaining to a particular investment opportunity.

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Get Local Experts—Selecting the Advisors and Ensuring Independence Legal due diligence process in China is one that requires interaction with many different groups of people, including the company’s stakeholders, competitors, and especially the local government officials. China, unlike the West, does not have centralized public information about the registered companies and this could only be obtained at the provincial level. This is really a process about knowing whom to ask and asking the right questions, which naturally would require local expertise and understanding of the culture and language. Thus, it is necessary to hire reputable local lawyers to assist the investor in the legal due diligence process. Especially for large transactions, some investors would even hire more than one local legal adviser to gain a second or third opinion on certain legality issues of the target company. At the same time, foreign lawyers are engaged to advise on the legal risks pertaining to cross-border transactions and consolidation—or even for future exits from a foreign exchange. After lining up the team of legal advisers, the next step would be managing them. Before arranging weekly calls with these parties, investors have to ensure that each party practices independence in their analysis. Putting the teams together in a group is great to discuss important issues, but that may lead to free riders and losing the independence of opinion among several parties. Encourage intellectual honesty between the law firms by controlling this process diligently. Send individual due diligence packs to each firm and request that individuals draft legal reports before convening a group meeting or conference call. Investors should also compare legal reports and interact extensively with the associates in each firm, which should provide a good picture of the working dynamics between the law firms. Do Not Take Paper Evidence and Claims at Face Value—Substance over Form Covered in the financial due diligence described earlier, paper evidence and claims gathered from the interview with the management team offer insight about what could go wrong in a Chinese company—but complete reliance on those two things would have disastrous effects. Documents like bank statements, company stamps, and sometimes even fapiao might be forged. At certain times, the forged documents might also slip past the most careful eyes simply because there are just so many ways to produce them. The safest and most assuring way is still to have a look at the physical operations itself. Always verify what is written on the documents and which

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numbers were keyed in for the financials. Although not entirely foolproof, seeing the actual operations and the physical objects could give the investor a better sense and estimation of the size of the business, the actual demand from the end consumers, and the manufacturing capacity of the company. Investors often have to question things that seem too good to be true, or even think creatively out of the box about what the entrepreneur may do to create a fraud scenario. Always carry a skeptical mind when interviewing with the management and reviewing the numbers even before physically seeing it. Speak to as Many Stakeholders as Possible—Gather as Many Opinions as Possible Always invest the time and resources to speak to people and organizations that revolve around the target company. That includes stakeholders such as employees, ex-employees, media, regulators, and those in the value chain, including suppliers, contract manufacturers, customers, and even the competitors. To check on the validity of certain contracts, lawyers or even the investors themselves could interview the counterparty and “test” to see if they actually know the terms of the contract. Further, competitors could provide intimate information about the target company, for example, whether they know that the target company is fraudulent or shadowy. Investors have to strategize the approach to the competitors; it is always better to speak to them from the perspective of a potential customer. Avoid Delegation of Work—Form Your Own Opinion The importance of using a range of third-party advisers and not relying on a single one was already discussed. Investors have to take ownership of the due diligence process and manage the lawyers during the entire process. Objectivity of business subordinates and outsiders might be lost in the process of interaction with the target companies, and some may have reason to conspire with the fraudulent companies. To solely rely on the final legal report from the lawyers would be risky, and investors also have to ensure that these third-party vendors do not subcontract their task to smaller vendors to save on costs and resources.

Uncovering Potential Liabilities An acquisition or investment into a company differs greatly from that of an asset sale. In an asset sale, the buyers only take over the assets, and they are not responsible for the liabilities of the company. Needless to say, buying into a company as a legal entity normally comes with liabilities as well as assets.

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In layman terms, the buyer would continue to be responsible for the current, future, and the contingent liabilities of the company. Some liabilities can be quantified, recorded, and provided for (provisions) in the financial statements. Others will not. The main task for investors is to make as certain as possible that there are no sizable unforeseen liabilities lurking in the background. These liabilities would mean that the buyer would have paid more than he or she should have, or in worse cases, the buyer can potentially go bankrupt. ■

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Company’s and management’s history Conducting a background check on the management team in China is often challenging because personal information is not as readily available and transparent as it is in the West. Ex-colleagues, ex-employers, and other people whom management has worked with are also unlikely to open up to give their honest feedback on the management team. This is the reason why many foreign firms hire private investigators to help the investors discreetly dig out a person’s past. Investors should never overlook the importance of the management team’s and the company’s past history. The last thing investors would want is to be associated with a management team that used to be ex-mafia or gang members, or to be invested in a company that used to be involved in prostitution or other illegal business activities. Such liabilities are beyond quantifiable amounts and usually would leave a nasty stain on the investor’s reputation if the due diligence work is not done sufficiently. The intricacies of the background check on management will be covered in the next chapter. Company’s litigations Another source of potential liabilities is litigation. One of the main tasks of the lawyers is to report on any litigation and disputes affecting the target company. Investors have to urge the lawyers to look beyond the existing claims and identify potential disputes and litigation that the company may encounter in the future. Another element of it is gauging the chances of success and failures and the likely costs incurred. The safest bet for investors is to request the target companies to, as much as possible, settle all existing and potential litigation liabilities before making the investment. Company’s shareholders and structure It is strongly advised that investors look into the company’s shareholders and understand their background and intentions, especially the

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significant shareholders, of holding a stake in the company. In the case of a messy shareholding structure consisting of one too many shareholders, investors also have to decide whether to have the minority shareholders bought out for the purpose of having a cleaner shareholding structure. Having too many shareholders could be an issue in the future, especially when they could potentially thwart a future exit of investments. Company legal structures Risks pertaining to legal structures could potentially be fatal to the buyer, especially when a locally registered company is transferred to a foreign structure. Due to the complexity and the legal hurdles to overcome for the transfer process for local companies to become owned by foreign entities, some foreign companies choose instead to enter into a series of contracts with the local proxies to have effective control over the local companies. Although this might be a quick and cheap method to “buy” over local entities, it is noteworthy for investors to know that such contracts are not recognized and enforceable under China’s laws. When dealing with industries that are permitted for foreign investment, the safest method would be to transfer local assets into the Wholly Foreign Owned Entity (WFOE). The shortcoming of this method is that the foreign entity would still not be able to own and benefit from several intangibles, such as the brand and trademark if it were considered a “well-known brand and trademark” by the Chinese government. This means that, from a legal perspective, the local founders and owners would still be the rightful owners of the rights and benefits of the company’s brand. For industries that are deemed to be prohibited or restricted for foreign investments, the variable interest entity (VIE) structure is the most popular legal structure that has been utilized by most foreign investors. The VIE has always been a gray area in Chinese laws where many information technology firms such as Tencent, Alibaba, and Sina have utilized its foreign listing. Although the central government has never openly expressed its opinion of this structure, investors’ confidence has been badly shaken by the Alibaba and Yahoo! incident, where Alibaba’s CEO has decided to carve out a very significant portion of the company’s operations without seeking approval from its shareholders (Yahoo! was a major shareholder). Even though this case has been resolved amicably by Alibaba compensating Yahoo! for its losses as a

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result of the significant changes to Alibaba, many investors see this as precedence for future incidents of such rogue behavior by Chinese management.

Intellectual Property Protection (IP) Intellectual property (IP) is a highly specialized legal area. Engaging a good and experienced IP attorney is crucial and most important for handling IP matters in China. There are basically no magic formulas or shortcuts to perform due diligence on IP issues, but the attorney must check the past records on IP registrations and filings and identify potential risks and red flags if the acquisition deal is to move forward.

Management of Company Stamps With myriad paper documents and statements in the Chinese business environment, it comes as no surprise that company stamps are also forged and used to endorse various false documents. There have been numerous instances where employees who were not authorized to use the stamps had abused them by engaging in business partnerships or stamping transactions to commit fraud or theft. As such, investors must exercise extra scrutiny in verifying the validity of company stamps and not take the authenticity of the stamps for granted. It must be noted that there are several types of stamps used in the Chinese business world. At the top of the authority chain is, of course, the official company stamp. The stamp carries the full official name of the company and should be registered with the Public Security Bureau (PSB) at least at the county level. It is important to note, however, that it is not mandatory for the stamps to be registered. The stamp is used in signing all important documents, representing that the company recognizes and endorses whatever was written on the documents; in other words, the presence of the stamp legally binds the company to whatever terms the documents or contracts stipulate. Other company stamps play more functional roles; these include contract stamps, fi nance stamps, human resource stamps, and invoice stamps, among others. Of this group, the fi nancial stamp is perhaps the most important; the stamp is used for fi nancial transactions both internally (such as issuing checks) and externally (opening of new accounts, cash withdrawals, or change of the company’s account information) with banks. Generally, the official company stamp can be used in place of all the other functional stamps, except the fi nance stamp.

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One of the most direct and commonly used methods of verifying company stamps is to check with the Public Security Bureau of the city/county where the company is incorporated to see if the stamp is officially and properly registered. If it is, the next step that investors should take would be to check that the same stamp is used on all the documents, including the records at the authorities’ end. If the stamp is not registered, one can compare the stamps used by the company in official documents. Upon completing these items, investors can even go one step further by visiting the company, and speaking with the management to find out exactly which people in the company are authorized to hold and use which stamps, and then again tally with the existing documents that have been endorsed by the stamps. (See Figure 4.8.)

FIGURE 4.8

One Stamp to Rule Them All . . .

Source: Illustration by Kenny Ng.

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CASE STUDY 4.3: CHINACAST EDUCATION CORP

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hinaCast Education was using a variable interest entity (VIE) as its corporate structure. The VIE is a structure commonly used to avoid Chinese restrictions on foreign investment. ChinaCast ’s shareholders invested in a U.S. company that has contractual arrangements with a Chinese company. But the Chinese company remains in the ownership of Chinese citizens.5 VIEs control a company through contracts instead of through share ownership, a structure that offers little of the protections that share ownership would confer. ChinaCast has two offices in Beijing and Shanghai and three campuses. ChinaCast has alleged that the key executives led by Ron Chan in the Shanghai office have refused to provide the necessary financial information to allow the ChinaCast ’s auditor, Deloitte, to complete their work to enable the issuance of its 2011 audited financial statements within the time periods required by the SEC. In addition, the management in the Shanghai office had not paid for the services of the auditor, advisors, and service providers. ChinaCast’s board of directors replaced Ron Chan, chairman and CEO, with Derek Feng and replaced Tony Sena, CFO, with Doug Woodrum. As part of the transition plans, ChinaCast sought the return of the company stamps, business licenses, and financial stamps of the company’s Chinese subsidiaries relating to its e-learning and training-services business and one of its universities, all of which items the company believes are in Mr. Chan’s possession or in the possession of persons under his direction. Under PRC law, the company stamps, financial stamps, and business licenses are necessary for these Chinese subsidiaries to enter into contracts, conduct banking business, and take official corporate action, including registering the change in management with the relevant authorities in China.6 On April 2, 2012, in an open letter from ChinaCast’s board of directors to shareholders, the company had alleged that “Ron Chan and a few other executives have chosen to unlawfully resist their terminations by refusing to return key company property, including corporate chops necessary to run the business in China.”7 In response, Ron Chan claimed that the allegations were untrue and that he “retained no company property” and did not interfere with the filings.8 In addition, Ron Chan alleged that the newly elected board of directors, including Ned Sherwood and other executives, had “acted to promote their own interest at the expense of the company and its other (Continued )

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(Continued ) shareholders.” Mr. Sherwood had also instructed management to disregard instructions from the executives and to take instruction, instead, from the board of directors instead. Among the company’s largest shareholders are two American investors, Fir Tree Partners and Ned L. Sherwood.9

About ChinaCast Education Corp The company was established in 1999 as ChinaCast Communications Limited (CCL) and subsequently raised a series A venture capital round, which included investors Hughes Network Systems and Intel Capital. In May 2004, the company was renamed ChinaCast Communications Holdings Limited (CCH) and made an initial public offering on the Singapore Stock Exchange. On December 22, 2006, Great Wall Acquisition Corporation, a U.S.-listed (stock symbol OTC:GWAQ) Special Purpose Acquisition Company, completed the 100 percent acquisition via tender offer of CCH in a reverse merger transaction. Great Wall Acquisition Corporation was then renamed ChinaCast Education Corporation in early 2007 (stock symbol OTC:CEUC) and then listed on the NASDAQ Global Market Exchange (stock symbol NASDAQ:CAST) on October 29, 2007. In April 2008, the company completed the acquisition of 80 percent of the holding company of the Foreign Trade and Business College of Chongqing Normal University. The company provides its e-learning services to post-secondary institutions, K–12 schools, government agencies, and corporate enterprises via its nationwide satellite broadband network. The company listed on the NASDAQ Global Market Exchange with the ticker symbol CAST on October 29, 2007.

BALANCED SCORECARD (BSC) The business balanced scorecard (BSC) has been launched in many businesses as a strategy performance tool to track the performance of a particular company in a variety of key performance indicators, and also to identify key areas for rework and improvement. It was designed especially to provide executives with a comprehensive framework translating a company’s strategic objectives into a coherent set of performance measures. Besides just looking closely at the financial reports, which are a lagging indicator of business performance, the balanced scorecard also places heavy emphasis on nonfinancial leading indicators, which usually are the cause of

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Financial

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179

Customer

Vision and strategy

Learning and growth

FIGURE 4.9

Internal business processes

Translating Vision and Strategy: Four Perspectives

the consequences reflected in the financial lagging indicators. (See Figure 4.9.) These nonfinancial indicators include (1) the company’s relationship with its customers, (2) its internal learning and growth, and (3) its key internal processes. It is a sophisticated tool largely for fine-tuning and coordinating a company’s operations with its overall strategy. The BSC has been widely adopted in English-speaking Western countries and is also implemented by many management consultants. BSC could be a helpful tool to measure the performances of Chinese companies and also for investors to zoom in on the issues of the target company— operational improvements they should include in the post-investment 100-day plan. Since most of the business founders in China do not have Western education and have not been exposed to a business framework such as the BSC, there would be a substantial value add if the BSC could be effectively implemented in the invested Chinese companies. As part of the due diligence on overall company operations, BSC could be used to measure the operational effectiveness of Chinese companies against the industry. This, however, does not mean that every single parameter should be compared and improved upon, since situations differ by macro conditions, geography, and even individual companies. Also, many of nonfinancial indicators are not publicly available and require a significant amount of discretion in their estimates. Clearly, this task is not a straightforward one and would require intimate industry knowledge and professional guidance to identify key areas of evaluation. Investors also have to understand that the BSC methods themselves

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have shortfalls, such as the inability to capture all the purposes from a nonfinancial-measure perspective, the lack of quantitative measures for implicit competence of employees or departments, and the difficulty of maintaining the list of key performance indicators consistently at a corporation. The Business Balanced Scorecard for ABC Hotel Management case study illustrates, on a simplified and basic level, the evaluation of a company’s processes using the BSC approach.

CASE STUDY 4.4: BUSINESS BALANCED SCORECARD FOR ABC HOTEL MANAGEMENT

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his case example is created to help investors understand the importance of a BSC in helping them evaluate a potential investment deal. If done correctly with the assistance of industry professionals and experts, this management tool could even be used in the post-investment work to identify areas of weakness and to craft a detailed work plan to address the issues. For simplicity and easy understanding, this case would compare a pseudo Chinese hotel management company’s BSC scores with the industry benchmark (or a top hotel).

Strategy and Vision Since most companies’ operations and strategy is built around the shortterm financial targets and measures, a gap is often created between the development of strategy with the company’s long-term objectives and sustainability. For example, ABC hotel could be too caught up with price settings in different holiday seasons to maximize short-term profits, often overlooking the importance of its positioning in the market against its peers, or the company may have a lack of focus on customer service and loyalty. As a result, many hotels in China end up having pathetic occupancy rates and stop making enough to cover their overhead. In the past years, we have seen many hotel management companies change hands and even several hotels deserted because they were so poorly run and maintained that it would be extremely costly for a new company to take over and revamp the entire operations and assets. Investors should work closely to identify the company’s actual strategy and vision. Chinese companies typically would have a mission statement on their company’s website, but they usually do not act on the words in the vision-and-strategy statement. The challenge is to discover the unsaid mission statement of the company by observing the company’s objectives

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and measures, and considering whether the overall strategy has been clearly communicated to senior management and the rest of the company. Through a closer study at the company’s operations, interviewing management and employees, and observing the other long-term “intangible” metrics that might positively impact the company, investors will gain a deeper insight into the sustainability of the company as compared to its peers and whether there are any big mines waiting to explode.

Four Perspectives of BSC and Setting Scorecard Measures The next step is the development of scorecard measures around the four perspectives of the BSC that circle the company’s strategy and vision. This process is identifying the key measures unique to each industry that determine the company’s competence in executing and communicating its strategy to the rest of the employees. The scores from this exercise could be benchmarked against peers’ scores to understand how the company stands compared to its peers. Industry professionals and experts could be engaged to ensure the effectiveness in this process or investors could start with the measures that are already publicly available. What follows are some examples of scorecard measures and their respective key performance indicators to quantify that specific scorecard measure.

Learning and growth Employee’s competency

Measured according to a mix of different skills sets like customer service, room turnover rate, training hours in a month, etc.

Internal business processes Management process

Measured by management’s qualifications, leadership, and rapport with employees

Customer Hotel service satisfaction

Measured by the customer survey results

Financials Room occupancy rate

Average occupancy rate in a year

An Example of Setting Scorecard Measures (Continued )

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(Continued ) In the hotel example presented earlier, the four perspectives are a cause and effect of each other: Employees’ competency and the effectiveness of the management process directly affect the customer ’s satisfaction and the overall room occupancy rate in a year. After identifying all the scorecard measures to be compared, investors can then score the company based on discretion and comparison with the peers. Actual Scoring of the BSC

Scorecard Measures

Learning and growth

Employee satisfaction

3

8.5

Education, learning, and growth

Employee competency

4

9

Learning and growth

Employee loyalty

4

7

Learning and growth

Employee productivity

4

8.5

Learning and growth

Employee morality

3

7

Learning and growth

Employee relationship

7

7

24

47

Management process

7

8

Internal processes

Infrastructure

6

8

Internal processes

Waste of resources

9

8

Internal processes

Price management tool

9.5

8.5

Internal processes

% Bill of Materials savings versus budget

6

7.5

Internal processes

Non-room services/products

9

8

36.5

48

Subtotal Internal processes

Subtotal Customers

Hotel-service satisfaction

6.5

8.5

Customers

Customer loyalty

5

9

Customers

Customer relationship

6

9

Customers

Customer complaints

6

8.5

Customers

Service delivery time

8

8.5

Customers

Brand perception

Subtotal

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Plan ABC’s Peers’ Score Score

Scorecard

4

8

35.5

51.5

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Plan ABC’s Peers’ Score Score

Scorecard

Scorecard Measures

Financials

Rate of sales growth

5.5

8

Financials

Room occupancy rate

7.5

8.5

Financials

Operation expenses

9

8.5

Financials

Net profit

9

8

Financials

Average spend per head

7

8.5

Financials

Non-room revenue

6

8.5

Subtotal Total score

44

50

140

196.5

Making Sense of Numbers Higher occupancy rates, higher net profits, higher spending per head

Service delivery time

Brand perception

Customer loyalty

Hotel service satisfaction

Financial

Customer

Management team efficiency, leadership, and productivity enhancement

Internal processes

Employee’s professionalism, training, and competence

Learning and growth

The Relationship between the Four Perspectives (Continued )

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(Continued ) Learning and growth 60 50 40

Peers’ hotel

30

ABC hotel

20 10 Financials

0

Internal processes

Customers

BSC Score of ABC Hotel versus Peers Hotel

After the scoring of ABC hotel, it would be helpful to put things in perspective and see how its results compare with its peers. At first glance, ABC hotel’s financial scores looked very healthy and very near the benchmark standard, which are the results for the bestmanaged listed hotels in comparison. However, one cannot look at only one perspective of the BSC. Financial scores are a lagging indicator, whereas the other three perspectives are the leading indicators of whether the company is well managed. Clearly, ABC hotel is not investing enough in the grooming of its staff, resulting in a poor score as captured in the learning and growth component of the BSC score. The customers and internal-process scores are also well below the peer average. This indicates the hotel’s lack of focus on the other aspects of the company that will have a significant impact on the company in the long run. As illustrated in the figure displaying the relationship between the four perspectives of the BSC, learning and growth of the employees is influenced by the internal process of the management team, which, in turn, affects the customer experience at the hotel and finally impacts the financials of the company.

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Therefore, even if the financial component of the BSC analysis reflects positively of ABC hotel, the distinct weakness in the other three perspectives could result in a long-term unsustainability of the company’s growth. Using this information, investors would then have to make the judgment call about whether they can accept this risk and still proceed with the investment. The most powerful tool of this BSC is the ability to identify key areas of the companies that would require rework and revamp. In this example, even if the investors decide to accept the risk of a weak learning and growth culture at ABC hotel management, they are now equipped with the knowledge to know what to focus on in the post investment 100-day plan for ABC hotel.

HOW TO PREDICT BANKRUPTCY—ALTMAN Z SCORES AND GEARING The Altman Z score formula was developed by Edward Altman, a New York University finance professor, in 1967. This formula was developed primarily to gauge the credit strength of a particular public company and to ascertain the company’s likelihood of bankruptcy. Although it was developed mainly to evaluate publicly traded stock in the United States that was in the manufacturing industry, this formula could also be used for Chinese companies as a creditstrength test. The values obtained should be compared neck to neck with the peer listed companies for a more effective comparison, but when used alone, the score would also give a rather good indication of whether the company has a going-concern issue. Z-Score = 1.2 × A + 1.4 × B + 3.3 × C + 0.6 × D + 0.999 × E Where: A = Working capital/total assets B = Retained earnings/total assets C = Earnings before interest and tax/total assets D = Market value of equity/total liabilities E = Sales/total assets

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The higher the score, the lower the likelihood of foreseeable corporate bankruptcy. Based on actual results of the application of this formula on U.S. companies of his time, Professor Altman came to the conclusion that a score below 1.8 meant that the company was probably headed for bankruptcy, whereas a scores above 3.0 meant that the company was safe. The detailed breakdown of scores is as follows: Score

Probability of insolvency

1.8 or less

Very high probability

1.8 to 2.7

High probability

2.7 to 3.0

Possible

3.0 or higher

Not likely

OPTIONAL CHECKLISTS Optional checklists cover aspects of a transaction that might be critical to several particular industries but may not be as important for some. They include: ■ ■ ■ ■

Human resource Sales and marketing Culture Environmental

If time and budget permits, and especially if transactions are of sizable values, it is highly recommended that the checklists, as discussed in this section, be looked at in depth. Note: This section aims only to discuss the common pitfalls and issues specific to the optional checklist due diligence in China, and investors should always hire local professionals to help them achieve the best results of the following due diligence processes.

Human Resource Due Diligence Human resource risks have been covered several times in the previous sections. Since human capital is the driver behind all businesses, it is undoubtedly one of the most important components of a company that could potentially make or break a deal.

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Not surprisingly, Chinese companies typically do not have a human resource strategy, and even if they did, the strategy is usually more form than substance. Chinese founders are too caught up running the business to spend their time on something that is perceived as a lower priority. Therefore, it is imperative that the potential investors work closely with third-party consultants to help cover the blind spots of the Chinese founders and uncover all potential human-resource risks. If risks are acceptable and the deal advances, investors would also have to help structure and design human-resource policies that would be implemented in the 100-day postinvestment plan. Matters that are usually covered in a human-resource due diligence include: ■ ■

■ ■

Executive and management structure Review of labor contracts in ensuring compliance with labor and employment rule Employee compensation, equity plans, retirement, and benefit plans Management-succession planning and designing of overall HR policies and strategy

Sales and Marketing Due Diligence The sales and marketing due diligence has been discussed previously under operational due diligence and this section does not seek to repeat it. Specific only to industries that are largely project based, ranging from construction companies, solar-farm-project companies to waste to energy-project companies, the sales and marketing function of these companies are usually more unique than the more traditional and common consumer product sales. Since each project could potentially be worth hundreds of millions, the ability to obtain these contracts is key to the sustainability of the company. It is imperative that investors spend more resources and time to learn more about the process of the company’s sales and marketing function, more specifically, how the company wins these projects. Due to the large amount of money involved in these projects, investors have to be wary of the manner in which these projects are won. Investors need to ensure that the target company is not involved in bribing, doing special favors, or other illegal activities to win over the projects. As such, investors need to understand very clearly how the sales and marketing departments source their projects, and the process of the auction bidding of these projects.

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Culture Due Diligence A better understanding of a company’s culture is always beneficial to investors— both financial and trade. A trade buyer would pay more attention to a target company’s overall company culture in order to understand the compatibility between the acquirer and acquiree during the integration process. Financial investors would be interested in the culture of the company to understand how easy or difficult it would be to implement changes in the company. The Chinese corporate culture predominantly is predicated on several elements, including the Chinese history, Confucian value system, and the imitation of successful Western corporate cultures like General Electric. Below are a few types of corporate cultures one might find in Chinese companies: ■

■

■

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Power distance: Taking after the Chinese emperor style of management, it is very common to find companies with a high power distance culture. Top management in China probably enjoys more influence over all corporate decisions than their Western counterparts. This culture also stems from the traditional Chinese culture that greatly honors authority and seniority. Trusting and harmonious culture: It is a long-standing Chinese culture to rely heavily on personal trust and relationships. Chinese are more emotional and affi liation oriented and, thus, many companies work on the fundamentals of maintaining harmony and order. This also stems from the Confucian philosophy that stability of the state depends on the maintenance of order within millions of families of which the state is constituted. Collectivism: The Chinese culture also promotes cooperation and consensus building rather than individualism. This also means that sometimes it would be necessary for an individual to give up his self-interest for the benefit of the whole group, which differs greatly from the Western meritocratic society in which individuals would look to outshine their peers to climb quicker than the rest. Risk avoidance and uncertainty avoidance: Due to a high degree of collectivism demanded by the Chinese culture, there is a tendency for many companies to avoid uncertainty and risk. This mentality is also similar to the government officials, whose main interest is to not make mistakes rather than to take risks and jeopardize their careers.

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The preceding list gives a few examples of the types of corporate culture investors can expect from Chinese companies and having a good understanding of it definitely aids in the integration process, especially for trade buyers. Understanding of company’s culture also gives clue to which are the potential risks that a company may have. The collectivism culture also prevents the more competent employees from shining and may result in the company’s inability to attract the best talent from the market.

Environmental Due Diligence Environmental due diligence is especially important for manufacturing companies that produce harmful waste in the process of their manufacturing operations. With the increasing awareness of health and quality of life, Chinese are becoming more outspoken about projects that are environmentally hazardous. Their voices are a reflection of the balancing act that Chinese leadership is currently managing, between the push for economic growth and the maintaining of social stability. Local officials are more anxious about meeting the economic targets that would benefit their political careers, and the local population is even more anxious about the increasing pollution in their backyards. When investing in a new construction project in China, investors have to comply by the procedures and formalities required.10 These procedures include submission of blueprints to authorities and obtaining all necessary clearances, licenses, permits, and certificates and receiving all the necessary inspections. One of the more important regulatory requirements is called the Construction Environment Acceptance Inspection for the environmental protection of the construction project. Failure to obtain this from a competent environmental authority could result in fines and penalties and, in the worst case, a cancellation of the business license. The Oji Paper Company case study shows the importance of environmental due diligence. When evaluating manufacturing firms that may contribute to environmental issues such as air, wastewater, waste management, soil and groundwater, noise, and others, investors not only have to hire experts in China who are familiar with the Chinese standards and requirement but they also need to have a keen foresight about assessing the development and changes in these regulations.

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CASE STUDY 4.5: OJI PAPER COMPANY

O

ji Paper Company is a Japanese manufacturer of paper products and it is the sixth largest manufacturing company in the world in terms of revenue. Oji Paper produces printing, writing, and packaging paper and has production sites all over the world, including Australia, Canada, China, and Germany. In 2007, Oji Paper made the decision to expand into China with the construction of the company ’s first paper mill in China. As witnessed by the increase in sales activity in its only sales office in China, it was obvious that the country possessed tremendous market potential as it develops into an economic powerhouse. The city of Nantong in the province of Jiangsu Province was selected to be the location of Oji Paper ’s first paper mill in China. Nantong city offers optimal conditions for paper manufacturing because it is situated at the mouth of the Yangtze River— allowing this water-intensive manufacturing company to have direct access to the water source. The preparations for construction of this pulp mill began and were later approved by the Chinese government. The Nantong paper mill project consisted of two phases: the first phase to be completed by the end of 2010 and the second phase to begin immediately after when the first paper line was completed. The second phase included a 100-kilometer wastewater pipeline extending from the factory to the East China Sea.

Reactions from the Local Residents The local residents began formal protests against this 200-billion yen project as early as 2009. The dissent escalated quickly as the company finished its first construction phase and started its output in early 2011, with an annual capacity of 400,000 tons. Since it was the Japanese paper manufacturer’s biggest project out of its 10 projects in China, local residents were concerned about the impact of the wastewater discharge that the Nantong plant could produce. It was calculated that, at full production of both paper-manufacturing lines, the project could be discharging more than 150,000 tons11 of wastewater via a 100-kilometer waste pipeline that was to connect the factory to the Tanglu Port, one of the Nantong City’s renowned fishing harbours.

Government ’s Response It was reported that the government evaluated this project when it first started in 2007 and approved the company for all the environmental licenses that are required to operate. It seemed that the local residents had very little trust in the government’s evaluation and accused it of being too short-sighted and too focused on development instead of sustainability. To

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appease the public, the local government officials started a department that collected the residents’ complaints and suggestions, and even announced that the project of building the waste pipeline was still under evaluation and would be aborted if the residents oppose it.

Company’s Response Reacting to the public’s concern, Oji Paper said, in a public statement, that the proposed pipeline was meant to discharge already-treated water fully compliant with government’s standards.12 The company claimed to have placed a high priority on protecting the environment and that the waterquality management system was very stringent.

July 28 Demonstration The local residents’ displeasure culminated in a 5,000-strong demonstration at the Oji Paper Nantong Factory on July 28, 2012 (Saturday). The factory’s operations were stopped as a result. The protest only subsided on the following day, after the government announced the permanent cancellation of the wastewater pipeline, effectively putting an end to Oji Paper’s intended second phase of the project. Although the first paper line resumed its operations immediately after the weekend protests, it shed light on a significant business risk in China, forcing Oji Paper to review its strategy in China.

Takeaways In this example, Oji Paper has obviously obtained the necessary construction permits and passed the inspections that were prerequisites to the construction of the paper mill long before the incident on July 2012. To put it simply, the local government had already given the green light to the company to go ahead with the construction project as early as 2007. Why, then, did the government overrule its previous decision? There could be several reasons that resulted in the government’s overruling of its previous decision. For one, it was the public’s perception of the damage that the project could cause that trumped the actual damage. In this case, given that Oji Paper is one of the largest paper companies in the world, with manufacturing plants all over the world, that may even have more stringent requirements of environmental safety than China, one can only imagine that the company probably has the know-how to ensure the wastewater discharge complies with the highest standard. Obviously, the public at large did not agree and naturally had a vested interest in society. The idea (Continued )

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(Continued )

Perceived damage versus actual damage

Strength of local competition

Using the environment “excuse”

General social sentiments

Change in leadership / government

Perceived Damage versus Actual Damage of discharging the wastewater into a fishing zone, not surprisingly, came as a huge scare to the locals, especially the ones who had their livelihoods depending on it. No matter what the company did to dispel public fears, they still could not ignore or deny the fact that the wastewater that they would discharge was not exactly beneficial to living organisms in the Tanglu Port. General Social Sentiments The other push factor for using the environmental excuse was the general sentiments of the local population. There were two very important events during that period of 2012: the once-in-a-decade leadership transition of the Communist Party, and the long-standing disputes between China and Japan over the Diaoyu Island. The Chinese government went through a delicate period of time as they prepared their new candidates in the cabinet. All efforts were channelled toward making it a smooth transition, and most of

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those efforts were populist-driven policies to appease the general public, who were increasingly critical with the government over issues like heated asset prices, unsustainable growth, high inflation rates, and corruption. The Chinese population also understood very well that this period was the best time to attack the government, and, therefore, it took every possible chance to be heard. On the other hand, the bilateral conflicts between the two countries have been going on for years and this has stirred many negative feelings toward Japanese-related companies. The double-punch effects of these two events left the local government with no choice but to agree to the residents’ request to cancel Oji Paper’s second phase projects. Change in Leadership at the Local Government Level When a new leadership takes over at the local government level, it is expected that the previous relationships formed with the predecessor may change. At the industry level, it meant that special favors and relationships might be discontinued with several companies. The new government may also have different priorities and typically would tend to support populists measures to build its own reputation and goodwill among the local residents. Strength of Local Competition It is not uncommon in China to have competitors pit against each other, either through legal, creative means or through unorthodox, vicious methods, to take one another out. Some even went to the extent of espionage—as witnessed in the Zoomlion and Sany saga in which it was rumored that Sany’s employees publicly released evidences of document fraud of its competitor, Zoomlion. For Oji Paper, although it is not known whether the local competitors had a part to play in instigating the demonstrations, it could very well be a reason that the second phase of the project fell through. In a nutshell, the Oji Paper case study serves to remind investors that environmental safety certificates cannot be treated as a guarantee that the company has passed all tests and that it will not encounter any future impact. Failure to anticipate, analyse, and see beyond the black-and-white regulations could very well lead to catastrophic results in the foreseeable future.

CONCLUSION By now, readers should already have a good framework of how to tackle the due diligence checklist process and also know what to look out for in the context of Chinese businesses. This is, indeed, a very challenging process that requires much preplanning before the start and much subjectivity in formulating the

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final opinion after reviewing the reports of numerous professional firms at the end of the process. The final investment hypothesis should be made in consideration of whether the investor can accept all the risks and whether they have the expertise and resources to mitigate the identified risks. The completion of this check-the-box due diligence process marks the end of the evaluation of the historical and present risks of the company. It is now time to proceed to the next more important phase: beyond-the-checklist due diligence. The following chapters are focused on drilling into the blind spots of most due diligence processes and go beyond what the typical due diligence checklist would entail. Most investors do not realize the importance of looking beyond what the professional firms produce and, as a result, find themselves paying more than they should for Chinese companies; some even went into bankruptcy. After the completion of the due diligence checklist, the journey has just begun. Chapter 5 aims to discuss the beyond-the-checklist due diligence, specifically on the founders and management of a Chinese target company.

NOTES 1. The 100-day plan is a precise set of value creation activities to be undertaken in the fi rst 100 days of the acquisition or corporate mergers. This is often used in a private equity investment and in corporate mergers and acquisition. 2. “Using Group ERP/Accounting System in China,” KPMG, November 2010. 3. Identity of Chinese company desensitized; numbers are for illustrative purposes and do not reflect true situation. 4. CIF stands for cost, insurance, and freight. “CIF London” meant that the quoted price would include the price of the goods plus freight up to London and insurance. 5. “Fraud Heightens Jeopardy of Investing in Chinese Companies,” Dealbook, April 24, 2012. 6. “The Joys of Auditing a China Short Target, Financial Times Alphaville, April 4, 2012. 7. Open Letter from ChinaCast’s Board of Directors to Our Shareholders, Press Release, ChinaCast Education Corporation, April 2, 2012. 8. “Ron Chan Issued Letter to ChinaCast Shareholders,” PR Newswire-Asia, April 2, 2012. 9. “Battle Over a Chinese Company Turns Physical,” Dealbook, April 19, 2012. 10. Refer to Appendix A on the DDIC Companion Website for the construction permit procedures. 11. “Pipeline Cancelled after Thousands Protest,” China Daily, July 30, 2012. 12. “Japan’s Oji Paper Resumes Output at China Plant,” BusinessWeek, July 13, 2012.

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C HAPTER F IVE

Beyond the Checklists: Founder and Management

U

N T I L N O W, W E H AV E D I S C U S S E D the more traditional methods

of conducting due diligence on Chinese companies. Most of the due diligence exercise carried out currently in China is steered by having standard checklists provided, administered, and implemented by the various service providers. These checklists typically cover the legal, financial, and operational aspects of due diligence. From time to time, a more careful acquirer might seek for additional due diligence on other areas often missed in conventional checklists, such as management, environment, and information technology. During a checklist due diligence process, the due diligence team may also conduct meetings and site visits; however, due to inexperience and other factors like time and costs, the team may not extract the best benefits of interview meetings and site visits, and these processes become more going-through-themotions checklist items. What the due diligence team really needs is a careful planning of interview meetings and site visits. The essence of good due diligence in China is performing the aforementioned beyond-the-checklist items in an exact, consistent, systematic, and planned manner. Beyond-the-checklist due diligence requires much more effort, time, and resources because it encompasses everything covered in a conventional due diligence checklists, plus the additional, yet absolutely critical 195

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items in the beyond-the-checklist due diligence process; in particular, much focus is put on the founders and management as it will be them who will drive the business in the future (see Figure 5.1). There have been many cases in which multinational corporations and seasoned investors find themselves with problematic acquisitions a few years into the investment, even though these companies managed to pass all the traditional due diligence checks prior to the capital injection. Often, the underlying problems with the companies or the management teams have been present for many years, but the effects might not have surfaced or are simply well hidden. As investors, if you are able to dig deeper and probe further beyond the typical checks prior to an acquisition, you will certainly be able to spot the existing problems and potential risks in the investment. Investors may feel that conducting due diligence into these areas is timeconsuming and tedious, and thus may choose to rely on the numbers and checks conducted by service providers. However, in many precedent cases, the cost savings from not performing a more thorough and holistic due diligence is miniscule compared to the losses one would incur from a soured investment. For example, Caterpillar Inc., the largest construction machinery maker in the world, discovered a coordinated and deliberate accounting misconduct

Conventional Due Diligence

Business (Past)

Due Diligence in China Business (Past and Future)

Founder/ Management Due Diligence Due Diligence Due diligence should also begin with the founder, who drives the past and, more importantly, the future business after an acquisition

FIGURE 5.1

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at a subsidiary of an acquisition it made just a year ago. The fraudulent misconduct caused Caterpillar to write off US$580 million of the investment, nearly 90 percent of its original investment in the company.1 If Caterpillar had spent a little more effort and resources to do a thorough due diligence, they could very well have averted the disastrous write-down. The reasons for conducting due diligence beyond traditional checklists in China can be summarized as follows: ■

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China is still a communist country, but the economy is transitioning from a socialist system to capitalist system. Many of the current generation of Chinese entrepreneurs are not trained in business schools and have little Western management knowledge. As a result, in some cases, frauds may begin with unintentional or habitual bad practices on the entrepreneurs’ part. Only one or two shareholders have full control of the operation of company; therefore, there is no incentive to install internal control systems. Founders are preoccupied and busy with challenging business issues and growth; therefore, there is no time to improve internal systems. Due to the boom of the Chinese economy propelling the growth of Chinese companies, many founders see no reasons to change the way they conduct business and manage the company. Unreasonable national tax regimes may cause entrepreneurs to evade or avoid tax returns and preserve cash flows. Chinese business and accounting environment is still primarily mandated by paper records. The ease of creating forged documents gives shrewd businesses an opportunity to deceive investors. The auditing standard is low in China by local accounting firms, and thus investors cannot simply rely on the expectation that auditors will do a good job. Business and family relationships in China are often very much interwoven. As such, it is very common for relatives or friends of founders to be reaping unfair gains through non-market-priced transactions. After successfully setting up a business, it is most common for the entrepreneurs to branch out into other nonrelated businesses or to set up companies in the same value chain to supply to each other. It is also typical that entrepreneurs will use another identity—that of parents or a wife’s name to register the business—in order to protect their own interests in case any unfortunate incidents were to happen to the current business. The establishment of these businesses is not to deceive any investors or potential partners, but rather, it is a common practice among entrepreneurs.

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The major shortcoming of the current due diligence checklists is that they focus mainly on the verification of the historical documents and analysis of only past financial performances. Any forecast of financial performance and evaluation of future cash flow needs to be done using complex financial models to decide whether an investment is worth taking up, and the results need to be presented to the board or investment committee. However, there are many assumptions made about the growth factors, the market size, and the capability of the management to execute and drive this performance, which are not checked by detailed and systematic due diligence processes. Also, the founder and the senior management are assumed to have the right attitude toward the M&A, the required management skills, and the correct personality and character to drive the business further with the new investors. Therefore, there is a mismatch of the traditional checklist due diligence process and the investment-evaluation process. What is missing in the process is really the behavioral parts of due diligence, for example, uncovering the personality of the founders, the family, and relatives of the founders, the relationships in the business, the relationship between revenues, and how the revenue has been generated. Due diligence has to go beyond the tangibles like financial statements, legal documents, hard assets, production procedures, and so on. It must delve deeper into the intangibles like the background of the founders who are still running the business, the supply chain, and drivers driving the business. Expectedly, beyond-the-checklist due diligence will prove to be a much larger, more extensive, time- and resources-consuming task than conventional due diligence (see Figure 5.2).

FOUNDER MANAGEMENT ROOT Besides the state-owned companies, most other businesses in China have been created mainly by individuals or groups of Chinese in the 1980s and 1990s, when China was trying to reform its economy and made restricted opportunities to individuals forming small businesses. With a great amount of individual effort, connections, and string-pulling, along with other macro factors like massive demand for products and economic growth, some of these private companies grew in size and expanded from a small business to sizable companies with revenues in the range of hundreds of millions. Most of these non-state-owned companies are still being run by the original founders who are now aging and in their fifties to seventies today. When evaluating these companies, simply looking at and analyzing the financial, legal, and operational aspects of the business

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FIGURE 5.2 Due Diligence That Goes Beyond the Checklists Involves Substantially More Tasks Source: Illustration by Kenny Ng.

is certainly insufficient to paint a full and accurate picture of the companies. Therefore, it is critically important to perform due diligence on the founder and the management team prior to any investments, because it may not always be easy or cost efficient to replace the management team post-investment. The Chinese business culture has a unique hospitality particularly toward guests who can benefit the business, such as potential investors, suppliers, and customers. Guests will be well treated and taken care of with point-to-point transport and sumptuous lunches and dinners with Chinese white wines and red wines. After rounds of interactions with the founder and management of the companies, the guests may feel touched and sometimes obligated by the very warm hospitality shown and, thus, they conclude that the founders are very “friendly and sincere” people, or nice people. This may be a very wrong conclusion, and may lead to making biased and unfounded decisions.

