MAGAZINE OF THE BRITISH CHAMBER

OF COMMERCE GUANGDONG
2009 SUMMER EDITION

SUBSCRIPTION COPY | NOT FOR SALE

SPONSORED BY

BRITCHAMGD.COM

Due
Diligence ARTICLES BY
DELOITTE, EXPAT-CFO, MERCER, KPMG
Kelcroft E&M Limited & MORE!
 CONTENTS CHAMBER EYE GUANGDONG
A DIFFERENT TOOLBOX FOR M&A DUE
10 DILIGENCE IN CHINA Guangdong Magazine

British Chamber of Commerce

Guangdong Chairman
COMMERCIAL DUE DILIGENCE - AN ESSENTIAL
14
Jeremy Sargent
Editor
TOOL FOR EVERY TRANSACTION IN CHINA Josef Jelinek
Chamber Executive Manager
Erin Beilharz

TECHNICAL DUE DILIGENCE

Business Development Manager

16
Pat Kwan
Office Administrator
Emelie Zou
Sales & Marketing Executive
Chris Chen

LEGAL DUE DILIGENCE

18
Shenzhen Sub-Chamber Manager
Anna Ma
British Chamber of Commerce Guangdong
Suite 1206, 12/F Guangdong International Hotel
339 Huangshi Dong Lu
Guangzhou 510098

DUE DILIGENCE IN A CAUTIOUS M&A

Tel: +86 20 8331 5013

21
Fax: +86 20 8331 5016
E-mail: manager@britchamgd.com
MARKET www.britchamgd.com
Shenzen Sub-Chamber
Roof 314, 3/F
Chinese Overseas Scholars Venture Building

HR INVOLVEMENT CRITICAL TO M&A

South District

23
Hi-Tech Industry Park, Shenzen 518057
Tel: +86 755 2658 8350
SUCCESS Email: shenzhen@britchamgd.com

Advertising Contacts
Josef Jelinek
EXAMINING THE FINANCIAL HEALTH OF YOUR
27
jj@inecko.com

DEAL - FINANCIAL DUE DILIGENCE Design

RADDISSHMe Design House
Room B5, 60 Xian Lie Dong Hen Lu,
Tianhe District, Guangzhou, China 510500
SUPPLY CHAIN VISIBILITY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
T: +86 20 28296215
F: +86 20 28296219
STARHOUSE 60 - GUANGZHOU . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 E: cedric@raddisshme.com
www.raddisshme.com
EVALUATION OF SUPPLIER’S ENVIRONMENTAL PERFORMANCE. . . . . . . . . . . . . . . . . . 9

WHY SO MANY CHINESE PRODUCTS ARE BORN TO BE BAD . . . . . . . . . . . . . . . . . . . 13

BRITISH CONSULATE-GENERAL GUANGZHOU . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

