May 12 2010
Every multinational company needs a China strategy. The country's resilient economic performance during the global downturn has made it even more attractive to overseas investors, but how should such companies arrive at a realistic appraisal of the potential risks and opportunities of a specific deal?
For many companies approaching a transaction, due diligence is a tool to confirm compliance or to seek confirmation that their project is not excessively risky. In the context of an acquisition in China, this is the wrong approach. Chinese companies are used to informal arrangements; as a result, non-compliance issues may arise in the fields of employment and social contributions, tax, licensing and intellectual property, among others. However, if a Chinese company raises no compliance issues, it is almost certainly not a viable option for a project - the target does not need the acquirer and the acquirer is unlikely to be able to afford the target. When properly performed, due diligence should uncover problems and compliance issues, but should go further and provide a plan - including price reductions, corrective measures and other steps - that allows for successful implementation.
A foreign company's ultimate decision maker may see little immediate opportunity in China, being reluctant to move hastily in a risky market and making full compliance a prerequisite for a deal. However, a visit to China can turn the most cautious chief executive officers into the most over-zealous converts. Due diligence plays its part in contextualizing a particular opportunity in the most practical terms.
A foreign investor normally starts conducting due diligence as soon as a letter of intent has been signed. This work is conducted in various ways:
The due diligence process follows an initial discussion with the client to gain an understanding of its industry, project and intended goal.
A strategy paper should give a basic legal opinion on:
Preparation for fieldwork
Preparation for fieldwork should involve:
In the case of a Chinese target, due diligence that is confined to data rooms and document review is highly unlikely to result in useful findings for the acquirer, whereas direct research can be remarkably revealing. Ideally, fieldwork should involve:
Picturing the target - an acquirer's checklist
In order to make a balanced decision about a transaction, an acquirer should have an overview of:
A would-be acquirer must be prepared for difficulties in areas that might be taken for granted in a transaction outside China, and an examination of potential problems should start with the basics - it seems unlikely that a foreign investor would buy a non-existent company, but this has happened. Beyond disaster avoidance, an investor must consider whether the problems are irreparable or whether realistic solutions can be found.
Land use rights and buildings
Many Chinese companies operate on the basis of an informal arrangement with local authorities. An apparent owner may see no problem with pursuing a deal even if it has only a short-term, unenforceable buy-back agreement with the local municipal government, which remains the target's actual owner. Land or buildings may be mortgaged and the company may operate on the basis of allocated rather than commercial land use rights.
In addition to the issue of actual ownership, an assessment of assets must consider customs supervision, production know-how and third party rights (eg, mortgage or retention of title).
Acquirers should be aware that state-owned enterprises can obtain licences for commercial activities that are not open to foreign-invested enterprises; thus, the involvement of a foreign entity may result in licences being withheld or not renewed. Most companies do not apply Western standards of environmental performance and different standards apply to different enterprises.
Although the approach to intellectual property in China has been changing fast in recent years, many Chinese targets value IP rights far less than a typical foreign acquirer would do, and may not even price them into the transaction. However, this approach demonstrates a less than rigorous approach to IP issues and often spells trouble. It is not unknown for a Chinese target to seek to sell technology in which it has no proprietary rights, and trademark and patent registrations must be cross-checked with official records.
Few Chinese companies can accurately claim to comply perfectly with labour obligations. In one transaction the due diligence report found that 220 of a target's 350 workers were classified as disabled, which enabled the company to take advantage of the value added tax exemption for certain enterprises employing disabled people as more than 50% of their staff. However, none of the employees actually performed work for the company; rather, the company's workers were found to be employed by a third party.
Although one purpose of due diligence may be to act as a corrective to 'deal destiny', a review of the potential pitfalls for M&A projects in China might be enough to dissuade some potential overseas investors entirely. Not all problems are surmountable and not all projects should proceed. Some risks may be legally remote but difficult to repair, and if a target is seriously flawed, the acquirer must be prepared to look elsewhere. However, many projects fail - or stall for long enough to allow a rival to swoop - because due diligence results are not read in context or because it is easier to list non-compliance issues than to remedy them. Firm but fair dealing with the target in the due diligence process and a clear message about the need for cooperation ensures that the process and results can be used properly: to reduce risk and optimize the legal structure of a deal. In this market in particular, it pays to be prepared.
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