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THE FOUNDER BACKGROUND CHECK Most of the private companies in China have been founded by strong-minded and battle-hardened entrepreneurs. Founders normally have their hands on all aspects of the operations in the initial stages of the company’s growth, securing all sales contracts and recruiting their most trusted employees. Such founders tend to have a very strong sense of ownership toward their businesses, and may not easily relinquish responsibilities. Employees of these companies will not execute any important or even secondarily important decisions without the consent of the founders, and the employees typically have a great amount of reverence and respect for the founders. With this in mind, many important positions in the companies may be filled with relatives of the founders. It is a common phenomenon in China to plant next of kin as employees, to safeguard and overlook the accounts, finances, and sales processes. Indeed, many due diligence exercises carried out in China recognize the importance of looking into the background of the founder, but, more often than not, the checks are insufficient and overly simplistic. A rigorous process on the background check on the founders should focus on the following: ■ ■ ■

The person himself or herself The founder and family Other business interests held by the founder

These are a few examples of failed or difficult and troubled deals due to founders, which will be discussed over the course of this and the next few chapters: ■ ■ ■ ■

Oriental Century NVC Lighting GOME Taizinai

Depending on the industry, founding members of the management team might also have built an extremely strong rapport with various stakeholders throughout the value chain, such as the company’s immediate suppliers and distributors.

Other Business Holdings The chairman or the CEO of a private Chinese company is normally the founder and the majority shareholder of the company. Investors performing checklist

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due diligence only on the target company would have missed uncovering many important aspects (including risks) of the investment if they had neglected looking into the life of the chairman/CEO of the company. When former paramount Chinese leader Deng Xiaoping encouraged the notion of entrepreneurship during his opening and reform policy, his promotion of the “Getting Rich Is Glorious” ideal spurred many Chinese into setting up businesses and speculating on stock markets. Many Chinese companies were founded during this time, and mainly due to the huge domestic demand and the rapid development of China, many of these companies enjoyed great successes. With the surplus of cash accumulated from personal income, the successful business founder started to think of venturing into other business and sectors. For example, an entrepreneur that started a chicken farm would probably set up other companies in the same value chain dealing in, for example, feed stocks, abattoir, and distribution centers. It is also not uncommon that entrepreneurs would venture into nonrelated businesses like real estate development and the food, beverage, and hospitality sector, sometimes for diversification purposes and others times simply to boost their personal ego. The most common of such ventures involve acquiring hotels or country clubs. Apart from the apparent risks of related-party transactions involving the target company and the founder’s other businesses, another reason that multiple business holdings could be detrimental to the investment is that such activities pose distractions to the founder’s ability to perform his or her fiduciary duties to the main company. Also, if the founder is engaged in nonrelated flamboyant ventures for the purpose of ego boosting or showing off, this should also raise red flags about the management team’s decision-making skills and risk-taking appetites. It is, therefore, very important to look into the founder’s other business activities, involvements, and shareholdings, apart from the target company that is going through due diligence. Sometimes, the founder might even arrange indirect shareholdings of other companies through a spouse, next of kin, friends, or even employees. Thus, it is important to make sure the founder declares all his or her holdings, whether they are direct or indirect, local or global. As such, information may not be publicly and reliably available, and one can certainly engage private investigation fi rms to carry out extensive probes for such information. In general, if the founder has other business holdings in the same supply chain, there will usually be a certain extent of related transactions between these companies. When the companies are all privately held by the same owner, this is not an issue. However, when new shareholders join the company, be it via new share issuance or transfer of ownership, the founder has the obligation

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to declare all related transactions prior to their investment into the company. If through their own means investors discover that related transactions are indeed present, they should next try to determine if these transactions are made on arms-length basis and at fair market prices. If they are not, this should raise a red flag in the due diligence process, and the team must look to other means to mitigate the risks, such as using contract covenants to forcing the founder and company to rescind all past transactions with the related party, to restrict future such transactions, or walk away from the deal altogether. Besides doing a thorough check on the founder, shareholders, chairman, or CEO of the target company, it is also important to run the same level of extensive background checks on the rest of the management team, including the other directors on the board, COO, CFO, sales director, purchasing director, and so on. Ultimately, anyone with significant influence on the company’s financial health, external business dealings, and internal operations should all be targets of scrutiny during the due diligence process. Again, resource use and time consumption should not deter investors from conducting these checks, because the costs incurred in doing a more thorough due diligence will be dwarfed by potential losses from a bad investment. If the senior management team is not related to the founder, how did the founder command and control his or her senior management and how did the founder build internal control within the company to ensure nonfraudulent affairs? The due diligence team should be keen to find out under what circumstance the senior management was recruited and how long they have worked with the founder.

CASE STUDY 5.1: ORIENTAL CENTURY

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he case of Oriental Century is a cautionary tale centered on an accounting fraud, weak corporate governance, and the failure of a majority investor in due diligence processes. Oriental Century is an education services company with operations based in Guangdong, China. Incorporated in Singapore in 2004, the company is principally engaged in the provision of education-management services, but also has holding stakes in several kindergartens and senior high schools in China. In 2006, Oriental Century was successfully listed on the Singapore Exchange. The initial performance of the stock attracted the attention of Singapore-based Raffles Education, a rapidly growing

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private education company. By the end of 2006, Raffles Education had invested S$30 million and accumulating a 29.9 percent stake in Oriental Century. On paper, Oriental Century seemed to be a good investment opportunity: For every year after the IPO, the company reported healthy revenues and profi ts. The Singapore-listed Chinese firm’s (S-chip’s) fairy tale run came to a halt in March 2009, when chairman/CEO of Oriental Century Wang Yuean revealed during a board meeting that the company ’s cash and cash equivalents of S$34 million had been “substantially inflated.” He confessed that fictitious records had been made to mislead directors and internal auditors to think that the cash was in real and that he had misappropriated the funds for use by other “stakeholders.” In a Chinese press interview the following month, Wang revealed that the funds had in fact been siphoned into Oriental Pearl College (the boarding school that Oriental Century was providing management services to). It turns out that Oriental Pearl College was in fact founded by Wang in 1994 with four other partners, riding on the boom of private education sector in Guangdong. The sector had seen fledging growth in the early 1990s because of the “education reserve” model, in which large lump-sum funds were collected from enrolling students. The fees were deposited or invested, and the schools fed off interest earned on these funds, returning the funds only when the student left the school. By the late 1990s, bank deposit rates plummeted, and the business model became clearly untenable. In 1999, the Guangdong government ordered all private schools to refund their reserves and charge fees instead. The majority of these schools closed their doors, and the few that survived, including Oriental Pearl College, struggled through by taking on heavy bank loans. It must be clarified that Chinese laws forbid the commercialization of basic education, so companies in the business do not own the schools, but the land and assets used by them earn revenues from rent and management services. Oriental Pearl College’s land and assets were owned by Dongguan Baisheng, an investment holding company controlled by Wang and his partners. In early 2000s, Wang was approached by his partners with the idea of raising money via an IPO to pay off the company ’s debts. However, in 2004, it was not Dongguan Baisheng that was listed, but a newly created entity Oriental Century. Oriental Century, via a China shell company, Oriental Dragon, became the new company providing management services to Oriental Pearl College. It, in turn, paid out rental fees to Dongguan Baisheng under a 20-year lease agreement. (Continued )

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(Continued) Four Partners

Wang Yuean

Oriental Century incorporated in SG in 2003 (Listed in 2006)

Owns 25.4%

Oriental Dragon (Operating Entity in China)

Leased out land and assets to Baisheng Dongguan (Investment holding company

Owns the land and assets used by the school

Rental Fees Rental and Management Fees

Provides Management Services to

Oriental Pearl College : Flow of funds

Holding Structure of Oriental Century and Flow of Funds

According to Wang himself, the IPO of Oriental Century did not alleviate the problems of Dongguan Baisheng. Wang then claimed that he began siphoning money out of Oriental Century in hope of propping up Dongguan Baisheng and Oriental Pearl College. In the process, he employed false bank statements, bribery, and fictitious accounts to deceive Oriental Century’s auditors. Following his confessions, the Oriental Century board filed a police report against him, and PwC was appointed to conduct an independent review of the books. The story does not end here. In May 2009, PWC released their findings, the most significant of which was that they could not find evidence substantiating Wang’s confessions. Instead, they found that in the past five years, Oriental Dragon had collected S$33 million from Oriental Pearl College, of which $15 million was unaccounted for, and the remaining $18 million had flowed to Wang’s own interests. One of Wang claims did come to light: Cash balances as of December 31, 2008, were S$280,000 instead of the reported S$34 million. The scandal finally came to a close in December 2010, when Oriental Century was liquidated. Becoming insolvent with limited resources, no exit offers were made to the shareholders. Raffles Education, the largest

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shareholder, wrote down its US$24 million worth of its shares in the company. Previously, the CEO of Raffles Education had said that the group is a passive investor, and that Oriental Century contributed just 2 percent to the company’s earnings. Yet, if Raffles Education’s management had been negligent in its due diligence processes, it should be deemed to have failed to uphold its duties to the company’s shareholders, regardless of how significant Oriental Century’s contributions were. In terms of corporate governance, there were several red flags that should have warded off a majority investor such as Raffles Education. Oriental Century’s board consisted of its chairman/CEO Wang, who was also the second largest shareholder, a nonexecutive director, and two independent directors. Apart from the lack of diversity on the board committees, there is also a clear concentration of power in Wang’s hands. Another telltale sign of weakness in the board emerged on April 26, 2007: Three directors had resigned from the board. The fact that these directors had left after being appointed for barely a year should have sounded off any investor’s alarm about the company’s management. The lesson here for investors conducting due diligence would be that in studying the target company’s board and its directors, one can paint a picture about the lack of soundness of the company—a picture that may well be very different from that constructed from financial figures and milestones. Another lesson that investors may draw from this case would be to always be wary of “beyond the checklists” items in conducting due diligence for Chinese companies. Was Wang Yuean’s involvement with Oriental Pearl College and Dongguan Baisheng disclosed in Oriental Century’s IPO prospectus? Probably not. Yet, had Raffles Education dug deeper, it could well have identified the underlying related-party transactions between the college, Oriental Century, and Dongguan Baisheng. Information could also have been easily obtained about the history of private education establishments and their funding measures in Guangdong. Knowledge of such information would have raised additional red flags about the financial obligations of Oriental Pearl College (and Dongguan Baisheng), and hence the stability of Oriental Century’s revenue stream.

Multiple and “Missing” Identities In recent years, there have been a spate of incidents involving government officials or businesspeople possessing multiple identities. These multiple identities, usually registered in places other than the people’s hometowns, can be used for various reasons, including extra town property, to maintain a second family with a mistress, to open bank accounts for bribe taking and money siphoning, and also to conceal any illegally obtained assets. If investors discover that

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the founder/chairman of the target company harbors multiple identities, they should seriously consider warding off the investment. As the Gong Ai’ai case study demonstrates, the root cause of this disturbing trend is the Chinese hukou registration system and the supervisory loopholes existing within it.

CASE STUDY 5.2: GONG AI ’AI AND HER FOUR IDENTITIES

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he most prominent case espousing the issue of multiple identities in China has to be that of Gong Ai’ai, a former deputy bank chief in Shenmu Rural Commercial Bank, a county bank based in Shenmu, a small city in northern Shaanxi Province with a population of about 420,000. Gong was also a member of National People’s Congress (NPC). Police investigations of Gong first started in December following posts by online whistle-blowers about her owning more than 20 properties worth up to 1 billion yuan (US$161 million). Because of several preceding high-profile cases involving seemingly average Chinese citizens owning ostentatious numbers of property, Gong earned the moniker of “Madame Property” on the net. The limelight cast on her eventually prompted a police investigation, and initially it was revealed that Gong had at least two separate identities registered (Gong Aiai, and Gong Xianxia) and two hukous, the household registration record. Attached to hukous are the rights to own homes and also social benefits, including health care, pension schemes, and free education for the household ’s children. Each citizen in China is entitled to only one hukou, and is not able to legally own property under other registrations. The hukou essentially helps to limit home purchases and control citizens’ access to social-support systems. Implemented since the Mao era, one of the system’s most apparent effects through the years is the control of urban migration of rural citizens. Further investigations by the police and Ministry of Public Security revealed that Gong amazingly had two other hukous, on top of the two that were reported earlier. That makes it a total of four hukous, of which only one (in Shenmu, Shaanxi) was legitimate. The other three identities and hukous were registered respectively in two counties in neighboring Shanxi province and Beijing during the period from 2004 to 2008. 2 With these four hukous, Gong owned a total of 41 properties in Beijing, of which 10 have since been confiscated on allegations that they were purchased through the fake hukou registered in the capital. Seven people from Beijing and Shanxi, including four police officers have since been detained to assist in the investigations, mainly on suspicions of fraudulently assisting Gong with registering the fake hukous. One of the four was the deputy head of the public security bureau of Shenmu county.3

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When quizzed by papers about how she had gotten the cash to purchase the massive number of properties, Gong said that she had used her profits from her family’s coal-related businesses to fund the purchases. Netizens were no more convinced after her response, and further probing revealed that Gong had indeed used loopholes in the system governing transfer of state-owned assets and private lending to accumulate her wealth. In the ensuing weeks, the case garnered much media attention, and finally, on February 6, 2013, Gong was detained by Shaanxi Police in Yulin city on allegations of registering and using the fake hukous. Investigations were also made about whether Gong’s funds used in purchasing the property were obtained legally.

Lesson Learned Gong is certainly not alone in possessing multiple identities and reaping illegal gains through them. In December 2012, former housing administration official Zhai Zhenfeng was arrested on allegations of corruption when it was revealed that he and his family owned 31 houses in Zhengzhou, capital of Henan province. Each of the four members of the Zhai family had two identities and hukous registered.4 By and large, a strong factor contributing to the rise of such cases is the government ’s implementation of cooling measures for the property market. From 2012 onward, no individual is allowed to purchase a third house, and many have pointed to this new regulation as a driver for the hukou black market. However, apart from a greed for owning more properties, an even more compelling reason would be that fake identities and hukous are increasingly used by corrupt officials or rich businessmen to conceal their ill-gotten assets or briberies, while maintaining a seemingly “clean” front on their real identities. In mid-December 2012, Tao Yong, a former head of the Public Security Bureau in a county in Anhui, was arrested on allegations of taking bribery through accounts opened under his fake identity. Certainly, on the supply side, one can also expect that it might be relatively easy to create a fake identity in China. In an undercover investigation, a Xinhua news reporter found out that it only takes 30,000 to 50,000 yuan to obtain a fake hukou at a grassroots police station in a county in Jilin province. The police officer “selling” the hukou even claimed that one photograph is the only document needed, and it will take only a month for the hukou to be ready.5 For a person with a fair amount of power and the right connections to higher-ranking officers, such as Gong, the task is bound to be a breeze. The Ministry of Public Security has in recent years launched a campaign to weed out the use of fake identities and hukous, punishing some 121 police officers in the process. Clearly, gaping loopholes still exist even (Continued )

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(Continued) after the cleanup. The loopholes exist not only within the registration system, but are created also by the very people responsible for supervising it—the police. Under such market conditions for hukous, one can only imagine how rampant the problem is today, particularly in the cracks of smaller cities and counties, where the iron fists of the government clean-up campaign still cannot reach. An even more pessimistic view is that, given that the recent cases uncovered involved only fairly low-ranking government officials, the corruption hidden through multiple identities can only get worse higher up the pyramid. The sole comfort from the case is that it demonstrates how increasingly important the role of whistle-blowers is becoming in helping to weed out corruption. To further encourage such acts, the Chinese Communist Party Secretary General Xi Jinping quickly conducted reforms to prevent local officials from intercepting and persecuting these whistle-blowers.6 Even so, investors should certainly not expect the market forces to take care of the process of uncovering possible multiple identities of the company founder. The speed at which corrupt officials and businessmen are brought down in the recent cases should provide an even greater incentive for investors to conduct thorough background checks on their target companies’ management team before making any investments.

CASE STUDY 5.3: ZHANG LAN AND HER MISSING IDENTITY

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et another high-profile case involves not multiple identities but rather a missing identity. The main character in this case is Zhang Lan, the prolific co-founder/CEO of South Beauty, one of the most popular restaurant chains in China. The story unraveled when Ma Yi, one of South Beauty’s co-founders, filed a lawsuit against Zhang Lan for breach of contract in September 2012. Apparently, in 2004, Ma had resigned from the board over personal health issues. At that time, as part of the severance package, Ma and Zhang had signed contracts stipulating for various compensations to Ma for his voluntary withdrawal from South Beauty.7 One such compensation was a residential property in Chaoyang District, Beijing, which was to be transferred from Zhang to Ma’s ownership. Ma alleged that Zhang refused to proceed with the official transfer procedures

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even though he had been staying at the aforesaid property since his resignation in 2004. In September 2012, Ma finally decided to bring Zhang to court. In November 2012, it was reported that the Chaoyang Court had directed court indictment and summon letters to Zhang at her residence and office, but these were all returned. Upon further investigation, it was uncovered that Zhang had actually terminated her hukou as of September 17, 2012, much to the outrage of the public. At that point, it was suspected that Zhang had already given up her Chinese citizenship and converted to another nationality. It is interesting to note that, at this point in time, South Beauty had in the weeks leading up to the scandal gained approval for an IPO on the Hong Kong Exchange (HKEx), and thus concerns were raised about whether Zhang’s scandal would adversely affect South Beauty’s IPO prospects. Earlier on in January 2012, South Beauty withdrew its application for IPO in China, stating that the company needed to reexamine its proposal for taking the company public. Just about a week after the outbreak of her missing identity, Zhang finally responded to all speculation about her whereabouts and status of her nationality via Weibo, lamenting that if it wasn’t for a listing on the HKEx, who would have given up a Chinese nationality to become an island dweller. She defended herself by saying that she made the decision purely to internationalize the South Beauty brand name. A chief editor of a newspaper operated by the All-China Federation of Labor disclosed that the island Zhang referred to was an island nation located in the Caribbean. The news fueled further speculations that Zhang had in fact changed her nationality to enjoy lower personal taxes as a foreign investor.

Takeaways Although the scandal ’s effects on the South Beauty ’s IPO prospects and also its future have not materialized, it is certain that the fiasco has drawn much negative attention to the founder, and indirectly to the company. For a company dependent on consumers’ discretionary spending and where many alternatives are available, it is not surprising that South Beauty ’s top line will be inevitably affected by this saga. When evaluating a target company, the founder ’s intentions to convert his nationality should be considered as a risk factor, particularly if he is a high-profile person within the locality. In a market where consumers are generally quite nationalistic, it might not bode well for the business if the founder or management team does not fit into the expectations of the general public.

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Personal Life of the Founder The check on the personal life of the founder encompasses not only the founder himself, but also the people and activities he engages with regularly during offwork hours. In particular, the founder’s family tends to be the group of people with the heaviest influence on the founder and hence the target company. Additionally, the founder’s obsession in unhealthy activities such as womanizing and gambling are also key areas of concern when conducting due diligence. Family Members and Involvement in Other Business The traditional due diligence checklists typically will not cover the understanding of the lifestyle of the founders in sufficient depth. In particular, the due diligence process should focus on the family of the founder: Does the founder have a healthy, happy family? It is important to understand the family members who include the parents, spouse, and children, and to know their background clearly, particularly whether they are involved in any business deals, shareholdings, or are legal representatives of the target company. In general, the family members are the most trustworthy people the founder could employ to represent his or her other business interests if the founder does not want to disclose them before or after due diligence, and if he or she has intentions to conceal them. The representation of family members might be done before the founder sells his or her stake for many reasons, for example, to avoid legal implication, to avoid tax, and to enjoy certain benefits. It would be best if family members were not shareholders of private businesses, and the check would also be necessary to verify the founder’s declaration of other business holdings. Due diligence process carried out for a company ready to go IPO may not look deeply into the background of the founder, or at best, it might do a simple background check. As long as the company’s financial performance can fulfill the listing requirements, and the process is led by a good investment bank as underwriter, the company will be able to list. Extramarital Affairs One of the most common and serious problems arising in running background checks on the founder’s personal life is that he has kept mistresses with or without the knowledge of his family members. It is not usually a positive sign for the investor if this is discovered during the due diligence process, largely for business reasons rather than morality reasons. As an investor, one should certainly expect the founder or chairman/CEO to have full concentration and

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focus on building and managing the business, and having a harmonious family and working with a peace of mind certainly aids that process. The mistress issue could easily be a huge personal problem when family members learn of the secret or can no longer tolerate it. When the founder is involved with trying to appease his family, handling divorce procedures, or even fighting lawsuits, his ability to perform fiduciary duties to the company is most certainly diminished. Also, a mistress or a second family will also increase the financial burden on the founder—a strong driver for the founder to possibly squeeze out more money from his natural source of income, which is the company he owns (see Figure 5.3). Very often, luxury goods, jewelry, and precious stones are bought for the mistress, which further increases the temptation of getting money inappropriately from the company or other business dealings. Yet another possible outcome would be that the boss tries to break off the relationship with the same mistress, either to appease his family or simply because he has gotten tired of her. Often, a breakup might stir up a retaliation act and fight between

FIGURE 5.3 Having a Mistress Can Render a Founder a Puppet of the Mistress Source: Illustration by Kenny Ng.

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the former lovers. Again, this would present a huge disruption to the business if the founder has to spend most of his time handling these issues rather than managing the company. If the founder were to divorce his or her partner, the shareholding structure of the company may be adversely affected when the founder either has to compensate the divorcing partner or if the divorcing partner is one of the major shareholders of the company. Gambling A founder’s gambling habit is also a possible red flag when conducting background checks. If the founder has a tendency of heavy gambling and visiting casinos frequently, it is definitely a negative sign (see Figure 5.4). It is highly possible that the founder would not win big in general but instead lose big either in a legal casino or an underground casino. Again, investors should be concerned about the temptation of siphoning money out of the business if the founder finds

FIGURE 5.4 Investors Must Be Wary of a Founder’s Excessive Gambling Habits Source: Illustration by Kenny Ng.

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himself or herself knee-deep in a pile of gambling debts. The scenario could be even more likely after the founder receives a huge sum of cash from the investors following a capital injection, as he or she would have lots of money to bet on the table. It was said that the founder of GOME, the largest electric appliances distribution network with hundreds of stores in China, Wong Kwong Yu (or Huang Guangyu), and once the richest man in China according to Forbes ranking in 2008, has a serious gambling problem and that might have led to his downfall by his carrying out of insider trading and bribery of government officials.8 Another reason that a founder’s addiction to gambling would be a strong red flag for the investor during the due diligence process is that it presents strong indications about the founder’s character. People who take excessive risks and endorse the notion of getting quick and easy money usually have a weak moral fiber to withstand these temptations. Often, these traits are consistent throughout a founder’s personal and business lives, and this does not bode well for his ability to manage a company. At work, these traits may translate to acts such as using company funds to make risky proprietary investments and bets, taking on excessive debt through bank loans or otherwise, and embarking on nonrealistic and overly aggressive expansion plans—all of which could be severely detrimental to the target company’s prospects. Ultimately, in performing due diligence on the founder’s personal life, an investor would also want to obtain signs about his or her character, and thereby make accurate postulations about his or her management capability. Addiction to vices such as gambling and drinking should certainly cast some level of doubt in an investor’s mind about the founder’s ability to fulfill his or her fiduciary duties to the company.

CASE STUDY 5.4: SICHUAN HANLONG CASE

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ichuan Hanlong (Hanlong) is a name that will certainly ring a bell in the global mining industry these days. Founded in 1997, Hanlong has, over its short 16 years of operations, established itself as a major player in the mining, infrastructure, real estate, and tourism industries. In 2010, the company announced ambitious plans to expand its influence beyond Chinese shores by investing some US$5 billion in steel-related raw materials, including iron, molybdenum, and manganese, as well as other renewable energy projects. In the same year, Hanlong completed two major deals, fulfilling part of (Continued )

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(Continued) the promise it laid out earlier. The first involved the company taking a 55.3 percent stake in Australian molybdenum miner Moly Mines; the deal was the largest ever Chinese commercial investment in Australia. The second deal involved a 25 percent stake in U.S.-based General Moly Inc., another molybdenum miner, which held an 80 percent stake in the world’s largest molybdenum mine in Nevada, United States.9 The man behind Hanlong’s phenomenal growth is Liu Han, the company’s multibillionaire founder, chairman, and CEO. Liu is reported to have struck his pot of riches trading steel futures in his early twenties. Although during most of his professional career, he has been known to be a fairly low-profile businessman, Liu has certainly had his fair share of drama. In 1997, the year of Hanlong’s founding, a gunman fired two bullets at Liu’s car as the latter watched from a hotel entrance. A multibillionaire, Yuan Baojing, was later found to be the mastermind of the assassination attempt, and was subsequently executed. The pair had apparently gotten into a dispute over Liu’s trade in futures contracts that resulted in massive losses for Yuan. In one rare 2010 media interview, Liu arrived in his Ferrari and draped in a mink coat, displaying his seemingly extravagant lifestyle. During the interview, he emphasized that he was a true businessman who did not do the bidding of the Chinese government. At the end of the interview, when quizzed about the Hanlong’s investments in molybdenum and his confidence in the material, Liu replied that he always wins and never loses.10 The interview gave a rare glimpse into Liu’s lifestyle, and painted a picture of a man who is extremely confident and forthrightness, but perhaps too much so. Hanlong’s history is just as colorful: In 2008, the CSRC placed share trading bans on Hanlong-related listed companies on suspicions of trading laws breaches. In September 2011, the Australian Securities and Investments Commission (ASIC) announced an investigation on several executives in Hanlong’s Australian subsidiary for insider trading, and had ordered an asset freeze on the subsidiary. Eventually, in 2013, a former vice president at the subsidiary was sentenced to two years and three months in jail for insider trading. In October 2011, Hanlong made headlines when it announced that it will buy out the Australia-based iron ore miner Sundance Resources (Sundance). Prior to the announcement, Hanlong was already Sundance’s single largest shareholder with a 17.8 percent stake. Hanlong’s offer price of A$0.57 per share was sweetened after its initial offer of A$0.50 per share was turned down in July.11 One of Sundance’s most notable projects is a contract with the Cameroon government to develop an iron ore mine in Mbalam, valued at US$4.7 billion, and Hanlong, in buying Sundance will

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gain full control of the project. Another key project that Sundance was negotiating for at that time was the Nabeba iron ore mine in the Republic of Congo. On a macro level, the deal would effectively allow China to reduce its dependence on the big three foreign iron ore producers, BHP Billiton, Rio Tinto, and Vale, and shift it toward a domestic player. However, this was not to be a clear-cut deal like Moly Mines and General Moly, particularly so since it is one that deeply concerned the Chinese government—in August 2012, the Chinese government forced Hanlong to cut its bid to Australian $0.45 per share after a slump in iron prices. On December 31, 2012, Hanlong took to the press again to announce that the long-running Australian $1.3 billion bid would finally go through after more than a year of negotiations, citing the approval of the government of the Republic of Congo on the Nabeba deal as the last hurdle cleared. Less than a month later, delays ensued once again over Chinese Development Bank ’s (the company’s lender) reluctance to provide the Australian $1.02 billion loan facility for the deal. As part of the deal, Hanlong was required to make a series of three Australian $5 million payments tied to a convertible note facility to Sundance; Sundance had the right to terminate Hanlong’s bid should it fail to make any of the three payments. In March, Hanlong missed the second payment, and Sundance’s shares sunk to Australian $0.21, well below the Australian $0.45 offered by Hanlong, signaling investors’ pessimism that the deal will go through. Around the missed payment date, prospects of a success took another heavy blow: Chairman/CEO Liu was reported to have been detained in China. Although exact details were not released, it was reported that Liu had been brought in on allegations of “serious crimes” including harboring a wanted murder fugitive, Liu Yong, who happened to be Liu’s younger brother. Liu Yong is suspected to be an on-the-run fugitive who murdered three people in Guanghan, Sichuan in 2009. Although it is believed that Liu’s arrest does not have anything to do with Hanlong directly, Liu’s arrest, if stretched over the long term, is bound to have a material impact on Hanlong’s operations.

Lesson Learned Although the foreign player in the picture in this case, Sundance, is the acquisition target and not the acquirer, a more thorough due diligence on Hanlong and its founder might have rendered the whole flow of the deal somewhat differently. Barring the macro factors resulting in the multiple delays, the arrest of Liu is certainly something that could have been anticipated had Sundance dug deeper into the background of Liu and his (Continued )

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(Continued) family members. It is difficult to imagine how a brother who is a murder fugitive did not raise any serious concerns on Sundance’s end had it known about it. This case once again underscores the importance of detailed background checks, not only on the founder himself, but also on his close relatives and family members. The fact that Liu was arrested on other counts of “serious crimes” seems to also suggest that there is more to it than simply harboring his wanted brother. Although it may be too early to deduce what other crimes Liu might have committed to warrant his arrest, given his history of surviving an assassination attempt, it is reasonable expect that Liu has garnered significant negative guanxi over the years as a businessman. If Sundance were to believe that Liu was a reliable, honest potential business partner, would they not have been concerned if they knew of the assassination attempt? Although it is difficult to pinpoint how much impact Liu’s arrest will have on the prospects of the deal at this stage, Sundance’s valuations will most certainly continue to be dampened given the uncertainty surrounding the company. Given that Sundance is itself in need of a quick resolution for external investments to fund its projects in Cameroon and the Republic of Congo, it would certainly have been better off without these continued delays. Further, should Sundance decide to drop the deal themselves and seek another suitor, its bargaining strength would have been diminished after these delays, and its valuation pushed down.

GUANXI (RELATIONSHIP) A company that has established a good relationship with the government, suppliers, and customers is generally viewed positively for an investor buying into the business. However, this is a simplistic way of just looking at the good side of guanxi, and a detailed diligence exercise should look at the flip side of the coin, that is, the negative implication of guanxi. Another way to look at it would be that, in China, any business founder who has gained positive guanxi throughout the years of running his business is also bound to have incurred negative guanxi in the process as well. For example, in choosing to shift the company’s headquarters from one city to another in which the company also has operations, the founder may have incurred negative guanxi in the fi rst city, where the officials might view the move as a means to lower tax revenues for the city government and less employment for the city’s inhabitants.

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Consequently, these officials may create difficult business conditions for the company’s remaining operations in the city. Negative guanxi does not only imply that the founder or company is subject to some form of poor or abusive treatment from officials, suppliers, or stakeholders. Negative guanxi would also include relationships that give unfair and illegal rights to the company, which may harm the company’s operations or reputation if these relationships were uncovered. Of course, the business environment in China is such that seeking and giving preferential treatment is almost a norm, but investors should certainly consider these treatments as negative guanxi if it is uncovered to occur at excessive levels during the due diligence process. Investors need to factor in the contingent risks accordingly. Another important point that is often overlooked is that a founder’s overwhelmingly good guanxi with various stakeholders can work against rather than for investors’ interests. Often, investors would be very glad to know that a founder commands strong respect from his suppliers, customers, employees, and even officials, because intuitively it would mean that the founder has good rapport, and thus greater ease in running the business. However, the flip side is that if a founder enjoys tremendous support from these various stakeholders, he might prove to be too powerful for effective decision making from the company’s perspective. Coupled with a founder’s command-and-control leadership style, this is certainly a potential recipe for trouble, should the investor intend to make any significant changes to the company, be it strategically or internally. The due diligence process should look deeply into the relationship of the founder and any government officials. Government officials can be as high ranking as the Communist Party secretary, governor, mayor of a province or city, to chiefs of various government bodies or bureaus. The diligence process ought to ascertain the following key questions: ■ ■

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Is there any corruption or are there kickbacks involved? How much do these government officials influence the revenue- generating capability of the company, that is, what would happen if the relationship turned sour? What is the background of these government officials? What is the political career prospect of these government officials?

Another group of high-profile business associates that founders might be dealing with could be Chinese princelings, or the founder himself might be a princeling. Princelings in China are people who are the next of kin to the first generation (Mao Zedong) of Chinese political leaders, third-generation

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(Hu Jintao), and the current generation (Xi Jinping) of political leaders. Besides the political direct leaders’ families and relatives, princelings could also refer to descendants from senior and high-ranking military officers, former military officers during the Sino-Japan wars, old guards who fought for the Communist Party with the Kuomintang (KMT). The local provincial and city government officials also have their offspring and close relatives who could benefit from regional business activities and development, and are thus candidates for business people to seek for. Even some former state council ministers or vice ministers families are involved in business, and the princelings form a group of fortunate and privileged brethren. For investors who are not familiar with the Chinese business environment, dealing with princelings could be a defi nite advantage, because this group of elites has the power, connection, and fi nancing to maneuver their ways through the complicated business community. Some view them as being an easy way to get approval for licenses that are difficult to obtain. More often than not, the princelings also serve as middlemen either for their own firms or they join some international finance houses to help multinationals making deals and doing business in China. Not surprisingly, industries that are heavily regulated would see greater involvement with the princelings, for example, energy, power, and utilities, telecommunications, media and entertainment. No ordinary checklists would adequately look at due diligence of guanxi, and the common misunderstanding and consensus remain that guanxi is always good, particularly guanxi at the higher level. This might be right if the guanxi due diligence is performed by powerful and strong multinational firms like BP, Apple, GM, Mitsubishi, and so on, but as smaller investors looking for returns in privately held Chinese companies, it would be best to view guanxi as a double-edged sword.

CASE STUDY 5.5: HUNAN TAIZINAI BIOLOGICAL TECHNOLOGY

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he case of Hunan Taizinai illustrates not only the perilous nature of the Chinese F&B industry but also how failures in performing thorough due diligence can further magnify the risks involved. This is a story of how a promising enterprise found its way into bankruptcy and litigation drama, marred by allegations of governmental power abuse.

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Hunan Taizinai Biological Technology (Taizinai), is a probiotic beverage maker based in Zhuzhou City, Hunan Province. Founded in 1997 by entrepreneur Li Tuchun, the company specialized in the use of lactobacillus technology for its production of yogurt beverages and was considered the pioneer of the niche segment in China’s dairy products industry. In 1998, Taizinai earned its big break when founder Li successfully bid for a primetime commercial slot on state-owned TV station CCTV for 88.88 million yuan. The investment paid off as Taizinai raked in its first major orders setting the company on track to strengthen its market position. Between 2000 and 2007, Taizinai’s sales revenue increased exponentially from 50 million yuan to 1.7 billion yuan, and at its peak held 76.2 percent of the probiotics beverage market share.12 During this period, the company also expanded its production capacity aggressively, establishing five additional major production bases in Hunan, Beijing, Hubei, Jiangsu, and Sichuan. As the company grew rapidly, so did Li’s ambitions, namely his plans for to list Taizinai in the United States was no secret, and he often declared that his aim was for Taizinai to break into the top 500 companies in the world. The company also diversified its revenues stream with forays into numerous other sectors, including clothing, spirits, media, and real estate. Behind all the glamorous growth, Li’s expansion and diversification plans had severely strained Taizinai’s cash supplies, and the company suffered from a shortage of liquidity. At the start of 2007, to alleviate Taizinai’s financial strains, Li brought in Morgan Stanley, Goldman Sachs, and private equity firm Actis to pump in a total of US$73 million in equity investment. However, this was no plain-vanilla equity investment. Perhaps taking heed from one of its closest competitors, Mengniu, Taizinai increased the stakes in the transaction via a value adjustment clause—if Taizinai was able to increase its sales by 50 percent within the subsequent three years, the three investors’ shareholdings would be substantially diluted, and if Taizinai failed to achieve that goal, Li would lose all of his existing shares.13 This clause is clearly skewed toward the equity investors, but the potential incentive for Taizinai proved too tempting for Li to resist. Eight months later, Taizinai found itself cash strapped again, and its private equity investors linked them up with six international banks, including Citibank, eventually striking a deal for a 500 million yuan three-year-maturity unsecured loan. In 2008, Taizinai’s fortunes took a turn for the worse. The eruption of a food scandal of unprecedented proportions shook up the Chinese dairy industry. Melamine-tainted milk found its way to the market, causing widespread panic and public outrage. Although Taizinai’s products were found to be safe, its 2008 sales took a hard hit as a result of the industry ripple effect. Taizinai’s losses were further amplified as the effects of the 2008 financial crisis spread over to this side of the globe. Taizinai was unfortunately caught in the financial equivalent of the “perfect storm.” Citibank, (Continued )

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(Continued) which suffered heavy write-downs in the crisis, demanded an early repayment of the loan, but most of it had already been spent on capital expenditure. Taizinai was further pressured by its dealers who had made early prepayments but had yet to receive goods, and also its own employees, whose wages were delayed. These were all reflective of the company’s failure in liquidity management. At this point in time, Taizinai ’s total debt obligations totaled some 2.5 billion yuan, nearly equivalent to its total assets of 2.6 billion yuan. In order to rescue his company from being crushed by debt obligations, Li began a series of informal fund-raising activities from his employees, relatives, and even the company’s retailers, promising repayment in accordance with market interest rates. (Two years later, these activities eventually came back to haunt Li, as they were the key allegations on which the Zhuzhou City government warranted an arrest for him.) Whatever effects these short-term loans had were merely short-lived. In 2009, with Taizinai on the brink of bankruptcy, Li looked to the Zhuzhou government for help. Eventually, a state-owned shell company, Zhuzhou Gaoke, was set up to manage Taizinai’s assets on an operating lease basis, for a period of one year. This essentially transferred the reins of Taizinai to a new management team appointed by the government, and Li was left responsible for settling and reorganizing the company’s debt obligations. More important, the three majority investors found their investments locked in until the end of the operating lease. Under Gaoke’s management, Taizinai still failed to turn things around. Revenues from 2009 were a mere 500 million yuan, less than half of what it earned in the troubling year of 2008. At the end of the year, Wen Dibo, head of Gaoke, proposed that Taizinai filed for bankruptcy reorganization. This decision had been made after pressure from Taizinai’s major debtor Citibank and majority shareholder Goldman Sachs. In 2010, Li staged a tussle with the Zhuzhou government over the bankruptcy reorganization, including open declarations that he did not recognize Gaoke’s operating lease any longer, allegations that Wen misappropriated 10 million yuan of the company’s funds, and eventually filing a lawsuit against Gaoke for compensations of 350 million yuan.14 Between May and June 2010, Li also visited debtors in over 20 provinces to garner support for his resistance against any bankruptcy reorganization or takeover plans initiated by Gaoke. These thorny actions eventually led to Li’s arrest in July, on the basis of “illegal fund-raising” activities conducted in 2008. Subsequently, a number of Li’s family members and former employees were also arrested, on the allegations of assisting Li with his illegal activities.

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With Li out of the way, Gaoke quickly went about the bankruptcy reorganization, as well as receiving tender offers for the takeover of Taizinai throughout 2011. In September 2011, an acquisition offer of 715 million yuan from a joint venture between Beijing Sanyuan Foods and property developer Macrolink Group was accepted. The two companies would wholly own 100 percent of Taizinai’s shares, and also repay all outstanding debts. Li was eventually released and acquitted of all charges in January 2012. Upon his release, Li and his lawyer openly made known allegations that the Zhuzhou government had wrongfully arrested him and his relatives, and in the process had abused their powers and mistreated them.

Takeaways In this fiasco, the three majority early investors most certainly had to write down their investments at some point. Yet, would a more thorough due diligence process prior to their investment have saved them? Although the 2008 “perfect storm” could not possibly be factored in during the due diligence process, the fact that Taizinai regularly found itself with strained liquidity is indicative of certain failures in the process. Most certainly, one of the most critical points that the investors missed out on was the wild ambitions of Li. Retrospectively, it was clear that Li’s aggressive expansion and capital investment plans placed immense pressure on the company’s financial health. Li’s diversification plans, originally devised to spread the revenue stream, had, in fact, also diverted the company’s focus from its core product, probiotic beverages. These strategies most certainly stemmed from Li’s open desire to lead Taizinai into the list of top 500 companies. Yet, from a pre-investment due diligence point of view, were there any telltale signs that indicated the imminent doom? For one, Li, was a leader who was not afraid to advertise the stature of his company in an outlandish manner. Following the capital injection in 2007, a new company headquarters was built, fashioned to resemble Beijing’s Tiananmen on one half, and the U.S. White House on the other. A report by Deloitte also revealed that Li purchased 240 cars on the company’s account for use by his relatives working in the company.15 It was also a widely known fact that Li only set sight on listing the company in the United States, having made this declaration several times to the media, and on one occasion, to then-CEO of NYSE, John Thain. Although some of these points were not significantly material in financial terms, together, they were indicative that the management of the company might have been more motivated by achieving certain material milestones rather than maintaining a healthy and steady growth of the company. Although they are unlikely to be deal-breaking factors, they should have raised enough concern in the investors’ minds to question the company’s strategic directions following the (Continued )

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(Continued) capital injection. Li’s seemingly lack of restraints in carrying out the aggressive expansion and diversification plans also suggest that the investors had failed to take into account measures to restrict Li from having a free rein during deal negotiations, and had simply relied on the value adjustment clause to protect themselves. The clause failed to come into effect after Zhuzhou government interjection via the formation of Gaoke. As a final point regarding character judgment in due diligence process, the apparent arrogance of Li could also have played a part in his demise. As the Chinese idiom goes, “A large tree attracts the most wind” (ᘦଫቂ㫕), Li most certainly attracted much strong “wind,” or negative attention, in his pursuits to grow Taizinai with strong statements such as that he would only list in the United States, that he did not drink conventional milk products, and that he only regarded MNCs as his true competitors.16 These declarations are likely to have contributed to Gaoke’s swift removal of his responsibilities and apathy toward his efforts to rescue the company. The message to investors would be that overly ostentatious management personnel of target companies should raise a fair amount of concern in the due diligence process. Another of Taizinai’s failures lay in its liquidity management. One of the earliest triggers of Taizinai’s breakdown in 2008 was the demanding of goods delivery by its retail dealers. This had, in fact, originated from the company’s business model. In exchange for promised high profits for its retail dealers, Taizinai had struck deals with them for prepaid fees for the good, or in accounting terms, recording unearned revenue. As for its suppliers, Taizinai instead deferred its own payments for raw materials till only after it had recorded sale of its goods to the dealers. Such a form of liquidity management was immensely reliant on the trust of the retail dealers on the company’s ability to deliver the goods, and was most certainly not sustainable when the company took a hit on its credit worthiness or general reputation. As early as 2007, retailers had already been making complaints that, despite being chased by Taizinai for early prepayments, goods delivery was always late. These data, if uncovered and considered during the due diligence process, should have raised major concerns about Taizinai’s financial health. Finally, like many recurring instances, this case brings up a point about investing in companies that are led by their founding members. Very often, this is a double-edged sword. Although a management team composed of founding members could mean strong support throughout the employee ranks, it could also turn against the investors’ favors when these members prove to be obstacles in initiating personnel change and takeover plans due to their strong allegiance to the companies and their overwhelming support from the companies’ stakeholders. In this case, Li’s interception delayed the bankruptcy reorganization and takeover plans by Gaoke, thereby reducing the possibility of the equity investors recovering any of their losses as the fiasco dragged on.

