China Private Equity Due Diligence: A Primer

So, what can we do? (Other than decide to abandon the Chinese market, a decision that seems analogous to a physician cutting off an arm to cure a hangnail.)

The short answer: Become better at due diligence. It is by no means a sovereign remedy for all the things that can go wrong when investing in an emerging market like China, but it is better than nothing.

The long answer, well, that’s actually a book and years of practical experience doing due diligence on and investing in Chinese companies under the tutelage of a master. The “investing in” portion is not optional; there is nothing that better focuses the mind on the essentials of a task than having one’s own money or livelihood at risk from a failure.

This is the middle ground. It covers enough, I daresay, to be a meaningful introduction to the topic, while making no pretensions of comprehensiveness. It should be seen solely as a primer, and where appropriate I have tried to include supplemental sources in footnotes and as links in the text. It is also a snapshot in time. Don’t still be using this in 2020, at least, not without checking if some of the advice is still relevant. (I expect the basic principles will stay unchanged but the implementation and relative importance of each principle will change.)

Beginnings

I should firstly begin by setting out the reasons why you should listen to me on this topic. In the last six years I have done a fair amount of work on Chinese private equity investments, including pre-IPO co-investments alongside some very well regarded private equity sponsors, minority growth stage investments in Chinese companies, Series B investments in Chinese startups, buyouts of established mid-market Chinese companies, and financing a reverse takeover of a Hong Kong listed company. I would like to say that I have had nothing but success, but that would be both untrue and also a reason to doubt the value of my observations. One learns more from one’s failures than one does from one’s successes, and there have been two notable failures that I have participated in, the names and details of which I am not at liberty to disclose.

Private equity due diligence, whether one intends to complete a buyout or take a minority stake in a growing enterprise, is a time consuming and energy intensive process. The amount of time and energy required does not vary significantly across the investment types; from experience I would say that there is no material difference in terms of the time or energy needed to do diligence on a $25 million growth capital investment or a $250 million buyout. Indeed, I might even go so far as to say that a minority investment demands more detailed due diligence on certain aspects of the target and its management, given that one will have limited control over the target post-investment.

I tend to treat private equity due diligence on a company (anywhere in the world and not just China) as consisting of two stages: first, an abbreviated phase of initial due diligence with a small subset of professional advisers aimed at assessing whether a target is worth pursuing at all; and second, an in depth phase of comprehensive due diligence in which one endeavors to evaluate the target in full with a full complement of professional advisers (lawyers, accountants, etc.).

First, let us set out our understanding of what the objective of a private equity due diligence process is: identify and quantify the key factors that affect the target in order to assess its present value (as is) and that can impact its expected value at exit (post operational and financial engineering). Re-read that objective twice, please. It’s important.

I am going to assume that prior to even beginning initial due diligence for a private equity transaction you have formulated an answer or a hypothesis for each of the following questions:1

What are your motivations for doing the deal?
What are the motivations of the counterparty for doing the deal?
What is the competitive position of the target and what are the factors that determine its ability to defend its position?
What is your preliminary valuation for this target?
What conditions would cause you to walk away from the deal?

The answers to these questions will guide you in deciding what aspects of the due diligence to emphasize and what aspects can be left for later.

Check the Business License

So, if that is our objective, then it stands to reason that among other things, we should begin by asking a deceptively simple question: Is this company actually in existence and is it operating in accordance with the business scope (经营范围) set out in its business license (营业执照)?2 Don’t laugh. First, always verify easily verifiable but critical matters like this. It takes relatively little time, and if somehow it should happen that you cannot verify something as fundamental as this, it’s a good sign that you ought to reconsider your pursuit of this target. Second, it serves as a check on the honesty of the managers and shareholders that you are dealing with. Ask the managers to send you a copy of the business license for the company and its subsidiaries, if any. The next step is to reconcile the information recorded in this business license with the information on the target held by the relevant office of the State Administration of Industry and Commerce (工商行政管理局) (the “SAIC”). This, it goes without saying, should be done either by Chinese qualified attorneys or by individuals with lots of experience with Chinese business licenses.