UK/CHINA RESPONSE TO THE GLOBAL ECONOMIC CRISIS . . . . . . . . . . . . . . . . . . . . . . . . 31

UK-GUANGDONG COOPERATION ON CLIMATE CHANGE . . . . . . . . . . . . . . . . . . . . . . . . . 32

LISTINGS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

NEW MEMBERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

EVENT PHOTOS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

3
 SUPPLY CHAIN VISIBILITY:
ILLUMINATING HIDDEN LINKS IN ASIAN SUPPLY CHAINS
Manufacturers in Asian emerging markets often meet the supply requirements
of their international customers through an interlinked network of sister op-
erations, business partners, subcontractors or even the sub-contractors of their
subcontractors. In many cases the buyer is not even aware that this trading
relationship is happening. This is particularly commonplace when buyers
seek a one-stop source of supply outside of the limits of their chosen supplier’s
capacity or competence.
Trading companies that make global sources accessible to compa-
nies who are buying abroad also add uncertainty to supply chains.
If they were to share information about the manufacturer, it opens
doors for buyers to purchase directly, thereby removing their role
and margin from the transaction.
Suppliers that subcontract or trade without notifying the buyer or
having trading companies that protect their commercial position by
hiding the identity of the suppliers are both accepted business prac-
tices in many industries in Asia.
Many industries are so fragmented that, in order to meet the prod-
uct range, volume or lead-time requirements, there may be no single
supplier that can produce the complete order. Furthermore, even
with rigorous supplier identification and screening processes the
most capable manufacturer may still be overlooked due to the lack
of public domain information about them or due to extreme market
fragmentation (for example, there are 10,000 electronics and tele-
communications equipment manufacturers in China with revenues
over $800,000).
Global Sources Buyer
Trading Trading
Company Manufacturer
Source Manufacturers
(entity unknown)
In Many Buying Relationships The True Source
Manufacturer Is Unknown By The Buyer
From whichever channel a product is sourced, it is therefore critical
in low cost locales to know where and by whom the product is being
made. Increasing the visibility of the supply chain not only mitigates
4 Chamber Eye Guangdong
BY JIM RIDGWICK
some key global sourcing risks, it also allows capture of further ben-
efits from companies’ Asian supply base.
What are the benefits of illuminating these hidden
links?
Open and transparent relationships with the trader helps ensure
that quality requirements have been met. Quality managers in the
buying organisation can speak directly with those responsible for
production, thereby building accountability. They can also see first-
hand evidence by visiting the factories to be reassured that produc-
tion workers and their managers understand, respect and adhere to
the buyer’s quality and social responsibility requirements.
The importance of nurturing direct relationships with Asian suppli-
ers should not be underestimated. It is impossible to build trust if
the buyer and the manufacturer never actually meet and spend time
together to understand one another. By communicating through
the trading entity, messages can be miscommunicated or, at worst,
manipulated to meet the objectives of the trading entity.
Building direct relationships can also provide the foundation for ser-
vice improvement, joint product development, and cost and price
reduction through value engineering. Suppliers in emerging econo-
mies are entrepreneurial and innovative; they are hungry to explore
such opportunities.
Whilst managing social and environmental compliance is possible
with suppliers that buyers know, it fails for those that are hidden. In
relying on the trading entity to conduct this due diligence the risk in-
creases exponentially. In a world with powerful global brands, con-
sumer expectations do not differentiate between product produced
domestically or overseas; to them the entire supply chain is all one
brand, one company.
This further demonstrates that the only way to have total confi-
dence is to see the supplier’s conditions first hand or to use an in-
dependent trusted audit firm. To accomplish this, each part of the
supply chain must be known and visible.

Case Study:
Following the recent deaths of 19 people,
the US’s Food and Drug Administration
(FDA) began an investigation into the
source of the contaminated doses of a
leading blood-thinning drug Heparin.
The apparent source of this contamination
is one of the Chinese suppliers of the active
ingredient in the drug.
Heparin is often imported to European or
US manufacturers or distributors through
import trade companies – or in this case,
through a US/Chinese joint venture. These
importers source from several direct
suppliers each using other sub-suppliers for
the ingredients.
In China alone there are hundreds of foreign
pharmaceutical ingredient manufacturers.
With the FDA inspecting only 13 in 2007,
both identifying, and adequately monitoring
all such sub-suppliers is a considerable
challenge for both US and European
companies and the industry watchdogs.
How can I illuminate these hidden
links?
Even if the trader is trusted to manage the
source manufacturer to the right standards
and in the buyer’s best interests, the case
for illuminating these hidden links is still
equally valid to control risk and to realise full
Source: Deloitte’s Global Manufacturing Industry Group ‘Innovation In Emerging Markets.
longer-term benefit.
Whilst many Asian manufacturers are will- Typical telephone interview questions
ing to share the fact they are using a net- to solicit the real manner in which the
work of partners to meet the requirement, supplier intends to fulfil the order include:
often they will not volunteer this informa-
tion. So during the supplier qualification, it •What is your current capacity utilisation?
is important to ask probing questions. Thor-
ough due diligence is required before any •When operating at high utilisation, how
effort-intensive on-site evaluations to start do you fulfil large orders?
to establish the facts on how they intend to •If you were to win this order - what would
fulfil the order. be your anticipated bottlenecks and how
do you intend to overcome them?
For example, it is good practice to request
photographs of the production floor to gain •Which parts of the end-to-end production
a sense of the scale of operations and to un- process do you outsource and why?
derstand which stages of production they
subcontract. In these supplier requests, •Under what circumstances do you
ensure they provide photographs of the outsource manufacturing?
lines where this exact product is currently
produced or if the supplier were to win the •What relationships do you have with
business, the production lines on which these factories?
the product will be manufactured. Further-
•Do these partners have experience of
more, reiterate the expectation that a sourc-
international export?
ing manager will visit the line in the next
round of qualification. •How do you ensure quality requirements
are met and consistency is achieved when
using other partners?
In a similar manner, buyers should make it
clear to trading companies that they will vis-
it all production sites as part of their global
report surveyed more than 650 executives
risk policies. This is easier to mandate at the
from both developed market and emerging
start of the relationship and does not have
market companies to learn how manufac-
to be adversarial or focused on penalties.
turers are responding to the intense scru-
tiny of product safety, quality, and environ-
Deloitte’s Global Manufacturing Industry
mental issues.
Group recently published its annual ‘Inno-
vation in Emerging Markets’ study which
This survey showed that most executives
this year focused on managing product
said they do at least some monitoring of
sourcing risks in emerging markets. The
their suppliers’ subcontractors, but only
Percent Of Developed Market Manufacturers
EXTENSIVE MONITORING
35%
LITTLE MONITORING
16%
SOME MONITORING
49%
2008 Annual Study’
5
 Finally, traders must understand the importance of buyer visibility
to all nodes in their supply chain, and therefore when they wish to
Percent Responding ‘Extremely Likely’ (6-7 On 7 Point Scale)
change the source manufacturer, they should notify the buyer and
gain their approval before any transition.