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DUE DILIGENCE ON MORE THAN ONE FOUNDER If the target company has more than one founder, it is generally a husband and wife team, siblings, or sometimes a business is set up by a few friends, and these founders of the company will sit on the board of directors. In such cases, additional considerations must be given during due diligence to assess the relationships between these multiple founders. In particular, the questions to ask are: ■ ■ ■ ■

How did the founders meet each other? How many years have the founders know each other? Have they been working together? For how long and what projects? Are there founders who have left the venture? What are the reasons?

As important as the start-up story told by the founders is the detailing of how exactly the founders have come together to set up the business. Due diligence is needed to understand in what circumstance the founders know each other: Were they former classmates or former colleagues during military services? The details are important to foresee the future working relationship among these founders when investments are poured into the company. More often than not, there are stories of fallings out among founders after the investment is made, and the businesses and companies unfortunately become the victims for such conflicts. While it is difficult to predict future conflicts, investors should protect their interests by ensuring that the founders had and will continue to have a positive working relationship. One key consideration in due diligence on multiple founder is the balance of power, that is, whether one founder is too strong for the other. While it might be good that there is a pre-designated final decision maker, such an arrangement is quite often the root of many fall-outs. It is also quite common that the different founders may have different spheres of influence. For example, one founder may have very strong links to the suppliers of the company while the other has established strong relationships with the distribution networks. Compared to having a concentration of power on one individual, this arrangement is certainly better for the investors, but the flip-side that investors have to consider is, should a fall-out between them happen, will the company be able to survive with one and not the other. In any circumstances the due diligence team has to prepare for a worstcase scenario whereby a conflict breaks up the founders’ relationships, (Figure 5.5), and draw up follow-on procedures to deal with this. In particular, the likelihood of the target company’s ability to maintain a normal state of operations must be weighed, and counter measures devised.

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FIGURE 5.5

Beyond the Checklists: Founder and Management

Fights or Splits among Founders and Shareholders

Source: Illustration by Kenny Ng.

SUMMARY OF BACKGROUND CHECK: SWOPEST AND TRI-BACKGROUND Until now, the importance of the background check on the founders and the management team has been extensively discussed. Given the array of items to look out for, investors might get lost in the process when faced with large volumes of (sometimes overlapping) information. As such, it is good to employ systematic frameworks to organize the background check on the founders. In the following sections, we offer two such frameworks.

The SWOPEST Framework The SWOPEST framework (see Figure 5.6) is a good way to collate all information collected about the founder into a rigorous due diligence perspective. It is a good way to assess the overall quality of the founder from various dimensions. This helps not only in the identification of potential red flags about the founder

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Strengths

• Strong ability to negotiate • Good knowledge of the media industry Weaknesses

• Overly risk averse • Perceived as a high-handed boss Opportunities

• Holds minority shares in ABC company that can be acquired

FOUNDER

Social

Weaknesses Opportunities

Summary of Background Check: SWOPEST and Tri-Background

Political

• Member of the local CPPCC Economical

• Listed X position in the Forbes Rich List • HSBC and UBS as private bankers

FIGURE 5.6

SWOPEST Framework

Threats

Strength

Social

• President of City Media Association • Active user of Weibo Threats

• Wife is the CFO of the company • The IT Supplier is the brother-in-law

SWOPEST Framework on Founder

but also helps to project whether the founder would be a suitable person to work with, should the investment go through. As far as possible, each point made under the relevant heading should be backed by factual evidence demonstrating that quality. ■

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Strengths: Personal attributes that are deemed to be good for the business, such as good business acumen and strong negotiating skills. Weaknesses: Personal attributes that are deemed to be detrimental for the business, such as excessive risk taking, poor relationship with suppliers, addiction to vices, and so on. Opportunities: Investors can highlight any other possibilities of working with the founder apart from the current deal with the target company. For example, if the investors have other portfolio companies that require products that the target company is manufacturing, the investor can look to strike a supplier deal. Political: The frequency of involvement with the local/central government, or if the founder has a personal relationship with any government officials (relatives, ex-classmates).

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Economical: The wealth and credit standing of the founder. This includes whether he has any personal bad debts, or if he has an abnormally high level of personal wealth (based on his current income and family background). Social: The social activities that the founder is involved in, such as trade associations, industry boards, charitable organizations, and so on; and whether the founder is holding any official or unofficial positions in these social and trade associations. The founders’ activities in social media (Weibo, Renren, QQ) platforms should also be recorded here. It is common these days that some entrepreneurs are active bloggers, which sometimes attract unnecessary attentions and controversy. Threats: Investors would want to highlight any potential threats that the founder may pose to the business or themselves. Generally, this portion would be quite extensive, as the points highlighted in the previous attribute heading could be translated to threats. For example, if the founder’s strength is his good relationship with suppliers, a possible threat could be that the investor might have difficulties changing to a better supplier if the investor were to acquire the target company.

The Tri-Background Venn Framework The Tri-Background framework (see Figure 5.7) can be used as an overall consolidation of the background check information uncovered. It can also be used at the start of the planning of due diligence, because it will help to provide clear directions to investigation efforts. Essentially, through the background check process, the due diligence team would have covered three major aspects, namely founder, family, and business. This is depicted in the innermost layer of the Tri-Background Venn framework. Note that the circles depicting the three major aspects intersect with each other. Pushing out one layer, the due diligence team will highlight the due diligence focus points within that particular aspect that have to be evaluated. For example, within the family aspect, the team will have to look into the founder’s direct family links, relatives, wife, and even possible mistresses. In the outermost layer, there are two types of due diligence focus points. First, there will be the direct extension focus points from the second layer. For example, after highlighting the relatives of the founder as the focus point, in the third layer, information will be collected pertaining to the relatives’ business holdings, criminal records, and so on. The second type of due diligence focus points (depicted in the top left and right corners, as well as the bottom

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Complications arising from family feud

Off-balance sheet “liabilities”

Strained relationships between founder and family

Potential gambling debt

Ties with illegal entities Illegal/Questionable business practices Corruption Conflicts of interests from other selfowned business units

Extramarital affairs Gambling problem Other moral issues

Founder Ties with government officials Background of all family members

Parents Wife

Education

Children

Criminal records

Relatives

Family

Business

Guanxi (

)

Other business

Ties with other business entities Subsidiary/Affiliated business owned by founder

Health

Background of all business units owned by family members Conflicts of interests from family business units

FIGURE 5.7

Tri-Background Framework

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middle of the diagram) stem from the intersection points of the circles in the innermost layer; the focus points refer to information that deals with two of the major aspects. For example, focus points stemming from the familybusiness intersection would pertain to related-party transactions. As highlighted earlier, the Tri-Background framework can be used as a planning tool, and also as a summary tool to ensure that all grounds of the background check have been covered.

CONCLUSION Due diligence in China goes beyond the sums and balances in the company’s financials, and it is certainly not about just tallying the various official and legal documents. The influence of the founders and management cannot be quantified by traditional due diligence methods. Nonetheless, we must never overlook such effects as they exert a profound impact on the overall due diligence process, especially in China. Unlike mature economies like the United States and Europe, the growth and establishment of Chinese companies is fairly recent. Companies in mature economies tend to have longer histories, have undergone multiple mergers and acquisitions, and have had their management replaced numerous times. In China, the growth of private companies only began after Deng Xiaoping’s reforms, less than 30 years ago. Most of the going-concern companies are still under the hegemony of their original founders and management team, who are approximately 50 to 70 years old. As such, they tend to have a higher sense of emotional attachment and ownership over their companies. We witnessed in the Taizinai case study how emotional ties can lead the founders to steer their corporation in the wrong direction. Li Tuchun’s empire-building mentality eventually destroyed the company. The relative youth of the rising Chinese private companies also presents another challenge to conventional due diligence; most Chinese entrepreneurs lack training and knowledge that Western business schools provide, and may unintentionally implement bad practices. The demise of Raffles Education’s nearly US$24 million write-down on Orient Century highlighted the poor corporate governance structure Wang Yuean set in place. Only a beyond-thechecklist due diligence investigation of the founder and his corporate structure can root out such information. The founders’ integrity and personality can also provide many pieces in the due diligence puzzle, which was the case for Gong Aiai and Zhang Lan.

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Both presented two contrasting examples of identity crises, but the most important conclusion we drew was the need to carry out a beyond-the-checklist due diligence of the founders’ identity. It is not an uncommon phenomenon that Chinese people go by two names. Branching out from the founder, we observed the potential risks stemming from the founder’ family members, friends, and personal network (guanxi) with external stakeholders like regulatory bodies and suppliers. Can conventional due diligence draw out all the aforementioned nuances from the founder and the management? It is unlikely so. After summarizing these important and humanistic factors in the due diligence process, we presented two useful frameworks (SWOPEST and Tri-Background framework), which act as guides to investors when conducting their own beyond-the-checklist due diligence on the founder and the management. All in all, an in-depth understanding and checks on founders and management must always be included in the due diligence process for companies in China.

NOTES 1. “Caterpillar Writes Off Most of China Deal after Fraud,” Reuters, January 19, 2013. 2. “House Sister Scandal Nets 7, Including 4 Cops,” ShanghaiDaily.com, January 31, 2013. 3. “Xinhua Insight: Hukou Forgey Scandal Highlights Police Corruption,” Xinhua News, January 24, 2013. 4. “Ex-Bank Chief Found with Two IDs,” China Daily, January 21, 2013. 5. “Xinhua Insight.” 6. “China: Shaanxi Superrich Corrupt Banker Disappeared,” Tiananmen’s Tremendous Achievements, February 2, 2013. 7. “South Beauty Chairwoman Charged in Court,” Sina, November 19, 2012. 8. “Huang Guangyu’s Gambling Funds,” Capitalweek, April 19, 2010. 9. “Sichuan Hanlong Controls World’s Largest Molybdenum Mine,” China Mining Association, March 11, 2010. 10. “In Nevada, a Chinese King of the Hill,” Wall Street Journal, December 28, 2012. 11. “Hanlong Acquires Australia’s Sundance with $1.3 Billion,” Sina News, October 4, 2011. 12. “MBA Alumni: From Graduation to Arrest,” Asian Business Leaders, February 16, 2012. 13. “Commercial Factors Behind Li Tuchun’s Loss of Taizinai,” Food.360.com, February 22, 2012.

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14. “Behind Li Tuzhun’s Innocence: Taizinai’s Capital Dispute,” Sanlian Life Week, February 23, 2012. 15. “Investors Learn How to Dance with the Dragon,” eFinancial News, September 3, 2012. 16. “How Venture Investing Caused Taizinai’s Failure,” Zheng Quan Ri Bao, November 5, 2008.

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6

C HAPTER S IX

Beyond the Checklists: Hard Facts

A

F T E R A N E X T E N S I V E C H E C K of beyond-the-checklist items on

the founder and management, the due diligence team will have to look into other tools to verify and supplement the information collected as well as those from conventional due diligence. Questions regarding the company’s financial health, operational model, supplier and customer reliability, corruption risks, and even the founder’s reputability can all be reliably answered via employment of these tools. This chapter is named as it is because the following tools and methodologies discussed are aimed at uncovering information (facts) that are difficult (hard) to retrieve based on a conventional due diligence approach. Hard here would also refer to having a healthy level of skepticism toward information obtained in other sources, and hence the need for these tools and methodologies to validate and confirm this information.

FACE-TO-FACE MEETINGS One of the most important tools of the due diligence process is to schedule faceto-face meetings with various groups of people that have material impact or knowledge on the company, founder, or the deal (Figure 6.1). With a beyondthe-checklist approach to due diligence in China, the face-to-face meeting 231

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FIGURE 6.1 Face-to-Face Meetings and Asking the Right Questions Are Critical Aspects of Beyond-the-Checklist Due Diligence Source: Illustration by Kenny Ng.

takes an even greater role in obtaining information that is not available in statements and books. In general, the people to meet can include: ■ ■ ■ ■ ■ ■ ■ ■ ■

Clients Suppliers Bankers Tax bureau Government officials Former employees Competitors Others (e.g., journalist) References (normally by the companies)

In setting up these meetings and attempting to convince the various parties to divulge information about the target company, the investors’ pitch could center on the advantages that the investors could bring, primarily that the target company would continue to grow and expand, meaning better products and services for the clients, more business dealings and transactions for the suppliers and bankers, and potentially more tax income for the tax bureau. The face-to-face meeting is extremely important because it is also a “physical” check on and verification of the business relationships between the company and the various crucial parties that the target company has dealings with. That is, investors get to validate whether these relationships actually exist. During the meeting, investor could also verify in a more casual way some numbers

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and information filed in the books and invoices, tallying them with the actual parties that these figures relate to. In addition to verification purposes, another objective for these meetings is to discover the various areas in which the target company can do better. As a potential investor, the need to implement changes in the target company might arise in the future. These early interactions with the key stakeholders of the business would help the investor to understand the potential value that can be unlocked in the target company. Face-to-face meetings can also help to verify and supplement the information previously uncovered about the founder’s background through other means. For example, the target company’s suppliers or customers may reveal that the founder regularly hosts them at KTVs or pubs, or has frequently invited them on gambling trips to Macau. Former employees may also reveal other negative points about the founder, such as rash decision making, poor relationships with subordinates, and even extramarital affairs. All these points could have simply been obtained by word of mouth from people not directly related to the events being revealed; face-to-face meetings can help to provide the evidence to back these points. With a myriad of objectives that can be achieved from these meetings, it is without a doubt that detailed planning of the meetings is a must.

Planning the Meeting Contrary to what most investors think, the actual setting up of the appointment to meet the various parties is probably not the most difficult thing to do for the face-to-face due diligence process. Rather, determining what information to get out of the meeting is the most crucial and important task in the preparation stage. Every single meeting needs to be planned thoughtfully by the due diligence team to maximize the benefit of meeting the person(s). Investors might not get the chance to meet these parties for a second time (particularly government officials, competitors, and former employees) and, therefore, they should make the best out of the first, and possibly only, meeting. Sufficient preparation would also mean that the team is confident in posting relevant questions and ready to counter any possible responses (hostility, avoidance, distraction, etc.) employed by the interviewees so that it is able to uncover the crucial points for making the investment decision. It may also be the case that the due diligence team is able to retrieve almost all information required during the meetings without much difficulty, and this information paints a rosy picture of the target company. The skill required here then would

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be to discern what is true from what is half-true and from what is completely false. As such, preparation and planning is required to prepare multiple phrasings of the same question, so that the team can question all the interviewees and check for consistencies in their answers. The team must also be astute enough to pick up any slip-ups on information that the interviewees might not have wanted to divulge. The key items to be prepared prior to a meeting include: ■

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The objective of the meeting and the information required to be obtained. The due diligence team should spend much thought on this because it will determine the approach of the meeting and the other key decisions to be made in the other preparation items. The objective should be complementary to the other due diligence processes that are being or will be carried out later, focusing on fulfilling information gaps in the entire due diligence flow or verifying information already collected. The questions to ask. After determining the objectives as well as the information that needs to be uncovered, the team should brainstorm extensively on the various questions that can be asked to retrieve each piece of information. As highlighted earlier, the more questions the team has for the same point, the better they will be able to test for the consistency in the answers of the interviewee, and discern which is the most accurate and reliable version. The designing and asking of questions during the actual interviews are very much an art rather than science and should differ on a case-by-case, person-by-person basis. The background of the interviewee(s). Through a background check on the interviewees, the most obvious advantage during the actual meeting would be to make the interviewees feel comfortable through discussions of common topics (for example, the interviewee’s education background, hometown, and even hobbies and interests). This would pave the way for easier retrieval of information from them later on, once you have achieved a level of comfort and trust. A thorough understanding of the interviewee’s background would also help the team in designing of the questions to be asked. How to set up the meeting. When planning for a face-to-face meeting, do not always expect the founder to provide you with names and people to meet. Although for some cases, it might be more appropriate for the team to make a request to the target company and for the company to set up the meeting (to be

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discussed in the following section), it is always important to possess your own networks and findings so that you can explore leads for interviews and meetings when the target company is unable or unwilling to do so. For example, one can certainly not expect the target firm to refer a former employee who was disgruntled about the company or management personnel from a close competitor in the industry for the due diligence team to meet. The venue to meet. Typically, the diligence team could host a lunch or dinner. Sometimes, the meeting could be at the offices of the respective parties, for example, the bank office or the tax bureau building. If the meeting were to be at a restaurant, investors could also arrange for subsequent sites or company visits. As far as possible, investors should decide on a venue that can best help them to obtain the information required— usually this would refer to venues where interviewees feel most comfortable for discussions of private information. For example, a former employee might not want to take the interview in a public area lest he gets spotted and placed in a difficult position with both the current and former employers.

The following sections elaborate the various parties who investors should consider interviewing and how their inputs contribute to the due diligence process:

Customers The main agenda for such meetings is to understand how major clients of the target company view the company’s products, delivery, and services. Investors can also ask many questions about the future orders from clients and new products demand, thus getting a sense of general industry trends and how the target company stands in face of these trends. Most importantly, through these meetings, investors can gauge the working relationship between the target company and key customers, particularly whether it has been fair in its pricings compared to other competitors, whether it delivers products on time, and whether it is providing reliable and adequate after sales services. Typically, the appointments to meet these key clients are made by the target company after initiation by the investors. Ideally, investors should not contact the clients and set up the meetings themselves, because this could sour the relationship with the target company early on should the clients make it

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known to the target company about the meeting. Understandably, investors might be concerned that since the arrangements were made by the target company, such meetings might be staged or the target company would only set up meetings with customers on good terms with them, and exclude the out-of-favors ones. One way to greatly reduce any possibilities of staged meetings would be to request meetings with the senior management personnel (chairmen, CEOs) and functional managers (CFOs, COOs, heads of purchasing) of the customers. Although it might be very easy for fraudulent target companies to stage meetings if they involved executive-level personnel, it is a very much more difficult task if investors only want to meet the highest-ranking management. As for the possibility of exclusion of out-of-favor customers, investors can substantially cover this risk by requesting to meet the 5 or 10 largest (depending on size of target company) customers. If the target company is unwilling or unable to set up a meeting with any and cannot give a reasonable explanation for that, investors may then reasonably suspect that business relationships with these excluded clients are less than rosy. Further investigations can then be made to uncover the reasons behind it. The key premises on which a list of questions could be prepared include: ■ ■

■ ■

The quality of the products and services of the target company. Speed of delivery of products and the volume of business dealings with the target company. Areas in which the target company can improve products and services. Status of any future orders in the pipeline.

Suppliers Meetings with suppliers are extremely important because they help to verify what product and services each supplier provides and renders to the company and the entire delivery process. Likewise, such meetings should ideally be requested by the investors and set up by the target company itself. Quite often, in looking at the target company from the suppliers’ perspective, one can see clearly the financial health of the company, particularly regarding liquidity and inventory management. When a company is cash strapped and facing a working-capital squeeze, the first crack would usually appear at the supplier end. Suppliers may report delayed payments for inventories and increasing requests for extension of terms of payments or inventory advances. Although these signs may also appear even under normal business conditions, if suppliers

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reveal that the target company tends to have a high frequency of such issues (compared to peers), then it should raise concerns in investors’ minds so they can probe deeper into the causes. Similar to the meetings with key customers, a meeting with suppliers can provide worthwhile informative session to understand the sector value chain and industry trends, and to verify what the target company has predicted in its sales forecasts and growth/expansion strategies. In gathering the thoughts and opinions of the company’s various suppliers, investors are better equipped to predict cost trends and margins and use them in its own valuations. On a more cautionary note, meetings with suppliers are also extremely important because, ultimately, the inputs of supplies affect the quality of the products manufactured or services rendered by the target company. This is particularly crucial if the target company is manufacturing consumer products. In a country in which food safety breaches and other health hazards are nearly always mentioned in the same breath as consumer products, an investor should certainly exercise caution to ensure that the target company is not subject to inputs from a rogue supplier. Although it may take a site visit to the supplier’s plant or office to determine the quality/safety of their products, the face-toface meeting with the supplier can give investors an idea of what to expect in the subsequent visits and an opportunity to tally the two sets of information obtained in the meeting and visit. Assuming that the due diligence team meets with the founder of the supplier company, another key point that investors can seek to uncover during the faceto-face meetings would be the possibility of related-party transactions between the target company and the suppliers. Of course, this would not be easy to detect if the target company had set up the meeting. The due diligence team can, instead, use casual questions about how the founder of the supplier company first got to know the founder of the target company, or how did the business relationship actually start. Again, although it is difficult that the team will actually discover related-party transaction relationships between the two companies, the meeting can certainly give an insight into such a possibility. Key points that should be covered in the meeting with suppliers include: ■

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The punctuality of the target company’s payments, and whether it has requested extensions or advances. The length and stability of their business relationships, and how it started. Industry trends and information pertaining to input costs. The suppliers’ own production processes, and also the profi le of their suppliers.

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Bankers The top three to five banks the company regularly do business with can verify the financial status of the target company. Similar to the interviews with suppliers, a meeting with the bankers gives the team an external perspective of the financial health of the target company beyond financial statements and ratios, albeit more on its credit standing. Through these meetings, the team can uncover whether the target company makes interest payments on time or frequently requests extensions. More importantly, these meetings also give investors an opportunity to verify whether the business relationships actually exist. For example, if there were some form of reported credit facility arranged previously to fund certain projects, the aim would be to check whether the bankers that the due diligence team meet are really from the bank reported by the target company. That is, the team needs to verify that the bank is, in fact, the real party providing the loan, and identify any possibilities that the loan actually came from a dubious source. In credit-crunch periods, companies who cannot receive bank loans may look to high-interest loans from other sources and report these as official bank loans to the team during the due diligence process. The key is really to test the interviewees about how well versed they are in the deal terms or even about their supposed employer (the bank). These meetings also give the team an opportunity to check with the bankers if the terms of the loan and nature of the project corresponds to what the target company had reported. Due to the sensitivity of information, it is nearly impossible for a due diligence team to set up these meetings on its own. As such, it will be ideal if the target firm does the arrangements. There is simply no good defense for a target company to decline liaising the due diligence team with the bank partners the firm is working with. Often, unless the target company is a big firm, chances are the bankers one gets to meet are executives directly servicing the target company. If the due diligence team is not fully convinced by the executives’ responses in the interview and their credibility, then they may request (through the target company) to meet someone one or two levels up to continue the verification process. Tax Bureau Officials The main objective of the meeting with the tax bureau is to ascertain that the company has a good-standing status with the local tax bureau and to find out

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any possible tax issues before and after the acquisition. A concern that many investors should have is whether certain preferential tax concessions that the target company is enjoying right now might not continue much further after the investment is made. The meeting with tax officials would then be a good opportunity to find out the exact period of concessions from the horse’s mouth, and if there are any intentions to renew these concessions if they were ending. From the potential investor standpoint, it is also good to get an endorsement from the local tax bureau that it would support the acquisition project should it materialize in the future. Also, the officials may be able to reveal previous investigations or reviews by the bureau on the target company that the latter might not have disclosed or recorded. Government Officials and Regulators Investors doing due diligence should try to meet with government officials who have direct impacts on the business activities. In general, local government officials from different departments, such as the customs and fi nance office, would fit the bill. If the investment is substantial, it would be also be good to meet with top government officials like the local city party secretary and the mayor, particularly if the investment is going to affect the locality’s employment, landscape, or natural environment significantly. As with tax officials, investors would want to ensure that potential investments receive a level of endorsement from the officials and regulators. It is also important to meet with industry-specific government officials if the company’s core business is in their area of specialization. For example, the due diligence team can arrange to meet up with the Department of Land Resources and the Forestry Bureau if the target company is in the business of timber production or processing. Industry-specific regulators are usually able to provide very pertinent information regarding licensing and standard practices, which may or may not be what the target company is currently compliant with. In positioning oneself as a very keen investor in the city/industry (depending on the interviewee), the due diligence team can leverage the potential benefits that the new investors can bring, such as greater employment, increased tax revenues, and improved R&D efforts. Essentially, if the officials and regulators recognize the advantages that the investors can bring to the table, convincing these officials to agree to the meeting and provide accurate information to the team will not be difficult.

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Former Employees and Shareholders It is always beneficial to meet and talk to former employees of the company. When performing human-resource (checklist) due diligence, the list of former employees should be obtained. By going through the employment records, the team is usually able to gather information of former employees, such as their date of service and contact information. Investors may then pick from the list of employees who have left the company, from the most recent to as far back as 10 years ago. The dialogue could touch on the reasons for leaving the company, their opinions of top management, the operations, the weakness and strengths of the company, and so forth. It would be extremely useful if one could speak to the former senior management personnel like the CFO, COO, or even ex-staff at the operation level like the human-resource director, warehouse manager, purchasing manager, security officers, and so on. Some employees might even have joined the target company’s competitors, and, thus, they would also be good sources of information not only about the target company but also about the sector and the competition existing between the companies. Of course, there must be a very strong reason for these former employees to be interviewed by the due diligence team. Inevitably, former employees would be worried about getting into trouble for taking questions from the team. To enhance credibility, the former employees can be invited to a lunch or dinner via introduction by a third party, for example, a local accounting firm or the local human-resource bureau. If invitation by third parties is not possible, the team will have to personally call up the former employees and tell them about the potential “joint venture” with their former employers and ask whether they would like to share their views of the target company. Competitors Meeting the competitors could provide a clear picture on the market position of the target company and its reputation. Typically, the competitors would give less-than-friendly comments or they may point out the strategic or operational weaknesses of the target company, such as an inferior product, inefficient supply chain, or poor costs management. If the target company has a high-standing market position, or if the sector is a tight-knit community, such interviews can also provide insights about the founder or senior management team of the target. For example, the CFO of a competitor fi rm may reveal that the CFO in the target company has very bad working relations with the founder.

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Like former employees, management personnel of key competitors usually require a strong motivation/reason before they agree to be interviewed by the due diligence team. Certainly, the team should not base their invitation on the sole proposition that it is carrying out due diligence on the target company. This approach gives an impression that the investor is already very much vested into the deal, and the team is merely using the competing firm to retrieve information. As competitors, there is no reason for them to help investors invest in a company that might eventually take away more market share from them. A better proposition would be that the investors are in fact still looking at the broad sector and identifying potential investment opportunities and that they are scheduling meetings with several firms to learn more about the sector. In the actual meeting, the due diligence team can then gradually steer the discussions to the target company. As one can expect, the team is likely to be able spend only a fraction of the total meeting time retrieving information about the target company. As such, it would be good to meet several competitors to gather sufficient information and piece together a complete picture in this area. Current and Past Service Providers Service providers include anyone from legal, audit and tax advisors, and consultants to utilities and telecomm providers. By interviewing personnel from the legal, audit, and tax service providers, the due diligence team can of course verify the transactions that took place with what is recorded in the company’s books. A meeting with utilities and telecomm providers is also a good place to begin some form of proportion check (to be discussed later in this chapter). As with the case of interviews with the firm’s bankers, these service providers are usually unable to reveal any information about their clients without their approval. Thus, it is better if the target company does the arrangement for these meetings. In meeting with past service providers, the due diligence team can also dig deeper into why and how the business relationship ended. It would not be an issue if it was simply a matter of a competing service provider offering better pricings. However, if these relationships were terminated abruptly with no apparent reasons, then the due diligence team may reasonably probe deeper with the target company’s management.

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References (Direct Family, Relatives, and Friends) The diligence team could ask the founder to provide character references, particularly family members and friends, and make appointments to meet them. The team could also obtain names of the references from other sources, such as previous meetings with suppliers and former employees, or even through casual conversations with company staff. These meetings with character references are cost-effective avenues to conduct background checks on the founder, particularly on more perceptive items such as his working relationships with the various stakeholders (officials, key customers, and suppliers). The limitation will be that being the founder’s closer or closest confidantes, they are unlikely to provide any negative pointers about the founder unless they have had feuds or conflicts with him. This is where the investors’ own networks and leads will come into play to identify the people who are most likely to be candid about the founder and the company (e.g., friends and distant relatives who are in completely different sectors and professions, former classmates in university, etc.). However, these meetings can also be a session for the interviewer to sense any hard-to-believe good words, and to match consistency of statements given by the family members, relatives, and friends. Also, through questions on the family members’ and relatives’ own business dealings, the due diligence team can also possibly uncover the possibility of related-party transactions. For example, a relative might get so caught up with singing the praises of the founder that he let it slip that the latter had set up a company in the same value chain (such as a retailing outlet) for the former to manage. Although the overlap of business and family relationships is very common in China, if this relationship was only discovered through the meeting and not disclosed before, then it should lead to a detailed probe following the meeting.

PROPORTION CHECK The proportion check, as the name suggests, is a check on the operational and fi nancial aspects of the target company by examining various related variables in the company. These variables can be anything from sales, utilities bills, number of production lines, number of R&D personnel employed, to the number of hours the plant operates. Essentially, anything that can be quantifiable in a company can be considered as a variable in the proportion check.

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The check is founded on the simple, elegant, yet often overlooked reasoning that the employment of, spending on, or receipt of certain variables should result in a proportionate use or receipt of one or more related variables in the target company. Although this reasoning can easily be understood by a layperson, many investors tend to take these relationships for granted and accept the amounts reported or filed for these variables at face value. These relationships, whether they are linear, exponential, inverse, or otherwise, should give investors a good gauge of how operationally or financially sound the target company is. Of course, one may point out that sometimes, the value of one variable can hardly be pinpointed as the direct impact of another variable(s). However, although an isolated causal relationship is unlikely, the general dependency should still be easily identifiable. Often, investors are much more able to circumvent a failed investment if they identify even the most glaring breakdowns in these general relationships. In essence, the proportion check is a quick sanity test for the due diligence team to verify the large volume of numerical claims made or filed by the target company’s management. The key objective in running the target company through proportion checks is to discover if there are any anomalies in the proportional relationships between the variables. These relationships may be established based on industry standards or reasonable assumptions. If the proportion check reveals relationships that violate logical sense or conventional industry norms, the due diligence team can then investigate further. Similar to the use of valuation multiples such as EV/EBITDA and price to earnings (P/E) ratios, the proportion checks can be structured into a ratio comparison with similar peer companies to check for any anomalies. The Yin Guang Xia is a case in which the use of proportion checks would have raised many red flags leading to more stringent checks. By examining the electricity bills from the 1999–2000 period and comparing them with past records or the industry norms for a similar level of production, the investor would have seen that the production level needed to meet the boasted sales to Fidelity was simply not achievable at that rate of electricity utilization. Yet this glaring anomaly was overlooked by auditors and investors alike for nearly three years before the journalists from Caijing financial magazine uncovered the extensive fraud in August 2001. Although performing proportion checks solely would not help an investor to pinpoint fraud directly, they will certainly help steer the due diligence teams to some of the more dubious aspects of a target company.

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FIGURE 6.2 Proportion Checks Can Reflect a Very Different Picture from What Is Reported in Official Numbers Source: Illustration by Kenny Ng.

The following section elaborates on the more common proportion-check pairs identified during the due diligence process: ■

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Revenues versus number of salespersons The number of salespersons employed should be in proportion to the sales figures. In performing the proportion check, the diligence team can match the monthly or yearly total sales figures to the changes in employed salespersons. It can also prepare a table to break down the performance of each salesperson and match them to the reported transactions. Generally, this information should be readily obtainable through the target company. If an increase in sales is not proportional to the increase in the number of salespersons, the due diligence team should do a sanity check on whether it is possible for the existing salespeople to increase their individual sales so significantly, even if the recorded transactions show that increase. Production levels versus number of production staff This proportion pair is applicable for companies involved in manufacturing or processing sectors. The production output must be proportional to the number of people doing the actual production, that is, the assembly- or manufacturing-line staff. If a company reports a

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meteoric rise in production capacity in any period, the first thing the due diligence team should do is to match it with any increases in employment of factory or plant staff. Unless there is a substantial purchase of machinery in that period, there should be no reason for an output–staff mismatch. Sales/production output versus warehouses/freight and transport charges/ handling fees These proportion check pairs essentially cover the logistical aspect of increased production. The combinations one can derive in this area can be numerous, and they really differ from company to company. For example, for a company running fish farms and selling to fish markets in the region, an increase in fish production for a particular period should result in a corresponding increase in orders of storage boxes and even ice blocks to maintain the freshness of the fish. If the company is also involved in the processing of fish-based products, then there should also be a considerable increase in the number of external warehouse spaces rented in the various areas where its fish is sold. For a company in a completely different sector, such as a consultancy firm providing advisory services, if the company reports an increase in sales from a spike in overseas assignments, then the due diligence team should expect to see increases in air fare expenses for the employees. Sales revenues versus utilities Electricity, light, telephone bills, and other utilities are essential in both product manufacturing and service provision. The due diligence team should check in detail at least the past three years’ worth of utility bill records and generate a time series matching them to production or service quantities to ensure that the trends are consistent. For example, a manufacturing plant reporting the same or even lower levels of electricity during the winter production period should certainly be of concern to the due diligence team. One of the key advantages of using utility bills in proportion checks is that the likelihood of a company fabricating a billing invoice for these items is much lower compared to other more official financial or operational documents. New equipment purchase versus utilities If the target company reported the purchase of a particular production equipment that increases production capacity or production efficiency, the due diligence team can then scrutinize the utilities bill to ensure that there is a reasonable increase in electricity usage after the acquisition. This proportion check helps to circumvent the risks of forged

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equipment-purchase contracts. There have been cases in which entire purchases of equipment are faked so that the target company can siphon the difference out, and then transferred back into the company unrecorded to cover expenses. In this way, the actual expenses are actually capitalized as equipment purchases, and the company’s earnings will be inflated. Sales revenues versus telecommunication Telecommunication is the basic tool to connect the business with the outside world. This proportion check is particularly important for companies with revenues driven by a significant amount of telemarketing, At least three years of past telephone bill records should be analyzed closely with respect to the revenues earned. Also, if the company reports a large proportion of sales to clients overseas, or orders frequently from an offshore supplier, then overseas phone calls should certainly be reflected in the telephone bills. For example, in the case of Ying Guangxia, the company would have never been able to produce any telephone connection records between itself and its supposed major German client if an investor were to request them. R&D (technology) versus number of (qualified) researchers If investors are looking to forage into sectors with advanced technology such as pharmaceuticals, chemicals, and resources explorations, they should look into the research staff and their backgrounds. Any claims of developed or developing advanced technology must be accompanied by a proportionate number of highly skilled research staff. In recent years, more and more researchers armed with Ivy League school degrees are returning to China to work for local firms. If one could identify researchers with reputable degrees employed by the firms, it is usually a comforting factor that the research efforts are authentic. For example, research professionals with doctorate degrees from the University of Pennsylvania (UPenn), Harvard, and MIT are less likely to collude to cheat. Hence, a right proportion of such researchers corresponding to reported R&D breakthroughs is a good sign. Besides overseas scholars, researchers who graduated from good Chinese universities are also acceptable in this proportion check. Of course, the above observation is meaningful provided that their academic qualifications are genuine. One should certainly not take their qualifications at face value. The next step is to perform a simple

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due diligence on the authenticity of their degrees by calling up former school professors or classmates. Also, the due diligence team can also perform a check on the company payrolls: If the target company were to really claim the presence of these highly qualified staff in its ranks, the payrolls must be reflective of their elite qualifications. Red flags should be raised if a company dealing with technology has engineering and technical staff with dubious backgrounds and a lack of advanced academic degrees from good universities. Very often, a company may claim that it is employing external advisors who are not full-time staff with the company, and that the technology has been developed through this avenue. In such cases, a face-to-face meeting should be arranged and background checks conducted on these advisors’ work experience and academic achievement. Number of employees versus number of employees in the insurance/ pension schemes The number of people under social-welfare plans, such as insurance, medical, or pension plans, should be proportional to the total number of employees. Likewise, the total contributions by the company to these plans should also be proportional to the total employee payroll. Although the risks of companies using these avenues to defraud investors is not very high, the main objective of conducting this proportion check is to ensure that improper accounting practices are identified early on and rectified accordingly later on, should the investment take place. When a single entrepreneur owns the company, the founder can structure such payments in any manner he wishes. When new investors inject capital into the company, however, greater accountability of fund use and correct accounting practices should be upheld.

Proportion Checks Examples Figure 6.3 offers two examples of how an initial proportion check table can be prepared, and how proportion check pairs may differ from sector to sector.

SITE VISITS After conducting the face-to-face meetings with all parties and partners doing business with the company, the follow-up is to make a site visit.

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Example 1: Proportion Check (PC) Consolidation Table Company: XX Co. Ltd Industry: Automotive Core Business Functions: Automotive Component/Module Production and Sales, Warranty Provision, Overseas Direct Sales Logistical PC Pairs Total Sales

×

Number of Delivery Trips to Client Factories

Total Production

×

Warehouse Utilization Rates

Total Production

×

Number of Rolls of Protection Film Ordered

Total Production

×

Utilities Bills

Total Overseas Sales

×

Overseas Phone Bills

Operational PC Pairs

Total Production

Warranty Provision Charges ×

Electricity Bills

Total Production

×

Total Assembly Line Staff

Total Overseas Sales

×

Total Salespeople

Production Line CAPEX Human Resources PC Pairs

Example 2: Proportion Check Consolidation Table Company: YY Co. Ltd Industry: Aquaculture and Fishery Core Business Functions: Grey Mullet Seedstock Breeding, Grey Mullet Rearing and Direct Sales, Grey Mullet Primary Processing (Filleting) Logistical PC Pairs Total Production

×

Quick-Freezing Machinery Runs

Total Production

×

Warehouse Utilization Rates

Total Sales

×

Trucking and Shipping Freight Fees

Total Sales

×

Styrofoam Storage Boxes Orders

Total Production

×

Number of Water Treatment Runs

Total Production

×

Number of Feed Additives Orders

Total Production

×

Amount of Seedstock Transfer

Aeration Equipment Purchases

×

Electricity Bills

Total Fish Filleting Runs

×

Electricity Bills

×

Total Filleting Plant Staff

Operational PC Pairs

Human Resources PC Pairs Total Processing Output

FIGURE 6.3

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Proportion Checks Exercise on Two Companies

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Planning a Site Visit Before the due diligence team embarks on site visits, the team leader must plan for an effective visit. First of all, the team has to decide where to visit, what to see, and what questions to ask. It is also important to make contact during the visits; for example, getting to know the person managing and running the operations. The due diligence team would have already visited the target’s headquarters before moving on to a site visit. In the headquarters, the due diligence team should discreetly count the number of personnel working and understand their responsibilities in the company. The first site visit is always the biggest or most prominent “production site,” be it a manufacturing plant, flagship restaurant, largest wind farm, or hospital, depending on which sector the target company belongs. The diligence team may visit as many possible sites of the target company. During each visit, it is important to pay attention to details and map the actual and reported numbers and figures from business, financial, and operational information on site. Site visits are an invaluable opportunity to verify information provided to the team from other sources (see Figure 6.4). For example, the

FIGURE 6.4 Site Visits Will Help to Verify Information Provided in Company Reports Source: Illustration by Kenny Ng.

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number of production lines, operators, and inventory should all tally with the paper check from the head office and the company’s products tally with the proportion checks. If the company is a contract manufacturer, the due diligence team needs to conduct checks on the client’s office and factories. During the tour of the factory, one can verify the use of the company’s products and services on the client’s premises. If the company is a seafood farm, due diligence should follow the distribution channels, from the source of catch to the restaurants. It may be practical for the team to just tag along delivery trucks en route to the delivery destinations, and at the same time observe the relationship between the customer and delivery man. A natural follow-up would be to arrange a site visit at the supplier’s office and factory. It is important to verify the business volumes between the two parties and the quality of products and services delivered. In general, a company cannot have too many suppliers in order for it to reap cost benefits via economies of scale. The tabulation of supplies from the major suppliers could be easily summed up, to verify sales volumes or production volumes. For example, the supply of one display panel could only be used for one product; if one can fi nd out the total number of display panels ordered, that translates into the maximum number of products that can be produced.

Site Visit at Other Parts of Value Chain The due diligence process can also include the entire value chain. As with the previous example, the due diligence team can arrange to meet upstream and downstream entities of the target company. For example, in a context of a mining site, one would not simply visit the mining site but also ask to speak with the suppliers of the mining equipment and machinery. One can also find information about the finance charges, to be tallied with the financial due diligence. If the orders are substantial, the team can make a trip to the office of the suppliers; there will be no reason for them not to host the team. Such a check reassures the team about the reputation of the suppliers. Questions can be asked about the maintenance of equipment and machinery. Under normal operating conditions, there will be wear and tear, and checking on the state of depreciation of such fixed assets can give the team an idea of the extent of equipment usage. During the visit, subject to the permission from the site owners, pictures and video recordings of important facilities and assets can be taken for future reference if arguments arise regarding the assets.

