Tbird Advice on M&A Due Diligence in China

Thursday, January 11, 2007 15:07
Comments Off on Tbird Advice on M&A Due Diligence in China

The Thunderbird community is one of the strongest alumni groups around the world, and with between 800-1000 alumni in China this is especially true.

Wired with language capabilities, strong in managing country operations, and willing always eager to travel, the Thunderbirds are a special breed to say the least.

Recently on one of our internal bulletin boards, an alumni outside of China asked what are the top 10 issues one should look at when preparing to buy into China, and the responses thus far have been very interesting

With their permission, I repost the original post as well as the three replies it received. Should other replies be posted, I will update.

Initial Post China acquisition issues: We are in the process of looking at a couple of acquisition candidates in China for manufacturing our line of products.Could you please let me know a good resource for understanding the main issues that need to be addressed? What would be the top 10 issues to consider when looking at a manufacturing acquisition in China?Thanks for your help.

Reply: China Investments
by Timothy Lamb of JLJ GroupAs with any market first and foremost you should be conducting Due Diligence:
Business Intelligence – Probably best to start here to get a general idea of the market, the company’s competitors, vendors, clients. Either my company or Rich Brubaker can help in this department
Legal – you should have a local lawyer assisting you with this. Do not rely upon their word or scanned copies of documents. You want to see originals and you want to verify with the local bureaus. A good local lawyer can do this for you. I often recommend Zhonglun law firm to our clients
Financial – Obviously important. Jay Boyle can help with this end.There are a myriad of issues you can run into depending on the industry you’re in what region of the country your looking at and the structure of the deal. Also acquisition regulations have changed recently. I’m not convinced that there is a top 10 list (perhaps a top 100?) and what follows is no where near exhaustive and can easily be added to:
– “The Special Chinese Way” that will get it all done faster is often illegal and can mean serious issues for the company in the long run.
– Use experienced service providers in China. It’s often better to have direct contact with the people on the ground then to go through partners in your home country.
– Rule of Law Exists and its getting better so do not think that contracts are useless as they are not enforceable. On the flip side don’t expect your contracts to do all of the work for you: sound due dil and a solid business plan is paramount.
– Be flexible. Chinese are well aware that western companies work on tight deadlines and will often take advantage of this by stalling tactics and carefully timed pressure. Regulations may change, target companies may not look so great after extensive scrutiny and your timeline will be adjusted.
– Follow the trends. Yesterday’s headlines will often turn into tomorrow’s investment environment. News on income disparity between 1st tier and 3rd tier cities, foreign investors skirting the law, creating a harmonious society etc, all eventually have an impact on how business is conducted.

My best advice though is to do your due diligence. I cannot tell you how many companies I have seen hastily run into investments without careful planning and quality information turn out to be what Rich calls “Fwoked” on his blog.

Reply: Don’t Get Fwoked!!
by Rich Brubaker of China Strategic Development Partners and All Roads Lead to China Tim frames it well (appreciate the plug as well) and creating a top 10 is impossible as investing in China (or any developing country) has a lot of moving parts that can change depending on region, industry, sales strategy, product, etc.My high line additions would be:
1) Do you have a previous relationship with the facility you are purchasing?
– If yes, DD is much easier (especially if you are their primary customer)
– If no, invest in market research, accounting, and legal DD teams to make sure you are buying into the right company, that your buy strategy has a strong foundation, and that your interests are protected through out negotiation and closing2) Is this firm a SOE or joint stock company?
– If yes, then underlying asset valuation and ownership issues will exist, and extra due diligence shoudl be performed to properly verify and assess assets (real estate, equipment, and intangible)
– If yes, then HR (pension, over employment, management sophistication, etc) should be a big focus as many current and former SOEs have may HR issues that have not been resolved.
3) Does your investment go beyond a financial investment?
– IP leaks here, and depending on the industry you may find competitive products that look similar to yours on the market. It is not always sinister, but be very careful as you risk training up managers who will be head hunted and/or open their own shops.

4) Are the conditions right for an acquisition?
– There have been a lot of regulatory changes recently (I have discussed on my blog) and there is a definite change in China’s willingness to accept any and all investment.
– Perform benefit vs. risk analysis

5) If the company is bringing to the deal promises of “future expansion”, make sure you investigate historical/current sales using accounting firm and perform a BI study of largest customers to make sure they are happy

6) Make sure you are buying for the right reasons and you choose the right location.
– If your acquisition is to build a domestic China sales market, do not buy a company that has 100% export sales.
– Invest in a region that has been overlooked historically as governments in those areas will be more supportive and provide better service (however, be prepared for delays if the investment infrastructure is still immature)

In the end, echoing Tim’s comment, the best piece of advice is to invest in due diligence and the service providers of due diligence.

In my previous company we were on the backend of deals and often the last service provider needed before a deal was chopped. I was always surprised by how little the buyers really understood about the company and many discounted benefits/ risks. Deals can go bad, but more often that not they do not need to. There is a lot of focus and blame on Chinese companies for failed deals, but a lot of times foreign companies will enter into deals without understanding the deal, the risks, the motives of the partner, and a number of other things that are critical to the success of the deal

Take your time in selecting the target, bring in the consultants/ accountants/ lawyers, and execute the deal on your terms..

There is never “the company” or “the deal”. don’t be afraid to walk away if it is going bad…. because it won’t get better…. and it can get a lot worse.

Hope that helps.

Reply: Due Diligence in China
By Jay Boyle of Expat CFO Thanks for the plug Tim!Some great advice here.Due diligence is the key both before and after you sign the LOI and it should be ongoing after your acquisition as well.Over the last 6 years I have been involved in 10 transactions on both the sell and the buy side in large state owned and small privately held companies.Lessons learned:

Make sure your LOI has a “no shop” agreement in it or sign a separate one at the same time. There is a lot of money chasing deals and it is common for the target to seek other buyers to drive up the price.

Use a cross functional team for the due diligence process and do the site visit at one time with all members.

The team should consist of operations and HR people that will be involved in ongoing liaison work with the target after the acquisition. This keeps continuity and prevents the more valuable employees from looking elsewhere.

Ideally, one of the operational people has manufacturing experience, as they are better able to correctly value the condition of equipment in the factory then even the so-called asset valuation experts.

You need outside experts with China due diligence experience for financial, legal and environmental. Ideally, these people or teams should have a foreigner or a local that has had significant international exposure.

The cross functional team is critical to get an accurate financial picture and valuation. Accounting records in the PRC are for compliance only and are kept as vague as possible to avoid tax. Only by exchanging info with the other members of the team, can the finance people find the off balance sheet and contingent liabilities that are so common here.

Know the cost and time to do a greenfield start-up before you begin negotiating that is your arbitrage price and should be kept in mind.

Let the due diligence drive the valuation process. It is common that to bring a local firm into compliance with the law it will kill a share deal.

However, an asset deal maybe still viable. Keep in mind however that some assets are not transferable and to do a asset deal you must have a legal entity. i.e. WOFE or JV to hold the assets.

Make sure you structure any deal to give the other party face if you can keep him on as management and structure the deal to have claw-backs for non or under performance. This will ensure a smooth transition and prevent the top management from starting a competing operation with the capital they just acquired as non-compete agreements are not enforceable.

Finally be ready to walk away their competitors might make a better target.


If you have any stories or advice that you would like to add to the above, please post your comments here.

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