Overall 45% This should be documented into the supplier agreements and should
Reputation 67% be monitored by plant visits through the contract term.
Quality Of While maintaining these higher standards can lead to higher operat-
89%
Products/
Raw Materials 88% ing costs, it must be factored into the total cost model that informs
the sourcing decision, they need to be seen in a larger context.
87%
Cost
77%
Is this the end of the trading entity?
80%
Reliability
89% Even in supply relationships where the buyer works directly with
the source manufacturer, the role of the trading entity may not nec-
67% essarily become obsolete. As buyers aim for transparent trade rela-
Product Safety
77% tionships, the traders must continue to demonstrate and improve
their value proposition to earn their share of each transaction.
Fast Delivery 65%
Schedule 75%

52% At one extreme their role could be to introduce the buyer to the
Flexibility manufacturer then to step back. At the other extreme, day-to-day
45%
communication is through them, they receive all payment and are
Environmental 40% ultimately accountable for product quality and delivery. Buyers
Record 40% should carefully consider the role of the trading company in their
Asian sourcing.
Product
40%
Development
Capabilities 60% Having the trader as a point of escalation or as an intermediary
can be invaluable to
Working reach a particular out-
32%
Conditions/ come, for example, to
Labor Practices 31% Trading entities value proposition may
overcome the source
include:
manufacturer’s resis-
Product Design 32%
Capabilities
tance to a low mini- •Established network of capable proven
58%
mum order quantity manufacturers;
Corporate 24%
or to a new, unknown
Citizenship 21% customer. The trading •Capability and infrastructure to control
entity may have more quality or to consolidate, label, package, or
negotiating influence hold inventory;
D eve l o p e d M a r ke t E xe c u t i ve s as it is likely to be
trading with the man- •Export license/customs brokerage;
C h i n e s e E xe c u t i ve s
ufacturer on behalf
of other buying com- •English speaking, professional service
Source: Deloitte’s Global Manufacturing Industry Group ‘Innovation In experienced in meeting the needs of
Emerging Markets. 2008 Annual Study’ panies. Alternatively,
the trader could gain international buyers;
one-third said that such monitoring was extensive. concessions leverag- •Knowledge of local regulations or
ing personal connec- government relationships;
The survey showed that roughly 90 percent of executives said they tions (or “guanxi”
visit supplier facilities in emerging markets, with half saying these in China) through •Provide pricing stability;
visits occur more than once a year. Nearly all said that these inspec- drawing on the trust
tions looked at quality control processes, followed by facilities/ gained through their •Intermediary with the source
equipment, raw materials, and the skills of quality control person- entire business rela- manufacturer in issue resolution or
nel. Companies that are more successful with emerging market tionship. This may negotiations;
sourcing were more likely than others to assess the skills of manage- have a far greater ef-
rial employees and working conditions in their inspections, as well. fect than the influ- •Ability to deliver special projects such
ence a foreign buyer as, joint product development or quality
In all such site visit audits, it is important to cross-reference each could apply even with improvement programme, and/or
answer from the supplier by requesting and observing supporting local sourcing staff.
evidence. Evaluate their true capacity. Seek evidence that the target •Ability to develop and integrate new
product is actually being manufactured and that production covers suppliers into global supply chains.
It is also wise to de-
the elements of the manufacturing process critical to quality and velop an exit strategy
not just assembly, finished goods testing or packaging.