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CASE STUDY 6.1: JIU GUI JIU AND THE BAIJIU INDUSTRY

O

n November 19, 2012, yet another food scandal broke out in China. This time, the scandal involved what has long been considered the Rolls Royce of China’s food and beverage industry—white spirits distilled from grains, or Baijiu. In the first half of 2011, sales of Baijiu reached 38.6 billion yuan, up 50 percent from the same period a year before.1 For investors, the largest breweries in China have proven to be downturn-proof cash cows. In the first half of 2012, Shanghai-listed Kweichow Moutai’s shares were up 35 percent, whereas those of Shenzhen-listed Wuliangye Yibin were up 14.2 percent, both outperforming the CSI300 Index, which edged up a mere 2.8 percent in the same period. So much has the stature and value of Baijiu grown, that wealth management products (WMPs) with the high-end liquor as the underlying asset have even been launched by Chinese banks. Needless to say, Baijiu also commands the status as an alternative investment on its own, similar to fine art and Western wine. In the past two years, institutional investors have also increasingly taken on bets on the potential of the industry. Some of the most prominent names include CITIC Industrial, Legend Holdings, and Diageo Plc., all of which have taken up significant stakes in Chinese breweries. It is no secret that the success of Baijiu can be attributed to strong support from the Chinese government; high-end Baijiu has always been extensively consumed at state banquets and dinners. Yet, as the 2013 Chinese leadership transition threatens to weed out lavish banquet making and liquor giving—strong drivers of demand for Baijiu—the latest food safety crisis shook up the industry much more than what companies and investors could imagine. The company caught in the latest food scandal is JiuGuiJiu, a topend liquor-maker based in Jishou, Hunan province. Founded in 1956, the company successfully filed for an IPO on the Shenzhen Stock Exchange in July 1997 and had since cemented its position in the top ranks of Chinese liquor makers. On November 19, 2012, the first rumors alleging that excessive levels of plasticizers were found in a JiuGuiJiu product surfaced. The Chinese online news portal 21st Century Business Herald reported that their staff had sent a bottle of JiuGuiJiu 50 percent concentration Baijiu for tests at Intertek, an independent laboratory based in Shanghai, and test results revealed the presence of three types of plasticizers, namely DBP (dibutyl phthalate), DEHP (di-2-ethylhexyl phthalate), and DIBP (diisobutyl phthalate).2 In particular, the tests confirmed as much as 1.08 mg/kg of DBP in the spirit sample. In a report released in June 2011 by the Health Ministry, a safety consumption limit of 0.30 mg/kg of DBP was cited. Based (Continued)

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(Continued) on this limit, JiuGuiJiu’s DBP levels were more than three times what was considered safe. Short-term effects of ingestion of excessive plasticizers include gastrointestinal irritation, nausea, vomiting, and diarrhea, whereas long-term effects include damages to the immune system and digestive system, liver diseases, and even liver cancers.

FIGURE 6.5 Both have such strong tastes . . . no one will be able to tell the difference Source: Illustration by Kenny Ng.

In the aftermath of the news report, shares of Chinese distillers all took a dive, once again demonstrating the ripple effect arising from a single safety breach. JiuGuiJiu quickly filed for a trading halt as a protective measure for its investors, but Wuliangye Yibin and Kweichow Moutai, the two largest Chinese liquor makers, were not so fortunate—shares for both companies dropped as much as 5.4 percent.3 By November 20, 32 billion yuan of combined market value from distillers had been wiped off the three Chinese exchanges. One of the first responses provided by JiuGuiJiu is that they had since sent their products for testing, and emphasized that there was no requirement for plasticizers in the Baijiu production process. Some

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industry experts concurred with this response by JiuGuiJiu, stating that the use of plasticizers has no material effect on the taste or quality of Baijiu. Perhaps the most alarming response in the immediate aftermath came from the China Alcoholic Drinks Association (CADA), the industry representative: It said that typically all Baijiu products contain a certain level of plasticizers, the highest being 2.32 mg/kg, and the lowest being 0.45mg/kg, with the average being 0.54 mg/kg. It also said that high-end products tend to contain a higher level than lower-end ones.4 With that statement, CADA became a new target board for netizens. A document believed to be an official report from CADA on the issue of plasticizers in the Baijiu industry began to circulate online. The report recorded that in December 2011, CADA had issued a warning to all industry players to beef up their monitoring processes and weed out any traces of plasticizers from Baijiu. It also provided that in two separate meetings with industry players in April and July 2012, CADA once again condoned the levels of plasticizers in Baijiu products.5 With regard to the report, CADA responded that the version circulated online was not complete, and that the content had been taken out of context. However, it certainly did imply that CADA had known about the problem for 17 months. Following CADA’s statement, many Baijiu distillers responded that they felt “let down” by the very organization that should represent them. Many moved to dispel CADA’s claims that Baijiu products “typically contained” plasticizers. The divergence between the stakeholders continued a few days later when CADA said that the most likely source of plasticizers in the Baijiu production is in the transfer of semi-completed product from storage pumps into blending machines via plastic pipes. Again, many companies felt that CADA’s statements were too extreme and responded that they only use steel pipes for such transfers. In the midst of the tussle between CADA and the various manufacturers, the General Administration of Quality Supervision, Inspection, and Quarantine (ASQIQ) has tasked its provincial subsidiary bureau in Hunan to conduct tests on the alleged JiuGuiJIu product for traces of plasticizers. On November 21, the bureau released its results: JiuGuiJiu’s 50 percent Baijiu sample was found to contain 1.04 mg/kg of DBP, not far off from the results released by Intertek at the start of the fiasco. In another official release, JiuGuiJiu acknowledged the results but argued that there were no nationally and internationally accepted regulations for DBP levels in alcoholic beverages set as of the date. It further said that based on risk assessment tools used by the China National Centre for Food Safety Risk Assessment, and the suggested DBP maximum intake levels set by the European Food Safety Authority, one can consume as much as 500g of the alleged product every day without suffering any health complications. (Continued)

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(Continued) However, the company did admit the possibility that excessive levels of plasticizers could have been released into the product unintentionally during transfer or packaging processes. In a press visit to the company’s plant on the same day, the Committee Secretary of JiuGuiJiu revealed that the company has been phasing out the use of plastic-based pipes since the plasticizer scandal in Taiwan a year earlier, but there were still some of such pipes in use. The company further issued an apology to consumers and promised that it would thoroughly inspect its processes to weed out the contamination source and make immediate ramifications, but maintained its stand of not conducting any product recalls at that point in time. Five days later, JiuGuiJiu announced that they have identified the three most likely sources of plasticizer found in the sample product: (1) a small plastic tube on the packaging line, (2) the plastic caps on the beverage bottle, and (3) a 10-meter long plastic tube that was used temporarily in 2011 during the maintenance of a packaging machine. JiuGuiJiu also stated that ramifications are already being carried out.6 Despite JiuGuiJiu’s damage control efforts, consumer consensus was that JiuGuiJiu should recall the affected line of products. Finally, on November 29, JiuGiuJiu finally gave in under media and public pressure, announcing that it would accept returns of the affected product line. This scandal saw JiuGuiJiu’s shares crash down by as much as 42 percent. Jiuguijiu Co Ltd-A (000799:Shenzhen)

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JiuGuiJiu’s Share Prices: August 2012 to January 2013 Source: Yahoo! Finance.

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Even after the ramifications made, the company’s share prices are still unable to recover to the levels prior to the scandal. However, the story does not end here—at least not for the rest of the Baijiu industry. Less than a week following the “closure” of the JiuGuiJiu case, another brewery giant was brought down to its knees. This time, it was none other than Kweichow Moutai: On December 5, an anonymous online blogger claimed that he had sent a sample of 53 percent Feitian Moutai Baijiu to a Hong Kong-based laboratory for tests on plasticizer levels. Despite having no apparent credibility or evidence, Kweichow Moutai ’s stock still took a dive, losing a total of 20 billion yuan in total share value. Five days later, the blogger revealed the test results, which showed 3.3 mg/kg concentration of DEHP, or about 1.2 times the level recommended by CADA earlier on. Unsurprisingly, Kweichow Moutai ’s response was that their products were certainly safe for consumption. Perhaps learning from JiuGuiJiu’s mishap, Kweichow Moutai also stated openly that they have sent their products for testing to three established laboratories in Guizhou, Shanghai, and Beijing. A day later, it was revealed that Kweichow Moutai ’s spirit did not, in fact, contain excessive levels of plasticizers. It is quite apparent that the most recent attack on Kweichow Moutai seemed more opportunistic than the earlier one on JiuGuiJiu. However, it is clear that the vulnerability of the companies in both cases, or even in the entire industry, can be attributed to a common factor: the absence of nationally recognized standards on plasticizer levels in Baijiu. A food safety expert stated that in China, standards (set by the Ministry of Health) did exist for the plasticizer levels in food, but these are not specific to the Baijiu industry. Further, daily supervision of Baijiu quality and safety is the responsibility of the ASQIQ and its provincial subarms, and these entities did not have plasticizer standards as a metric of Baijiu safety levels. Additionally, numerous other agencies including the State Council Food Safety Committee, Ministry of Commerce, CADA, State Food and Drug Administration are all also involved in the regulation of Baijiu quality and safety at different stages. A State Council Act, in fact, started such a multi-bodied supervision system in 2009, and it snapped into action on the 2011 Taiwan Plasticizer scandal. Although the system was created with the intention of increasing the effectiveness in food safety supervision, experts feel that regulatory blind spots were created because the various bodies may tend to shirk responsibilities. Thus, a key takeaway for investors conducting due diligence is to rely on oneself rather than expecting the various supervisory watchdogs to do their jobs. As an example, independent testing laboratories can certainly be engaged to carry out product tests. Also, site visits with external consultants could also have revealed the underlying dangers such as the plastic pipes in JiuGuiJiu’s production plants. Ultimately, the sum spent on conducting through tests and due diligence rounds would be a token, compared to the potential loss one may suffer should a food scandal hit the target company.

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DUE DILIGENCE GOES ONE STEP DEEPER: THE FOUR DEADLY A’S Until now, the beyond-the-checklist items covered includes in-depth background checks on founders and top management personnel, extensive face to face meetings with various stakeholders involved with the target company, as well as comprehensive site visits and proportion checks. This final section of the chapter focuses on areas which, if not uncovered during the due diligence process, could potentially damage the investment severely. Such damages can be reputational, operational, or even legal in nature, and would force the investors to write down the business substantially or even completely. These areas can be grouped into four major categories, termed the four deadly A’s for the severity of risks they may pose: 1. 2. 3. 4.

Authorization and control Abnormalities Anti-corruption and bribery Accounting frauds and cheats

To a very large extent, the four deadly A’s stem from the nature of the Chinese business environment. As such, it is good to have one or more members on the due diligence team with very intimate knowledge of the Chinese business environment to take charge of the due diligence efforts for these areas. Like the other aspects covered in this chapter, the specialist’s efforts should encompass checklist and also beyond-the-checklist items of these areas. In the due diligence process, these risks would be uncovered and investigated partially through other checks such as legal due diligence, or even beyond-the-checklist checks such as checks of the founder. The key point, however, is that due to the severity of potential damages, it pays to have dedicated members of the team specifically looking into these areas. The follow sections examine these four categories of fatal pitfalls in detail.

1. Authorization and Control This category of pitfalls deals with issues involving authorization breakdowns and the loss of control over the company by investors. Company Stamps As highlighted at the start of the chapter, the business environment in China is still very much mandated by paper records. Although a due diligence checklist

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mandates that all documents examined during the process are endorsed by the company stamps, there is still also a need to run extensive checks on the stamps themselves. In China, company stamps, and not the signatures of management personnel, carry the most power. In Chapter 4, the role of the company stamp and its potential misuse in a company was discussed, and we looked at the most commonly used methods of checking on the company stamps. However, although these checks allow for a fairly strong assurance on the authenticity of the company stamps, they still do not cover entirely the risks of false authorization. What these checks do not cover are really the human-factor risks, that is, the risks of people (including founders, management personnel, and other employees) actually abusing the use of the company stamp. In an earlier cited case, the ousted chairman and CEO of ChinaCast Education Corporation, Ron Chan, was alleged to have refused to surrender company stamps he had in possession after he was replaced. As the legal representative of the company, chairmen/CEOs are granted the responsibility to make various decisions about the stamps. However, when the legal representative is replaced, as long as the stamp remains in his hands, all agreements made with the endorsement of the representative and stamp continue to legally bind the company. Further, a change of the company’s legal representative must be officially filed with the State Administration for Industry and Commerce (SAIC), and this filing must be accompanied with a company stamp—the company will not be able to register a new legal representative without the stamp. Thus, investors lose control of the company unless they are able to recover the company stamps physically. Although the investors may choose to file a lawsuit against a person to retrieve a company stamp, the lawsuit also requires the company stamp’s endorsement or the legal representative’s signature. Once again, if the one withholding the stamp is the original legal representative of the company, then the petition to recover the stamp will not be able to go through. Generally, in such cases, an investor should then make a report to the Public Security Bureau (local police) for the lost, stolen, or abused stamp. This solution will really depend on the PSB’s ability and willingness to help the supposed innocent party rather than on any specified legal procedures. Compounding the fact that recovering these stamps is already a difficult task, it is also not easy for companies to apply for a new stamp, as the company will need to provide sufficient material evidence that it had indeed been stolen or abused. From what has just been described, it is clear that the risk of an investor losing control of the company in the face of company-stamp theft and misuse is indeed very real. Therefore, it is critical that investors avoid ever reaching this stage altogether.

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Of course, it is ultimately very difficult to predict whether a person might misuse the company stamp in future. However, at the due diligence stage, the team must still be able to assess the risk that the company stamps would be misused. This can only be done via an analysis of the founder/management team’s personal history and other background information as discussed earlier in this chapter. Although the actual acts of misuse or theft would be contingent on the prevailing factors at that time, a thorough due diligence on the founder early on should reveal tell-tale signs about whether his characteristics and values are consistent with such acts. The due diligence team should also evaluate whether there is a robust check system in place to keep tabs on the use of the company stamp, that is, if the use is completely within the discretion of one person (i.e., the founder). Founder/Management Mutiny This subcategory refers to risks of the founder or top management personnel conducting a mutiny against the investors, forcing the investors to perform certain decisions against the investors’ interests, or in the worst case, forcing the investors to lose control of their investment entirely. A precedent case of how a mutiny may play out, leaving an investor with virtually nothing, involves an investor buying into an automotive business that is substantially reliant on the existing personal relationships between the founder and downstream dealers (the customers). Upon making the full acquisition of the business from the founder, the founder sets up a new company, and poaches all the customers from the original company, leaving it with no orders. Again, in the due diligence process, it is important to identify how risky it is that the founder would turn his back completely on the investors, and in the worst case, the effects that such a mutiny would have on the company. The three key factors to look at in making such an analysis include 1. The relationship between the founder and his co-founders or early business partners (if any), be it in the target company or previous companies. 2. The strength of the relationships among the founder and key stakeholders in the value chain, such as customers and suppliers. 3. The level of support the founder enjoys from the employees of the target company. The first factor should raise a serious red flag for the due diligence team if it is discovered that the founder had previously forced his co-founders out of a business.

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Although most investors would consider this a green light for investment, a strong rating on the second and third factors should also be considered as a possibility that the founder might turn his back on investors after the deal. After all, with the tremendous support from these stakeholders, he would have no problem setting up a whole new company after selling off the target company.

CASE STUDY 6.2: NISSIN LEASING

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he case of Nissin Leasing is a stark reminder that even the most experienced of Western investors can also fall prey to struggles with Chinese portfolio companies. Nissin Leasing is the Shanghai-based Chinese subsidiary of NIS Group, a Japanese financial leasing company considered to be one of the four largest nonbank financial institutions at that time. Established in 2004, Nissin Leasing primarily provided machinery leasing and financial support services to small and medium Chinese enterprises. In 2007, private equity firm Texas Pacific Group (TPG) successfully raised US$4.2 billion for its TPG Asia V fund and was actively sourcing for deals in the region. TPG was not a newcomer in the Chinese market: In 2004, TPG made a prolific foray into China with a US$300 million investment in Shenzhen Development Bank (SDB) for a 17 percent controlling stake. This was a landmark deal because it was the first-ever investment from a Western investor into a Chinese bank. (TPG’s stake in SDB was subsequently sold to Ping An Insurance Group for about US$2.1 billion.) In 2007, the Bank of Japan rejected a crackdown on the consumer lending industry. New rules allowing borrowers to obtain refunds on previously paid high interest payments were implemented, and consumer lenders such as NIS Group therefore suffered huge losses. Subsequently, NIS Group’s share price took a dive of 69 percent in 2007, and TPG sought to take advantage of the cheap valuation. For TPG, however, the main driving factor behind its interest in NIS was in fact the latter’s subsidiary Nissin Leasing. TPG had been seeking a greater portfolio exposure to finance sectors in China, and Nissin Leasing provided a sweet opportunity to do so. Under the macro environment of tightening controls by the China Banking Regulatory Commission (CBRC) over bank loans to small and medium enterprises (SMEs), Nissin Leasing’s business model (which was not subject to CBRC’s new restrictions) appeared to be a profitable bet at that time. A deal was quickly struck in February 2008 by TPG involving an investment of US$288 million in exchange for a 43.4 percent stake in parent company NIS Group, plus warrants convertible to an additional 3.4 percent stake. Additionally, (Continued)

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(Continued) a US$102.5 million investment was made for a 50 percent stake in Nissin Leasing.7 At the time of the investment, former TPG Managing Director Mary Ma stated that Nissin Leasing could greatly fulfill the financing needs of the SMEs. However, unlike the private equity firm’s investment in SDB, this project would prove to be far from smooth sailing. What ensued was a slew of disputes between TPG and the management team of Nissin Leasing at that time. The main character embroiled in the corporate tussle is the chairwoman and CEO of the Nissin Leasing, Ms. Chen Yunwei. Chen, a mainland Chinese, had left China to work in NIS Group in 1992. In 2004, Chen persuaded the Group’s top management to expand their leasing operations to China and was eventually appointed as the top gun in the Chinese subsidiary. Although her performance from 2004 until 2008 had been criticized to be subpar compared to her accolades in Japan, Chen was undoubtedly seen as the founder of Nissin Leasing. Prior to the confirmation of the deal, a significant change took place in Nissin Leasing’s ownership structure. In December 2007, NIS Group had applied to the Chinese Ministry of Commerce to transfer its ownership in Nissin Leasing wholly to a new shell company, Nissin Hong Kong. In turn, Nissin Hong Kong would be wholly owned by Nissin Cayman Islands, and the latter is held by Nissin USA. The application was approved, and TPG’s investment and 50 percent stake in Nissin Leasing was eventually made and held through Nissin USA, with NIS Group holding the remaining 50 percent. Seemingly, this organization restructuring was made specifically for the purpose of the deal. After the confirmation of TPG’s investment in February 2008, one of the first issues that emerged was regarding the currency settlement for the transfer of funds from TPG to Nissin Leasing. According to Chen, TPG had instigated for Nissin Leasing to use a shell company to circumvent currency control restrictions in order to accelerate the remittance of the investment funds from the former to the latter.8 However, Chen said that she had rejected this proposal because it was an unlawful practice, and that her refusal to comply had resulted in a foreign exchange loss of 13 million RMB. Chen provided that this incident had ignited TPG’s discontent with her and the rest of the Nissin Leasing management team. Yet another issue that surfaced was an accusation by Nissin Leasing that TPG billed the company excessively in engaging external consultants. On November 6, 2008, Nissin Leasing officially announced the departure of Chen from the company, citing corporate factors behind the decision. Several days later, during a Chinese press interview, Chen revealed that she had, in fact, been forcefully removed from her duties, and that four other senior management executives from the original Nissin Leasing team had also suffered the same fate.

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The entire saga had actually begun several months earlier, on July 10, 2008. Chen claimed that she had been asked to attend a directors’ meeting at an external venue with another Japanese directors, but upon reaching the venue, she realized that there was no such meeting and had left. That evening, she received a notice from Nissin Leasing relieving her of her chairperson and CEO duties. The reasons provided in the dismissal notice included the violation of the company ’s articles of association, refusal to adhere to decisions made by the board of directors, and causing severe damages to the company ’s interests.9 Chen argued that, even though TPG held three out of five seats on Nissin Leasing’s board, the fact that she and another representative from NIS Group held the remaining two seats meant that TPG’s decision to rehaul Nissin Leasing’s top management could not be made without consulting her and the Japanese representative. Wang Yong, one of the four other removed executives, added that TPG had been keen to shift Nissin Leasing’s core business of deals with small and medium enterprises to larger ticket leasing transactions, and that a removal of the company ’s founding team would make this shift much easier for TPG. It was later reported that the TPG board had appointed Shan Weijian (then a senior partner at TPG) as the new chairman, and Steven Schneider (former head of Asia Pacific at General Electric) as the CEO on July 10, 2008. Schneider had arrived in Nissin Leasing’s main office the next day with security personnel and other TPG staff to retrieve the company seal from Chen and her team, but Chen instead called the police on the incumbent team, forcing them to flee. Following the mutiny, TPG applied to local authorities for a replacement seal. In the week following the first release of Chen’s and the rest of the management team’s dismissal, Chen continued to lambast TPG through a series of press interviews. Chen even alleged that the application for the ownership structure change in Nissin Leasing had completely left out information about the potential deal (TPG’s investment) that was to take place. Nissin Leasing responded that all applications that the company had filed with the authorities are completely done in line with the prevailing procedures and protocol, and that, in fact, Chen had been the one who endorsed the application for ownership structure change. It was also revealed that Chen and the five senior executives had brought TPG to court for wrongful and invalid termination. On November 20, 2008, Nissin Leasing made an official press release, revealing Chen’s refusal to surrender the company seal and business license after her termination, and alleging that she continued to make unauthorized loans, car purchases, and even sent company executives on vacation with the intentions of disrupting the company ’s operations. TPG (Continued)

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(Continued) (through Nissin Leasing) then launched a counter attack on Chen and her team by bring them to court on the aforementioned allegations. The two parties continued to be embroiled in lawsuits in the months leading up to March 2009, but without the same media fanfare that surrounded them at the start of the fiasco.10 The proceedings and outcomes of the lawsuits were completely kept under wraps, leading market watchers to deduce that the two parties may have settled the conflict out of court. On April 29, 2009, Nissin Leasing obtained approval from the Shanghai Administration of Industry and Commerce (SAIC) to change its name to UniTrust Finance and Leasing Corporation, and TPG continued to be vested in the leasing company. Chen Yunwei took on the position of chairwoman and CEO at another leasing company, Great China Financing Leasing Co., which focuses on the automobile-leasing segment.

Takeaways Although TPG has not seemingly suffered any material losses in its investment in Nissin Leasing through the entire tussle, it is without a doubt that the time spent caught in the infighting could have been better spent in more constructive activities that can add value to the portfolio company. The change in name initiated in April 2009 also demonstrates the need for the company to dissociate itself from its original brand name—one that has no doubt been marred by the series of events. Again, the efforts spent to rebuild a new brand name could also have been avoided. It is clear that one of the key negligences TPG made in this case was that they had failed to consider the influence of Chen. It also failed to involve Chen early in the stage of acquisition negotiation in Japan with the NIS Group. While she was not exactly the founder per se, she certainly enjoyed that status as she was one who initiated and spearheaded the parent company’s first foray into the Chinese market and the lucrative Chinese market is exactly what TPG’s objective of acquisition. While the real story of who had been telling the truth throughout the saga may never be disclosed, it is apparent that Chen had not been happy with TPG’s entry right from the start. This was evident from the early conflicts with currency control and hiring of external consultants. Eventually, the less than rosy relationships culminated in the removal of Chen and her team from their positions. While the real motivations behind TPG’s strong resolve to remove the management team led by Chen remain unknown to the public, the fact is that they encountered much trouble doing so. If the intentions had really been to clear the path for the company to shift its core business to larger ticket transactions, then TPG might have been better off with a less hostile approach. While there are bound to be cases where investors see the critical need to replace the management team in order for the target company

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to flourish, this case demonstrates that it might not be easy to do so in a Chinese private company, particularly when it involves a large-scale upheaval of the existing team. The previous sub-section’s discussion on company stamps highlighted that the transfer of authorization and control to the hands of the new investors might not be as clear cut as desired, and indeed, Chen too had prolonged the thorny saga with her refusal to hand over Nissin Leasing’s stamp. Thus, the better option is still to seek for a target company with a good management team in place, specifically one that possesses an alignment of interests with the acquirer, negating the need for any major replacement efforts. In the event where replacements are absolutely required to carry out the overall investment strategy, the due diligence team must then identify the key risks that will accompany such replacement efforts during the due diligence process. In particular, potential backlashes from the to-be-replaced management personnel must be raised, and mitigating measures devised. In doing so, the due diligence team must consider all the personality traits covered earlier in background checks, as well as the personnel’s spheres of influence. The case also demonstrates the role of media in amplifying the tussle within Nissin Leasing. With extensive media coverage, and considering the need for future opportunities in China, TPG had to tread carefully throughout the saga as they are inevitably seen as a foreign party coming to China to reap gains from the Chinese market. The media scrutiny is in no small part due to Chen, who had been the one feeding the press with various allegations of TPG’s wrongful dismissal and other wrongdoings. Yet, all this should have been expected—Chen, ever since her return to China following her successful stint in Japan, had been regarded as a media darling. This eventually turned against TPG’s favor as Chen employed the media extensively to lambast TPG. For investors, a media-prolific founder or management team may be good for the business in marketing terms, but in the event of conflicts, investors may find themselves on the losing end instead. All in all, one cannot simply assume that a replacement effort would be as straightforward and free of complications as in the West. While the macro conditions and company valuations may have been very attractive for TPG at the time of investment, it is clear that the implementation of their investment strategy turned out to be less of a cakewalk than they had expected.

2. Abnormalities Abnormalities cover a wide ground of potential pitfalls, but broadly refers to social- and industry-level events that can negatively and severely impact the target company’s business. Although often considered in a conventional due diligence on the macro-environment of a target company (PEST analysis),

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there is usually not enough focus on how these factors can potentially cause fatal damages to the company.

Social The impact of social forces simply cannot be underestimated in China. Although one may expect that in a country in which the use of Facebook is banned and all forms of media are tightly controlled by the government, the risks of social forces affecting companies should range in the lower scale. It is certainly not the case today: With the advent of new online social platforms in China, in particular Weibo and Weixin, social activism has gained powerful tools, tremendously increasing their influence on corporations. In an earlier cited case, thousands of residents in Qidong City, Jiangsu province, took to the streets to protest a wastewater discharge project sponsored by the Nantong City government. The project was slated to support the expansion plans of Oji Paper, the fourth largest paper manufacturer in the world, which had made its fi rst foray into China with its fi rst paper mill in 2010. The protest turned violent as the demonstrators clashed with police forces, and multiple arrests were made. The protest only quelled when the Nantong City government announced that the pipeline project would be permanently cancelled. Although the case primarily deals with the failures in environmental due diligence, and overreliance on the authorities’ approval as a green light for the expansion plans, the role of social forces in bringing the expansion plans to a screeching halt cannot be undermined. Had Oji looked thoroughly into the risks of social uprising, they would defi nitely have gathered red flags about the impact that the city residents could have on future projects. Environmental and legal due diligence would not have been sufficient to produce an overall “pass” rating on the investment. Such a case is certainly not unique. In August 2011, a chemical plant in Dalian city was ordered to be shut down following street demonstrations by some 12,000 residents voicing their concerns about the pollution. In 2012, in Shifang City, Sichuan, residents also successfully forced the city government to cancel the construction of a copper plant.11 The possibility of social opposition should be a top priority during due diligence. Investments can directly affect people’s lives substantially. The due diligence team should assign the task of investigating possible social impacts to a member who is well versed, not only with the local culture, but also with the analysis of social media. That member should also be astute in fieldwork and quick in picking up local sentiments and trends.

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If and when red flags pertaining to negative social impacts are raised, the team should then collectively assess the worst-case scenario whereby the target company will suffer the most severe damages. The team must then decide if preemptive actions (such as predeal CSR) may be taken, or if the damages can be effectively contained should the worst-case scenario really take place. If these assessments still point to a high level of risk, then the team should consider walking away from the deal. Industry This section covers sector-specific events that eventually produce ripple effects on a large number of companies in the particular sector. The cause for concern here would be that even if an investor’s company is not directly involved in a particular event, due to an across-the-board dip in confidence levels of consumers on the sector’s products/services, the company could still take a fatal hit. Another risk factor would be that the government can simply choose to shut down all companies within a certain locality altogether if it feels that it is not able to contain the damage. Industry-level events in the food and beverage as well as the pharmaceutical industries have garnered much media attention in recent years, and for good reasons. Apart from wars, natural disasters, and pandemics, nothing can cause quite as much widespread panic as a food scandal. In fact, a nationwide survey revealed that nearly 70 percent of the Chinese public do not feel confident about food safety levels for domestically produced products.12 For any investors in companies involved in production of goods for public consumption, the risks of safety breaches should warrant one of the top priorities in due diligence. In such cases, the investor may even consider having dedicated member(s) looking into the risk factors in this single “deadly A”. Certainly, sector-specific events can extend beyond the F&B industry, but generally the ripple effects are not as widespread and severe. So, how do investors mitigate the risks of industry-specific pitfalls? Generally, unless there are clear signs that such events are going to take place, investors have fairly little control over what can hit them, and at what time. The only saving grace during such events would be that the acquired company is not the direct perpetrator. Thus, it boils down to thorough industry research, preferably through face-to-face meetings with other industry players and officials from regulatory bodies, to understand the potential risks in this area. In particular, the due diligence team should examine large-scale precedent events in the industry in detail, and via site visits and interviews with the target company, ensure that there are sufficient checks in place to prevent future industry breaches from taking place in the target company.

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CASE STUDY 6.3: HEBEI XUEYANG GLAIR AND GELATIN

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he case of Hebei Xueyang Glair and Gelatin Factory is the epitome of the latest Chinese food scandal, once again serving to remind investors and consumers alike of the lurking perils in China’s consumables sectors. Against a backdrop of disturbing predecessors, including melaminetainted milk, sewage-recycled cooking oil, and formaldehyde-laced cabbages, the latest product to find its way in the notorious record book is an unassuming yet essential raw material in the pharmaceutical industry—the medicinal capsule. Although they did not cause any casualties, the scandal sparked public outrage because of its wide-spreading ripple effects across various sectors, fueled by extensive media coverage. Hebei Xueyang, a private gelatin factory based in Fucheng County, Hebei province, specializes in the production of edible and industrial gelatin, glues, and adhesives. Unlike edible gelatin, which is used in foodstuffs and capsule coating, industrial gelatin contains higher levels of toxic chromium and is used mainly in the production of handicrafts and furniture. Hebei is one of the two major gelatin production bases in China, the other being Shandong. Prior to the scandal, Hebei Xueyang boasted an annual production of 280 tons and was one of the few factories in Hebei qualified to produce edible gelatin. The scandal unfolded on April 15, 2012, when major Chinese broadcaster CCTV aired an investigative program alleging that several capsule manufacturers in Zhejiang’s Xinchang County, a major pharmaceutical production hub, produced and sold medicinal capsules using industrial gelatin, resulting in excessive levels of carcinogenic chromium in these capsules. Shortly after the broadcast, the manager of Hebei Xueyang, Song Xunjie, allegedly set fire to the factory in a bid to destroy evidence documenting the sale of industrial gelatin to capsule manufacturers. Song, along with a county official linked to the company, was detained at the scene. However, a report by Southern Metropolis Daily claimed that an account book dating back to 2000 was found after the fire, documenting transactions between Hebei Xueyang and several food and cosmetic companies, including state-owned Beijing Sanyuan Foods. Sanyuan has since released statements denying any business relationships with Hebei Xueyang. In the immediate aftermath of the scandal, the State Food and Drug Administration (SFDA) suspended the sales of 13 types of medications confirmed to contain excessive levels of chromium. The pharmaceutical companies alleged by CCTV to have used industrial-gelatin-based capsules in their production saw their share prices plunge, as did Beijing Sanyuan Foods, which was dragged into the scandal by a charred account book. The following day also saw the Fucheng county government shutdown 40 gelatin workshops. As for the capsule sector, Xinchang county government

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had also closed 57 production lines linked to the scandal. Since the scandal broke, the Chinese police have detained 45 people, arrested 9, and seized more than 77 million capsules tainted with chromium. Industry insiders claim that a gap of 10,000 tons in the supply of edible gelatin is the driving factor for capsule manufacturers to turn to the chromiumladen alternatives. However, the desire to cut costs and drive up margins, be it by the gelatin, capsule, or drug manufacturers, is also a strong possibility. According to reports, edible capsules cost twice as much to produce as industrial-gelatin-based capsules, driven by the low price of industrial gelatin, which could cost between one-fifth to one-sixth the price of edible gelatin. Others point to the oversight of authorities in this saga, questioning how such a scandal could have unfolded in the heavily regulated pharmaceutical sector. Indeed, spokespersons from the National Rational Drug Use Monitoring System have admitted that more attention was paid to the quality of medicine inside the capsules rather than to the capsules themselves.

Takeaways For any investors wishing to put money into the broad Chinese consumables/pharmaceutical sectors, this case serves to underscore a key lesson in the due diligence process: Due diligence should not be limited simply to the target company. One must be extremely skeptical, not only about the target company, but also about its suppliers and customers. This is particularly pertinent for investments in such sectors. Owing to the notoriety of food safety accumulated from the various scandals, one can be sure that an incident stemming from one sector is bound to have a massive ripple effect on upstream and downstream related industries, as demonstrated in this case; a single TV program caused upheaval in multiple sectors across the country in a matter of days. A negligent investor with stakes in the affected gelatin or drug capsule production facilities could have had his investments wiped out completely. Yet, in studying the broader supply chain, one could have certainly spotted the lurking dangers of the nonedible gelatin, and scrutinize the books of the target company for any dealings in the cheaper alternative. For the pharmaceutical companies, things might not be as clear-cut. As the secondary user of gelatin (in the form of manufactured drug capsules), it might be more difficult to determine the origins of the raw material. Indeed, a spokesperson from one of the nine pharmaceutical companies whose products were suspended, Tonghua Yason Pharmaceuticals, said that pharmaceutical producers typically do not possess the capability to examine capsules, and thus depended solely on the quality reports provided by capsule suppliers. As an investor conducting due diligence, with the knowledge of the existence of a dangerous alternative, would the company’s statement have earned a tick on your due diligence checklist? Hopefully not. (Continued)

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(Continued) Finally, the failure of regulatory watchdogs in this scandal serves as a reminder of the limitations of Chinese authorities in these sectors. Although industry shake-ups from earlier scandals may be beneficial, with weak companies being weeded out and Chinese regulators vowing to crack down on perpetrators, this will take time. Until the day when “China” doesn’t automatically become associated with “food safety,” investors should rely on their own due diligence as the safest bet.

3. Anticorruption and Bribery (ACID) This deadly A deals with the issue that has become virtually synonymous to the business environment in China—corruption. Although many have heard of the notoriety of corruption practices, few have delved deep into investigating these practices prior to making an investment in a target company as part of the due diligence process. Most people accept it as a norm in the overall business-scape in China. However, as this section will seek to illustrate, ignoring such practices can prove to be fatal for the investment. Today, 70 percent of China’s wealth rests in the hands of the Chinese government; it is the majority shareholder of approximately 30 percent of all public companies; SOEs still do and will continue to dominate the business environment in China for some time to come. Further, as highlighted earlier in this book, due to the low compensation scheme of civil servants and public officials, there is a greater propensity for them to seek out alternative forms of compensations to supplement their main income. On the business end of the picture, for some business owners, the benefits of bribing government officials to have a piece of their pie may greatly outweigh the costs of bribing. For others, bribery could even be the only way for the business to start and get going. Since the economic reforms of 1979, China has fostered a generation of strong-minded people who are willing to work hard for profits. As Deng Xiaoping famously surmised, “to let a portion of the population to get rich,” and the only way to be getting rich during that era is to either be an entrepreneur, to build a successful business, or to possess authority and power within the governmental organization that has the right to grant the platform to conduct business. Thus, since the dawn of post-Deng China, the relationship between businesses and the government has become ever more intertwined.

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Once again, there is no suggestion that all businesses in China are performing some form of corruption, but rather, investors looking into China need to first accept and acknowledge that the risks of corruption are significant and assess and address the risks specific to the target company thoroughly during the due diligence process. In fact, corruption can be thought of as the lynchpin to all other forms of due diligence because it affects virtually every other item on the checklist, like the company’s financials and personnel; extra revenues from bribing, or costs of bribing have to be hidden off the balance sheet; subsidiaries are being used to make bribery payments; certain personnel may be purposely omitted from the company’s records because they are tasked with the under-the-table jobs; customers and suppliers may have to be cooked-up from thin air to account for new businesses. All this accentuates the importance of anticorruption due diligence prior to making any investment in China. Before examining the framework for carrying out anticorruption due diligence, one may wonder why there is a need to uncover corrupt practices in the target company since corruption is supposed to be the “norm” of the Chinese business environment. Once a company executive is revealed to have performed bribery, for example, the impact is suffered by the entire company, and not just the person doing the bribery. The costs of corruption are fourfold: 1. 2. 3. 4.

Write-downs on business Reputational loss Legal liabilities Loss of business altogether

ACID (Anticorruption Investigative Due Diligence) Overview Anticorruption should be looked into at every stage of due diligence discussed in the previous chapter, that is initial due diligence, advanced due diligence, full due diligence, and post-deal due diligence. Henceforth, due diligence specifically conducted to look into corruption and bribery practices will be termed as anticorruption investigative due diligence or, in short, ACID. Figure 6.6 shows the flow of the different stages of ACID corresponding to the stages of due diligence. At any of these stages, firms can choose to carry on with due diligence if the amount of anticorruption risk falls within the firm’s risk threshold, or they can abandon the project entirely if the risks discovered break the threshold. The exception to this is the post-deal due diligence stage.

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All that can be done here is damage control, and, as the name suggests, damage has been done, be it in the form of time spent cleaning up the books, explaining to regulators, paying a hefty fine, or an altogether write-down or loss of the business. In carrying out anticorruption due diligence, one has to simulate the corruption and bribery scenario by thinking like a businessman who “endorses and carries out” bribery practices, and how he would hide it from a potential investor potentially filling his pockets for his overvalued fi rm. The more bribery the company or the founder has dished out, the greater the effort that is needed to make it less obvious. Usually, this means that there are, in fact, more (rather than fewer) traces or leads for an astute due diligence team to track down. Initial ACID: Prenegotiation As highlighted early in the four deadly A’s overview, in order to assess, mitigate, and eliminate the risks related to anticorruption, investors should

Initial ACID

• Purpose: Preliminary assessment of corruption risk • Sources/Tools: Online databases, word-of-mouth, social media • Task: Assess risk, taking into consideration industry corruption risk levels

• Purpose: To determine the extent of corruption risk, and whether it is beyond firm’s corruption tolerance threshold • Sources/Tools: Financial statements, bank accounts, past M&A advisors, corruption questionnaire Advanced ACID • Task: Assessment of all available firm information released

Full ACID

• Purpose: To fully identify and assess corruption risks, and determine risk mitigation • Sources/Tools: All information available in advanced ACID stage, plus additional information obtained • Task: Full assessment of every available data and transaction, past and present, and crystallize anticorruption policy amongst acquired staff

• Purpose: To eliminate any undiscovered corruption, and ensure risk factors mitigated • Sources/Tools: Everything available in predeal stage plus internal information available after deal Post Deal ACID • Task: Monitoring of risk factors raised in predeal stage, continued scrutiny of stress points

FIGURE 6.6

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consider setting aside a group of people within the due diligence team, focusing specifically on ACID processes. The team should preferably have received training in the field of detecting anticorruption, and have ample knowledge on the under-the-table business scene in China. The need for anticorruption must be emphasized at the start to the due diligence team. Statistics show that anticorruption due diligence is often omitted by fi rms in the due diligence process. It is crucial to set the tone of due diligence right. This gives the due diligence team vision and direction about where their work is heading. Emphasis on anticorruption right at the start is important, because if anticorruption due diligence were to start later on during the course of the deal, the target may have begun implementing counter due diligence measures by temporarily severing ties or practices related to bribery and corruption. Below is a partial list of items to be screened by the anticorruption due diligence team during the prenegotiation phase, or the initial ACID: Potential Personnel for Bribery ■ Industry that the firm is operating in: ■ Does the industry require license issuance? ■ Which governmental department issues the license? ■ Who are the key personnel in that government department? ■ Customers: ■ If B2B, who are the managers of the businesses? ■ If B2C, who are the major customers of the target? ■ Suppliers: ■ Who are the managers of the supplying companies? Relationships ■ What are the known relationships between management and the identified personnel who have bribery potential? ■ Social media (Weibo, Renren, Facebook, LinkedIn) ■ News (local and international) ■ Search engines ■ Hired investigators If any of the managers were found to have close personal links with any of the personnel who have bribery potential, that implies a high corruption risk and it should be marked as a red flag. For example, discovering that the target firm’s CEO was the university school mate of the civil servant in charge

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of approving licenses for their business, or that four out of five of their largest customers are actually owned by the relatives of one of the target firm’s management team, are telltale signs that there might be corruption in the business. The due diligence team will need to take note of such cases and highlight them to the firm’s management. Based on the preliminary screening, the acquirer has to make a judgment call about whether the inherent risks of corruption are too high to carry on with the deal. If the acquirer deems such risks able to be mitigated, they will need to clarify the origin and details of such relationships with the target’s management further on in the negotiations. Advanced ACID: Preacquisition In the preacquisition stage, it is assumed that the investors have met the target’s management and that the possibility of a deal between them has been expressed. Information asymmetry is greatly reduced, because the fi rm will have access to, albeit limited, financial statements, customer/supplier information, and meetings with the target’s management. The essence of advanced ACID is to conduct a thorough but relatively costefficient anticorruption due diligence on the limited information received from the firm to date. After all, at the preacquisition stage, there are many variables from the financial, operational, and legal perspective that have yet to be assessed. One of the most effective ways to understand whether a business endorses illegal practices is by finding out the standpoint of the management on corruption. This can be done by asking anticorruption-specific questions during face to face meetings, and gauging their responses to these questions. The investor fi rm’s management should also procure information on the target’s customers and suppliers. With this list, the ACID team must not only verify the accuracy of the information but also do a preliminary screening based on the criteria stated in the prenegotiation checklist. They should also arrange meetings with the management to fi nd out more about their corruption risk if time permits. The purpose of the meeting is to ensure that the company’s customers and suppliers do not have a track record for corruption, which may be a red flag to the possibility of corrupt transactions arising between the target company and them. What has happened in the past may happen again in the future. Another good source for learning about corrupt practices would be the fi nancial/legal/accounting advisors for previous M&A deals. Track down the individual advisors who have had contact with the target fi rm, and find out more about their perceptions of the target company in terms of corruption.

