Brick by Brick

What’s the difference between performing due diligence in Suzhou, rather than Cleveland? Or, in St. Petersburg Russia as opposed to St. Petersburg, Florida?  The difficulty most readers will have answering those questions, either intuitively, or based on hands-on experience, illustrates some of the challenges PE firms and other Western investors face in evaluating investment opportunities in the world’s largest emerging markets, now known, colloquially of course, as BRICS.

In our experience, certain common due diligence themes run across Brazil, Russia, India and China.  For example, businesses in BRIC countries often feature the kind of tangled related party transactions that would necessitate (and reward) detailed due diligence in the West.  Unfortunately, unlike their Western counterparts, these businesses also share a general lack of familiarity with, and reluctance to be subjected to, the due diligence process.  On the other hand, there are important differences among BRIC targets.  The level of financial transparency and legal compliance, for instance, varies widely among the BRIC countries.

Based on our experience in executing deals and performing due diligence in each of Brazil, Russia, India and China, we will highlight some important (albeit by no means exhaustive) considerations associated with performing business, legal and accounting due diligence in each of these jurisdictions.

Due Diligence Process

Lack of familiarity with due diligence process and requirements. “Due diligence” is a relatively new concept in China; Chinese companies and their personnel often do not appreciate its relevance and importance. Moreover, Chinese companies traditionally are reluctant to share information with outsiders.

Poor internal organisation. Chinese companies are relatively weak on internal organisation. Many Chinese companies do not have a legal department or even any in-house counsel.  Decentralisation of information and knowledge is a common issue. Another issue is the lack of standardised documentation — material information or events may not have been properly documented; some important documents may be missing or contain errors.

Business Due Diligence

FCPA; UK Bribery Act. China is a “high-risk” country in so far as bribery is concerned. Chinese officials tend to seek free meals, gifts, entertainment, travel and other business-related opportunities that may be deemed to be “kickbacks.”  Since many large companies in China are state-owned or controlled, their directors and employees are deemed to be “government officials” under the FCPA, and these companies may also be subject to the UK Bribery Act.

Occupational safety and health. Chinese companies generally neglect to ensure safe and healthy working conditions. China does not yet have sophisticated occupational safety/health laws and regulations, and any enforcement of safety standards is weak and difficult. A foreign investor may face reputation risk if the company in which it invests, or with which it does business, has serious occupational safety/health issues.

Environmental protection. Many Chinese companies do not conduct their business in compliance with environmental laws, partly because statutory penalties for environmental violations usually consist only of a modest fine which can be substantially lower than the compliance cost (mandatory remedial action is rare). Moreover, there is currently no active government enforcement of environmental violations. Under current law, it is less likely that a foreign investor will be required to shoulder or share a large bill for pre-existing environmental issues.

Legal Due Diligence

Regulatory environment. The Chinese legal system is based on written statutes.  Compared to common law jurisdictions, prior court decisions have limited precedential authority or value in China. Chinese laws and regulations have undergone substantial development over the past decade and are still evolving rapidly. Many laws and regulations are relatively new and contain broad and sometimes ambiguous provisions. As a result, government authorities and courts have much discretion in interpreting and enforcing Chinese laws and regulations.

Foreign investment approvals. All foreign investments into China are subject to governmental approvals. In most cases, approvals from the Ministry of Commerce and the National Development and Reform Commission (the top government agent in charge of economic planning) or their respective local counterparts are required.  Moreover, most subsequent changes (e.g., ownership, capital, name, constituent documents) concerning a foreign-invested enterprise require approvals by the same governmental authorities that approved the original investment.

Foreign investment restrictions. Foreign investments are categorised under Chinese law into four categories — encouraged, permitted, restricted and prohibited. In particular, investments in “prohibited” industries (e.g., operations of news agencies and radio/television networks) are off-limits for foreign investment.

Financial Due Diligence

Accounting records. Accounting books and financial records of Chinese companies are less transparent than those of US companies. Furthermore, some Chinese companies deliberately keep two sets of accounting records, one for the statutory reporting purpose and the other for internal use. The latter reflects a company’s actual financial condition and results, whereas the former set of records tend to reflect less revenue and/or more expenditures with a view to reducing the company’s tax liability.

Financial Audit. Compared to the “big four” accounting firms, Chinese local accounting firms may be less credible and impartial in performing audits, as they tend to react to pressures from the company under audit due to their eagerness to win engagements or maintain relationships.

Accounting standards. Chinese companies are required by law to prepare audited financial statements under Chinese GAAP.  Following multiple rounds of revisions, the current version of Chinese GAAP is believed to be substantially in line with the IFRS, although differences still exist between the two standards.

As should now be clear, the difference between performing due diligence in Suzhou rather than Cleveland is about as great as the geographic distance between those two cities. Concepts that are taken for granted in a typical western due diligence exercise such as appreciation (albeit not affection) for the legitimacy of a buyer’s need to perform diligence, the availability of accurate internal records, extensive public search resources and one set of financial statements prepared in accordance with a well-established, standardised set of accounting principles and audited by a Big Four type accounting firm are simply not common in China. Further complicating matters is the lack of a well-developed legal infrastructure in China that would aid a buyer’s ability to streamline its diligence and provide certainty with respect to contractual risk allocations by the parties based on potential exposures discovered in the diligence process.

Buyers can nonetheless seek to maximise the success of their diligence in this challenging environment by, among other tactics (1) engaging advisor teams consisting of people who can speak Chinese, know China well, and fully understand the intricacies and unique features of China deals, (2) relying, to the extent feasible, less on well stocked data rooms and complete paper trails and more on talking to employees, customers, competitors and other commercial constituents of the target as a basis to spot issues, and (3) spending time early in the transaction process emphasising the importance of due diligence as a basis to build trust and maximise deal value from a Western-based buyer.

Still, PE firms must recognise that even in the best of circumstances, diligence of Chinese-based companies may well provide them with scant information or, even worse, raise more questions than it answers. In that respect, buyers will likely need to rely on the same measures they utilise when confronting similarly inadequate diligence targets in, say, Cleveland: discounting valuation to self insure against contingent exposures, utilising earn-outs, negotiating indemnities that are designed to ensure that the indemnification will be available in the event of covered claims and, in the most extreme cases, simply deciding not to proceed with the deal.

A version of this article originally appeared in the Spring 2011 issue of the Debevoise & Plimpton Private Equity Report.