6 Chamber Eye Guangdong

that aims to remove the intermediary trader from the transaction ward, this evolution will greatly benefit the buying companies.
after a period as the direct relationship grows. This should also be
discussed with all three parties present under the auspices of keep-
ing the 3-way business relationship lean and competitive. Writers Profile:

Based on the recent phenomenal growth of exports from Asian Jim Ridgwick, Deloitte.
sources, if a trader with a sustainable value proposition is removed jridgwick@deloitte.co.uk
from one buying chain there are many other opportunities for them
to capture! In this fashion a trading company partner can become Jim is part of Deloitte’s Supply Chain practice. Over the last 3 years he
an element of continuous improvement in a global sourcing pro- led their Sourcing practice for China in Shanghai; he advises European
gram. and US leading companies on the design and successful implementation
of their Global Sourcing programmes. He is currently based in the UK.
In summary, an accepted practise amongst Asian suppliers is that
manufacturers will trade or subcontract to fulfil orders – in some
cases without the buyer’s knowledge – and trading companies will
protect their role in the transaction by concealing their manufactur-
ing sources. This leads to concealed nodes in global supply chains
that represent lost opportunity at best, and at worst a significant
risk to product quality and corporate brand equity. Through under-
standing the importance of full supply chain visibility and by ad-
dressing this point of exposure directly, tactics can be employed to
shine light on the hidden parts of Asian supply chains.

As global companies press for transparency, trading companies will

have to step up their offering to remain competitive. Looking for-

7
 STARHOUSE 60 - GUANGZHOU
BY AJOY SAHU & CEDRIC MOREE
FROM RADDISSHMe

Over the past decade, there has been a big global push towards sus-
tainable and responsible development, leading many governments
and businesses to start considering their impact on the environ-
ment.
Already the major cities in China have worked hard to regenerate
and promote old industrial areas, turning them into artistic and
cultural centres. Most notably, Beijing ‘798’ and Shanghai ‘Mo Gan
Shan’ have shown that these areas can give artists and other cre-
atives the chance to flourish.
artistic movement.Guangzhou has an opportunity to make a name
for itself as one of China’s leading cities for creative arts and busi-
nesses.
Give the young people spaces that will let their dreams and hopes
evolve as Guangzhou moves to a post-industrial era of aesthetic and
ethical regeneration.

Guangzhou is no different.

While many big building and infrastructure projects are underway

in preparation for the 2010 Asian games in Guangzhou, the regen-
eration of old industrial sites is also picking up speed. Disused inner-
city factories and warehouses are being converted into office studios
that are giving young local and international entrepreneurs afford-
able rent in a creative environment.

Starhouse 60 in Guangzhou is a good example of how the re-cycling

of buildings can be done in a way to promote young creative busi-
nesses. Situated at an old factory, Starhouse 60 has quickly filled up
with design studios, fashion showrooms, stylish bars, publishing
companies, graphic design studios, a music studio and even a yoga
centre.

In the old industrial cities of Manchester or Detroit the factories

and warehouses that were left empty soon became home to artists
and musicians. Those inspirational environments contributed sig-
nificantly to some of the most important musical revolutions of the
late 20th century.

Berlin is another good example of a city with old buildings that

instead of being torn down were developed into cultural centres,
leading to the renaissance of Germany’s old capital and its now
world-wide fame as a top global city for artists, musicians and other
creative industries.