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At the preacquisition stage, the fi rm may, wisely, not reveal too much information, limiting the efforts of the ACID team. As the possibility of the deal crystallizes, stemming from positive reports from the other preliminary aspects of due diligence, management may decide to pursue full due diligence. Full ACID: Preacquisition For the ACID team, this translates to a full-fledged investigation into every possible facet of corruption. Similar in detail level of the founder (SWOPEST, Tri-Background) and fi rm (face-to-face, site visits) beyond-the-checklist due diligence, the ACID team will do the same but with a focus on weeding out corruption. Full ACID would be the time to investigate information gaps that the advanced ACID was not able to fill. Cost is less of a factor here than in advanced ACID, and the ACID team should employ all possible means to eliminate information asymmetry. Due diligence must be detail-oriented during full ACID. A good example would be to use managements’ bank accounts as a source for finding corrupt transactions. Match all company-related debits and credits, with the financial statements provided. Red flags include mysterious sums of money transferred between accounts and unmatchable sums of money. Such level of detail is required, even if it may strain ties with the target’s management team because through these checks it may appear that you assume the target is corrupt. However, that attitude in itself may be a red flag, because if the target company is committed to enforcing anticorruption measures, they will most probably understand the need for the investor’s actions. In fact, as the Chinese saying, be a gentleman only after verification (֥ൄξ ‫ޕފ‬ವ), being thorough in checking for anticorruption serves as a confidence booster for the target’s management that their new shareholder treats corruption seriously, and is highly integrity oriented. Post Deal ACID Post Deal ACID is equally important to ACID in all other stages. Ernst & Young’s 11th Fraud Survey found that 42 percent of firms omit this step and, therefore, it is noteworthy to emphasize its importance. A firm is still subject to all the aforementioned costs of corruption after the acquisition is made. Having access to all the company’s data after the deal, the ACID team should assume a greater responsibility in examining all financial statements/bank

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accounts/receipts (a large number of Rolex watch purchases will raise the red flag!) and every other data available to ensure that: ■ ■

■ ■

■

There are no secret transactions to any governmental officials. There are no suspicious transactions occurring within six months of license issuance. There are no secret transactions to any customer or supplier. There are no secret transactions to any non-customer/non-supplier entities. There are no hidden credits into the target’s or management’s bank accounts.

Such ACID checks should be regularly performed for at least two years after the deal. ACID Framework Summary The following shows a summary of the flow of ACID activities alongside stages of main due diligence. 1. Start of initial due diligence, anticorruption team established. 2. Initial ACID begins. Preliminary assessment of corruption risk: a. Online databases b. Word-of-mouth c. Social media 3. Preliminary decision made to abandon project if risks are too high, or carry on if risks are deemed manageable. 4. Advanced ACID begins. Preacquisition due diligence and assessment of corruption risks. Due diligence team now has direct access to management of target company. The following can be done: a. Review existing anticorruption policies, if any. b. Review all disclosed fi nancial data (get as much as possible, which will be difficult. In fact, it will be odd if company divulges all available information. It could be a red flag, pointing to the management wanting to get the company out of its hands). c. Carry out informal/formal interviews with management and staff. d. Carry out informal/formal interviews with the friends/family of management and staff. e. Carry out informal/formal interviews with the friends/family of management and staff.

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5. Transition to full ACID, filling up information gaps from advanced ACID. 6. If no jarring red flags, proceed with deal and transit to post-deal ACID. a. With full access to financials and other data, investor must do a thorough screen to ensure no signs of corruption exist. b. Ensure that acquired company complies with new anticorruption measures.

Core Integrants of ACID Processes and Implementation This section covers the three critical areas that investors should look into in planning their ACID process, namely, business licenses, business drivers, and business fi nance. The three areas are essentially business aspects whereby signs of corruption or bribery practices are most likely to show up. As such, these three aspects should form the core of investigative processes in the various stages of ACID, be it initial, advanced, full, or post-acquisition. Business Licenses: Approving Authorities and Regulators The legal due diligence team will scrutinize and verify all types of business licenses that the target business possesses, from the first business registration license to all special-sector related licenses like forestry ownership license, restaurant hygiene license, just to name two. The ACID team will focus on the ways these licenses were obtained and approved. The team will link the relevant authorities and government officials in charge of approving these licenses and their relationship with the company’s founder and management, to ascertain there was no illegal transaction among the parties. The ACID has to pay more attention to licenses that are known to be difficult to obtain and highly restricted and selective for approval, like licenses for fi nancialrelated product licenses. It is during the due diligence and valuation process that the diligence team will challenge the valuation of these licenses, and the founders typically will defend the monetary value of these licenses and claim that those are hard-to-get assets of the company. Figure 6.7 shows the flow of the due diligence to be conducted on business licenses. Business Growth Drivers: People Involved (Government Officials, Clients, Suppliers) When presented with a good and sound business model with excellent growth, the ACID team will work with the valuation team to look very carefully and critically on the growth drivers and assumptions. All drivers of the business must be identified and listed in a tabulated table with relevant and associated

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Due Diligence Breakdown

Licenses

Types of License

Approving Authority

People Involved

H

M

H

L

L

FIGURE 6.7

M

H

Level of Risk

Follow-Up

Follow-Up

Follow-Up

L

Follow-Up

Due Diligence Report

Actionable Follow-Up Follow-Up

Flow of Due Diligence on Business Licenses

personnel identified. The ACID team has to look into each individual person and decide on the possibility of each of them being involved in any corrupt activities. Typically, these business drivers are associated with the macro environment, clients, and suppliers. See Figure 6.8. Business Finance: Financial Institutions and Government (Bank Loans, Funds, Subsidies) The sources of finance for the continuous growth of the business and its working capital and capital expenditure are other important aspects that the ACID team ought to pay close attention to. The team needs to ensure that all sources of capital were obtained in a legitimate way. If there were any preferential treatments or privileged terms and conditions associated with financing, the team needs to find out the reasons and background of such arrangements and whether there are any corrupt or illegal activities behind the scenes. See Figure 6.9.It is important to make a relationship chart for the founder and the members of senior management. By evaluating the chart, one can identify high-risk relationships among all parties. It is always important to state the motivations behind help rendered to each party, and based on the assumed motivation, question and interview the related parties to verify the true motivations.

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Business Driver

Customer

■

277

Due Diligence Breakdown

Supplier

Drivers/Success Factors

Others

People Involved

L

L

H

M

H

Follow-Up

H

H

L

Follow-Up

Actionable Follow-Up

Due Diligence Report

Follow-Up

FIGURE 6.8

Level of Risk

Follow-Up

Follow-Up

Flow of Due Diligence on Business Drivers

Business Finance

Banks

Due Diligence Breakdown

Government

Financing Institution

Others

People Involved

H

L

M

M

L

L

Level of Risk

Follow-Up

Follow-Up

FIGURE 6.9

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Follow-Up

Due Diligence Report

Actionable Follow-Up

Flow of Due Diligence on Business Finance

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CASE STUDY 6.4: MORGAN STANLEY REAL ESTATE

I

n August 2012, a former Morgan Stanley real estate senior executive was sentenced to nine months in prison for evading the bank ’s internal controls in order to obtain unlawful gains from bribery activities, violating the U.S. Foreign Corrupt Practices Act (FCPA). Garth Peterson was a managing director in Morgan Stanley ’s Real Estate Investment and Advisory division in Shanghai from 2002 to 2007. In 2008, an internal probe by Morgan Stanley resulted in the termination of Peterson from his role. Prior to the sentencing (made by the Brooklyn federal court), Peterson had also settled a parallel civil case with the U.S. Securities and Exchange Commission over the same allegations, agreeing to a US$250,000 penalty, permanent ban from the securities industry, and a surrender of his personal property in Shanghai valued at US$3.4 million.13 Although the identity of the party receiving benefits from Peterson was not revealed in SEC nor the federal court proceedings, the Chinese press have deduced (based on the description provided in the proceedings) that the party is Wu Yonghua, the former chairman of Yongye Group, a state-owned real estate company.14 It was reported that Peterson had personal and business links with Wu from as early as 2002 when he started his employment with Morgan Stanley, and that these links with Wu and Yongye Group had been instrumental to Morgan Stanley in building up its real estate portfolio in China. One key project that was involved in the case was Jinlin Tiandi, a residential and serviced apartment development in the highly coveted Xintiandi area in Shanghai. The project developer was none other than Yongye Group. In 2002 and 2004, Morgan Stanley ’s real estate arm in China had separately invested in the project. For 2004’s investment, Peterson was put in charge of the whole deal, and eventually Morgan Stanley bought over the entire serviced-apartment segment of the development. However, during the negotiations for that deal, Peterson had set up a British Virgin Islands-registered company called Asiasphere with Wu and a Canadian lawyer. In 2005, following Morgan Stanley ’s completion of the purchase, Asiasphere then acquired shares in the Jinlin Tiandi project, and Peterson had then lied to his superiors that Asiasphere was a wholly owned subsidiary of Yongye Group. Peterson also claimed that Morgan Stanley had bought into the project earlier at a cheap valuation because of their relationship with Yongye, thus painting a picture that it was a fair exchange for Asiasphere to repurchase some shares at a good price. With the property market going on a bull run from 2005 to 2006, Asiasphere’s shares in the Jinlin Tiandi project more

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than doubled. Throughout the whole time, Peterson never once disclosed his personal involvement in the project. Apart from this violation of his employer’s disclosure regulations, Peterson was involved in bribery activities for at least five other projects in Shanghai, all involving Wu in some way or another. Peterson devised an unconventional proposal for Wu, in which for every project that Wu successfully introduces to Morgan Stanley, he is entitled to receive 3 percent shares of the project by paying only 2 percent actual cost. In these five projects, although Yongye Group was not the developer in charge, their state-owned status meant that they were usually appointed as the key broker for the project.15 In 2006, Peterson told his superiors of the unconventional arrangement he had with Wu and Yongye, and they had warned him that such an arrangement could result in implication charges, and instructed him to cease such dealings immediately. However, Peterson turned a deaf ear to their instructions and continued the arrangement with Wu. In another transaction, Peterson made a payment (on behalf of a Morgan Stanley Real Estate Fund) of US$2.2 million to an unnamed individual on the basis of agent fees. From those fees, US$1.6 million was subsequently transferred to Peterson, who in turn transferred US$0.7 million to Wu (who at that time had already retired from Yongye Group), demonstrating another attempt to turn a personal profit.16 In 2008, an internal probe by Morgan Stanley revealed Peterson’s misconducts, and he was subsequently terminated. In April 2012, Peterson was charged by the U.S. SEC in a civil lawsuit, and also in a parallel criminal lawsuit for violation of the FCPA rulings, where he pleaded guilty to all the charges, and subsequently received the nine-month sentence detailed earlier. Prosecutors had earlier sought for 51 to 60 months of jail term. Morgan Stanley was not charged in this case.

Takeaways Unlike most of the cases detailed so far, this case involves not only a party from the Chinese target, but also a member of the investment team. Although investors may tend to focus due diligence efforts on the Chinese target company, they should not forget the possibility of bribery influences stemming from within the acquiring company. This case also highlights the U.S. FCPA at work. The FCPA is a United States federal law that applies to any person having a certain degree of connection with the United States, and who engages in foreign corrupt practices. The law applies to any act by U.S. businesses, foreign corporations trading securities in the United States, American nationals, citizens, and residents acting in furtherance of a foreign corrupt practice, regardless of whether they are physically present in the United States. (Continued)

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(Continued) Peterson is regarded to be the first individual from the financial-service industry charged under the FCPA laws. However, one can see the sentencing is relatively light compared to what prosecutors representing the SEC initially sought. Law academics following the case noted that the outcome demonstrated prosecutors’ inability to win tougher punishments for FCPA violators, and that typically, judges do not impose jail terms of more than one year for such cases. As such, a foreign investor can certainly not rely on the FCPA as a strong deterrent against employees carrying out corrupt practices when dealing with investments in China.

Accounting Frauds and Cheats After an extensive discussion of the problem of corruption and how investors can avoid falling into the pitfalls, we turn our attention to the final deadly A, which is accounting frauds and cheats. Unlike corruption and bribery practices, accounting frauds and cheats only really came to attention in the past decade or so, as investors increasingly sought to impose Western accounting standards in Chinese companies. As discussed in Chapter 2, there are still major differences between the West and China in terms of the quality of financial statements and business processes. In the past few years, accounting frauds in China has also gained worldwide notoriety, thanks in no small part to a group of research firms and individuals known as short sellers. Short sellers ply their trade by publishing free equity research reports on listed companies, which they believe to have fraudulent misconduct or have made some form of untruthful representations. The highest-profile short sellers include Muddy Waters, Citron Research, and Bronte Capital. In general, most accounting frauds in China involve the following few areas of the company’s books, namely sales, cash, assets, and accounts receivables and payables. For sales, the most common fraud cases involve some form of inflation, either through ghost transactions with customers or through related-party transactions. Frauds involving cash and asset accounts usually also involve an overstatement of the company’s cash position or net asset or inventories value. Another common type of asset fraud would be overpaying for an asset through a related-party transaction, and siphoning back the difference to cover the company’s expenses. In this way, the expenses are not recorded in the company’s income statement, but capitalized as asset value on the balance sheet. Frauds involving the manipulating of accounts receivables

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and payables are most often used to siphon smaller amounts of cash out of the company for personal use. In the due diligence stage, the uncovering of these accounting frauds can all be made possible via through financial due diligence and, more importantly, the use of beyond-the-checklist tools covered earlier such as face-to-face interviews and proportion checks. Generally, the investors that are most vulnerable to the impact of accounting frauds are really the ones investing in Chinese public companies. For one, public investors usually do not have access to the beyond-the-checklist due diligence avenues previously mentioned such as face-to-face meetings, and also the full suite of company information that can allow them to perform a thorough financial due diligence or proportion check. Secondly, public investors ultimately put much of theirs and the company’s fate in the hands of market sentiments. Chinese public companies, upon being hit by a fraud accusation, tend to take a massive nose-dive in the stock market. As highlighted earlier, the emergence of high-profile short sellers in recent years have greatly exacerbated the herd mentality sell-off in the markets, particularly for Chinese companies. Majority investors who cannot offload their position quickly will see the value of their investments wiped out in a matter of hours. What usually follows is a trading halt, followed by an investigation by the respective securities regulatory body for that market. Whether the fraud allegations turn out to be true or false, investors in the companies usually find it difficult or impossible to recover their investment outlay. On the contrary, for an investor in a private Chinese company, the uncovering of accounting fraud would typically not have such a drastic impact on the investment value. As long as the underlying business model is still sound and of a profit-generating nature, and provided that the fraud is discovered early, the investor usually has the time to minimize the impact and rectify the problem. This can be through the removal of the personnel involved with the fraud, putting in place a better accounting system as well as a better monitoring system. However, this is not to suggest that the investor in Chinese private companies is guaranteed complete safety from fraud risks. For the negligent private investor, what really causes severe damages to their investments are frauds and cheats involving dummy companies, false ownership of assets, or even a bogus business model altogether. That said, as long as investors rely on the principle of “seeing is believing” in performing their due diligence, they should be able to avoid these pitfalls easily. Seeing here would refer to the sighting of every single claim made by the company, including the factory, the machinery, the products, the employees, and even the actual customers and suppliers in person. This is where site visits, face-to-face meetings, and proportion checks will prove to be not only useful, but absolutely necessary.

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CASE STUDY 6.5: SINOFOREST

S

inoforest was one of the most successful Toronto-listed companies for the past few years, attracting the likes of renowned investors such as Paulson and Co. and Wellington Management Company, which together held close to 20 percent of the company. The company exhibited a phenomenal 30 percent annual revenue growth since 2004 and an EBITDA of 52 percent year on year. Such achievements resulted in a slew of awards, including being ranked fifth on The Investor 500 by Canadian Business in 2007. However, these episodes of amazing profitability and growth were brought up short by allegations of fraud by many parties, in particular Muddy Waters LLC. We examine the case and discuss what should have been done during the due diligence process that would have painted a more accurate picture of Sinoforest’s operations.

History Sino-Forest Corporation (Sinoforest) was founded in 1992 as Sino-Wood partners and incorporated in 1994 in Canada by Allen Chan and Kai Kit Poon. CEO Allen Chan has no direct experience in the forestry industry, having been an urban planner for the Hong Kong government and having done consulting and project management with Bechtel, and President Kai Kit Poon worked for 15 years as an engineer for the Forestry Bureau in Guangdong. The company started with a business model producing and selling woodchips, having access to land in China via a few joint venture (JV) structures they had in place, and in 1992 they were managing about 20,000 hectares of plantation land. On these plantations timber was grown, harvested, and processed into wood chips, and subsequently exported out of China. In 1993 Chan and Poon decided that a listing would be beneficial to the growth of the company, and they were successful in carrying out a reverse take-over (RTO) via Mt. Kearsarge Minerals in 1994. They were trading on the Ontario unlisted market in March 1994 before moving to the Toronto Stock Exchange (TSX) in October 1995. Sinoforest was operating a similar business model for most of the 1990s, including signing a US$10 million equity joint venture (EJV) with the Leizhou Forestry Bureau to primarily produce wood and woodchips for the domestic market. It was an extremely profitable EJV, with Sinoforest generating 65 to 77 percent of its revenue during 1994–1996 via the EJV. The company also implemented a rapid expansion plan in the mid1990s. The company was managing 37,000 hectares in 1996, which increased to 100,000 hectares in 1998 from signing a series of JV agreements in the late 1990s that allowed it to secure close to 600,000 hectares of land. With the plantation investments in the 1990s paying off, Sinoforest expanded operations into the timber production value chain, diversifying operations into the sale of felled timber and mature timberland.

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Sinoforest ’s had three different models for timber production. The first was Purchased Plantations, which were existing forests that were held until trees were ready for harvesting, then sold harvesting rights and re-leased land for replanting. The second was Planted Plantations, which were long-term leases of up to 50 years for Sinoforest to manage proprietarily and counted for more than 90 percent of Sinoforest ’s revenue. The third was Integrated Hybrid Plantations, where logs were harvested for sale or used as inputs for their own integrated manufacturing operations. Most of the transactions and sales that took place were via authorized intermediaries (AI), which were entities that could legally engage in the timber and woodchip business in China. The purpose was also to minimize Chinese tax liabilities at the parent company level. These AIs are largely timber trade customers that act as both a customer and a sales channel for Sinoforest, and at the same time process much of Sinoforest ’s income and value-added taxes. For the first four years ending in 2010, Sinoforest achieved meteoric annual growth of 41 percent in revenue, 24 percent in diluted earnings per share, and 41 percent cash flow from operations. This attracted investors such as Jon Paulson and Wellington Management Company, who invested 14 and 6 percent into the company, respectively. The company also engaged Jakko Poyry to write valuation reports on its business operations, and Sinoforest typically utilizes these reports as means of convincing new investors. However, things were not as they seemed.

Fraud Allegations A research report published by Muddy Waters on June 2, 2011, led a massive wave of investors to dump their shares in Sinoforest, causing the share price to plummet by more than 70 percent in a day. Carson Block made allegations that the company was fraudulently overstating assets and earnings, and claiming that Sinoforest was essentially a giant Ponzi scheme. The foundation of fraud was built on transactions carried out by the AI structure, which allegedly allowed Sinoforest to fabricate sales transactions without processing VAT invoices. The review of tax invoices is the primary method whereby firms are audited in China. These allegations, if true, should have been discovered at the start during the due diligence process by any potential investor. We would examine the allegations of fraud and discuss how the due diligence process should have been done. Fraud 1—EJV with Leizhou Forestry Bureau The EJV came into being on January 29, 1994, with Sinoforest subscribing to 53 percent of the equity and Leizhou Forestry Bureau (LFB) taking up the remaining 47 percent. The purpose of the EJV was to produce wood (Continued)

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(Continued) and woodchips by leveraging Sinoforest’s expertise in the sector and LFB’s assets. Sinoforest, in accordance to the terms, was to contribute US$5.3 million in phases, with the injection of US$1.5 million within the first three months of incorporation and the rest in two years, and LFB was to contribute forest assets of 3,533 hectares. However, the EJV did not go according to plans, because Sinoforest had issues with contributing equity to the JV. Sinoforest put in US$1.0 million at the start of the JV and by mid-1995, the remaining US$4.3 million was still not contributed to the JV. Requests from LFB for meetings and discussions went unanswered, and once the contribution deadline arrived in January 1996, the Sinoforest management team still could not be contacted and skipped a board meeting of the EJV called to discuss this issue. Furthermore, Sinoforest withdrew capital (approximately US$500,000) that it contributed to be given to an unrelated third party to the JV, Huadu Baixing Wood Products Factory. The JV, having not achieved the intended scale of operations, also lost more than US$1 million in 1995. Yet Sinoforest claimed that the JV was doing very well in the Canadian filings. (See Table 6.1.) LFB filed complaints in 1998 to the Commission of Foreign Trade and Economic Cooperation (China), detailing the various breaches of contract of Sinoforest, including the failure to inject capital and improperly distribute money to an unrelated third party, and requesting the EJV to be terminated. Sinoforest agreed to the termination of the EJV in 1998, with the termination agreement detailing that LFB would receive all the assets they originally contributed and Sinoforest would keep the entity and look for a new partner.17 Sinoforest, however, did not manage to find a new partner and converted the entity into a wholly foreign owned entity (WFOE). A new scope of business, producing and selling wood products, was formally approved. TABLE 6.1 Leizhou Forestry Bureau EJV Sales Year

BDMT (Thousands)

Average Price (US$/m3)

Amount (US$, millions)

1994

156.3

85

13.286

1995

204.2

103

21.033

1996

212.5

102

21.675

1997

45

98

4.410

Total

618

–

60.403

Source: 1994–1997 Annual Reports.

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Yet Sinoforest decided to deregister the WFOE in 2003 without additional capital contributed, and at the same time in their 2003 annual report disclosed that they would need to conduct business via authorized intermediaries due to lack of licensing. Furthermore, they did not disclose the winding down of the very entity that was legally authorized to operate the woodchip business. Evidently it was to prepare the company to conduct business via the AI structure. Fraud 2—Authorized Intermediaries and Woodchip Sales The core of the fraud lies in the AI structure, where Sinoforest designates domestic wood dealers as licensed operators to conduct business in China on its behalf. These AIs act as both customers and sellers. They purchase timber supplies, deliver them to the chipping facility, process the wood into woodchips, sell the processed wood to customers, collect payment from the end-user, and pay Sinoforest after expenses deducted. The supplies of the timber are sourced by Sinoforest and the customers are typically pulp and paper mills. The AI would pay Sinoforest a fee on a net basis after withholding of applicable taxes, so no tax documentation is available to confirm whether Sinoforest received any money from these AIs. Sinoforest also refrains from disclosing the identities of the AIs in order to protect its competitive advantage. It states in its annual report that it would “reimburse the costs of the AI, including cost of the purchase of raw timber, and to pay both a processing fee and a management fee . . .,” but these fees are deducted from the sales proceeds. Basically, Sinoforest contributes no capital, assumes minimal risk in the entire process, and yet generates a 55 percent gross margin from the AI on standing timber sales. The purpose of this structure was basically to allow Sinoforest a free pass to fabricate sales revenue, since there would be no tax receipts available during the audit and hence no way to authenticate whether the transactions and sales actually took place. Even if one assumes the business model is actually taking place as claimed, there are a few financial issues with the model that make it ultimately unrealistic to have taken place in China. First, it is illegal for the AI to pay Sinoforest’s value-added tax, since regulations clearly state that the names entered on the tax receipt must be that of the seller of the good. The managements of the AIs would be risking sentences, possibly lifetime in nature, in order to process these transactions for Sinoforest. Second, as AIs are not importing the timber, they would not have custom invoices for the sales, which were transacted in yuan. Since (Continued)

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(Continued) Sinoforest is an offshore company, the AIs would not be able to convert the yuan into foreign currency and pay Sinoforest offshore. With over US$1 billion in payments made annually, it is also unlikely that the AIs combined would have sufficient capital in their offshore accounts to be able to pay Sinoforest. Taking these factors into account, it is highly unlikely that substantial actual sales transactions took place via the AI structure, and it is more probable that the AI structure was only used to fabricate sales of the woodchip business. Fraud 3—Timber Sales The company also engaged in fraud for the timber aspect of its business. In 2010 the company claimed to have sold 507.9 million yuan of standing timber at an average price of 102 yuan/m3, primarily (close to 45.5 percent) from broadleaf trees in Yunnan. This is equivalent to about 2,265,000m3 of broad leaf timber. Taking into account regulations prohibiting clear cutting of broadleaf forests, a sales amount of this size requires at least 25,000 hectares of forest with a yield of 90m3/ha.18 This figure, however, exceeds the total possible area to be harvested in the Lincang region in 2010. Since 2001 there has been an annual quota system nationwide, which states the maximum size of land one can harvest. The quota is established in each five-year plan, with the provincial forestry bureaus proposing quotas to the national forestry bureau and the State Council, which has the approval authority. The quotas are then allocated by the provincial forestry bureau to the local forestry bureaus, with Lincang City having a full-year quota of 376,000m3. This implies that Sinoforest ’s claimed sales far exceed the stated quota by more than six times. Furthermore, assuming somehow that the quota system was pushed aside, the actual task of logging is also extremely difficult. Logging broadleaf in Yunnan is even more difficult than other places because of the substantial distances required to cart the logs to roads that are passable to trucks. Lincang itself is also 92 percent mountainous and the hilly areas make for an even more difficult harvest as most of the processes would have to be done by manual labor. Even if the trees were able to be taken down to the roads, it is about 200 km away to the nearest railway station whereby distribution could then take place. A majority of the roads are also leading into agricultural areas, which means they are typically low quality and unpaved and may not even be able to comfortably fit the size of one truck. Assuming a typical truckload of about 20–30m3 of trees, this implies about 70,000–100,000 truckloads were required. It is highly improbable that this process could have taken place in the context of the Lincang region.

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Due Diligence #1—Investigate Business Partners When doing due diligence, one of the first things to investigate should be the parties doing business with the target firm, including suppliers, customers, and partners. Meeting the parties who are doing business with the target firm is one of the key ways to verify the target company’s financial claims. In this case, one could find out the status of the JV with Leizhou Forestry Bureau by contacting the bureau directly regarding the case. There have also been many documents submitted to various parties, including the Guangdong Provincial Forestry bureau and the local Zhanjiang government regarding the status of the EJV. One reason for the lack of cross checking could be that the Canadian audit firms were unfamiliar with Chinese regulations as well as the presence of a potential language barrier during the 1990s. Without the Internet, it would be significantly more difficult to conduct detailed investigations into partnerships outside Canada before the twenty-first century. Yet it was a significant event that was not managed properly by the authorities, which, in turn, gave Sinoforest an opportunity to further expand fraudulent activities.

Due Diligence 2—Understanding Business Models The second due diligence that should have been carried out would be to obtain a full understanding of the business model of a particular firm prior to an investment. After verifying the parties that the company conducts business with, the next step would be to understand the detailed operations of the target company within a specific business environment. In the case of Sinoforest, one could intuitively feel that something may not be right with the AI structure. Sinoforest is earning too large a profit from minimal value-added to a transaction. For instance, if the company refuses to disclose the identities of the AIs, a party that is highly relevant to the operations of the firm, it would certainly raise concerns about the legitimacy of these parties. The fact that the AIs also conveniently pay the taxes of Sinoforest such that attempts at auditing the firm would have no official evidence of revenue should also raise questions to an investor. Short of being suspicious, evaluating these situations logically should yield significant doubts about the legitimacy of the business operations. Specific knowledge of the sector would also play an important role. An expert on the timber industry in China would question whether the harvesting of a large number of trees in the Lincang region is realistic given its mountainous terrain and underdeveloped infrastructure and roads. (Continued)

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(Continued) Understanding the key issues that a typical company in the industry would face is invaluable in the evaluation process of a company’s operations. Often, investors should consult an expert’s opinion on the industry and business operations of the target company, especially for more complex industries, because more insights could be obtained compared to viewing it from a layman’s perspective.

Due Diligence 3—Understanding Regulatory Environments A further understanding of the regulations and laws in a specific environment yields even more clues about whether the business model can be carried out within the regulatory framework. If the operations of the company seem to go against certain regulations, it would certainly raise questions about both the legitimacy of these operations as well as the risks of investing in this company. In the case of Sinoforest, if one is cognizant of the foreign-currency exchange issues within China, Sinoforest’s business models should raise questions about how they obtained the revenue from within China to be transferred to an offshore entity. Having a complete understanding of the regulations within China would allow investors to conduct a far more detailed due diligence process and evaluate the company’s operations with a specific set of criteria and yardsticks in mind. It is also important to understand the provincial and local laws that may provide more specific information to the due diligence process, such as the quota system for harvesting timber within Lincang city.

Takeaways To paint a complete picture of the target firm, investors would need to focus on the fundamentals of the company in order to ascertain the accuracy of the financial data, since logically it is the business operations of the company that produces the set of financial figures. To fully understand the business operations of the company, investors would need to also understand the industry and the local regulatory framework, both of which give clues about whether the company ’s operations are realistic. Sinoforest ’s fraud was primarily successful because there was no party that thought to fully evaluate the fundamental business of the company, until Muddy Waters began the two-year research process and subsequently released the research report; therefore, one of the key takeaways to this case study is that the due diligence process on a company should always, without fail, focus on the fundamental business of the company rather than evaluating the results of the company ’s operations, that is, the financial data.

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CASE STUDY 6.6: NEW ORIENTAL

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ew Oriental Education & Technology Group Inc. (New Oriental) is the largest provider of private educational services in China based on the number of program offerings, total student enrollments, and geographic presence. It was the first Chinese education institution to enter the New York Stock Exchange in 2006 and currently trades under the symbol EDU. On July 17, 2012, New Oriental issued a statement that it was under investigations from the U.S. Securities and Exchange Commission.19 According to New Oriental, the area of investigation was about the use of variable interest entity (VIE) in the company’s structure. Within a day, the share price nosedived 34 percent.20 On July 18, 2012, Muddy Waters, a short seller that sparked a 74 percent drop in Sino-Forest Corp shares before it filed for bankruptcy, published a report that questioned the ownership structure of New Oriental’s schools and the consolidation of financial statements with the parent company. It alleged that New Oriental’s numerous franchisees are a “substantial fraud in EDU’s accounts.”21 In the report, it claimed that New Oriental’s CFO, Louis Hsieh, had denied the existence of franchising in New Oriental.22 However, according to Muddy Waters research, New Oriental’s franchising focus is on POP KIDS store, packaged as a cooperation facility. Also, concerns on weak VIE in New Oriental were raised. The share price of New Oriental crashed another 35 percent to close at $9.50, its lowest in five years.23 Together, these two incidents wiped out US$2 billion from the company’s market value as its share price fell more than 57 percent over the past two days. On July 19, 2012, New Oriental responded: “the Muddy Waters report is wrong.”24 As of May 31, 2012, the 664 schools and learning centers branded under New Oriental are its own, whereas the cooperation facilities were immaterial. The cooperation facilities never exceeded 21 and the license and training fees represented 0.009 and 0.045 percent of New Oriental’s total revenue. Share price hiked 17.9 percent higher to US$11.2.

Takeaways From the response of New Oriental, “franchisees” (term used by Muddy Waters) or “cooperation facilities” (term used by New Oriental) were immaterial to the financial statements of New Oriental. However, it was a poor judgment for the CFO to claim that New Oriental grew organically and does not engage in the aforementioned model. Given (Continued)

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(Continued) the poor reputation of foreign-listed Chinese companies, his conflicting statement made New Oriental looked less than credible. Variable interest entity is a method by which a publicly traded company is allowed to consolidate operations that it does not own. This allowed Chinese businesses (e.g., Internet, education) to consolidate operating businesses, which Chinese law prohibited foreigners from owning, to be listed in the United States. New Oriental’s VIE were substantially weaker in terms of management agreement and equity pledge as compared to some of the Chinese stocks listed.25 In other words, investors were not as well protected. Although the reason for the structuring is unknown, investors should have noticed it and raised alarm bells when it was listed in 2006.

CONCLUSION This chapter describes in details the things to look out for when conducting face-to-face meetings and site visits, and how to use proportion checks as an additional due diligence tool. The four deadly A’s are a must for all due diligence team to seriously looking into, each a universe of due diligence pitfalls specific to the Chinese environment that may be missed out from the checks on the founder (SWOPEST and Tri-Background model) and company stakeholders (face-to-face meetings). That will wrap up the comprehensive beyond-thechecklists due diligence. Beyond the conventional due diligence, a large trove of information can be obtained via face-to-face meetings. Every single stakeholder and supply chain participants can produce new and invaluable qualitative information that conventional due diligence can never provide. Just as the SWOPEST and TriBackground framework places the locus on the founders and management, the face-to-face meetings focus on the stakeholders and related parties of the target company. There may be overlapping entities; for instance, the founder may have a close relationship with a government official under the SWOPEST framework, whereas the same government official comes under the ambit of face-to-face meetings with related government officials of the company. This serves as a good mechanism to magnify and cross-check potential red flags. As the saying goes, “fail to plan, plan to fail.” To ensure that investors make full use of each face-to-face meeting and extract the greatest quantity and most relevant information, thorough research must be carried out. By presenting meeting objectives alongside the planned questions, investors can

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evaluate how relevant their questions are in covering all aspects of the objectives to meet the information shortfalls. It is important that interviews not be solely scheduled from the name lists provided by the target company; the due diligence team can delve deeper into old records to sieve out disgruntled employees and ex-management, who may provide the information that is sine qua non to the due diligence process. Details like the date, time, and location must be looked into to ensure a comfortable sharing environment for the interviewee. Site visits provide a great opportunity to collect data on the various processes involved in the production process. Additionally, site visits allow verification of what was mentioned during the interviews, and first-hand evaluation of the physical presence of tangible and intangible said assets and state of wear and tear. The data can then be fed into the proportion check for an in-depth analysis of the company’s statistics. A company can fake sales, but it will not be easy to fake all possible permutations from the factors of production, logistics, and value chain to generate the sales and profits figures; therefore, the proportion check is a simple, intuitive, and highly effective tool of due diligence. Lastly, the four A’s, namely authorization and control, abnormalities, anticorruption and bribery, and accounting frauds and cheats, would help to weed out the deadly pitfalls that would otherwise mar the entire investment altogether. From company stamps to social media, fraudulent fi nancials to ACID framework, one-up the ante on the beyond-the-checklist due diligence to cover every possible loophole conventional due diligence might have missed in China. The new Chinese leadership under Xi Jinping and Li Keqiang vows to clamp down hard on corruption. Besides stricter laws and some high-level deterrence punishment, investors can wonder how long such anticorruption campaigns will last. ACID framework will stay relevant for many years to come in an increasingly transparent business environment in China. Looking back at the many Chinese companies that have been listed on overseas stock exchanges that were involved in accounting frauds and cheating, and that have subsequently been delisted, one cannot understand how they got listed in the first place. Taking Sinoforest as an example, did the due diligence team meet face-to-face with the Chinese dealers (intermediaries) and related government officials? Did the due diligence team do a proportion check (land versus production)? Did the due diligence team properly and intelligently plan the meeting and site visit? If only the deal team were to plan their due diligence process in accordance to what is described in this chapter, many M&A deals involving Chinese companies would not have taken place, and only good Chinese companies will go overseas for listings successfully.

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NOTES 1. “Profitable Baijiu Makers Turn Investors Tipsy,” Caixing Online, September 30, 2011. 2. “Fatal Crisis: JiuGuiJiu’s Baijiu Plasticizer Levels 260 Percent of Safe Standards,” 21st Century Business Herald, November 19, 2012. 3. “China Finds Excessive Levels of Plasticizer in JiuGuiJiu Liquor,” Bloomberg News, November 22, 2012. 4. “CADA Claims That All Baijiu Products Contain Plasticizders,” Huanqiu Finance, November 19, 2012. 5. “CADA Admits Presence of Plasticizers Is Common in Industry,” 21st Century Business Herald, November 19, 2012. 6. “JiuGuiJiu Scandal: Three Sources of Plasticizer Identified,” YNET.com, November 26, 2012. 7. “Nissin Leasing No.1 Woman Departs Company,” NBD Mei Jing Wang, November 6, 2008. 8. “Behind the Nissin Leasing Conflict,” 21st Century Business Herald, November 15, 2008. 9. “Nissin Leasing Chen Yunwei: TPG’s Share Transactions Are Against Rules,” Sina, November 12, 2008. 10. “Nissin Leasing, Chen Yunwei and Wang Yong Case,” LawXP, November 20, 2008. 11. “Order Restored to Qidong after Protest,” GlobalTimes.cn, July 30, 2012. 12. “Low Public Confidence in Food Safety: Survey,” China.org, January 4, 2011. 13. “Ex Morgan Stanley Exec Gets Prison Time in Bribery Case,” Reuters, August 16, 2012. 14. “Ex Morgan Stanley Employee China Bribery Case,” Zhongguo Jingying Wang, April 27, 2012. 15. Ibid. 16. “Morgan Stanley Chinese Official Bribery Case,” 21st Century Business Herald, April 27, 2012. 17. Interestingly, Sinoforest in its 1997 annual report stated they would receive US$12.4 million of assets from the EJV. 18. Sino-Forest Corporation, “Valuation of China Forest Crop Assets as at 31 December 2009,” Final Report, 15 and A5-3. 19. “SEC Scrutinizes China’s New Oriental,” Wall Street Journal, July 18, 2012. 20. “Shares of New Oriental Up Nearly 18% after Michael Yu Responds to Questions,” Caijing, July 20, 2012. 21. “Muddy Waters Research on New Oriental,” July 18, 2012, 1. 22. Ibid., 2. 23. “China’s New Oriental Rejects Muddy Waters Account Allegations,” Reuters, July 19, 2012. 24. “New Oriental Responds to Muddy Water Reports,” July 19, 2012, Press Release. 25. “Muddy Waters Research on New Oriental,” 29.

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C HAPTER S EVEN

Implementing a Due Diligence Workflow

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N T H E L A S T F O U R C H A P T E R S , we’ve looked at a multitude of tools

that are used in conventional checklist due diligence, as well as beyondthe-checklist due diligence. Although seemingly disparate, the two types of due diligence and the tools comprising them should be seamlessly integrated into an organized process flow during the actual due diligence. With so many tasks to be completed, a careful planning of the entire course of due diligence is critical to ensure that implementation is smooth, and members of the team do not do unnecessary and overlapping work. In this way, the due diligence is conducted in an organized manner whereby information uncovered, using beyond-the-checklist tools will fulfill the various information gaps not covered by checklist due diligence. It should not be the case that the due diligence team only starts to look toward beyond-the-checklist tools only when information gaps surface. Treating the two types of due diligence as disparate processes will render the course of due diligence cumbersome and inefficient. Having extensively discussed the tools and methods that may be used, this chapter examines the actual implementation of due diligence. To elaborate, the chapter seeks to put all the due diligence tools covered previously into an

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organized framework, from planning and formulating the strategy, to forming the team and the actual implementation of due diligence.

GETTING THE MIND-SET RIGHT Performing mergers and acquisitions in China usually causes much worry to the buyers, particularly those who are not familiar with the way business is being conducted in China. More often than not, the buyers have been fed with far too many horror stories of shareholders infighting, under-the-table transactions, accounting frauds, and so on. It is indeed true that such business tussles do happen in China. However, it must be noted that the same kind of dishonesty and corporate misconduct also happens in other countries (as mentioned in Chapter 1), such as with Olympus, Enron, Parmalat, and so on. Though some level of worry is unavoidable, the only solution that can ease the anxiety of these non-Chinese buyers is really to carry out a well-planned, detailed, and thoughtful due diligence exercise. Many cases of failed mergers and acquisitions are the direct consequence of poor due diligence, such as in an earlier cited example, Caterpillar’s acquisition of mining machinery manufacturer ERA. Yet, there is also no guarantee that “extensive” due diligence, typically claimed by the acquirer, is a good and effective due diligence. Usually, extensive due diligence may actually mean spending too much time and effort looking and digging into something that is not crucial to the success of the deal. Extensive due diligence is only a reflection of spending much time and resources on the due diligence exercise, but it does not mean that the due diligence team is well organized and that the team members possess the right set of skills required to perform an effective due diligence. It is also very typical to find many acquirers, who are preparing to buy Chinese businesses, harboring a level of love-hate emotion towards the acquisition. They are generally fearful of buying into a bad company and feel that it is virtually impossible to conduct a fool-proof due diligence, but at the same time, they yearn after the huge business potential and attractive returns offered by the massive Chinese market since the economy has opened up. Having such an attitude will typically make the acquirer extremely cautious about every step he or she makes during the acquisition process, but unknowingly, the untrusting and unfriendly attitude that the acquirer projects can eventually become a deal breaker. The Chinese business culture, similar to that in Japan and Korea, essentially puts a large emphasis on trust and image. When the acquirer does not trust the founder (seller of the business) and continually bombards him or her

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with difficult questions at the early stage of initial due diligence, the founder can at times be offended, and, as such, the mutual chemistry between buyer and seller cannot be developed for further negotiations. Therefore, the acquirer needs to remove all his or her previously formed personal biases and perceptions about the Chinese business, and adjust his or her mindset to view the deal as if it were conducted in the West, at least in terms of interactions with the founder. In this way, there is mutual understanding between buyer and seller and sets the stage for greater communication. That said, treating the company founder with trust and respect does not mean that one has to believe everything the founder has said and claimed. Instead, the buyer should be adopting the “innocent until proven guilty” approach to communicate with the founder. Thus, the acquirer should ideally project a sincere and earnest attitude toward the deal, but at the same time retain a reasonable level of inquisitiveness. The acquirer has to understand that the more he or she shows trust and friendliness, the more comfortable the founder would be with meeting him or her, and consequently the more information he or she will be willing to divulge and talk about his or her business and family. This is exactly what due diligence is all about.

