Due Diligence: Deal Killer or Deal Saver?

Why a Smart Approach to Due Diligence is Needed in China

Every multinational company needs a China strategy. The country’s resilient economic performance during the global downturn has made it even more attractive to some 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 contextualising a particular opportunity in the most practical terms.

Types of Due Diligence

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.

Legal due diligence is carried out by law firms, which check the legal status of the Chinese target, including its ownership structure, assets, operations, and staff. Financial due diligence is carried out by accounting firms to check compliance with accounting and financial requirements, and may overlap with a law firm’s work. Investigatory due diligence is conducted by private investigation firms to check the good-faith basis of key management or business operations. This is normally necessary only in sensitive cases or to address serious concerns that are brought to light by financial or legal due diligence.

Environmental due diligence is increasingly common. A law firm’s research usually determines whether the target has the necessary environmental permits and operational licences, but it is based on documentation and interviews. In some cases a foreign investor also requires a technical assessment of a factory or other asset in order to assess its level of compliance. For example, soil sampling can determine whether the land involved in the deal is contaminated.

Procedure

The due diligence process follows an initial discussion with the client to gain an understanding of its industry, project, and intended goal.

Strategy Paper

A strategy paper should give a basic legal opinion on:

  • The restrictions on the intended business (eg, whether a wholly-owned foreign enterprise can be used and which operational licences are required);
  • The potential advantages of incorporating a new company, including any preferential treatment available to a foreign investor on this basis;
  • Operational requirements.
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Mark Schaub

Lawyer

King & Wood

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