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Due Diligence: Success in China (Part I)

You are a successful business-owner. You own a thriving company in Europe or North America and your progress is continuing year upon year. You thus begin to consider overseas expansion– specifically into the ever-growing Chinese market. However, before making any concrete move into China, you must be wary. Over-confidence has often seen Western business owners invest heavy sums into a new venture in China, only for their previous tried-and-tested business formulas to be unsuccessful with their new partners. What went wrong?

They did not conduct sufficient due diligence before entering the Chinese market, an absolutely essential process when seeking expansion to a business environment entirely different to that of the West.

Due diligence in business sense means to conduct thorough research of the company or person you wish to deal with prior to signing any contract with them. The process must be as detailed as possible in order to red flag any potential hiccups which could cause irreversible future damage to your investment. If you cut corners because you wish to avoid the cost of extensive due diligence, you risk far greater losses in the future. In a market of such potential, it would be a huge disappointment if your Chinese venture were to become unravelled simply because of a lack of prior research. You may be thinking: of course I will research my prospective partners – it’s a standard process. China, however, is a whole different ballpark when it comes to the level of thoroughness needed for your due diligence procedure. There are multiple factors which make the country unique in this sense:

–   Two decades of foreign direct investment has done little to change the Chinese business culture which accepts fraud as norm. The absence of a strong moral backbone in China’s business environment is due to historical turbulence, societal conflicts and nationwide oppression

–   The prominence of “guanxi” can result in government and local business collaboration in order to undermine foreign investors. Maintaining positive networks and relationships is helpful but does not eliminate the possibility of exploitation

–   Chinese regulations and business laws lack substantial enforcement and consequent punishment. Additionally, experienced and successful Chinese businessmen can easily manipulate or distort ambiguous rules to their own advantage.

–   The language barrier: needless to say, thorough comprehension of written Chinese contracts is crucial but also challenging. The smallest details can be crucial, and misunderstanding them can be potentially hazardous to your venture.

–   Quality control can be compromised in China, attributing to opaque production and purchasing processes. The pressure to maximize profit margins often encourages manufacturers to cut corners. Therefore you need to ensure that the product you are purchasing is up to standard.

–   If you find yourself dealing with state-owned enterprises (SOEs), you must be extra cautious. China’s judiciary is not de facto separate from the influence of the Chinese Communist Party, thus legal disputes involving SOEs usually result in an expensive defeat for foreign investors.

Once you have gained a sufficient overview of your prospective partners, you will need to dig further to truly understand their internal processes. This process is called operational due diligence (ODD), which includes assessing a target company’s functional operations, operational processes and systems used for these processes. Additionally, ODD focuses on how a company’s operations are connected and the effects these operations have on financial projections. Extensive ODD can sometimes irk potential associates, with some reluctant to allow overseas investors to obtain information on their operations. Nevertheless, the course of action is essential and, if conducted patiently and professionally with the help of a consultancy firm such as Maxxelli Consulting, ODD will be extremely worthwhile.

Here are some specific areas of ODD for your reference:

(One) Evaluate areas for improvement or deal killers in the target company. This ODD process is useful for estimating an appropriate price during competitive bidding or post deal (whether joint venture or M&A) assessment. Specifically, you can practice “on-site observation” of the company’s production capacity and awareness its day-to-day business, operational systems, raw material flows, inventory flows, etc. Identifying enhancement potential in a target company will benefit both parties. You will be increasing the value of the investment for both you and your partner whilst giving yourselves an advantage over competitors.

(Two) Pay attention to Chinese limited liability companies. In theory, the same rules as that of Western limited liability companies apply: investors are liable for the amount of registered capital. With that said, perspectives can be distorted in the Chinese business environment. For example, obtaining public records of your target company can be a challenge and the registered capital stated in business licences cannot always be trusted for accuracy. Therefore, digging into the actual registered capital amount is essential too, so that you are clear on to what extent Chinese investors are liable. Additionally, a capital verification report, which is issued by a third party, confirms that the money has indeed been injected.

(Three) When working with Chinese companies, especially in the field of manufacturing and production, an understanding of your partner’s land rights is imperative. The government holds strict oversight of land use in China. In other words, the central government can intervene or even revoke the development rights depending on whether you satisfy commercial or industrial development criterions. If you invested heavily in the development of a factory or plant on property supplied by your Chinese partner, please make sure you know whether it is granted rights or allocated rights presiding over the land. Allocated rights only indicate permission to use the land but all benefits ultimately go to the landowner. Granted rights imply the ownership of the land under consideration, a profitable long-term option upon the sale of rights in the future.

(Four) Regarding human resources, ODD offers you an overview of the target company’s employee characteristics and competencies. In addition, organisational structures and managerial habits should be observed to be prepared for what your business is venturing into. If you had merely accepted the personnel you were given without scrutiny, only to be unsatisfied, this would not be a good start to your venture.

(Five) ODD should also be conducted on the Chinese government departments associated with the target company’s operations. More specifically, you must make sure which ministry, agency or bureau is granting the licence, giving authority or approving procedures for the company under consideration. This is important because approval from one agency does not guarantee actual implementation. Local ministries, regional agencies and different departments have contradictory policies especially in regard to new FDI rules. Additionally, different layers of government offices have separate responsibilities and legal liability.

(Six) Due diligence on environmental liabilities of your target company cannot be overlooked. Increasingly important in China, environmental regulations and standards are becoming stricter and businesses are held with more accountability. Therefore, you must check the target company’s environmental track record, current situation and any solutions to previous hazardous environment problems as part of your ODD procedure.

Now that you are familiarized with the background of conducting due diligence and the key criterions of operational due diligence, you are perhaps prepared for a joint venture or a merger and acquisition opportunity in China. However, ODD is only a portion of the entire process of due diligence. For our next blog post, we will elaborate on Financial Due Diligence and the essential checklist.

Contact Maxxelli Consulting for any inquires regarding due diligence or other issues on doing business in China.

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