FORMULATING THE DUE DILIGENCE STRATEGY Prior to the start of the due diligence process, it is extremely useful for a team to think about and design a detailed due diligence strategy. The strategy will guide the team throughout the process and ensure that due diligence can be conducted in a timely and efficient fashion. Although the planning of some of the later steps certainly require more information that may only come later in the actual due diligence processes, such as formulating the negotiation strategy and planning the due diligence report, it would certainly help to discuss these steps early on because they may bring up more information gaps that might not have been otherwise surfaced. Figure 7.1 provides a general flow of the formulation of the due diligence strategy.

Steps 1 and 2: Identify Acquisition Criteria and Targets An acquirer can be a corporation, a private equity fund, an individual investor, or any entity that has financial capability and resources to buy or invest in a business entity. These acquirers will narrow down their leads and identify their acquisition targets by categorizing them by sector and size of the firm, in terms of revenues and profits, assets, and so on. The criteria and purpose of the

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Summary of Formulation of Due Diligence Summary

acquisition will vary from one acquirer to another. For some, the criteria may be that the business must help the acquirer to expand market share or enter into a new market, whereas others may simply want to look only at distressed companies to turn them around. Some acquirers may even have the stringent criteria that the business must be profit generating. The investment criteria is important because it sets the premise for the acquisition objectives and, subsequently, for the due diligence objectives.

Step 3: Set Acquisition Objectives It is extremely important to always remember the objectives of an acquisition deal. The key questions to ask and communicate to the due diligence team are: ■ ■ ■

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Why Are We Buying It? Different acquirers may buy into a company for different purposes. For example, a corporation (strategic buyer) may be looking for exponential growth or seeking new technology/market; a private equity fund may be seeking a profitable exit within five years; and an investment firm might require good steady cash dividend from the company every year. With these objectives in mind, the due diligence team will have a very different focus when they carry out the due diligence process. For example, if an acquisition was to obtain an advanced technology from the target company, the team has to put in extra effort to ascertain the legitimacy of that technology, the IP rights governing the technology, as well as the scientists and engineers involved in developing it. On the other hand, for a private equity fund seeking to acquire the same target company, the cutting-edge technology might just be an ordinary due diligence item, as its considerations will steer more toward the scalability of the company’s operations. What Do You Want the End Product to Be? After defining the clear objective, it is important for the acquirer to have in mind what the final company is going to be after the acquisition. That is a vision for the target company (or the merged company) after the acquisition, planned with the objective in mind. For example, if the objective of acquisition is to acquire the technology of the company, the vision must be the acquiring company successfully using this acquired technology for the development of new products, and thereby enlarging its market share and top and bottom lines. Similarly, for a private equity fund, the vision could be for the company to expand its footprint into regional and international markets. How Do We Achieve It? From setting objectives to the actual implementation of acquiring a company, the due diligence process starts on the day the acquiring team makes the decision to progress further into the deal and when the deal has already passed the first phase of screening and financial analysis. The acquirer should have a blueprint of the strategy pertaining to the post-deal integration and the value addition. However, in order to ensure the successful implementation after the deal, a full and thorough due diligence has to be carried out to ensure that the planned strategy is feasible.

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Step 4: Know the Acquisition Target To design an effective due diligence plan and process, the team leader has to know the target company well by requesting information from the target company even before the due diligence process starts. The due diligence team has to convene for a preparation meeting, and each member of the team has to be assigned the appropriate role and responsibilities. Everyone must participate in the preparation work by going through all available information and performing a detailed analysis of the target company. A list of document requests should be quickly prepared when certain information is missing from the first round of provided documents.

Step 5: Identify Business Drivers and Risks After getting familiar with the sector of the target company, the products, and performance, it is important to understand the business drivers of the target company. The acquirer should determine if these drivers are sustainable and real. The potential risks should also be identified, so that the team can assess and decide if they can be mitigated before the acquirer decides to proceed further.

Step 6: Determine the Time-Cost Details A due diligence process can be completed within a day or within a year. It all depends on the objectives of the due diligence exercise, and whether the target company is a small company with good housekeeping and simple operations or a larger company with a complex business model. Chinese companies, in general, are the latter type, with a below-average or average standard of corporate governance and general administration. As such, investors should expect the time to carry out due diligence to be longer than it would be if it were carried out for a Western counterpart. The acquirer should also draw up a detailed allocation of a reasonable budget to conduct due diligence, and should not rush into any deals. The details of the diligence process should never be compromised, and all aspects of the target companies should be considered for due diligence investigation. The scope of due diligence is determined also by the replaceability, that is, what areas within the target company are replaceable after the acquisition. For example, one has to determine whether the senior management will be replaced. That will determine the extent of background check on the management, and also the time and effort to be spent on due diligence of departments

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or business units that are to be replaced. Once the intensity level of due diligence can be decided upon based on these considerations, the time-cost-details corresponding to it can be drawn up. With a good understanding of the target company, and having decided on the budget and timelines for the due diligence process, the due diligence team leader should then chart the implementation strategy for the process.

Step 7: Prepare the Implementation Plan This segment of the strategy should be the most comprehensive, because this is where the bulk of the work done during the due diligence process will take place. The implementation plan should first and foremost detail the information gaps in each of the main due diligence categories, such as financial, legal, tax, and founder/management. The information gaps should be done with close reference to the identified business drivers and risks, because these factors would drive the areas of focus during the implementation of due diligence. As the actual implementation of due diligence involves several main stages (to be discussed later in this chapter), it is important to have an efficient and realistic timeline to guide the completion of the various stages. This timeline should be done up based on the time-cost-details derived earlier.

Step 8: Formulate Negotiation Strategy Deal negotiation is always an important process in any M&A transactions. If the due diligence exercise is to be thorough, extensive, and effective, the information gained can be used to decide the approach to negotiation with the target company. As the old Chinese military saying goes, “He who knows oneself and one’s enemy will win every battle.” The information gained during the due diligence process can be used to decide the BATNA (best alternatives to a negotiated agreement), the walk-away price and valuation for the target, and the ZOPA (zone of possible agreement) of the deal. The due diligence team must confidently possess all of these pieces of information prior to entering a negotiation process with the target company. This will not only enable the team to make the right on-the-spot decisions during the negotiation but also will help to strengthen the team’s bargaining position and ability right from the start. If, during the due diligence process, contingent items are uncovered that will significantly lower the deal valuation if materialized, the team must be able to use these items to their advantage in striking the deal. For example, it may be discovered that a target company operating a restaurant chain may encounter difficulties in renewing rental contracts

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after interviewing the landlords; although this information might not be easily priced into the valuation, it can be used to strengthen the team’s bargaining position during the negotiation.

Step 9: Plan the Due Diligence Report There is no fixed format for a due diligence report. The due diligence team should prepare the due diligence report based on the need and reading comfort level of the intended readers. What is more important is to ensure that the report covers all aspects of the due diligence process. For example, the anticorruption check should link the different sections of the report together, from the background of the founders, to financial payout to suppliers, to government relationship. The team should also focus on the risks identified and the mitigating measures.

Step 10: Post-Acquisition Review Plan Most due diligence processes end with the production of the final due diligence report. This is, in fact, a huge negligence, and one of the worst mistakes an acquirer can make. The due diligence team should continue to review the risks and red flags, even after the deal has closed, and convene regularly for an update.

FORMING A TEAM The due diligence team should be led by a team leader who has in-depth local knowledge on China. It will certainly not be a good idea to send someone from the home country of the acquirer to lead the team in China if he is not well versed with the Chinese business environment. The composition of the team will also largely depend on whether the acquirer wants to outsource any of the due diligence work to external parties, typically the full legal and accounting services. In general, an in-house team will work with external parties for most due diligence processes in China. It is advisable to engage a consultant who is familiar with the business environment and practices, who has extensive deal-execution experience, and who is able to provide advice to the team leader about the due diligence step-by-step process, making and arranging contacts, and providing an opinion on collected information of the target company. That consultant should also provide the final

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recommendation of the execution of the acquisition deal, that is, whether the acquirer should go ahead with the deal. A suggested team line-up can consist of the following members (see Figure 7.2): ■ ■ ■ ■ ■ ■

Team leader China advisor: China know-how specialist Internal legal counsel Accounting director or financial controller and executives Operation director and executives External consultants (legal, accounting, management consulting, IP attorney, sector expert, etc.)

FIGURE 7.2 It Is Critical to Form the Due Diligence Team with Experts in Various Functions Source: Illustration by Kenny Ng.

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CASE STUDY 7.1: STAR EXPRESS

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n 1994, Chen Ping started Zhai Ji Song (ZJS), a logistics company, with his two elder brothers. In 2007, the privately owned company reached 1.3 billion yuan in sales revenue, surpassing the state-owned China Rail Logistics and China Aviation Logistics company. In the beginning of 2008, Chen Ping, then-CEO of ZJS, saw that China’s consumers were moving toward e-commerce and wanted ZJS to participate in this new business space. In a short span of nine months, he expanded ZJS from a pure logistics player to an express courier service provider. In his own words, he wanted “to sell gold digging equipment besides this goldmine.”1 However, Chen’s aggressive stance to transform ZJS resulted in huge liquidity pressure and losses for the company. As a result, he was forced out by his two older brothers at the end of 2008. Although China was hit with the global financial crisis in 2008, the e-commerce industry grew at a rate of 190 percent. In March 2009, Chen set up Star Express with a team of followers from ZJS to set out what he had not achieved at ZJS. As Chen puts it, Star Express was established to fulfill his dream of providing express courier service to the fast-growing e-commerce industry. By March 2010, Star Express received a 70 million CNY strategic investment from Alibaba Group (Alibaba), parent company of Taobao, the biggest consumer-to-consumer (C2C) online shopping platform in China. Alibaba had wanted to use data-sharing methods to achieve a seamless connection between e-commerce and logistics. Using Star Express, Alibaba can free Taobao users from the labor-intensive actions of pasting shipment bills, sending shipments, and managing shipments. With Alibaba’s investment and the readily available Taobao platform, it seemed that Star Express had found the ideal partner. Now Chen could sell gold-digging equipment besides the goldmine, with the support from the largest goldmine. In less than five months, Star Express realized that providing express courier service for C2C was not feasible. In August 2010, it shifted to the business-to-consumer (B2C) domain, acting as express courier service provider for Amazon, DangDang, and 360buy. However, these big players already had their own warehouses and courier services in the accessible and high-volume regions. Star Express was only able to fill in the gaps in the less accessible and low-volume regions. Eventually, this only meant lower revenue and higher cost. In the next eight months, Star Express was always in the red. Facing this predicament, Chen went for the last gamble in October 2011—by acquiring Xin Fei Hong (XFH), an express-courier-service provider

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from South China that carried 40 million CNY of debt. The new company was renamed Star Express-XFH. Why did Chen, a man with nearly 20 years of experience in the logistics industry undertake such a huge risk? According to Chen, he had the intention of spinning off Star Express, but with the current platform, it would be a hard sell. After months of searching, it seemed that that ZJS, his previous company, was the most likely buyer. ZJS lacked networks in the rural regions and an express courier network in South China. A merged Star Express-XFH would be a perfect fit for ZJS’s needs. However, this acquisition would prove to be the final nail in the coffin for Chen’s ambitions. On March 5, 2012, Chen sent a text to company’s employees, declaring that the company was filing for bankruptcy. Alibaba’s 70 million yuan investment, his personal investment of 50 million yuan, and 20 million worth of payments to counterparties could not be repaid. There were 1,400 employees, who had their wages in arrears for the previous two months and had been unemployed. Chen is personally sorry for that and would like everyone to forgive him.2

Due Diligence Key Takeaways Alibaba’s Investment in Star Express It was understood that Alibaba had invested in Star Express so Taobao users (sellers on the marketplace) could tap on Star Express’s services and achieve a seamless connection between e-commerce and logistics. However, most of the users were franchisees of the well-established five external expresscourier-service providers on Taobao (ShenTong, YuanTong, ZhongTong, HuiTong, YunDa), and they were reluctant to switch to Star Express. For example, a shirt-seller on Taobao (user) would usually buy and sell a shirt at cost price. As a franchisee of the five external express-courierservice providers, the shirt seller would pay a lower fixed price/kg for a shipped shirt but charge his customer at the standard rate of delivery. Instead of the product, a seller’s profit is now derived from the spread on courier service. According to Chen, the five external express-courierservice providers “can be seen as first-wife for the sellers.” At best, Star Express “can only be a mistress.” Alibaba’s investment in Star Express was meant to replace the existing external express-courier-service providers and synthesize the logistics segment to be under Taobao’s charge. However, it appeared that Alibaba overlooked the interest-binding relationship among the users and expresscourier-service provider. If this critical obstacle had been identified during the due diligence process, it would have been a deal breaker because Star Express’s business proposition would then be inapplicable to Taobao. (Continued)

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(Continued) Chen Ping’s Investment in Xin Fei Hong (XFH) Chen Ping disclosed that the due diligence on XFH was conducted by a team of Star Express’s staff in a span of 15 days. Although the team highlighted the financial risks involved, Chen dismissed it. In his opinion, out of the 40 million yuan debt, only 20 million yuan had to be repaid immediately with the rest to be repaid at a later date. Chen’s eagerness to conclude the deal for a spinoff to ZJS at a later stage had overshadowed the risks to XFH. Moreover, the due diligence team was not a team of independent professionals. They reported to Chen directly and might have conducted the due diligence in a manner that would assist Chen in achieving his objective of securing the deal. Also, the lack of professionals in due diligence may have caused the team to overlook the hidden risks involved in the transaction. On the other hand, although it was in talks to acquire Star ExpressXFH in early 2012, ZJS had sent an independent and professional team to conduct due diligence on XFH. ZJS discovered that the financial gaps in XFH were larger than it had reported and decided not to go ahead with the acquisition. If Star Express had conducted the due diligence on XFH independently with a team of professionals, events for Chen and Star Express could have ended up differently.

STARTING THE DUE DILIGENCE PROCESS Having formulated a clear due diligence strategy and put together a strong due diligence team, it is time to put everything to work. The due diligence implementation process consists of the following nine steps: 1. 2. 3. 4. 5. 6. 7. 8. 9.

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Initial due diligence First meeting, visits and dinner Evaluation and verification Follow up meeting, visits and dinner Evaluation and verification Initial deal structuring and negotiation Full due diligence Deal structuring and negotiation Closing deal

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Initial Due Diligence The initial due diligence involves macro and sectors analysis, web search (Google, Baidu), use of social media (Facebook, Twitter, LinkedIn, Weibo, Renren), and simple reference checks. The team should also perform an initial analysis of financial statements and macro and sector due diligence. The acquiring company will receive information about the target company either via an agent or from the target company itself; this is the initial phase of the deal sourcing process. The target company will generally provide basic company profile, core product information, and an overview of the financial performance. With these pieces of information, the acquiring company can perform an early-stage due diligence that is the basic analysis of the target sector, the demand and supply, and the basic analysis of the financial information. After a satisfactory evaluation of the target firm, with some basic queries in mind about the target company, the acquirer can arrange a conference call or e-mail for clarification.

Meetings, Visits, and Dinner (First MVD) After one is satisfied with the initial due diligence, the team would arrange a visit to the target’s office. Typically, the meeting would be at the target company’s conference room and followed by site visits and a meal. In the conference room, the founder will do a basic introduction of the company and a questionand-answer session. The setting of the conference will make the interactions among buyers and sellers more formal, and discussion will be restricted to a more diplomatic tone. By the end of the formal meeting, it is common to arrange a meal, usually a dinner, together at a famous or nearby restaurant hosted by the target company. This is a typical Chinese business practice that the buyer should be glad to attend because this is really the starting point of a due diligence process. The diligence team should not only prepare and do their homework for the formal meeting but should also prepare a list of questions to ask at the dinner table. Sometimes, the formal meeting conducted at the target company’s conference room is skipped and both parties start the fi rst meeting directly at a dinner table. (Investors are sometimes puzzled why there are so many private dining rooms in Chinese restaurants in China.) The founder of the target company will start by welcoming the guests and talking about his entrepreneurial story, about why and how he started his company, and his successes thus far. The atmosphere is relaxed because there are informal small talks going on, unlike the business conversation in a meeting room. The famous or notorious Chinese

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wine toasting during dinner adds to the free and easy mood. During dinner, the diligence team should start to ask intelligent questions in a casual and polite way. Seven questions that can be asked include: 1. When did you earn your first million? (company history) 2. Did you start the business with business partners? Who were they? (about the shareholding structure) 3. What was the most difficult time in your business? How did you overcome them? (growing up) 4. Did the government help? (relationship and anticorruption question) 5. How did you secure your first major customer? Are they still buying from you? (major clients) 6. Why did the suppliers support your business? (main suppliers) 7. How old are your children? What do you want them to be? (family) It is important to remember what the founders said during the dinner, and it is always good to have more than one person on the due diligence team to listen intently to the founder’s responses and to take notes discreetly. The due diligence team should meet immediately after the dinner to discuss what they heard and piece all information together to form a full picture about the founding history of the company and the background of the founder (the team cannot be drunk). The objectives of this exercise include the following five: 1. To ensure that there is no contradiction in information gathered before and after the dinner. For example, are the major customers mentioned verbally the same as those who were presented in writing. 2. To verify the authenticity of customer and supplier relationships. It is important that the due diligence team understands not only who the customers and suppliers are but also how they came together to do business. From this point on, the shareholding structure of customers and suppliers will need to be verified against this story. For example, if the CEO mentions that ABC is the boss of the suppliers, the due diligence team needs to verify that the business license of this supplier registered as ABC. 3. To ascertain the role of government in helping the growth of the business and whom the highest-ranking government officials involved are. This information is important for the team to start looking into any possibility of corrupt practices and to map out a business relationship map (or flowchart).

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4. To identify the business difficulties that the company has encountered throughout its history. The most difficult times will typically reveal the major risks of the business and the sector it operates in, and look into if the company has ever reached a bottleneck in growing the company— this information can provide a good gauge of the founder’s management skills and the availability of any external help the company has. It is common that founders will disclose and talk about how their difficulties were overcome, sometimes proudly, and the due diligence team should verify all information to form a final opinion. 5. The due diligence team will start asking about the spouse and children of the founder thereby assessing the motivations of the founder’s personal goals and fi nancial commitment. In general, most founders like to have their children educated overseas. That information might give the due diligence team an idea about the founder’s long-term succession plan. The team could offer help in counseling children’s career plans. From questions about the children, the team can move to questions about the spouse. For most investors, the very puzzling and frightening part of the dinner session probably is the drinking culture in China. The drinking culture sometimes has its own advantages and one should learn to exploit these to their favor. It is common that, after an hour of some guarded small talk, the dinner talk can become very casual and freewheeling with the magical effect of alcohol. Everybody can propose toasts, and a queue will form to toast the most senior persons of the acquisition team. It is also a common practice that subordinates will take turns to toast the senior executives and the guests. While the rest of the dinner guests toast one another, the host will start to give a speech, and everyone will be silent again and listen. This cycle can go round and round and much information can be extracted from this single session that may or may not be disclosed under a more formal setting. See Figures 7.3 and 7.4 for some illustrations of the MVD.

Evaluation and Verification All information gathered during the first MVD must be recorded properly and analyzed critically. The due diligence team leader will assign each member to look into specific area and to proceed to qualify all information. Team A—Customers/suppliers and the entire value chain. Team B—Government relationship/founder background check.

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FIGURE 7.3

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MVD: The Meeting, Visit, and Dinner

Source: Illustration by Kenny Ng.

FIGURE 7.4 The Buyer Must Be Ready to Take Toasts from Many Members from the Target Company Source: Illustration by Kenny Ng.

After some days of work, the team will come together and discuss their findings. In general, there will be three verification results, which are the following: verified, false, and no information found. Correct information must be supported by proper documents or proof. If there is a false claim, it would be a red flag and the team will have to decide how serious this false declaration is. When there is no supporting proof for any

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claims, the team should put them into “Keep in View” (KIV) and decide whether it is best to verify with the founder again or to keep these items for the next process to shed some light in a face-to-face meeting or a site visit.

Follow-Up Meeting, Visit, and Dinner (Second MVD) After the initial meeting and the verification process is carried out, the followup meeting can be more targeted and focused. The diligence team has to work on a list of questions, particularly those with red flags that arise from the previous meeting. As usual, the meeting can be arranged in the office or over dinner. If the meeting starts at the office meeting room, the team can ask questions about factual clarification, for example, questions about major customers and suppliers, which are more related to the core business of the target company. A site visit can also be arranged for the team to look at issues they want to verify. At a dinner, questions about the background of the founder can be asked one more time, but in a different way. Most important, the follow-up dinner can serve to clarify any findings since the last dinner that appeared to be dubious and unverifiable. For example, if the founder mentioned that his son was studying at the Massachusetts Institute of Technology (MIT) at the previous meeting, this time, the question can be, “Are you visiting Boston this year?” One can also mention that the team member is visiting Boston sometime and would like to be introduced to the son. Small talk can be about things that the team is concerned about, in particular, the founder’s loyalty to his family, gambling habits, alcoholism, and so on. One can casually mention that Macau is developing rapidly and many new casino projects are on the way, to observe the founder’s reaction to this topic. The team can also mention that it has a good appetite for investing in the gaming sector, such as new casino projects in the Philippines and Korea. The objective is to arouse the interest of the founder to ascertain his interest in gaming. Bring up these three questions and statements in the follow-up dinner (on personal wealth management, property investment, corruption): 1. Do you work with a private banker? That leads to questions on the way the founders dealing with their wealth. 2. The Western world sees the Chinese property sector growing like a bubble. What do you think about property investment?

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3. To find out about ties with the Chinese Communist Party leadership and the local Chinese government officials, investors could bring up a hot topic like the fall of the former Chongqing City party secretary Bo Xilai or the corrupted government official Yang, who was spotted by the netizens while wearing different luxury watches at different occasions. Investors’ representatives can get some sense of the relationship (guanxi) of the founders and officials, and that, in turn, can give some idea about the founder’s view on corporate governance and transparency when running an organization. With the team leader and the founders having more interaction, the talks and discussion can be more private and intimate. The objective is to remove the defensive mind-set of the founders and probe more deeply into the founder’s way of conducting business and his or her private life. The post-dinner analysis is equally important. The team should meet immediately after the second dinner (if all members are still sober) to discuss all topics mentioned. The team must check whether red flags have been answered and unverifiable queries have been verified. The conversation during the dinner must also be recorded in writing with details. This time, the team summarizes a new list of red-flag items and categorizes them according to old red flags or new red flags. The diligence team has to discuss whether old red flags were cleared, and if they were not, is this a deal breaker? What is the new information gathered during the second meeting and dinner? The diligence team again has to verify new information and analyze the first and second meeting in the following way: 1. Founder background a. Family b. Wealth and banking facilities c. Gambling habits of the founder d. Other business activities 2. Political connection and involvements 3. Customers 4. Suppliers 5. Supply chain External service providers can be engaged to help with the due diligence after the meeting and dinner.

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Evaluation and Verification, Initial Deal Structuring and Negotiation If the outcome of two or more MVDs shows positive results and no major red flags have been raised after a second round of verification and evaluation, the due diligence team could proceed with the investment team to discuss initial deal-structuring terms, conditions, and potential valuation. That would be followed by another meeting, but the focus would be at a conference desk where the two sides discuss initial ideas about deal terms and conditions. The discussion would also touch on the process of due diligence, in particular on what the founders and the target company could expect of the due diligence process. The target company usually has not been involved in a due diligence process before, so it is good for the potential buyer to suggest to the target company how they could organize and work together as a team to achieve the best results. The buyer can also help the target company to set up a due diligence team and appoint a team leader. The selection of this team leader must be a senior staff member who has been with the company for many years. For example, if the company was founded by a husband-and-wife team (which is very common in China) or two partners, the target company diligence team leader can be one of the founders. The data room is a very common form of electronic storage of all documents from the target company. Instead of paper documents, all legal, financial, and operation documents are scanned and stored in the data room. Since most private Chinese companies hardly ever use electronic data rooms, the due diligence team leader can offer to help the target company to set up a data room and, at the same time, go through all documents during the scanning process.

Full Due Diligence (FDD) Upon the satisfaction of both parties, the buyer would launch a full due diligence exercise on the target company. As mentioned in the previous sections, initial due diligence would have started the day the acquirer received the basic information (teaser) of the target company. The advanced due diligence process would consist of a deeper analysis of the legal and financial information provided, and also the subsequent meeting-visit-meal with the founder and management team, and the evaluation and verification after. With all positive observations from the earlier rounds of due diligence, the full due diligence can be officially started.

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The full due diligence process is officially announced to the target company and the due diligence team leader can begin with a meeting with the management team from the target company. Generally, the due diligence team can appoint a person to coordinate all logistic matters and arrange subsequent meetings and interviews. As highlighted earlier, the company is unlikely to have a data room (virtual or physical) as Western companies do, and sometimes the volume of physical documents to be reviewed can prove to be very daunting. Thus, some level of coordination on logistical arrangements will be required from the due diligence team. The due diligence process can then continue with each functional team meeting one another, and the due diligence team can start to interview the target company team. It is important to brief the entire due diligence team that, throughout the due diligence process, the team members have to keep a professional image and be very polite in asking questions, showing respect in the meetings and also in requests for documents. It is not uncommon for some form of conflicts to arise between the due diligence team and the target company team due to different working attitudes and culture. One of the most common problems is that the target company team refuses to provide information that the due diligence team requests. In such cases, the target team should always refer the release of documents to the approval from the founder or top management.

CONCLUSION One of the most important factors to success in the implementation process is the mind-set of the due diligence team and the leadership of the team leader. Although the team must understand that due diligence in China is markedly different from the rest of the world, and requires a much higher level of scrutiny, it is also critical to establish a good relationship based on mutual respect with the target company. A good due diligence team is one that can strike a balance between these two factors. During implementation process, it is possible that, despite a detailed planning and formulation of the due diligence strategy, new unexpected information or events arise, necessitating a change of due diligence strategy. For example, during the implementation, a functional manager from the target company may have resigned. The team must react quickly to such an unforeseen event, such as tailoring due diligence efforts to the department that the manager

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supervised to fi nd out the reason for the resignation, or even arranging for a meeting with the departed manager to better understand the situation. That said, it is not uncommon for employee turnover or other organizational changes to take place during the due diligence process. After all, a comprehensive due diligence process can stretch over several months, and sometimes, the existing management of the target company may want to implement certain changes to make the company more attractive for potential acquirers. Thus, the team must still exercise reasonable sense in dealing with contingencies, and not be unnecessarily distracted. Very often, the actual flow of the implementation process may also be quite different from what is planned. For example, the fi rst contact with a target company could be a visit to the company. Therefore, it is crucial for the due diligence team to be fully prepared to handle such unexpected events, knowing what to take note of for subsequent meetings, even prior to the first meeting. Being fully prepared at all stages of due diligence acts as a psychological boost to the due diligence team as well; portraying confidence to your Chinese counterpart will contribute greatly to their confidence in your firm and your ability to execute the deal. Another point to note is that the due diligence team must not fall into the trap of escalation of commitment. Very often, investors who have spent considerable resources and effort in due diligence may develop a greater inclination toward progressing through the various stages of due diligence and seeing the deal through, as whatever they have put in earlier might go to waste if the deal falls through. Certainly, the due diligence team should give its utmost effort in every stage of due diligence, but, if serious red flags are raised during the implementation process, the team should remain impartial to assess the possibility of mitigating the risks involved, and pull out of the deal if necessary, regardless of which stage the team is in or the quantity of resources put in. The due diligence team must always remember that the due diligence costs incurred in a failed deal would be minute compared to the potential loss that may be suffered should the company go ahead with acquiring the problematic target.

NOTES 1. “Chinese Entrepreneurs 2012: A 120 Million Dollars Lesson,” Youku, September 30, 2012. 2. “Star Express Faces Financial Difficulties, Wangyi News, March 5, 2012.

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8

C HAPTER EIG HT

Post Due Diligence and Case Studies

T

H I S F I N A L C H A P T E R D E A L S W I T H the tasks after the formal due

diligence process is completed, namely the preparation of the due diligence report, conducting the post-due diligence review, and, if the deal is to go through, conducting the post-deal monitoring process. Although most of the work in the entire process is done during the implementation stage, the post-implementation stage is just as important in ensuring an accurate evaluation of the due diligence results, and a smooth transition from due diligence stage to deal completion and review. For cases in which the due diligence team fail the target company and the deal does not go through, the information leading to this conclusion must also be recorded and managed to serve as learning points for future deals. In the final sections of this chapter, two cases will also be extensively discussed, through which some of the tools brought up earlier in this book will be employed in the context of these cases, simulating what should or should not have been done in the due diligence processes for these cases.

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PREPARING THE DUE DILIGENCE REPORT Prior to beginning the preparation of the due diligence report, all the team members should convene for a meeting to ensure that all tasks drawn up in the due diligence strategy have been completed. The team tallies whatever it has done with the due diligence strategy frameworks used earlier, and it determines if there is any missing information. If so, the team should then quickly decide the activities that need to be conducted to fulfill the information gaps, whether it is follow-up meetings and site visits or additional interviews with relevant personnel. After the due diligence team determines that the information collection process is complete, the team can then go ahead to prepare a detailed due diligence report for the senior management team of the acquiring company to evaluate whether the acquisition should proceed. Although there is no specific format for the due diligence report, it is typically organized into the various due diligence aspects mentioned in the previous chapters, namely legal, finance, taxation, commercial, operations, and most importantly—the lynchpin of due diligence in China—a deep and rigorous section on the founder and his family. Each piece of evidence or information retrieved should be presented in an objective manner as far as possible, regardless of the results of other due diligence items. In order to ensure this, the team member preparing a particular section of the due diligence report should be the one who has conducted that portion of investigation or check. Finally, one of the most important deliverables of the due diligence report is, of course, the final recommendation. As the recommendation here would determine the series of important follow-up activities, it is extremely important that this should not be a singularly made decision by the team leader, but rather one reached after extensive discussions by all team members of the evidence collected.

DUE DILIGENCE OUTCOME REVIEW The management team of the acquirer should review and evaluate the due diligence results with great care. The review typically begins with the due diligence team making a presentation to the senior management team and sometimes even to the board of directors (depending on the decision-making process and hierarchy within the company). A thorough evaluation should then follow about whether the acquisition is to go ahead or be aborted and why.

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If the final recommendation from the due diligence team is to abort the acquisition plan, the team should seriously and thoroughly reflect on the dealsourcing process, why the project passed the initial due diligence, and what lessons can be learned from the entire exercise. The due diligence team should also have a member who is in charge of knowledge management (KM) of the company so that such knowledge learned through this exercise will be appropriately stored and not wasted. When a company fails the due diligence, the team should also make another recommendation of an acquisition in a similar sector and of comparable size to the senior management team of the acquirer. On the other hand, if the target company were to pass through the scrutiny of the due diligence team, the follow-on review would be very different. After the due diligence team completed weeks of the due diligence process at the target company’s premises, and prepared a positive due diligence report for the senior management with a “buy” recommendation, the senior management must spend a great amount of time scrutinizing the report and asking questions about the reasons for acquisition. Risks identified by the due diligence team can be mitigated easily if those risks are familiar to the acquirer. However, because the target company is in China and operating in the Chinese macro and business environment, the risks involved usually need to be evaluated from a different point of view than the acquiring country is used to. There are some risks that one has to face when acquiring a company in China because of the political legacy and business environment mentioned in Chapter 1. For example, after a detailed due diligence check, the founder cannot have two identities when the decision has been made by the acquirer to move ahead; however, the acquirer still must face the authorization-process issue, which is the management and handling of the company’s legal stamp, financial stamp, and the contract stamp. Buyout acquisition is sometimes the solution of some of these potential risks, but, unfortunately, the Chinese government tightly controls majority stake ownership and for foreign capital and corporations, it is not allowed in most industries. For example, when Coca-Cola tried to acquire majority shares of Huiyuan Fruit Juice, the Ministry of Commerce turned Coca-Cola down on the grounds of antimonopoly regulations. Recently, “pseudo majority ownership,” another way of achieving majority ownership, by using variable interest entities (VIE) agreements has been a hotly debated topic in China due to the tussle and dispute between Jack Ma, the founder of Alibaba and Yahoo!. Investors may not want to enter into such agreements with any private companies or individuals as far as possible.

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DEAL STRUCTURING, NEGOTIATION, AND DEAL MAKING In the normal scheme of things, once the green light is given by the key decision-making personnel (senior management team or board of directors) to proceed with the deal, the appointed deal team (which may or may not be the same as the due diligence team) will work on the deal structuring process. One of the deal team’s main objectives is to work on previously established valuation metrics and deliver the final bid price for the target company, as well as the accompanying deal structure. More than just taking into account financial considerations, these deliverables must be crafted with the due diligence outcomes in mind. In other words, the team should work with the due diligence team to devise the structure that can best mitigate, or at least minimize the risk factors surfaced in the due diligence review. For example, in the case of a minority stake acquisition, the deal team can design various clauses that will limit and control the authorities of the founder/chairman. Of course, if the deal is a complete buy out (assuming it is possible) as discussed earlier, the deal structure becomes less critical in mitigating risk factors, as the buyer will generally have full control and authority to implement changes. Even so, the deal structure can also take into account clauses and measures to safeguard the acquirer’s position after the deal. With the deal structure and valuation (which includes the acceptable range and walkway price) prepared, the deal team can then proceed with the formal negotiations process with the target company. Likewise, the due diligence outcomes play a very important role at this stage. As highlighted earlier during formulation of due diligence strategy, relevant information collected can help to strengthen the deal team’s bargaining position or even gain a better valuation. The two stages discussed in this section refer to the formal deal structuring and negotiations. As detailed in the previous chapter, preliminary deal structuring and negotiations will often take place in the midst of the due diligence process. However, these will serve more as a build up to the formal stages. Nonetheless, these intermediate stages should also exercise the same level of closure with due diligence outcomes at that point.

POST-ACQUISITION DUE DILIGENCE Assuming that deal negotiations go well, and the acquirer successfully makes the acquisition, due diligence would proceed on to the post-acquisition stage.

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Very often, investors tend to cut back on due diligence efforts, or skip them entirely after the deal. This can prove to be fatal, particularly for deals in China. The fundamental purpose for post-acquisition due diligence is for the close monitoring of the acquired assets, and it ultimately allows the management team to uncover risks that were left out in the formal due diligence process. This comes naturally with the physical presence of the acquirer in the acquired company and greater access to company information. The post-acquisition period is also a time when the acquired company management lets its defenses down, and previously closely guarded information may become easier to dig out. Post-acquisition due diligence is extremely important, regardless of whether it is a minority acquisition or full buyout. If key risks can be uncovered early, then the acquirer can take timely measures to mitigate these risk factors or, if necessary, exit from the deal altogether to avoid suffering a heavier loss later on. Often, companies might think of cutting costs, and using a new and much smaller team to conduct the due diligence and monitoring at this stage. However, having completed months of due diligence work on the company, the original due diligence team is the best group of people to perform postacquisition due diligence. Again, the cost of any potential losses from a poor due diligence will outweigh the costs of executing a thorough due diligence. Thus, it is still ideal for the original team to remain engaged after the acquisition to perform the post-acquisition due diligence. In terms of timeline, the post-acquisition due diligence in the 100 days following the completion of the deal should be regarded as the most critical, and should warrant the most effort, time, and resources. Subsequently, depending on the performance of the acquired company and presence of any red flags, the due diligence can then be scaled down accordingly.

SUMMARY MODELS With the post-acquisition deal due diligence completed, the entire due diligence implementation process is concluded. As a summary to the implementation process, three models will be discussed in this section. Firstly, the formula for effective due diligence (see Figure 8.1) is presented. Essentially, the formula for effective due diligence requires conventional due diligence, coupled with beyond-the-checklist tools of extensive founder and management check, face-to-face interviews, site visits, proportion checks, and a thorough review of the possibilities of four A’s. Beyond just combining

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Checkli Checklists

Due Diligence in China Legal/Financial/Operational Due Diligence

+ Founders & Management

Beyond Checklists

+ Face-to-Face Site Visits

+ Proportion Check

+ 4A’s

Planning Customization

FIGURE 8.1

Formula for Effective Due Diligence

all these tools generically, detailed planning and comprehensive customization of these tools to industry and company characteristics are necessary to make the due diligence formula even more robust. Additionally, two models are detailed next, namely the Galaxy Model and U-chart, which can be used to provide an overall view to the entire due diligence process. Although these two models are presented here at the end of the implementation process, they may also be employed at the formulation of due diligence strategy, or at any other stages of deal diligence, as good planning tools.

Due Diligence U-Chart The U-chart (see Figure 8.2) is essentially an extended framework for the due diligence formula, with a greater focus on the beyond-the-checklist tools. The U-chart brings together all the tools discussed earlier to give the user an overall view of what has been completed in the implementation process.

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SWOPEST • Strengths

• Weaknesses • Opportunitiess

Founder/Management Mutiny

Mistress • Background of mistress

Company Stamp

Financial DD

• Known remuneration

Legal and Tax DD

Environmental DD

Commercial and Operational DD

• Founder’s character • Robust check system

• Social

Company Stamp

Relationship • Family Fueds

• Relationship between founder and key stakeholders • Relationship between founder and employees

• Political • Economical

• Relationship between co-founders

Mistress

SWOPEST

• Threats • Other

Founder/ Management Mutiny

Relationship

Founder & Shareholders

Factory

Authority & Control

Checklists

Social Forces

• Existence

Social

Factory • Efficiency Shop

Shop

• Existence

Site Visits

Due Diligence

• Local sentiments and trends • Possibility of mitigation measures

Industry Events

Industry

Abnormality

• Precedent industry scandals or events

• Stress points in the industry

• Efficiency

Shop

Environment

Office

• Existence

Face-to-Face Meeting

• Efficiency Management

Anticorruption (ACID)

Proportion Check

Management

Licenses

• CEO

• CFO • COO

Employees

Business Finance

Other Stakeholders

Business Drivers

Environmentall Hazards • Natural disasters and other detrimental events

Business Drivers • Government/Regulatory bodies who issue license • Difficulty of obtaining license

Employees • Employee 1 Business Finance

• Employee 2 • Employee 3

Total Production vs. Utilities

Sales vs. Transport Costs

Overseas Sales vs. Overseas Phone Bills

Other Stakeholders • Accountants

• Lawyers

Analysis of Proportion Pairs • Time series analysis

• Financial Adviserss

• Comparables with peers

FIGURE 8.2

• Determine financing bodies • Determine relatiionships with financiers

Business Drivers • Success or revenue generation factors

• Personnel involved in each factor

Due Diligence U-Chart

321

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Financials

Site Visit Site Visit

Financials

• Verify Existence

• Liquidity/Solvency

Overall Product Comparison

Financials

• Credit terms given to target

• Verify Existence

• Comparables analysis

• Pricing • Positioning

Supplier Dependence • % of supplies from top Five suppliers

Customer Dependence • % of sales from top five customers

• Competitive advantages

Country-wide Policies

Regionspecific policies

s er

Suppliers

Future Business Policies

Marketing Plan

Management Strategy

Expansion Plans

Management

Management Team

BUSINESS

Experience • Past job experiences across value chain • Network and connections in China

Track Record • No. of Projects worked together

Production

Expertise

Macroeconomic Factors

Geographic Factors

Natural Disasters within region

Realistic Schedule

Proximity to Infrastructure

Proximity to Other Transportation Means • Roads/Ports/Rivers/Train stations

FIGURE 8.3

Capital Structure

tit or s

Vertical and Horizontal Businesses

Other BusinessSpecific Factors

Whether Business Resides in Disaster-Prone Region

Co m

pe

m

to

s Cu

Government’s Next Five Year Plan

Performance

Utilities Bills

Basic Utilities

• Understanding of local regulations

Number of Workers

Productivity

• Water/Electricity/Human Resources

Macro Micro Galaxy Model

322

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Galaxy Models The galaxy model (see Figure 8.3) is essentially a thorough breakdown of all the business drivers for a target company. As its name suggests, the model allows the user to congregate all the factors that contribute to the profit generation and growth capabilities of a business. When used at the end of the implementation process, the user can cross-check whether the underlying risks in each of these business drivers have been appropriately answered with the various due diligence checks. As mentioned, the galaxy model may also be used at the formulation stage to drive the due diligence tasks. A case study employing the use of the galaxy model during the deal due diligence on a wind energy company, after a site visit to the company’s wind farm operations, is detailed next. The adapted galaxy model (Figure 8.4) is provided at the end of the site-visit report.

CASE STUDY 8.1: ABC WIND FARM SITE VISIT

T

he overall purpose of the site visit was to generate as complete and accurate a picture of ABC’s operations in China and determine if the value of the company is represented on the financial numbers generated on paper. It was an attempt to find the degree of correlation between the value ABC proposed and the actual value of the company. A secondary aim of the visit was also to identify any potential red flags that may not be apparent from a preliminary due diligence, especially on the operations aspect of the company. The way that we went about formulating questions was to evaluate each step of the entire process from construction to operations. For instance, step 1 would be to transport the materials and parts to the wind farm. Are the roads wide and flat enough for these big parts and equipment? How would they get through the checkpoints? We would then move on to the next step and ask questions based on what we saw on the ground. For instance, we did not see every wind turbine in operation, and we would ask about potential downtimes or maintenance issues. Basically the idea was to deconstruct every single part of the entire process and identify any potential issues with the way things were run. Another objective was also to identify the areas that could be improved should we decide to invest in the project. Information collected during the site visit may be entered into the galaxy model so that the due diligence team has a complete and clear picture of the company and projects for further discussion and follow-ups. (Continued)

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(Continued) Overview of site visit: ■

Met with CEO of ABC China.