If there are material differences between the business license you have been provided and the information at the SAIC office, this is a sign to ask more questions, and listen very carefully to those answers. If the answers are not convincing, it is better to walk away. There will be other deals, and more importantly, you will not be risking your investors’ capital in a speculative endeavor with counterparties of uncertain trustworthiness.

If the information you are receiving from management regarding the company does not match the information at the SAIC office or in the business license, you should also conduct further investigations. This is another point where you should consider walking away if the answers are not convincing.

In conducting the sort of further investigations triggered by the aforementioned discrepancies, I would counsel you to be cognizant that sometimes honest errors may be made, and that sometimes a discrepancy in certain details may be attributable more to human fallibility than malice. One of the marks of a skilled investor is the ability to discern the difference between the two. For that, I’m afraid there is no substitute for experience coupled with a measure of skill at reading people.

Registered Capital

Check the registered capital (注册资本) and paid-in capital (实收资本) stated on the business license and request a capital verification report through an audit firm or a CPA. Here, you are looking for discrepancies between the nature and scale of the business and the registered and paid-in capital that need to be answered before progressing to a more expensive and time consuming phase of due diligence.

I should add—in case any of my fellow lawyers and pedants are reading this—that following revisiions to the Chinese company law on December 28, 2013, the registered capital and paid-in capital systems have changed. In practice, though, these changes do not alter the checks one should do on the registered capital of the business. You are still looking for obvious discrepancies that justify re-assessing your views of the trustworthiness of management and whether the target is on its face sufficiently capitalized to have begun its operations in the industry in which it operates.

The Due Diligence Team

Due diligence for a private equity deal is an endeavor that requires a good team. I have yet to encounter anyone who can singlehandedly conduct comprehensive due diligence. The people you assemble for your due diligence will include: investment professionals with backgrounds in the M&A departments of investment banks to build the financial models and make projections as to appropriate valuation, industry experts (often part of a relevant practice at one of the big strategy consulting firms, though highly niche targets may require specialist consultants from within that industry) to assess the operations of the target and its overall position in the industry, attorneys to assess the legal documents and other legal issues associated with the target and the deal, accountants to assess the books of the target, tax experts to determine if there are any material outstanding tax issues that would affect the target, and investigators to conduct background checks on the management of the company and its suppliers, customers and business partners.

Quite a list, isn‘t it. Oh, and make sure that your due diligence team consist of people with local knowledge, ideally people who are either Chinese nationals or people who have lived and worked in China for many (at least five) years and are fluent in Mandarin. Finally, do not simply look at the name on the door of the firm you are hiring. Look at the specific people who will be doing your due diligence for you and understand their backgrounds. The persons you will be working with are, invariably, more important than the (often deceased or no longer active) people who founded the firm.

Initial Due Diligence

As mentioned above the whole purpose of the initial due diligence is to determine, as cheaply as possible, if the target is worth pursuing. At this stage, you will have signed a non-disclosure agreement (“NDA”) and obtained access to financial statements, tax filings, corporate registry filings, contracts with suppliers and customers, litigation records, etc. This being China, in practice the amount and quality of the materials provided to you will be, well, extremely variable. The management and shareholders of the target will almost always be unfamiliar with the level of due diligence expected by a private equity buyer and may resist providing access to some or all of these documents. My advice is to spend the early part of your time with management and shareholders developing their understanding of the importance of due diligence to a successful deal. It will pay dividends later when your questions become—by necessity—more specific.

Now, when conducting initial due diligence, a fair bit of it will be tailored to the target. That being said, there are a few universal constants that can help you decide if you are going to continue with the deal.