■

Met with Clean Development Mechanism (CDM) manager at ABC.

■

Met with agent from investment bank who introduced the project.

■

■

■

Visited wind farm A, phase I and phase II. Phase I is officially in operation; phase II still under construction/not yet officially commissioned. Visited the control station and workers’ quarter. ■

Briefed on worker ’s management system.

■

Stayed on the farm for a week; switch with another team.

■

One week on, one week off.

■

Workers have rooms at the farm.

■

Noticed the number of workers on the farm.

Briefed on how electricity is generated and sent to the state grid. After generation from turbines, directed into transformer and sent to state grid.

■

■

■

Amount of electricity generated measured via power meter at transformer. Both wind farms are connected to the same transformer. ■

■

■

■

■

Briefed on how a turbine is erected (heavy machinery is required). Since ground is hilly, first have to construct roads wide enough for construction vehicles (e.g., cranes, trucks) to drive on. Once the vehicles can access the site, they have to wait for winds to subside in order to erect turbine. Construction has to stop whenever winds exceed a certain speed. Claims that process takes about two to three days per turbine, limited by construction machinery/vehicles.

Questions asked were generally directed at three main areas: 1. Management. 2. Operations. a. How many people are required to run the wind farm? b. Does the answer fit the number of people that we saw moving around? c. Do the rooms look as though they were being lived in?

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d. Was there “activity” on the ground? e. Were there wind-turbine operations? i. Were the wind turbines actually running? Some were not (approximately one out of six were not). ii. Downtime and maintenance? Apparently some downtime was normal. iii. Did the inside of the wind turbines look well maintained? Yes, but it was only the turbine that was shown to us. iv. Was construction of new wind turbines actively happening? There was machinery on the ground. v. How were wind turbines being transported to the locality? Are the roads wide enough? 3. Relationships with state grid a. Main issue: Grid problem. b. Background: Grid is required by regulation to purchase all the electricity that is produced from the farms. c. However, ABC management states that, in reality, the grid puts a limit on how much electricity is produced and tells the company to stop producing when the limit is reached. d. Some days the turbines would not be running. e. Also, electricity produced is measured by power meter at the transformer, and is shared by both wind farms. f. On some days, when one wind farm generates less electricity than limit, management activates one or two additional turbines from phase 2 to generate more electricity. g. Technically not allowed, because phase 2 is not yet commissioned. Potential red flags: ■

State grid’s actual stance is different from official regulations.

■

Wind farm’s operations do not follow stated guidelines.

■

Questionable schedule for erecting next few phases of turbines.

■

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Unlikely to be on schedule based on available equipment and time required.

■

Safety standards for turbine construction.

■

Overall government stance on wind energy/outlook unstable.

■

Tariff system.

■

Questionable if grid system is going to improve.

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Frequent cutoffs? Connectivity?

PPM Payout to firm

Purchase History

Check at NDRC or local DRC

After sales servicing

Exit opportunities?

Decided by tariff structure

Differences in production and PPM

State Grid

Costs

Future Policies

Pipeline projects

Government Approval

Existing projects

Maintain or changing tariff structure? Will grid purchase 100% of generated power?

Future New transmission lines built? Development

Revenue

Continuing subsidies?

Tariffs structure

Infrastructure

Turbine Manufacturer

Wind Farm

Wind Potential

Management Team

Competitors

SOE

Other indicators Advantage?

Size of staff, maintenance team

Daily monitoring

Research firm

Internationally certified?

Operating history

Track records

Pricing

Costs

Why choose this particular manufacturer? - (e.g., GE, Vestas, Goldwind)

Experience in industry

Production

Vs. other people’s prices

Across value chain? Network and connections in China?

Number of projects working together?

Utilities bill

Whether production Activity of supporting corresponds to geographical data processes, e.g., Transformer

Expertise

Understand local regulations (e.g., China)?

FIGURE 8.4 Galaxy Model for a Wind Farm Project

326

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FINAL CASE STUDIES In this fi nal section of the book, two landmark case studies, namely GOME Electrical Appliances and NVC Lighting Technology, are discussed. These two cases were selected because they are both good representations of a characteristically difficult Chinese investment. Expectedly, these two cases highlight the inadequacy of the acquirers’ consideration of beyond-the-checklist items during the due diligence process, and they will serve as a final highlight of the theme of this book.

GOME Electrical Appliances Holding Limited The case on GOME and its founder, Wong Kwong Yu, is an exemplar on the intricacies and complexities involved in beyond-the-checklist due diligence. Many private equity and investment behemoths were involved, including Warburg Pincus, Morgan Stanley Private Equity, Bear Stearns Merchant Banking, KKR, and Bain Capital. The corporate tussle that ensued after Wong’s imprisonment in 2010 soured Bain Capital’s investment, who to date remains the second largest shareholder. GOME Electrical Appliances Holding Limited (GOME) is one of the largest electrical appliance retailers in China. It was founded by Wong Kwong Yu, a Chinese businessman in 1987. Riding on China’s phenomenal economic growth and urbanization, it has developed rapidly outside Beijing since 1999 and was listed on the Hong Kong Stock Exchange in 2004. As of June 2012, GOME had a total of 1,096 stores in China. In February 2006, private equity heavyweight Warburg Pincus announced it will make a US$150 million investment for 10 percent of GOME. The deal will be made via US$125 million worth of convertible bonds and US$25 million worth of warrants. As discussed earlier in Chapter 5, one relatively consistent characteristic across private Chinese companies is the influential role of their founders. For due diligence on such companies, it is necessary to dig deep and find out, from all possible sources, the personality, character, and background of the founder, and that of his family and his business. Wong Kwong Yu: A Colorful Background Born in Shantou, the city in Guangzhou province famous for being the hometowns to Li Ka-shing and Ma Hua Teng, Wong came from a humble background. Having dropped out of school when he was 16, Wong and his elder

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brother went into their first venture with a simple business model: buy cheap goods and sell them at a premium. They started off with consumer goods, like watches and fabric, but came to realize that tastes come into play when they were not able to market fabrics of foreign design sourced from other parts of China in Beijing. Therefore, Wong decided to shift into goods with a homogeneous taste: consumer electronics and household appliances. GOME was founded in 1987 in Beijing, and the rest was history. By 2008, Wong had risen to become China’s richest man, with a net worth of around US$6.3 billion.1 It comes as no surprise that Wong’s personal life has come under much scrutiny over the years, and information uncovered about his personality and his various business dealings with family members and acquaintances have become readily available. Had Bain considered all these factors prior to making its hefty investment into GOME, they may well have made a very different decision. One of the earliest public indications of Wong’s ambitious nature was revealed in 2006 during the press conference after Warburg Pincus’s $150 million investment, where he told China Daily reporters his high ambitions for GOME, now with the support from one of the largest private equity firms in the world. His ambitions are clearly reflected in GOME’s short-term plan: opening a total of 200 outlets by the end of the year, a twofold increase in number of outlets from what GOME told reporters it was planning to open last December. In total, GOME plans to open 800 stores in three years’ time, and targets a fivefold sale multiplier to the tune of 800 billion yuan. Another facet of Wong’s character is revealed in his interview with The Economist in February of the same year. A noteworthy point from the interview is how Wong treats his GOME business, in light of immense competition in the consumer electronics and household appliances sector. Essentially, he had explained his foray into the real estate industry as a hedge against adverse business conditions that may affect GOME. Such a statement should sound the alarm for the prudent investor’s attention to wonder how much commitment Wong actually puts into the company. Perhaps unbeknownst to the public till Wong’s arrest and conviction five years later, GOME had a few subsidiaries prior to 2005, two of which are Eagle Legend Securities Limited and Eagle Legend Futures Limited. Both companies were sold off by GOME in April 2005. At that time, the stated reason was for GOME to concentrate its focus on the core businesses.2 Apparently, Wong is also known by people close to him as being attracted to the high-yield stock market. Sources from GOME stated that, the real reason for selling the two companies was because of a four billion yuan lost from a futures wager at the start of 2005.

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The Wong family also owns Pengrun Investments, a company focusing on real estate, and the manifestations of Wong’s ambitions to make it big in the lucrative real estate industry. GOME also has two subsidiaries namely Pengtai Investment Co. Ltd. and Beijing Eagle Investment Co. Ltd. The latter is controlled by Wong himself, whereas Pengtai’s CEO is Xu Zhongmin, Wong’s close friend. As mentioned previously, Wong’s wife, Du Juan, served as head of Pengtai Investments in GOME. In the interview with The Economist previously, we also get a rare snippet of information of one of Wong’s family member: his brother, Wong Junqin. It is stated that the humble beginnings of GOME was attributed to the efforts of his brother and himself, as they sourced for cheap watches in Mongolia to sell in Beijing. Their working relationship was maintained until 1992 when their business split into a real estate sector (Beijing Towercrest Group Ltd), managed by his brother, and the consumer electronics sector, that is, GOME. The skyscraper that houses his office in Beijing then was co-owned by his brother and him, and that may hint that the nature of the split was not acrimonious. Moving on, we examine Wong’s other half. Du Juan, head of Pengtai Investments, graduated from Beijing University of Science & Technology. She previously held the position as a credit officer in Bank of China. It is not uncommon for Chinese entrepreneurs to leave powerful positions in the company for family members but ultimately retain control over the whole firm. We should hence examine how much influence Du Juan has over the GOME. We should also keep Du Juan’s involvement in the credit sector in the back of our minds. A notable person linked to Wong is Zhan Peizhong, Wong’s fi nancial mentor.3 Both share the same hometown. They first met in 2000, and it was through Zhan’s advice that Wong orchestrated the reverse merger of GOME onto the Hong Kong stock exchange via a partial listing of Pengrun. Zhan Peizhong is a member of Legco, the Legislative Council of Hong Kong, in addition to holding various board positions. Zhan did not have a clean history; he was jailed in 1998 till 1999 for forging documents,4 and we can only speculate how negative or positive an influence he had on Wong. As a government official, Wong’s relationship with Zhan would be classified as a key political relationship to be taken into consideration for the beyond checklist due diligence. Another high profile political figure that Wong was known to socialize with is Huang Songyou. He was born in Shantou as well, and elected to become vice-president of Supreme People’s Court on December 28, 2002. In 2008, Songyou was suspended and subsequently removed from office after a corruption scandal. He was sentenced to life imprisonment in 2010 for receiving

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bribes amounting to 3.9 million yuan, and embezzling funds during his stint as a Guangzhou judge.5 With connections to such a high-ranking official in the judicial realm, one may speculate how much “help” Wong may have received through his career rigged with corporate crimes, and if the crimes as reported by the media subsequently understate the crimes he had committed. As mentioned, the Wong family owns Pengrun Investments. In 2002, Zhang Zhiming, brother-in-law of Wong, took control of the company. He succeeded in a property development known as “GOME champion city,” using GOME’s model of pricing below competitors in the region. However, his stint at Pengrun was shortened when disagreements with Wong led to his departure. Zhang Zhiming went to start another real estate firm, Mingtian Real Estate, and carried on to develop another successful “GOME champion city” project. Albeit the bad blood between Wong and Zhang, 40 percent of Mingtian Real Estate shares are held by Du Juan, and the other 60 percent by Zhang himself. Enter Morgan Stanley PE and Yongle (2005–2006) In 2005, Morgan Stanley provided Yongle, another major competitor in the household appliance and consumer electronics business, with a conditional investment of $50 million should their net profit will be greater than 600 million yuan in 2006. The target was not achieved, and then-chairman of Yongle, Chen Xiao, was close to losing his position in the company, together with 4.1 percent equity stake in Yongle as part of the conditional investment. In June 18, 2006, GOME took the opportunity to bid for Yongle. Under the bidding conditions, GOME will swap one of its shares for three shares of Yongle. In addition, there will be a cash consideration of HK$402 paid to Yongle. Yet through this period, many significant events deserving investors’ attention occurred. By July 26, 2006, in a short span of eight days, the entire acquisition was completed. GOME is actually registered as a foreign company in the British Virgin Islands, and it is very unusual for such a foreign entity to achieve such a speedy approval from China’s Ministry of Commerce. It was subsequently revealed at the time of Wong’s arrest in 2008 that a number of senior police and tax officials were also detained for investigation, of which two key officials of the approval were Deng Zhan (Deputy director of the Department of Foreign Investment Administration) and Guo Jingyi (inspector of the Department of Treaty and Law). Several were forced to step down subsequently, during the large-scale crackdown.

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Second, both Wong and his brother had their bank accounts frozen in the same month. The duo was investigated for a 1.3 billion yuan loan received illegally from one Bank of China branch in Beijing. This event again highlights the close business relationship between the blood brothers and their possible involvement in illegal shadow banking. Nonetheless, the findings for the alleged botched loan were significant: the loans, which constituted the seed funding for the Wong brothers’ early GOME ventures, were made through falsified loans. Most of the 1.3 billion yuan has already been repaid, with 400 million worth of interests and principal remaining. Wong attempted to repackage this debt as a non-performing loan with the help of a bank, and this was sold to Cinda, one of the state-owned distressed assets management firms. Cinda then placed this NPL on auction, of which one of the bidders was the Wong family, who bid for a price representing a 75 percent discount to the original amount owed. In fact, the Wong family bid twice when the first bid failed due to the stepping in of bank regulators. It was this event that subsequently triggered the investigations that led to the revelation of Wong’s wrongdoings. Third, it was discovered later that in April through June that year that Wong has been amassing shares of Beijing Centergate Technologies through Pengtai Investments. Wong later invested directly into the firm. Beijing Centergate Technologies engages in real estate development and management, and construction activities. This may be coherent with Wong’s interview saying he wants to “diversify into real estate.” Nonetheless, his investments might also have links to serving his brother’s real estate business. The ultimate motive was discovered: a reverse merger of Pengrun Investments. In addition, during the same period, Pengtai Investments acquired a majority stake in Zhongguancun Corporation. The investment doubled up as an “image booster,” as Wong positioned his investment as rescuing Zhongguancun from the verge of failure. However, settling the debts of Zhongguancun took a toll on Wong’s assets: Wong footed the debt amounting to more than 1 billion yuan. Moreover, it may also appear that Wong is trying to manipulate stocks by investing directly in the company and buying up public stocks to inflate its price. It was discovered later on that the purchase of Beijing Centergate Technologies, a shell listed company, was to facilitate the planned reverse merger of Pengrun Investments as well. One possibility for the real reason of listing Pengrun is Wong’s ambition to replicate the magnitude of success he had in GOME to his real estate business.

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This appears consistent with his “empire-building” mentality that he has been showing time to time. Bear Stearns PE and Bain ’s Entry (2007–2010) In March 2007, it was revealed that Wong had forged a strategic alliance with Bear Stearns, launching a US$500 million private equity fund under the name of Eagle Investment Group. The joint venture ownership is divided 50–50 between Wong and Bear Stearns. The fund will be used to invest in the retail sector, with minimum investments of US$25 million.6 Eagle Investments, chaired by Wong, was structured as an investment holding managing Pengrun, Pengtai, and Beijing Centergate Technologies, and also a stake in GOME. James E. Cayne, then-chairman and CEO of Bear Stearns remarked that Wong will be “an excellent partner.” Even though Bear Stearns’ collapse was not linked to the joint venture, some red flags should have been picked up prior to the collaboration: Sometime before 2007, Wong acquired ownership of a Hong Kong-based magazine The Red Capitalist. It was later revealed that the purpose of acquiring the magazine was an attempt to boost Wong’s botched image over the years. Nonetheless, Wong was not able to achieve his intended purpose of boosting the company’s image; the magazine closed down in 2007. On November 24, 2008, the Hong Kong Stock Exchange halted trading indefinitely on GOME amid reports of a police investigation for stock market manipulation on Wong, company chairman, executive director, and controlling shareholder. Two months later, Wong resigned as executive director of GOME Electrical Appliances Holding Limited, and his position as chairman of the board ceased. The board immediately installed then-president Chen Xiao as chairman of the board. Amid the huge shake-up at GOME, Bain Capital made the decision to invest in GOME. By April 2009, it was reported that GOME had fi nancing issues, and was in talks with Kohlberg Kravis Roberts & Co (KKR), Warburg Pincus (Warburg), and Bain.7 In the end, it was Bain who struck a deal with GOME, despite knowing well that Wong could be jailed. On June 22, 2009, it was announced that Bain would buy $233 million (approx. 1.8 billion HKD) of convertible bonds from GOME.8 The seven-year convertible bonds have a 5 percent interest rate per annum and can be converted to around 10 percent of the enlarged share capital. With this investment, Bain will also nominate three nonexecutive directors to the board of GOME. In the event that this request did not materialize, GOME would pay Bain 2.4 billion yuan immediately as compensation. The deal was seen as a boost for GOME as the liquidity risk was

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resolved. When trading of GOME shares resumed after a seven-month trading halt on June 24, 2009, the stock closed at HKD 1.89, up 68.75 percent from the pre-suspended price. During the past year, while Chen Xiao was in charge, he attempted to enlarge the share capital base (thereby diluting Wong’s shareholding ratio) by supporting the deal with Bain and embarking on a share option program with the senior management of GOME. However, things were not to be smooth sailing for Bain. In May 2010, Wong was found guilty for his stock market manipulation allegations and was sentenced to 14 years in jail. During the annual shareholder meeting on May 11, 2010, the Wong family exercised their power as controlling shareholder to veto the appointment of the three Bain representatives into the GOME’s board. Later, GOME reappointed the three Bain representatives to avoid paying the penalty.9 This point marked the beginning of Bain’s strained relationship with the domineering Wong family. By August 5, 2010, the rift between the management team led by Chen Xiao and the controlling shareholder had surfaced into the public domain. Despite being imprisoned, Wong requested a special shareholder meeting to vote on a series of resolutions that included restructuring the board to include Wong’s sister as a director and removing Chen Xiao from his position as GOME’s chairman. Simultaneously, Bain was exercising all its convertible bonds into 1.63 billion shares at a price of HKD1.108 per share on September 15. Effectively, Bain had become GOME’s second largest shareholder with 9.98 percent of total equity whereas Wong’s portion had been reduced to 32.46 percent.10 This was an interesting turn of events, since it thwarted Wong’s plans to restructure the board. It was a well-known fact that Bain favored Chen Xiao as chairman of GOME, since Chen Xiao was a supporter of Bain’s investment into GOME earlier. On September 28, 2010, the special shareholder meeting requested by Wong was held under the glare of intense media interest. Locally, it was termed the “9.28 incident.” The meeting was characterized by the public and the media, as a tussle between a local entrepreneur (Wong, the founder and controlling shareholder of GOME) and foreign capital (Bain, who supported Chen Xiao). When the voting results were out in the evening, four out of the five resolutions that Wong proposed (including the proposal regarding the removal of Chen and the inclusion of Wong’s sister) were rejected by the shareholders. In addition, the three representatives from Bain retained their seats in the board.

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But was this truly a victory for Bain? As Chen Xiao was holding his celebratory dinner in Hong Kong, Jonathan Zhu, the head of Chinese operations for Bain Capital, reacted counter-intuitively. Instead of celebrating, he flew straight to Beijing to begin negotiations with Wong’s wife, Du Juan. Jonathan understood that for Bain to make returns on GOME, it hinged largely on the Wong family. Next Steps for Bain The chips on the Wong’s family hands were the unlisted GOME stores wholly owned by them. In 2009, the unlisted stores contributed about 233 million yuan of management fees to GOME.11 This amount is equivalent to about 16.7 percent of the profit from the listed stores. A breakaway of these unlisted GOME stores would be undesirable for the shareholders. Furthermore, it was understood that some of the unlisted stores like Dazhong Electronics and Beijing GOME were graded A-class internally. If these unlisted stores were to go for listing and subsumed under GOME in the future, it would expand and enhance GOME’s assets. Clearly, this would increase Bain’s bargaining powers and allow Bain to exit at a better price. To a large extent, this was the driver that led to Wong’s advances. On December 17, 2010, Wong’s sister (and spokesperson) was finally appointed as director on the board. Subsequently, Chen Xiao resigned as chairman on March 9, 2011. Faced with a powerful controlling shareholder, Bain could only retreat and compromise on their choice of chairman and board structure. In August 2011, GOME’s share price hit HKD3.34 on better sales and profitability margin.12 Bain’s 9.98 percent shares would give them a profit of around HKD3.6 billion from an initial investment of HKD1.8 billion, giving them a decent twofold return. There were talks that Morgan Stanley was tasked to assist Bain in looking for buyers but none was keen. The “9.28 incident” and ensuing events reflected the dominant influence and unyielding nature of the Wong family. The well-publicized tussles between the Wong family and Bain had stymied potential fund managers’ interest to hold a minority stake in the company. The Year 2012 In the first half of 2012, GOME had posted a loss of 500 million yuan.13 As of November 30, 2012, GOME’s share price had plunged to HKD0.78 and has amounted to approximately HKD 534.6 million of paper loss for Bain. The instability on the board for the past two years resulted in frequent strategy

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tempering and alteration. Yet, during the past two years, transformational changes took place in the retail sector as Chinese consumers started shifting toward e-commerce. GOME’s competitor, SUNING electronics had moved ahead of the e-commerce competition with sales revenue of 5.9 billion yuan in 2011, whereas GOME’s online sales revenue was a meager 1 billion. As a result, Bain is caught in a maladroit situation. It had underestimated the complex dynamics of Wong’s family dominant influence on GOME. The Wong’s family possession of the crowned unlisted assets provided them the upper hand in their negotiations with Bain. Even with three directors on board, it appeared that Bain had little influence in the company’s structure and strategy. More importantly, the overpowering stance adopted by the Wong family in the “9.28 incident” had turned off potential investors to buy out Bain’s stake and participate as a minority investor in GOME. This is in stark contrast to KKR’s attitude toward the GOME debacle. It was common knowledge that KKR was interested to invest in GOME four years earlier, at the same time as Bain did. However, they were largely deterred by the Wong family’s powerful control on the company and reluctance to dilute the family’s equity. Right now, Bain could only wish it was as insistent as KKR four years earlier. Takeaways Even prior to the onset of corporate tussle and boardroom drama, an examination of the information pertaining to Wong’s character, his rumored gambling habit, his non-core business dealings, and the heavy involvement of his relatives and acquaintances in the business should have raised red flags about the reliability of Wong as a leader of the company and as an investment partner. While one may not have so accurately predicted the arrest of Wong, had there been a more thorough analysis of beyond-the-checklist factors, an investor might have been sufficiently cautioned to ward off the investment. With regard to Wong’s personality, investors may tend to note that being ambitious is a positive trait. However, being zealously ambitious may be a red flag to the company. As investors, one will want the management team to cater to one’s best interests. That may translate to forgoing potential projects, limiting company expansions if the business environment is deemed poor. An overambitious founder may choose to pursue such projects as part of an “empire-building” mentality associated with ambition and ego. The danger that needs to be highlighted is the “empire-building” mentality that management might develop. In striving for the expansion of a company, the some founders may engage in negative NPV projects just to boost

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their current asset base. The seemingly positive media attention they receive in return makes it seem as if they are steering their company toward greater heights, or in more extreme cases, the actions could have just stemmed from the simple selfish need to feed their own ego. As we mentioned, Chinese company’s management are usually the founders who have steered the company to success in a short period of time. As nouveau riche, they may be more ambitious and have greater tendencies to pursue an ‘empire building’ strategy. One may argue that the consumer electronics was in their heydays during that period of time, with an estimated value of $55 billion. Wong’s expansion strategy might be justified after all. Nonetheless, prudent investors should note down such clear indications when performing a background check. Pertaining to Wong’s divided interests in GOME and real estate, there is no doubt that diversification is a wise thing, but in the context of due diligence, it deserves much greater attention. The last thing an investor likes to find out is how their financing has been channeled to fuel another business unit of the founder. In the interview with The Economist, Wong ended with a playful tone, saying that the beauty of property investments is that “you don’t have to deal with so many people.” What this might translate to is that he doesn’t like to go through lengthy discussions to reach a consensus, and that he prefer things his way. This may suggest that Wong has a stubborn nature, unwilling to take other peoples’ advices or opinions, even advice not to conduct illegal activity. That will definitely constitute a red flag in the due diligence team’s overall analysis. If Warburg Pincus had delved into understanding Wong’s personality, and dug deeper into the business relations with his brother, they may have avoided the fiasco of the soured investment that ensued. In fact, when interviewed by Asia Times on February 2006 about their investment into GOME, Sun Chang, managing director of Warburg Pincus, commented on the macro environment and booming household appliance/consumer electronics sector, but made no mention whatsoever about Wong, or GOME-specific due diligence positive findings. This would be indications that Warburg Pincus had focused too much on the traditional due diligence, particularly on the sector’s macro prospects, and downplayed the importance of beyond-the-checklist due diligence, especially on the founder and management. It is clear that Warburg Pincus underestimated the total risk involved in the GOME investment. Wong’s relation with Zhan Peizhong and Huang Songyou presents itself as a prominent red flag. An interview with the founder of the Hurun Rich List revealed that entrepreneurs would often set up a “political moat” by knowing

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and developing the right relationships with strategic officials. But once you have a foot into the murky Chinese political world, the enemies of the political friends are automatically your enemies as well. The sudden arrest and stepdowns of the officials may signify a tumbling of the delicate relational balance of Wong and the political parties/enemies. In a due diligence perspective, this is a good example of the importance of investigations into the political ties a founder has. The points mentioned above represent the telltale red flags that could have and should have been surfaced prior to Bain Capital’s investment. Had these factors been identified earlier on, perhaps Bain would have thought twice having realized that Wong had a history rigged with investigations and clandestine activities. Once again, this highlights how traditional due diligence is unable to incorporate the non-tangible, non-quantifiable risk factors that beyond checklist due diligence items touch on, namely, the founder and management and the four deadly A’s.

NVC Lighting Technology Corporation In May 2012, news of the resignation of one of the most prominent figures in China’s lighting industry broke out. Wu Changjiang, CEO and chairman of NVC Lighting Technology Corporation, China’s largest lighting products manufacturer, citing personal reasons, tendered his resignation of all his fiduciary duties. NVC’s shares plunged as much as 20 percent. Market watchers anticipating a corporate drama to unfold were not disappointed. Following the high-profile resignation, a three-month-long battle involving the company’s majority shareholder, suppliers, customers, employees, and Wu Changjiang himself ensued. Through it all, as the alarm bell once again rang on corporate governance in China, investors conducting due diligence on Chinese companies can once again take heed of the perils of being skimpy or missing out on beyond-checklist-items in due diligence processes. NVC’s Beginning—Founders ’ Tribulation and Flight NVC’s meteoric rise to become a lighting behemoth began in Huizhou City, Guangdong, in 1998. Wu Changjiang, a budding entrepreneur who had experienced small successes starting a company manufacturing industrial transformers, gathered two of his high school classmates, Hu Yonghong and Du Gang, to found NVC Lighting Technology with a total paid-in capital of 1 million yuan. The company’s ownership was divided among the three founders as such—Wu held 45 percent of the shares, while Hu and Du each had 27.5

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percent. From the founding, the trio had drawn up clear roles and responsibilities for themselves—Wu in charge of operations, Hu running marketing and sales, and Du taking helm in the company’s finances. Under the trio’s leadership, the company reaped in 30 million yuan in sales for its fi rst year of operations and achieved stellar growth in sales every year thereafter. In reality, working relations between the founders were certainly not as smooth sailing as the company’s growth. They had very different views about how the company should reinvest its profits. Wu, known for his highly ambitious and risk-taking nature, felt that the NVC should expand as quickly as possible to consolidate its position in the market, whereas the more conservative Hu and Du both felt that the company should focus on building its foundations, and that paying off the shareholders (themselves) should take precedence over expansions. Amicable discussions over these issues transpired until Wu took matters into his own hands, directing funds to expand the company’s operations without consulting his partners. Eventually, disagreements pertaining to their remuneration also arose: Hu and Du were disgruntled that Wu received more in dividend payouts due to his larger share ownership. Wu, perhaps recognizing that his position would come under threat should the two team up against him, relinquished 5.83 percent of NVC’s ownership to Hu and Du each in 2002, resulting in an even control of NVC among the three founders; each of them held about 33.3 percent of NVC’s shares.14 In 2004, Wu was appointed general manager of the company, wholly taking charge of the company’s production and downstream distribution. Guided once again by his ambitions, Wu set sight on doubling NVC’s sales for the year and taking NVC public. By end of the year, NVC astounded the industry by achieving the sales forecast, and Wu became increasingly regarded as the undisputed front man of NVC, both internally and externally. In 2005, NVC’s strained top management finally began to split at its seams. According to NVC’s press release, the three founders had a serious disagreement about the company’s distribution channels. In particular, the ambitious Wu was bent on revolutionizing this aspect of the company. He had a vision of restructuring the hundreds of distributors to 35 provincial distribution hubs, and giving control autonomy to each of these hubs. Hu and Du were averse to this restructuring and called for a board meeting to veto Wu’s decision. During the meeting, in the heat of an argument, Wu said that he would pull out from NVC. Even though it was certainly not his intentions to do so, Wu knew that there was no turning back; the conditions of his withdrawal were quickly drawn up and signed.

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Yet, the drama did not end there. In a matter of days, hundreds of distributors showed up at NVC’s headquarters in Huizhou, seeking the reinstatement of Wu. Numerous suppliers who also turned up shared their goal, as well as some of NVC’s employees. Hu and Du had no choice but to appease them. Perhaps sensing that their positions in the company would no longer be tenable after this saga, both Hu and Du agreed to pull out of NVC with a severance fee of 80 million yuan each, in exchange for their ownership in NVC. However, the ownership transfer fee proved too much for NVC to cover, and it was subsequently agreed that 50 million yuan would be paid out each to Hu and Du first, and the remainder would be paid out over the next six months. Mao Ou Jianli Enters the Picture NVC was left severely short of cash by the end of the saga, and between 2005 and 2006, Wu spent most of his time seeking financing. Into the picture came Mao Ou Jianli, founder and CEO of Ascend Capital Partners, a Hong Kongbased financial advisory and private equity firm. Mao, with her team at Ascend, offered Wu and NVC a full suite of financial services, and perhaps more importantly, provided a 20 million yuan loan. In the ensuing months, Mao was also working to attract further capital injection into NVC. Finally in 2006, three individual investors agreed to put in a total of US$4 million into NVC, and Mao herself invested an additional US$4.94 million. In return, Mao received a 20 percent share ownership, whereas the other three shared 10 percent. Wu remained the company’s largest shareholder with 70 percent ownership. This round of capital injection valued NVC’s shares at a PE ratio of 4.7, a figure that was much lower than the industrial average of about 8–10 for first-round venture investments. It was clear that Mao, who arranged the sale, had taken advantage of NVC’s dire need for cash, thereby pushed down the valuations. SAIF and Goldman Sachs ’ Entry Despite the capital injection, NVC was still short of cash after fulfilling its obligations to its former founders. It comes as no surprise that Mao, who had been heavily involved with NVC, was again the one who matched the company with its next investor, SAIF Partners, a private equity/venture capital firm. The SAIF decision maker was Andrew Y Yan, the firm’s managing partner, who would eventually also become the main character in the most recent corporate tussle. According to Yan, he had made the decision to invest in NVC on the same day that he met Wu for the fi rst time. The two men had hit it off from the start

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due to their similar academic backgrounds in aerospace engineering. Wu’s humble disposition at that time, coupled with Yan’s positive outlook for the Chinese lighting industry, convinced the latter to put in US$22.2 million into NVC without further due diligence. SAIF received a 35.71 percent share ownership in NVC for its investment, making it the largest shareholder after Wu himself, who held 41.79 percent. Yan, an industry veteran, was shrewd enough to negotiate for several beneficial provisions in his investment. For example, SAIF had the option to request for a share buyback by Wu should NVC not complete its public listing by August 2011. More importantly, SAIF received two seats on the company’s board, and Yan was appointed as a nonexecutive director. Further, SAIF had veto rights with regard to major projects and other strategic decisions. Seemingly, Yan had done enough to protect his firm in this investment, and was ready to kickstart the value-adding process for NVC. Indeed, in the following years, NVC saw itself readily consolidate its position in the industry. (Figure 8.5 provides NVC’s financial results from 2008 to 2011.) This was due in no small part to the strategic acquisitions Yan negotiated for the company, including, among others, that of Zhejiang Sanyou, an energysaving lamp manufacturer, and Shanghai Arcata, a manufacturer specializing in production of ballasts (a key component in lamps and LEDs). During the acquisition of Zhejiang Sanyou (which involved the purchase of its parent holding company, Shitong Investments) in 2008, NVC once again found itself cashstrapped for the transaction. NVC managed to rope in Goldman Sachs, who put in US$36.5 million in exchange for a 9.39 percent share in NVC. SAIF also followed suit with an investment of US$10 million, boosting its own shareholding to 30.73 percent. In this turn of events, Wu unwillingly found his control of NVC diluted to 29.33 percent.15 IPO and Schneider Electric ’s Investment Between 2010 and 2011, two major events took place at NVC. First, in May 2010, the company was successfully listed on the Hong Kong Exchange (HKEx), and a year later in July 2011, French electric equipment manufacturer Schneider Electric became NVC’s third-largest shareholder (9.1 percent) with an investment of HK$1.27 billion. From Schneider’s point of view, its decision to invest in NVC was a clear-cut one: At the time it did not have any retail outlets in China, and NVC’s 3,000 retail stores countrywide provided an established distribution option on a silver platter. Later, Wu admitted that at time of the deal, he had viewed Schneider’s entry purely as a strategic partnership. However, he began to see things differently in late 2011, when the Schneider representative on

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2008

2009

2010

2011

Revenues

256.4

305.8

471.7

589.3

Cost of Goods Sold

193.5

221.7

334.5

438.3

Gross Profit

62.9

84.0

137.3

151.0

Selling and Administrative Expenses, Total

27.7

47.2

66.4

74.2

Other Operating Expenses

−4.4

0.4

0.6

1.0

Total Operating Expenses

23.3

47.7

67.0

75.2

Operating Income

39.6

36.4

70.2

75.9

Interest Expense

−5.0

−8.7

−2.6

−0.5

0.6

0.8

1.9

3.3

Other Nonoperating Expenses, Total

−14.9

−8.1

13.5

20.2

Other Nonoperating Income (Expenses)

−14.9

−8.1

12.7

18.3

0.0

−0.2

−0.7

−0.1

20.2

20.1

82.3

98.6

Interest Income

Gain (Loss) On Sale Of Assets EBT Income Tax Expense

2.1

5.4

8.4

8.1

Minority Interest in Earnings

−0.1

−1.8

−2.6

−4.1

Earnings from Continuing Operations

18.1

14.7

73.9

90.6

Net Income

17.9

12.8

71.3

86.5

FIGURE 8.5 NVC Lighting’s Financial Performance (2008–2011, in US$ millions)

NVC’s Board Zhu Hai nominated his subordinate Li Xinyu as vice president at NVC, putting him in charge of industrial lighting division (one of NVC’s core business units).16 Wu, perhaps sensing Schneider and SAIF’s creeping influence, began purchasing shares in the secondary market, boosting his stake to 19 percent. Wu’s aggressive bid to regain pole position as the largest shareholder was clear indication that working relations between Wu and Yan were far from rosy. Indeed, when the recent saga blew out of proportions, both Wu and Yan admitted through various outlets that there had been underlying tensions from as early as 2007. In particular, one key accusation of Wu was that he was rash and had no sense of accountability. One incident cited by Yan was the acquisition of a UK-based lighting solutions company, which was agreed on by Wu before consulting NVC’s board. Perhaps the most notable incident would be the

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shift of NVC’s headquarters: In the second half of 2011, the board got news that the company’s headquarters were to be shifted to Nan’an District in Chongqing City—a decision made by Wu that the board knew nothing off. Wu was called up to a board meeting, and the eight other directors all vetoed the decision. Yet, in February 2012, Yan and the rest of the board received news that hundreds of employees had shifted to Chongqing. Upon further investigation, the board found out that Wu had signed an agreement with the Nan’an District government for the move, promising a sales volume of 10 billion yuan in exchange for land, subsidies, and other preferential policies. Yan further added that the board had requested meetings with Wu several times over the next few months, but none of these meetings materialized. Family Ties and Discrepancies More insights can be gleaned by examining Wu’s family ties. In 2009, Wu Lian, the wife of Wu Changjiang, bought land from the Chonqing government with the intention of setting up housing for the employees of NVC. Wu Lian did so under the NVC Real Estate entity, a company she set up with another partner. This decision may be linked to the uncalledfor headquarter shift by Wu in 2011. Apparently, the land used to build the new headquarters is owned by a Hong Kong Wuji Lighting Co., where Wu Lian used to be a director. The land was bought through a cheap discount. We are left to guess how much influence Wu Lian had on the shifting of the headquarters, and any other business decisions made by NVC. Another discrepancy surfaced through an entity known as Enweixi Industrial Development Co. In 2008, Enweixi Industrial signed a contract with the Rongchang County in Chongqing to build production plant. Initial fi lings stated that Enweixi Industrial was a subsidiary of NVC, but subsequent fi lings stated them to be a supplier for outdoor lighting. Notably, Wu’s father-in-law owns 49.67 percent of Enweixi. The grayed relationship between NVC and Enweixi, and family related ownership of the entity casts shadows on Wu’s business connections and if Wu had attempted to shield the extent of his actual control on the whole group of companies. The two aforementioned findings contributed to the resignation of Wu. The Corporate Drama Unfolds On May 20, 2012, Yan finally received a phone call from the elusive founder: Wu told Yan that he had been called up by the Commission for Discipline Inspection (of the Central Committee of the CPC) for assistance with a bribery

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case involving Xia Zeliang, former party secretary of the Nan’an District, and that he might not be returning to China in the short term.17 A board teleconference was held thereafter, and it was decided that, in accordance with HKEx’s regulations, Wu would resign from his duties as he was no longer able to fulfill his obligations as chairman and CEO. Wu agreed. With his resignation, Yan was nominated to be the nonexecutive chairman, and Zhang Kaipeng, former operations director at Schneider, was appointed as the CEO. Wu’s resignation, along with the new appointments, was made public on May 25, 2012. However, the truth behind Wu’s resignation was not disclosed, and the media and the public were left to speculate on the underlying reasons. The uncertainty only served to fuel the verbal and virtual battle between Yan and Wu that took place on Weibo and through various media interviews in the following weeks. Further, personnel reshuffling resulting in the appointment of former-Schneider’s staff to other key positions sparked outrage among those on Wu’s camp. On July 13, 2012, the saga seemingly spun out of control when NVC employees at the Chongqing headquarters, Huizhou production center, as well as the company’s 36 regional operation hubs, went on a coordinated strike. It was reported that the board had met with representatives from the company’s employee, distributor, and supplier bodies the day before to discuss demands to reinstate Wu, but the discussion quickly escalated to a heated confl ict. On the same day, Wu made a public declaration that he had been forced out of the company. In the three weeks that followed, distributors defected on their orders and suppliers also ceased their deliveries, potentially crippling NVC. And although the company had released an official filing on August 16, stating that the findings of the investigation team (established after demands to reinstate Wu were made) rendered the return of Wu as chairman/director inappropriate, it seemed that the board has finally succumbed to majority’s will at the start of September; an official release stated that a temporary management committee will be set up to take charge of NVC’s daily operations, and Wu had been placed in charge of the mentioned committee. A month later, in a press interview, Wu revealed that the three major shareholders of NVC at the time (himself, SAIF, and Schneider) are back on amicable terms, formulating the company’s next step ahead. Yan also declared that Wu would return to the board in three months’ time.18 In December 2012, it was announced that Elec-Tech International, a Shenzhen-based lighting manufacturer listed on both the Shenzhen Stock Exchange and Hong Kong Exchange, was to become NVC’s largest shareholder. Wu had agreed to sell nearly two-thirds of his shares to Elec-Tech, amounting

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to 11.81 percent of the share capital of NVC. Prior to the transaction, Elec-Tech had amassed some 260 million NVC shares, or 8.24 percent of the company. With a combined stake of about 20.05 percent, Elec-Tech edges past SAIF’s last reported 18.48 percent to become the largest shareholder in NVC.19 On paper, Wu retains a mere 6.79 percent in NVC. In fact, in order to finance the purchase, Elec-Tech had itself issued an additional 230 million shares, of which Wu had purchased 130 million shares. In other words, through the sale of NVC shares, Wu had received both cash and Elec-Tech shares, indirectly retaining a higher stake in NVC than the direct 6.79 percent. (Figure 8.6 shows the shareholding transitions for NVC from 1998 to 2011.) On January 15, 2013, Wu was officially reappointed as the CEO of NVC, and Wang Donglei, chairman of Elec-Tech was elected as a nonexecutive director on the NVC board. Lesson Learned To date, various media outlets continue to portray SAIF and Yan as manipulative investors seeking to wrench control from Wu throughout the entire saga, and Schneider has also received its fair share of criticism as a scheming foreign enterprise looking to swallow an easy slice of pie in the Chinese market. (Figure 8.7 shows how it is not easy for a foreign investor to gain access to a domestic distribution network, even with the promise of bringing in technology.) On the other hand, supporters of SAIF and Schneider point to Wu’s lack of accountability, rashness, and shady dealings as glaring reasons for him to leave. It is uncertain whether the saga will come to a happy end. What is clear, however, is that SAIF and Schneider, being investors putting in a substantial amount of capital into NVC, have certainly failed in their due diligence processes. From a financial viewpoint, NVC seemed like a worthy investment. Having achieved stellar sales growth consistency at the turn of the millennium, coupled with its innovative distribution networks, NVC was poised to make its mark in the industry. Yan, an investment veteran, would have been fully aware of the company’s potential before meeting with Wu to discuss SAIF Partners’ investment. Further, Wu was known throughout the industry as a pioneering and ambitious individual who had built up a strong rapport within the employee ranks as well as among the company’s distributors and suppliers. Yet, there was a glaring fact that Yan and SAIF were likely to have missed out—one that would have been indicative of the corporate turmoil that was to come. Wu had simply too much support from and, therefore, too much influence on the employees and external stakeholders.

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Wu Changjiang Wu Changjiang

Wu Changjiang

Wu Changjiang

Wu Changjiang

Mao Jianli

Goldman Sachs

Other Shareholders

Du Gang

Mao Jianli

Other Shareholders

Other Shareholders

SAIF Partners

Hu Yong Hong

Kingview

SAIF Partners

SAIF Partners

Schneider Electric

100%

9.21%

10.00%

90%

27.50%

80 %

20.00%

Goldman Sachs

35.71%

30.73%

18.48%

70% 60%

9.64%

27.50%

30.54%

50%

12.86%

40 %

70.00%

30% 45.00%

20%

48.67%

9.39%

41.79%

5.65%

29.33%

10%

15.33%

0%

1998

NVC Lighting Technology Corporation founded

FIGURE 8.6

Jun-06

After Du and Hu’s exit, Mao pulled in three individual investors (who formed Kingview Company) and also put in US$4.94 million of her own money

Aug-06

SAIF Partners invested US$22.2 million into NVC, for a 35.71 percent share

Aug-08 During 2008’s acquisition of Shitong, NVC roped in Goldman Sachs for more capital. SAIF followed up with a US$10 million investment, boosting its stake to 30.73 percent

Jul-11

In 2011, Schneider Electric invested HK$1.27 billion into NVC, becoming the third largest shareholder with 9.22 percent ownership, after SAIF and Wu

NVC’s Shareholding Structure Transitions (1998 through July 2011)

345

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FIGURE 8.7 It Is Not Always Easy for a Foreign Investor to Gain Access to a Domestic Company’s Distribution Networks

Credit has to be given to Yan for successfully negotiating for seats on the board as well as the various covenants that have given SAIF a certain extent of control over NVC and Wu over the course of the investment. Restrictions on Wu’s ability to approve projects for example, somewhat kept his risk-taking nature in check. However, SAIF clearly underestimated Wu’s influence, not only on the company, but also across the value chain. Contractually, SAIF might feel that it had protected itself with the provisions and seats on the board, but in reality, Wu’s influence extends beyond these. Yan failed to recognize that Wu was no mere CEO. His status as founder and one of the most prominent figures in the industry granted him powers that covenants could not restrain. Yet, had Yan looked a little more closely at NVC’s history, he would most certainly have recognized this fact. In 2005, Wu successfully (but perhaps unintentionally) evicted his two founding partners through his resignation. The overwhelming call for his reinstatement left his partners with no choice but to leave NVC. This strategy was replayed again seven years later in yet another tussle between himself and other majority shareholders. The public may never know whether Wu had masterminded this whole saga, but it is clear that his rapport with the various parties has helped him retain his position not once, but twice. Schneider Electric was no different despite having different objectives from SAIF. As a trade buyer, one would have also expected a thorough due diligence process from the French company. Yet, from the resignations of its former staff who were appointed into various key roles in NVC, it is clear that Schneider was

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also not prepared for the overwhelming revolt by the employees, suppliers, and distributors, and had buckled under pressure from the various parties. The lesson for investors conducting due diligence on Chinese companies is to always be especially wary of a significant concentration of power in any individual. This was clearly the case here, and as SAIF has demonstrated, it is possible to curb such power to a certain extent by making contractual provisions at the time of the investment. However, beyond the checklists on the qualifications and responsibilities of the target company’s top management, an astute investor should also look at the level of support of the management personnel, not only within the company, but also among the external stakeholders. Although good rapport may reflect the capabilities of the management team, an unhealthy level of support poses a potential obstacle, particularly to an active investor such as a private equity fi rm or trade buyer, for cases in which decisions over personnel reshuffling need to be made. The key takeaway for investors here is that good rapport can be a double-edge sword. Also, an investor should also scrutinize the changes in shareholding structures throughout the history of the target company to identify the presence of any rogue shareholders. In this case, had Yan examined the sudden exit of Wu’s former founding-partners, he might have been prompted to dig deeper. Moreover, the involvement of Wu Lian in the land purchase related to NVC’s headquarter’s shifting, and Wu’s father-in-laws large ownership in a Enweixi Industrial with an unknown status in NVC’s structure should ignite further suspicions that the structure and control of NVC is not as simple prima facie. Finally, from Schneider’s investment, the lesson that we can draw would be that beyond giving the target company a thorough strip-down, investors should always examine the socioeconomic factors underlying their investments. On paper, the investment and partnership seemed mutually beneficial. However, the strong opposition to its appointment of former employees to NVC, and widespread perception that it was trying to “seize” control of the company, appear to suggest that Schneider had not been viewed too favorably right from the start. Barring exceptional support for existing personnel, a socioeconomic factor like this could also pose a potentially serious obstacle for an investor.

CONCLUSION The tasks following the implementation of formal full due diligence are often allocated much less effort and resources. As the earlier discussions have demonstrated, this should not be the case. Post-due diligence should in fact be the

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Post Due Diligence and Case Studies

time when most outstanding assessment and analysis take place, because one is granted full access to company information after becoming a shareholder or having board seats, be it financials, operational, legal documents, or any matters in and beyond the checklists. In particular, post-acquisition due diligence review usually receives little or no attention at all. Yet, stringent monitoring on the various due diligence items after an acquisition can prove to be useful in helping the acquisition team to uncover red flags that might have been missed out earlier. Sometimes, the information gained can also be used to reverse previously seemingly passible checks. After all, the due diligence team has spent considerable amount of time and focused efforts in these areas and are in the best position to continue monitoring the key risks. Ultimately, post-acquisition due diligence review gives the acquirer an opportunity to minimize damages should severe risks be discovered either through implementation of structural changes to mitigate these risks, or through an early exit from the problematic acquired company altogether in the worst case scenario. The two final landmark cases of GOME and NVC will hopefully serve to remind readers that even the most experienced of acquirers or investors can fall prey to common pitfalls related to investments in China if due diligence is conducted solely based on conventional checklists. The two cases should also demonstrate that beyond-the-checklist items can ultimately take many forms, and while several models have been discussed in these final few chapters of the book, there is simply no one-size-fits-all due diligence strategy. In-depth knowledge of the sector, adequate experience with the Chinese business landscape, and a tireless, negotiable, and earnest attitude are the key ingredients for an effective concoction that can help investors tailor their due diligence strategies to navigate through potential pitfalls for a successful investment.

NOTES 1. 2. 3. 4. 5. 6.

“CNN China’s Richest Man under Investigation,” CNN, November 24, 2008. “The Seven Deadly Sins of Huang Guangyu,” China.org.cn, December 3, 2008. “Dead End for a Tycoon’s Creative Financing,” Caijing, December 11, 2008. “Controversial Chim jailed for forgery,” IFR Asia, August 8, 1998. “China jails former top judge for corruption,” The Guardian, January 19, 2010. “Eagle Investment Group Partners with Bear Stearns to Launch Private Equity Strategic Alliance in China,” PRnewswire, March 20, 2007. 7. “Bain in Exclusive Talks to Buy 20% of China’s GOME,” Reuters, June 3, 2009. 8. “GOME Gets Bain Capital in $418mln Deal,” Reuters, June 22, 2009.

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9. “Bain Converts GOME Electrical Bonds to 9.98% Stake,” PE Daily, September 16, 2010. 10. “Bain Capital Bounces to Be GOME’s Second Largest Shareholder,” Global Times, September 16, 2010. 11. GOME 2009 annual report, 193. 12. “GOME Electrical Appliances Holding Limited,” Wall Street Journal, August 31, 2011. 13. GOME 2012 interim report, 3. 14. “NVC’s Two Different Defences,” China Business Journal, August 24, 2012. 15. “NVC ’s Capital Robbery: Wu Changjiang Launches Unconventional Retaliation,” Sina, August 20, 2012. 16. “Wu Changjiang’s Bitter Farewell to the NVC Fiasco,” GE Magazine, June 19, 2012. 17. “Thoughts on the NVC Fiasco: Corporate Politics or Governance Revolution,” Eastmoney, September 17, 2012. 18. “Wu Changjiang: Back to the Capital Battleground,” Hexun, October 19, 2012. 19. “NVC Founder’s Share Sale Pushes Down Stock Price,” South China Morning Post, December 28, 2012.

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About the Website

P ■ ■

L E A S E V I S I T T H I S B O O K ’ S C O M PA N I O N website at www.wiley .com/go/ddinchina, password yong123. The website includes the following documents to supplement the information in the book:

Appendix A: Due Diligence Checklists (Word Document) Appendix B: Beyond-the-Checklist Tools and Diagrams (Word, PowerPoint, and Excel Documents)

In Appendix A, a list of the checklists used in conventional due diligence is provided. These checklists should provide a guide to conducting conventional due diligence on various focus areas, including Financial, Tax, Operational, Legal, and Environmental. In Appendix B, a collection of all the tools and diagrams that have been covered in the book are provided, with the aim of producing a set of worksheets that readers may use for their own due diligence exercises. These worksheets are presented in a flow simulating an actual due diligence process, but readers may also use each of these independently for specific areas in their course of due diligence. It is to be noted that these checklists, tools, and diagrams are created generically, with no specific industry or company in mind for the purpose of catering to all readers. Certainly, they may be used in their plain-vanilla forms to good effect for the due diligence on most types of Chinese (non-SOE) companies. However, if readers are able to customize these worksheets according to the sectors and regulatory premises that the company is operating in, as well as the size and internal management of the firm, the use of these tools during the due diligence exercise can be even more effective. Please also visit the author’s website at www.ddinchina.com for some due diligence news, alerts, updates, and so forth.

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About the Author

Kwek Ping YONG has more than 12 years of private equity investment experience in China. He manages a total fund size of more than US$4.2 billion to date. He started his fi rst US$ China-focused growth fund in 2001, and has since made more than 35 investments in different cities in China across various industries and has gone through numerous due diligence process at different stages on Chinese companies. Kwek Ping has also planned and executed many successful exits through trade sales and pre-IPO transactions. Kwek Ping launched his first Chinese RMB private equity growth fund in 2010. Prior to joining Inventis, Kwek Ping founded an IT system integration company that was later merged and listed at the Helsinki Exchanges in Finland in 2000. Kwek Ping’s track record is well recognized, and he is frequently invited to speak at international conferences and seminars. Kwek Ping is an adjunct faculty at the Singapore Management University, where he developed and teaches private equity courses for the Financial Training Institute (FTI@SMU), and he is a visiting lecturer at the Imperial College Business School, UK. Kwek Ping sits on the Board of Advisors of the Asia Pacific Academy of Economics and Management (APAEM) at the University of Macau. He is also the author of Private Equity in China: Challenges and Opportunities published by John Wiley & Sons in 2012.

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Index

100-Day Plan, 35, 120, 144, 179, 185, 187, 194, 319 360Buy, 302. See also Star Express 9.28 Incident, 333–335. See also GOME ABC News, 74 ABC Battery Manufacturing Company, 162–163 Hotel Management, 180–184 Wind Farm Site Visit, 323–326 Abnormalities, 256, 263, 291. See also Four Deadly A’s Accounting Fraud. See Fraud, accounting Accounting Law People’s Republic of China, 147. See also Accounting standards, People’s Republic of China Accounting standards People’s Republic of China, 28, 84, 121 United States, 28, 84 Western, 280 Accounting information system (AIS), 86, 117, 124–125, 159 Actis, 219. See also Hunan Taizinai Advisers, advisors, 66, 71, 85, 131, 172, 247, 270, 272, 321 financial, 29, 272 legal, 29, 170–171, 272 tax, 241 Amazon, 302. See also Star Express Ambow Education, 46–47

Anticorruption Investigative Diligence (ACID), 268–275, 321 advanced, 270, 272 framework, 274 full, 270, 273 initial, 270 post deal, 269–270, 273, 275 Anticorruption, 256, 268–275, 291, 300, 306. See also Four Deadly A’s campaign, 10 Alibaba, 174–175, 302–303, 317 All-China Federation of Labor, 209 Altman, Edward, 185. See also Altman Z scores Altman Z scores, 82, 144, 185–186 Altis, 7–8 Areva, 9 Arthur Andersen, 97 Asahi Group, 71–72 Ascend Capital Partners, 339. See also NVC Lighting Asiasphere, 278. See also Morgan Stanley, real estate Asset sale, 172 Australian Securities and Investments Commission (ASIC), 214. See also Sichuan Hanlong Authorization & Control, 256, 263, 291. See also Four Deadly A’s Authorized Intermediaries (AIs), 283, 285. See also Sinoforest AXAM, 7 AXES, 7

355

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Bain Capital, 327, 332, 334, 337. See also GOME Bank of America, 17 Bank of China, 329, 331. See also GOME Bank of Japan, 259. See also Nissin Leasing Bankruptcy Predicting. See Altman Z scores Bank confirmation letters, 119 Balanced Scorecard, 82, 144, 147, 178 Best alternative to a negotiated agreement (BATNA), 296, 299 BDO China Dahua, 76, 101, 103 Bear Stearns, 63 merchant banking, 327, 332. See also GOME Bechtel, 282. See also Sinoforest Beijing Centergate Technologies, 331–332. See also GOME Beijing Eagle Investment Co. Ltd., 329. See also GOME Beijing Friendship Hospital, 11 Beijing Lawyers Co., 103 Beijing Sanyuan Foods, 221, 266 Beijing Tian Yuan Xin Yu Co, 51 Beijing Towercrest Group, 329. See also GOME Beijing Xinlong Biology and Technology Co., 167. See also Yin Guang Xia Beijing University of Science and Technology, 329. See also GOME Basic Standard for Enterprise Internal Control. 21, 127 BHP Billiton, 215. See also Sichuan Hanlong BlackRock, 50 Block, Carson, 283 Brean Murray, 75 Bribery, 6, 14, 204, 207, 213, 256, 268–271, 275, 278–280, 291. See also Four Deadly A’s Bronte Capital, 280 Business culture Chinese, 12, 199, 294 drinking, 307

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Business environment Chinese, 10, 27, 35, 175, 217–218, 256, 268–269, 291, 300, 317 Business finance, 276–277, 321 growth drivers, 275 licenses, 48, 151, 177, 189, 261, 275–276, 306 operations, 39, 63, 144–145, 150–158, 287–288. See also Due diligence, operational Buyout, full, 36, 39, 40, 62, 319 BYD Auto Company, 123–124 C Illies and Co., 90, 98–99. See also Yin Guang Xia C-SOX. See China SOX Caijing, 8, 92, 98, 166, 243 Capital verification report, 49 Carlsberg, 71 Caterpillar, 107–111, 196–197, 294 Cayne, James E. See also GOME CCTV, 55, 219, 266 Celestial Nutrifood, 50–51 Chan, Allen, 282. See also Sinoforest Chan Ming Fon, 7 Changsha Tutoring, 47 Channel stuffing, 88, 106 remedies for, 111 Chaori Solar, 115–116 Cheats, 256, 280–281, 291. See also Four Deadly A’s Checklists. See Due diligence, checklists Chen Chuan, 89. See also Yin Guang Xia Chen Ping, 302–304. See also Star Express Chen Xiao, 330, 332–334. See also GOME Chen Yunwei, 260, 262. See also Nissin Leasing Cheng Tonghai, 9 Chengdu Economic and Information Commission, 8 Chengdu Industry Investment Group, 8

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Index

China Teachers Day in, 11 SOX, 21, 127 China Alcoholic Drinks Association (CADA), 253, 255. See also Jiu Gui Jiu China Aviation Logistics, 302 China Banking Regulatory Commission (CBRC), 21, 148, 259 China Commission for Foreign Trade and Economic Cooperation, 284. See also Sinoforest China’s Criminal Law amendment to, 13–14 doing business in, 1–2, 12, 19, 24, 27, 35, 68, 218 China Hongxing, 22–23 China Insurance Regulatory Commission (CIRC), 21, 148 China Ministry of Commerce, 255, 260, 317, 330 China Ministry of Finance (MOF), 21, 97, 100 China Ministry of Health, 251, 255 China Ministry of Land and Resources, 123–124, 239 China Ministry of Public Security. See Public Security Bureau China National Centre for Food Safety Risk Assessment, 253. See also Jiu Gui Jiu China National Nuclear Corporation, 9 China Rail Logistics, 302 China Securities Regulatory Commission (CSRC), 21, 43–46, 75–76, 92, 98, 102, 105, 131, 136 ChinaCast, 177–178, 257 Chinese Communist Party Central Commission for Discipline Inspection (CCDI), 9, 342 Secretary General. See Xi Jinping Chinese Development Bank, 215. See also Sichuan Hanlong ChiNEXT, 102,105, 115, 131, 136 Chongqing Normal University Foreign Trade and Business College, 178

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Cinda, 331 Citibank, 219–220. See also Hunan Taizinai CITIC Group, 74–75 industrial, 251 private equity arm, 74 Citron Research, 280 Clean Development Mechanism (CDM), 324 Coca Cola, 317 Cole, Bruce, 66–67 Commerzbank AG, 7 Commission for Discipline Inspection. See Chinese Communist Party Central Commission for Discipline Inspection (CCDI) Communist Party of China (CPC), 5, 9, 342 Central Committee, 5, 8–9, 342 Company stamp, 171, 175–177, 256–258, 263, 291, 321 Compensation schemes, 2, 5–6, 27 Construction Environment Acceptance Inspection, 189 Corporate culture, 2, 14, 19, 24, 27, 30, 68, 143, 145–146, 150, 188–189 making sense of, 146 list of types of, 188 Corporate governance, 19, 21, 23, 30, 53, 78, 130, 202, 205, 228, 298, 310, 337 Corruption, 2, 5–14, 27, 30, 119, 207–208, 217, 231, 268–269, 271–275, 280, 309, 329 anti. See Anticorruption clamping down on, 156 costs of, 269, 273 Corruption Perception Index, 6 Certified Public Accountant (CPA), 49 76, 84, 97, 105, 132 Dai Xiaoming, 8 DangDang, 302. See also Star Express Dazhong Electronics, 334 Deal breakers, 52, 56, 59 stage of deal process, 59–60

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Deal (continued ) post deal monitoring process, 315 selection, 59–60 sourcing, 59–60, 305 structuring, 59–60, 304, 311, 318 Deloitte, 177, 221, 108 Deloitte Touche Tohmatsu, 76 Deng Xiaoping, 2, 6, 201, 228, 268 Deng Zhan, 330. See also GOME Diageo Plc, 251. See also Jiu Gui Jiu Diaoyu Island, 192 Ding Gongmin, 93. See also Yin Guang Xia Dong Bo, 93. See also Yin Guang Xia Dongguan Baisheng, 203–205. See also Oriental Century Du Gang, 337, 345. See also NVC Lighting Du Juan, 329–330, 334. See also GOME Due diligence advanced, 48–49, 69, 269, 311 aim of, 33, 60, 85 anticorruption, 269–272. See also Anticorruption Investigative Diligence (ACID) beyond-the-checklist, 30, 56, 60, 70, 87, 194, 195–196, 198–199, 228–229, 231–232, 256, 273, 281, 291, 293, 319–320, 327, 335, 347–348 challenges doing, 2, 6, 14, 19, 30, 37 checklist, 28, 34, 41, 56, 60, 64, 68, 70, 81–82, 87, 193–195, 198, 210, 256 commercial, 116, 167, 321 culture, 188 differences between M&A and private equity investments, 35, 38–39, 78 environmental, 152, 189, 264, 321 financial, 82–85, 130 formula for, 319–320 full, 36–37, 39, 40, 48, 52–55, 60, 68–69, 269, 273, 304, 311–312 human resource, 186–187, 240 initial, 48–49 60, 269, 274, 295, 304–305, 311, 317

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intensity of, 61–62, 36 legal, 140, 167, 169–171, 256, 264, 275 macro, 167, 305 mindset, 294–295, 312 operational, 37, 56, 70, 120, 125, 131, 139, 144–167, 320 optional checklist, 81, 140, 143, 152, 186–189 poor, 68 post acquisition, 60, 85, 315, 318– 319, 348 pre-IPO, 40 reasons for conducting, 197 report, 54, 64–65, 277, 295–296, 300 315–317 sales and marketing, 187 strategy, 295–299, 304, 312, 316, 318, 320–321, 348 team, 29, 33, 48–49, 54, 63, 68–71, 78, 85–86, 195, 202, 226, 231, 233–235, 237–250, 256, 258, 263–265, 270–272, 274–275, 290–291, 293–294, 296–301, 304, 306–307, 311–313, 315–319, 323, 336, 348 vendor, 64–66 U-chart, 321 Discipline Inspection Commission for. See Chinese Communist Party Central Commission for Discipline Inspection (CCDI) Distribution model in China, 112 Eagle Investment Group, 332. See also GOME Eagle Legend Futures Limited, 328. See also GOME Eagle Legend Securities Limited, 328. See also GOME Ebbers, Bernard, 18 Economic Cooperation Framework Agreement, 3 Economic reform, 2–4, 24–26, 268 zones, 126

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Index

Elec-Tech International, 343–344. See also NVC Lighting Eli Lilly & Co., 13 Embezzlement, 6, 118. See also Corruption Enron, 14, 17–18, 96–97, 294 Enterprise Resource Planning (ERP), 23, 124, 147 Entrepreneurs. See also Founders characteristics of Chinese, 147, 197, 200–201, 226, 228, 329, 336 home-grown, 156 first-generation, 24–25, 30 Enweixi Industrial Development Co., 342, 347 Ernst & Young, 22–23, 76, 84, 273 ERA Mining Machinery. See Caterpillar Erceg, Lynne, 72 European Food Safety Authority, 253. See also Jiu Gui Jiu Exit, 38, 59–60, 115, 171, 174, 297, 319, 326 Face-to-face meeting, 231–232, 234, 237, 247, 265, 273, 281, 290–291, 309, 319–321 planning of, 233–235 Facebook, 264, 271, 305 Fapiao, 97, 125, 127–129, 138, 171 Fastow, Andrew, 17 Feng, Derek, 177. See also ChinaCast Flavoured Beverages Group, 72 Fraud, 2, 6–8, 14–18, 22, 24, 26, 28, 30, 68–69, 73–77, 88–100, 106, 108, 113, 117–120, 131–139, 172, 175, 193, 197, 202, 206, 236, 243, 247, 273, 280–289, 291, 294 accounting, 7, 94, 96, 119, 136, 202, 256, 280–281, 291, 294. See also Four Deadly A’s cases, 2, 6, 14, 30, 73, 75–76, 131, 280 charges, 8, 77 scheme, 106, 136 vendor, supplier or procurement, 15 Fraudsters, 69

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Fraudulent. See Fraud Cases. See Fraud cases Fraud Survey Ernst & Young’s, 273 Fictitious customers, 88 Fidelity Trading GmbH, 90–91, 97–99, 164–167, 243. See also Yin Guang Xia Fir Tree Partners, 178. See also ChinaCast Five-Year Plans, 3, 322 Foster’s, 72 Forbes, 213 Foreign Corrupt Practices Act (FCPA), 11–14, 278–280 China’s. See China’s Criminal Law Founders. See also Entrepreneurs characteristics of Chinese, 24–25, 27, 83, 87, 130, 150–151, 153–154, 170, 174, 179, 187, 197–200, 210, 217, 223–226, 228–229, 257–258, 275, 290, 307, 310, 327, 335–336 WFOE ownership, 174 settlement of unpaid taxes of, 125 Four Deadly A’s, 256, 270, 290, 337 Freehills, 72 Free Trade Agreements, 3 FTI Consulting, 50–51 Fudan University, 21 GAAP PRC. See Accounting standards US. See Accounting standards Galaxy model, 320, 322–326 Gearing, 185 General Administration of Quality Supervision, Inspection and Quarantine (AQSIQ), 253, 255. See also Jiu Gui Jiu General Electric, 188, 261 General Moly Inc., 214–215. See also Sichuan Hanlong Gini coefficient, 4–5 Glancy Binkow & Goldberg LLP, 46 Goldman Sachs, 219–220, 339–340, 345 Goldman Sachs Asset Management, 2

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Gong Ai’ai, 206–208, 228 Gong Xianxia, 206. See also Gong Ai’ai GOME, 200, 213, 327–337, 348 Graft, 6. See Also Bribery, Corruption Great China Financing Leasing Co., 262. See also Nissin Leasing Great Wall Acquisition Capital, 178. See also ChinaCast Guanxi, 24, 216–218, 227, 229, 310. See also Personal relationships Guangdong Academy, 101 Guangdong Xindadi Biotechnology Co. Ltd. (GXB), 100–106, 113, 126 Guangzhou Southern Flour Co., 166. See also Yin Guang Xia Guo Jingyi, 330. See also GOME Gyrus, 7 Han Guizhi, 8 HealthSouth, 14, 15–16 Hebei Xueyang, 266 Hengdeli, 52–53 High-technology parks. See Economic zones Ho, David, 66 Hong Kong legislative Council of (Legco), 329 stock Exchange, 43, 327, 329, 332, 343 Wuji Lighting Co., 342. See also NVC Lighting Hong Hui Lung, 43 Hontex International Holdings, 41–42 Hsieh, Louis, 289. See also New Oriental Hu Jintao, 9, 218 Hu Yonghong, 337, 345. See also NVC Lighting Huadu Baixing Wood Products Factory, 284. See also Sinoforest Huang Gang, 103. See also Guangdong Xindadi Huang Shuangyan, 103–104. See also Guangdong Xindadi Huang Songyou, 329, 336. See also GOME Huang Xianxian, 103. See also Guangdong Xindadi

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Huang Yunjiang, 100, 105. See also Guangdong Xindadi Hughes Network Systems, 178. See also ChinaCast Huitong, 303. See also Star Express Huiyuan Fruit Juice, 317 Hukou, 114, 206–209 Humalabo, 7–8 Hunan Taizinai, 200, 218–222, 228 IAS. See Accounting standards IBM Corporation, 12 Income inequality, 4 Independent Liquor, 71–72 Industrial and Commercial Bank of China, 99 Industry Outlook, 167–168 Information Technology Systems (IT Systems), 21, 144–145, 147–149, 158, 160, 195. See also Due diligence, operational Intel Capital, 178. See also ChinaCast Intellectual property, 82, 121, 144, 175 Interest conflict of, 10, 14–15, 22, 78, 105, 227 alignment of, 71, 263 Internal control, 2, 12, 15, 20–24, 27, 43, 70, 75, 86, 118, 127–130, 137–138, 159, 202, 278 company’s reports on, 21 effective, 22 enterprise. See Basic Standard for Enterprise Internal Control framework for, 21, 127 IT-enabled, 23–24 risks, 22, 100, 159, systems, 19, 23–24, 30, 70, 127, 138, 159–160, 197 weak, lack of, questionable, 2, 23, 75, 127–128 International Finance Corporation, 20 International Mining Machinery Holdings, 109–110 International Organization of Securities Commission’s Multilateral Memorandum of Understanding, 76

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Index

Intertek, 251, 253. See also Jiu Gui Jiu IPO, 78, 210. See also Stock exchange listing. China’s ten step, 43–46 Pre-IPO due diligence. See Due diligence pre-IPO Jefferies, 4 Jiaduobao, 150 Jinlin Tiandi, 278. See also Morgan Stanley, real estate Jiu Gui Jiu, 251–255 Joy Global, 110 Joint venture (JV), 13, 67, 122, 221, 240, 282–284, 287, 332, Equity (EJV), 282–284, 287 JP Morgan, 63 Kai Kit Poon, 282. See also Sinoforest Kang Rixin, 9 Katsuki, Atsushi, 72 Kelly, Harvey, 16 Keyuan Petro Chemicals, 77 KFC, 55 Kickbacks, 24, 27, 128, 130, 159, 217. See also Corruption Kikukawa, 7 Kirin, 72 Kohlberg, Kravis, Roberts and Co (KKR), 327, 332, 335. See also GOME Knowledge Management (KM), 317 Kravis, Henry, 35 Kroll, 14 Kuomintang (KMT), 218 Kweichow Moutai, 251–252, 255. See also Jiu Gui Jiu Land Administration Law, 121, 123 Land-use rights, 121, 123–124 Land leasehold, 122 allocated, 122 grants, 122 Landry, Kiaus, 99. See also Yin Guang Xia Legco. See Hong Kong, Legislative Council of

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Legend Holdings, 251. See also Jiu Gui Jiu Leizhou Forestry Bureau. See Sinoforest Li Anchun, 77 Li Chuncheng, 8 Li Ka-shing, 327 Li Keqiang, 291 Li Ruoshan, 21 Li Rubo, 109. See also Caterpillar Li Tuchun, 219, 228. See also Hunan Taizinai Li Youqiang, 89–91, 94, 164. See also Yin Guang Xia Li Xinyu, 341. See also NVC Lighting Lin Shaoqing, 103. See also Guangdong Xindadi Ling Meilan, 100. See also Guangdong Xindadi LinkedIn, 272 Lion Nathan, 72 Liu Han, 214. See also Sichuan Hanlong Liu Yong, 215. See also Sichuan Hanlong Liuhe Group, 55 Longtop Financial Technologies Ltd., 76 LVMH Moet Hennessy, 52–53 Ma Hua Teng, 327 Ma, Jack, 317 Ma, Mary, 260. See also Nissin Leasing Ma Yi, 209. See also Zhang Lan Macquarie Capital, 75 Macroeconomic conditions, 2–6, 30, 116, 179 miscalculated implications of, 167 Macro conditions. See Macroeconomic conditions due diligence. See Due Diligence, macro environment, 263, 276, 317, 336 factors, 30, 198 landscape, 167 overview, 167 view, 61

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Macrolink Group, 221 Macro Micro Galaxy Model. See Galaxy model Majority investment, 36, 38–39, 40, 62, 73, 153, 317, 331 Mamtek International, 66–67 Management and employees, 143, 145–147. See also Due diligence, operational Mao Ou Jianli, 339, 345. See also NVC Lighting Mao Zedong, 217 Market economy. See Planned economy Marketing 5 P’s, 152–153 Meeting, Visits and Dinner (MVD), 304–305, 307–309, 311 Mega Capital, 42–43 Mengniu, 219. See also Hunan Taizinai Mergers and acquisitions, 34, 52, 228, 294. See also Due diligence, differences between M&A and private equity investments Microsoft, 153 Ming Dequan, 51 Ming Zhao, 74–75 Mingtian Real Estate, 330. See also GOME Minority investment, 36–39, 41, 62, 130, 174, 318–319, 334–335 Mistresses, 205, 210–211, 226, 321 Moly Mines, 214–215. See also Sichuan Hanlong Moore Stephens, 75 Morgan Keegan, 67 Morgan Stanley, 219 Morgan Stanley Private Equity, 327, 330, 334. See also GOME Morgan Stanley Real-Estate, 278–279 Mt. Kearsarge Minerals, 282. See also Sinoforest Muddy Waters, 280, 282–283, 288, 289 Nanjing Securities, 102 NASDAQ, 77, 178 National Audit Office, 21 National Bureau of Statistics (NBS), 5

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National People’s Congress (NPC), 13, 206 National Rational Drug Use Monitoring System, 267. See also Hebei Xueyang National Standard of Data Interface of Accounting Software, 147 New York Stock Exchange (NYSE), 74, 221, 289 New Oriental, 289–290 News Chef Inc., 7–8 Ni Kailu, 116 NIS Group, 259–262. See also Nissin Leasing Nishimura, Kenichi, 8 Nissin Leasing, 259–263 Nomura, 71 Nondisclosure agreement (NDA), 49 Ntan Corporate Advisory, 23 NVC Lighting, 200, 327, 337–348 NVC Real Estate, 342. See also NVC Lighting NYSE, 47, 221 Oberhelman, Douglas, 110. See also Caterpillar Oji Paper Company, 189–193, 264 Olympus, 7–8, 294 One-child policy, 11 O’Neill, Jim, 2 Oriental Century, 200, 202–205, 228 Oriental Pearl College, 203–205. See also Oriental Century Pacific Equity Partners, 73 Parma, 16 Parmalat, 14, 16–17, 294 Parmatour, 16 Paulson and Co., 282–283. See also Sinoforest Pengrun Investments, 329–331. See also GOME Pengtai Investments Co. Ltd., 329, 331–332. See also GOME Personal relationships, 53, 225, 258. See also Guanxi

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Index

Peterson, Garth, 278–279. See also Morgan Stanley, real estate PEST, 167–169, 263 Ping An Insurance Group, 259. See also Nissin Leasing Planned economy, 2–4, 6, 27 Ponzi Scheme, 283. See also Sinoforest Portfolio management, 59–60 PriceWaterhouseCoopers (PwC), 7, 76, 108, 204 Princelings, 217–218 Private equity, 36, 64 deals, investments, 34, 35, 52 firms, 35, 39 investment strategy, 39 minority investments, 130 purpose for investment, 297 Proportion check, 139, 242–248, 250, 256, 281, 290–291, 319–321 Pu Shaoping, 92. See also Yin Guang Xia Public Offering Review Committee (PORC), 43–45 Public Company Accounting Oversight Board, 74 Public Security Bureau, 175–176, 206–207, 257 QQ, 226 Raffles Education, 202–205, 228. See also Oriental Century Rapp, Ed, 111. See also Caterpillar Regulation on Using Computerized Accounting System, 147 Rekorute, 8 Related party transactions, 22, 29, 100, 117, 159, 201, 228, 237, 242, 280 Renren, 226, 271, 305 Rent-seeking, 10, 27, 44 Reverse mergers. See Reverse takeovers Reverse takeovers (RTOs), 73, 78, 109, 178, 282 Rio Tinto, 215. See also Sichuan Hanlong Risk tolerance, 38–39, 59 Robinson, Deborah, 76 Rothschild, 71

bindex.indd 363

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363

Rodman & Renshaw, 74 Ron Chan, 177, 257. See also ChinaCast S-Chips, 203 SABMiller, 72 SAIF Partners, 339–341, 343–347. See also NVC Lighting Sany, 193 Sarbanes Oxley Act, 21, 127. See also China SOX Schneider Electric, 340–341, 343–347. See also NVC Lighting Schneider, Steven, 261. See also Nissin Leasing Seagers Gin, 71 Securities Exchange Commission (SEC), 10, 12–13, 16, 40, 46, 73–76, 177, 278–280, 289 Securities and Exchange Act, 76 Securities and Futures Commission (SFCI), 41–43 Sena, Tony, 177. See also ChinaCast Septwolves, 150 Service providers, 64, 68, 71, 75, 78, 83, 105, 130, 137, 139, 195–196, 241, 310 Scrushy, Richard, 16 Shan Weijian, 261. See also Nissin Leasing Shanghai Arcata, 340. See also NVC Lighting Shanghai Food and Drug Administration, 55 Shanghai Stock Exchange, 21 Shao Ten-po, 42 Sheaman & Sterline, 75 Shenmu Rural Commercial Bank, 206. See also Gong Ai’ai Shentong, 303. See also Star Express Shenzhen Development Bank (SDB), 259–260 Shenzhen Stock Exchange, 21, 251, 343 Sherwood, Ned, 177–178. See also ChinaCast Shitong Investments, 340. See also NVC Lighting

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364

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Index

Short sellers, 280–281, 289 Sichuan Hanlong, 213–215 Sina, 174 Singapore Airlines (SIA), 37 Singapore Stock Exchange, 178 Sino-Japan wars, 218 Sinoforest, 282–288, 291 Sinopec, 9 Site visits, 49, 63, 70, 161–163, 195, 237, 247–250, 255, 256, 265, 273, 281, 290–291, 305, 309, 316, 319–324 SL Industries, Inc, 12 SL Xianghe Power Electronics Corporation, 12 SL Shanghai Power Electronics Corporation, 12 SL Shanghai International Trading Corporation, 12 Small-to-medium enterprises (SMEs), 10, 23, 87, 124, 259–260, 261 Social Insurance Law, 114 Social media, 9, 225–226, 264, 270–271, 274, 291, 305. See also specific social media platforms Societe Generale, 7 Song Xunjie, 266. See also Hebei Xueyang South Beauty, 208–209. See also Zhang Lan South China Agricultural University, 101 South China University of Technology, 101 Southern Metropolis Daily, 266. See also Hebei Xueyang Special Purpose Acquisition Company, 178 Star Express, 302–304 State Assets Supervision and Administration Commission (SASAC), 37 State Administration for Industry and Commerce (SAIC), 48, 257, 262 State Administration of Work Safety (SAWS), 152 State Council Food Safety Authority, 255. See also Jiu Gui Jiu

bindex.indd 364

State Food and Drug Administration, 255, 266 State Forestry Administration’s Camellia Research and Development Center, 101 State-owned assets, 207 audit firms, 94. See Also Zhongtianqin companies. See State-owned enterprises enterprises (SOEs), 4–5, 8, 10, 12, 116, 198, 268, 326 land, 121 non, 198 shell company, 220 TV station, 219 Stock exchanges, 169. See also specific stock exchanges listing, delisting, 21, 40–41 74–75, 139, 178, 251, 282, 291, 327, 343 overseas, 40–41, 291 regulations, 111 Stock Exchange Executive Council (SEEC), 91–92 Strategy plans Corporate, top-down, bottom-up approach, 156–157 Sullivan, Scott, 18 Sun Chang, 336. See also GOME Sundance Resources, 214–216. See also Sichuan Hanlong SUNING Electronics, 335. See also GOME Supply chain management, 58, 144–145, 158–161. See also Due diligence, operational Swatch, 52–53 SWOPEST, 224–225, 229, 273, 290, 321 Tanaka, Mioru, 8 Tanglu Port, 190, 192 Tao Yong, 207. See also Gong Ai’ai Taobao, 302–303. See also Star Express Tax incentives high-technology enterprises, 125–126 Tencent, 174

12-08-2013 12:20:56

Index

Temasek, 37 Texas Pacific Group (TPG), 259–263. See also Nissin Leasing Thain, John, 221. See also Hunan Taizinai The Economist, 328–329, 336 The Red Capitalist, 332. See also GOME Thompson III, James Edward, 109. See also Caterpillar ThyssenKrupp, 98, 166 Tianqing accounting. See Zhongtianqin Tianyang Food Co., 55 Tonghua Yason Pharmaceuticals, 267. See also Hebei Xueyang Tonna, Fausto, 17 Toronto Stock Exchange, 282 Transparency International Corruption Perception Index, 6 Tri-background Venn Framework, 224, 226–229, 273, 290 Tsinghua University, 165 UBS, 72 University of Nottingham School of Contemporary Chinese Studies, 10 Unitas Capital, 73 UniTrust Finance and Leasing Corporation, 262. See also Nissin Leasing Utz, Clayton, 71 Vale, 215. See also Sichuan Hanlong Value-added-tax (VAT), 88, 93, 97–98, 283 Value adjustment clause, 219, 222 adjustment mechanism. See Value adjustment clause Variable Interest Entity (VIE), 174, 177, 289–290, 317 Vladivar, 71 Walk-away price, 59, 299 Wanfu Sheng Ke, 131–139 Wang Donglei, 344. See also NVC Lighting

bindex.indd 365

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365

Wang Jingqing, 5 Wang Yong, 261. See also Nissin Leasing Wang Yuean, 203–205, 228. See also Oriental Century Warburg Pincus, 327–328, 332, 336. See also GOME Wealth Management Products (WMPs), 251. See also Jiu Gui Jiu Weibo, 209, 226, 264, 271, 305, 343 Weixin, 264 Welfare mandatory in China. See Social Insurance Law Wellington Management Company, 282–283. See also Sinoforest Wen Dibo, 220. See also Hunan Taizinai Wholly foreign owned entity (WFOE), 13, 174, 284–285 Whyte & Mackay Scotch Whisky, 71 Williams, Emory, 109. See also Caterpillar Wong Junqin, 329 Wong Kwong Yu, 213, 327. See also GOME Woodrum, Doug, 177. See also ChinaCast Woodford, Michael, 7 Worldcom, 14, 17–18, 120 World Trade Organization, 2 Wu Anqi, 89. See also Yin Guang Xia Wu Changjiang, 337, 342, 345. See also NVC Lighting Wu Lian, 342, 347. See also NVC Lighting Wu Yonghua, 278. See also Morgan Stanley, real estate Wuliangye Yibin, 251–252. See also Jiu Gui Jiu Xi Jinping, 9, 208, 218, 291 Xi’an Jiade Co., 166–167. See also Yin Guang Xia Xia Zeliang, 343. See also NVC Lighting Xin Fei Hong (XFH), 302–304. See also Star Express Xinhua, 207 Xu Zhongmin, 329. See also GOME

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366

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Index

Yahoo, 174, 317 Yan, Andrew, 339. See also NVC Lighting Yan Jindai, 93. See also Yin Guang Xia Yang Jichu, 165. See also Yin Guang Xia Yao Shujie, 10 Yongle, 330. See also GOME Yongye Group, 278–279 Yingtai Food Group, 55 Yin Guang Xia (YGX), 243 case study, 88–100 follow-up of analysis of operational due diligence, 164–167 Yuan Baojing, 214. See also Sichuan Hanlong Yuantong, 303. See also Star Express YunDa, 303. See also Star Express Yum! Brands, 55 Zhai Ji Song (ZJS), 302–304. See also Star Express Zhai Zhenfeng, 207. See also Gong Ai’ai Zhan Peizhong, 329, 336. See also GOME Zhang Jisheng, 89. See also Yin Guang Xia Zhang Kaipeng, 343. See also NVC Lighting Zhang Lan, 208–209, 228

bindex.indd 366

Zhang Yuping, 53 Zhang Zhiming, 330. See also GOME Zhao Gang, 105. See also Guangdong Xindadi Zhao Heyu, 105. See also Guangdong Xindadi Zhejiang Sanyou, 340. See also NVC Lighting Zhongguancun Corporation, 331. See also GOME Zhonglei CPA firm, 132. See also Wanfu Sheng Ke Zhongshan University, 101 Zhongtianqin, 94–95, 97, 100 Zhongtian accounting. See Zhongtianqin Zhongtong, 303. See also Star Express Zhou Qiong, 103–104. See also Guangdong Xindadi Zhu Hai, 341. See also NVC Lighting Zhu, Jonathan, 334. See also GOME Zhu, Liping, 73 Zhucheng Haotian Pharmaceuticals, 67 Zhuzhou Gaoke, 220–222. See also Hunan Taizinai Zoomlion, 111,193 Zone of possible agreement (ZOPA), 299

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