Understand whether a foreign private equity investor can invest in the target’s industry. (I am making the not unreasonable assumption that if you are reading this English language post you are a foreign private equity investor.) If foreign investment is restricted (to certain percentage limits) or outright prohibited, you may have to make some difficult choices about whether to proceed with the deal, and if so how to proceed with the deal.3
Check that the firm has all the licenses and approvals it needs in order to operate its business. I cannot emphasize this enough. The entire reason for acquiring the business (at least for most private equity investors) is to own it, improve it, and then sell it at a higher price to a trade buyer or the public. That is easier done if the company is still operating.
Spend time understanding the background and motivations of management and shareholders. One of the most important determinants of whether a deal is worth doing is whether the interests and end goals of management are aligned with yours: if they are then they will either cooperate with you to achieve those end goals or pull you with them towards those end goals; if not, well, the situation can rapidly deteriorate. This is especially the case when one is doing a minority growth capital investment.4
Assess the likelihood of bribery, corruption, or embezzlement. Try to put yourself in the shoes of a Chinese businessperson trying to hide bribery, corruption, or embezzlement and model scenarios of how you would hide such activities. Look for unusual patterns of payments, particularly in cash. Look at bank account balances and expense accounts and search for discrepancies between the reported transactions and the bank account transactions. Examine any readily available information about management and its relationships with suppliers, customers, business partners, and government. If you find suspicious patterns, investigate (and if necessary confront management). It is never a wise decision to turn a blind eye to such things. For one thing, anti-corruption laws in the United States (the Foreign Corrupt Practices Act) and the United Kingdom (the Bribery Act 2010 (c.23)) can apply to bribes made by a private equity firm’s portfolio companies in China (and elsewhere).5 Rest assured that one does not wish to have to explain that the reason one did not find corrupt practices in one’s portfolio companies was because one didn’t do a thorough due diligence. The Department of Justice and the Crown Prosecution Service are not likely to be sympathetic.
Assess any potential merger control issues that might arise from the investment. Merger control filings can take time and can be required in more than one major market, e.g. the United States, the European Union, and China. As a condition of obtaining merger control approval you may have to agree to divest certain assets or commit to doing or avoid doing certain things. It’s a potential issue for many private equity firms because their portfolio companies, treated as a group, may trigger merger control reviews.5
Spend time evaluating the relationships the target, its management, and its shareholders have with suppliers, customers, and other key business partners. Look for family relations, old classmates, former colleagues, among the suppliers, customers, and other business partners, and make some initial evaluations of whether there appear to be signs of business transactions that do not make commercial sense. Not every Chinese company, manager, or shareholder is engaged in inappropriate related party transactions. It is entirely appropriate though to be thorough and verify that the target is not engaged in such transactions.
Verify the land use rights of the target. In particular, check if the target’s factories or buildings are built on arable land without appropriate approval and conversion of the arable land to industrial or commercial use, and check that the land use certificates have not been forged. This will require, at least for the most part, dealing with the local Land and Resources Bureau (国土资源局) in the place where the land is located, since China does not yet have a centralized registry of land use rights.
Be very cautious about the financial statements you receive from the target. Ask yourself how you might inflate the value of the target and disguise its liabilities to an outside investor. And then look for signs of that. For example, fictitious sales, sales to related parties, channel stuffing, unusual patterns in the aging of accounts receivables, fictitious inventory or failure to write-down or write-off obsolete inventory, unusual patterns in accounts payable, improper depreciation or amortization of assets, etc.

One final note. You can do all of the above, to the best of your ability, and still fail to find that missing link that would make it clear that you are being sold a lemon. It can happen. You are only reducing the probability that you will be sold a lemon. Make your peace with that.

In Depth Due Diligence

If your initial due diligence finds no immediate reasons for you to “walk away”, you now face the more arduous task of completing in depth due diligence on the target. This is where you begin to delve deeper into the company. You switch from a headlong rush through the materials provided and become more methodical and discerning. Initially you were looking for reasons to drop the deal. Now you are looking to quantify risk and adjust your expectations of what the value of the target will be to you. Your lawyers will be looking at how to draft appropriate protections (if at all possible) into your investment documents, for example requiring corrective measures to be taken as a “condition precedent” to the deal occurring, or including additional “representations and warranties” to impose liability on the sellers.

There are a few rules of thumb I use I’m working on in depth due diligence:

I have never encountered a company anywhere in the world that is perfectly “clean”, with not even a single minor violation of corporate governance, internal controls, regulations, laws, etc. If I find that the company looks too “clean”, my spider sense starts tingling. It usually isn’t wrong. There is a kind of “Goldilocks” zone for targets, neither too clean to be true nor too full of problems to be worth pursuing. Learning how to identify that zone, though, is hard and can be earned only by experience of successful and failed deals.
The data room is not your friend. Repeat this after me. The data room is not you friend. In tamer jurisdictions with better corporate governance and professional managers, you may (and I remain skeptical of even this) assume that the materials in the data room offer a fairly reasonable picture of the company, and that your queries will unearth most of the other documents that you need to properly assess the risks of investing in the target. In China, reliance solely on the data room is a good way to lose a lot of money very quickly.
On-site due diligence is not optional. Instead of relying solely on documents in the data room, speak to people in different business functions, seniority, and locations in the target on a one-on-one basis. Ask different people overlapping questions about the target and compare their answers. Again, perfectly synchronized answers are a dead giveaway that something is not right in the state of the target. Completely divergent answers, too, signal a problem. Be Goldilocks.
Reconcile the scale of the operations you are seeing with the scale of the operations implied by the financial statements. I can say with some degree of confidence (from prior experience) that sometimes that the scale of operations implied by the financial statements grossly overstate the reality, for example a target that claims to have incredible sales revenues but seem to have retail stores that almost no one purchases anything from. If you are fortunate you discover that before investing. You should not hesitate to get industry experts to assist you with this if the industry is one that you and your team are unfamiliar with. For example, in one prospective investment I worked on, we brought in agricultural experts to assess the target’s facilities in northeastern China. This was to ensure that we understood whether the facilities were well-run, and what value to place on certain agricultural assets of the target.
Assess the depth of talent and quality of the corporate culture of the target. Initially, you will typically have been dealing with senior management and shareholders. Now, assess the quality of the people below them. These employees will often be the ones that execute the target’s strategy. Evaluate the strength of the corporate culture.
Make sure that you do a detailed industry analysis of the industry and geography in which the company operates. This will typically be a combination of market research and strategy consulting. Map out scenarios for base, worst, and best case, and determine if acquiring the target would still make sense in the worst case industry and macroeconomic scenario.
Evaluate the environmental footprint of the target, particularly whether it operates in an industry that produces significant environmental liabilities like soil, water, or air pollution. If there are significant contingent liabilities decrease your purchase price. Remember that just because a Chinese company is able to be “free and loose” with environmental laws and regulations does not mean that you can. Also, remember that standards of enforcement are likely to improve over time, so you should factor in a margin of safety when assessing how likely a contingent environmental liability is to come due.

This is by no means a totally comprehensive list of all the factors you should consider when looking at in depth due diligence, but I think it conveys a bit of the flavor of what you should be thinking about as you proceed.

Vendor Due Diligence

Finally, I would like to say a few words about vendor due diligence (henceforth “VDD”). VDD is due diligence on a target commissioned by the “vendor” (the current shareholders of the target who are planning to sell their stake or seeking additional capital). It is often prepared in an auction scenario by the investment bank, lawyers, accountants, tax experts, and industry consultants hired by the vendor. The purpose of preparing such VDD reports is to facilitate the due diligence process, particularly where there are multiple bidders that seek to conduct due diligence as part of their bid.

I am invariably skeptical of such reports, regardless of which high profile firm prepared it. If you must rely on VDD rather than independent due diligence conducted by your own advisers, be very careful. Read between the lines and verify everything that looks unusual.

Some ways to check VDD include:

Check how many drafts of the reports the adviser prepared. The more drafts, the more suspicious you should be.
Check if the adviser has had a prior relationship with the vendor. If they have worked together extensively before, be cautious about taking everything that is said at face value.
Speak face-to-face with the adviser to ask questions about their due diligence work. Do not do it over telephone or email. Observe their body language and see if they try to avoid certain questions or give generic answers.
Negotiate with the vendor and advisers for reliance on the VDD report if you acquire the target. This implies that if there are material instances of “gross negligence, fraud or misconduct” by the advisers, you have a legal claim against the advisers. The effect of this is not to compensate you for losses (an unlikely prospect since most claims would typically be limited to some multiple of the fees paid to the adviser), but rather to use as a tool to put the reputation of the advisers on the line. An adviser with a reputation for being willing to compromise on its integrity is soon an adviser that cannot signal “peaches” from “lemons” and out of a job.