Given the wealth of industrial buildings available, Guangzhou is well

placed to give its young creatives an environment to build their own

8 Chamber Eye Guangdong

EVALUATION OF SUPPLIER’S
ENVIRONMENTAL PERFORMANCE
If you are a manufacturer in China and your
client starts asking you about your environ-
mental performance what do you do, why
are they asking these questions and how are
you supposed to respond?
Pressure
Global competition forces companies to
form commercial alliances, suppliers with
weak environmental performance can dam-
age their business and business partners
want to minimise risk by working with lead-
ing companies.
Views
A “Clean” environmental image equates to
efficient & innovative management, be-
cause good environmental management re-
quires waste minimisation and prevention
of pollution. Effective waste minimisation
and pollution control maximises profit.
Customers in the supply chain cannot af-
ford to buy products which do not meet
their environmental standards; would you
want to admit you bought supplies from
Union Carbide after their Bhopal incident or
from Exxon after the Exxon Valdes disaster?
Like ISO 9001, large companies have adopt-
ed ISO14001 & are forcing their suppliers
to follow their lead (witness HKSAR Gov-
ernment who have certified most of their
Works’ departments and are now asking for
environmental management in their tender
specifications)
If your client is certified to ISO 14001 then
they have requirements under clause 4.4.6
Operational Control to:
• Establish & maintain procedures related to
identifiable significant environmental aspects
of goods and services used by the organization
• Communicate relevant procedures & require-
ments to suppliers and contractors
Impacts
When purchasing raw materials or prod-
Customer
Contract
Requirements
Communication
BY DR IAN NICOLSON
ucts there may be significant environmental
impacts associated with their extraction,
production, transport, intermediate stor-
age and/or contracted out services, or ser-
vices provided by JV partners. Although you
might like to conveniently ignore some of
these your client will regard all environmen-
tal impacts associated with your product or
service as yours and so you have to be seen
to be managing them.
Control
Clients will normally try to keep suppliers
under control by:
• Use of contractual terms
• Establishing lists of preferred suppliers
• Adhering to a consistent Purchasing Policy
• Use of supplier questionnaires and audits
• Applying bans to certain products/suppliers
etc.
Information Management
Your client will probably store supplier
questionnaires and audit responses in a
database, allocate ratings re performance,
rating suppliers re risk, visiting and inspect-
ing suspect responses! Where there is doubt
they will seek to find alternative lower risk
suppliers or maybe even eliminate high risk
suppliers altogether.
Questionnaire
Typical questions you will be asked to an-
swer are as follows:
1. Do you have an Environmental Policy?
2. Who is ultimately responsible for Environ-
mental Issues within your organisation? Give
name & position
3. Can you provide a list of applicable Envi-
ronmental Legislation, with which you have
to comply?
4. Do you know what to do to comply with this
legislation?
5. Do you have any Environmental Licences
in place?
6. Have you ever been prosecuted for breach-
es of environmental laws /regulations?
( give details, dates & outcome)
Management
Commitment
Envirenmental Management System
Policy
Plan
Do Aspects Act
Check
7. Can you supply a list of Environmental
Issues arising from your activities, products or
services?
8. Do you use any environmentally damaging
Chemicals or Processes?
9. Have you carried out any work to minimise
their impact on the environment?
10. Do you have an EMS (Environmental
Management System) in place?
11. Do you intend to get it Certified?
Your Response
If you cannot answer these questions easily
then it’s about time you took some action.
You could consider implementing an envi-
ronmental management system which will
address these issues as illustrated below.
To achieve this you could ask your friendly
neighbourhood consultant, but make sure
you get an Environmental Consultant and
not a Quality guy who sees an opportunity
to earn a fast buck. Ask how they can dem-
onstrate their environmental competence.
If they shy away then you’ve asked the right
question!
Alternatively you could look at the HK Gov-
ernment’s Environmental Protection De-
partment’s web page to find some answers,
most of what you need is there in English
& Chinese. A good source of info is the In-
stitute of Environmental Management and
Assessment in the UK, (IEMA.net). Oth-
erwise go on an Environmental Awareness
course and start to learn about Environ-
mental Management.
Remember “Treat the earth well: it was
not given to you by your parents, it was
loaned to you by your children”. (US In-
digenous Rights Quote)
Dr Ian T Nicolson is founder of Enviro
Solutions(HK) Ltd. He can be contacted at
MD@Enviro-Solutions.HK
Continual
Improvement In
Environmental Sustainability
Performance
Customer
Satisfaction
9
 A DIFFERENT TOOLBOX FOR M&A DUE
DILIGENCE IN CHINA
BY JAMES BOYLE AND MATTHEW WINTER
A Different Toolbox for M&A Due Diligence in China
If we accept that the goal of any diligence process is to understand
the inner workings of the target business and that what the acquir-
ing party ultimately needs is a clear, valid and exhaustive portrayal
of the company being scrutinized, then it is easy to understand why
a document-driven due diligence is inadequate in China. The corpo-
rate culture of local companies is not typically one that values trans-
parency, and serious analysis combining operations, finance and
accounting is critical in order to arrive at meaningful numbers and
avoid investing in a mirage or a house of cards. The document review
that would comprise the entirety of a due diligence in the West is
certainly an essential part of diligencing in China, but an acquirer
that limits itself to mere examination of the paper trail will fall on its
face. The key to a powerful diligence in China is rigorous analysis and
fact-checking and cross-verification on site by a multidisciplinary
team. Only this kind of thorough, cross-functional approach will ad-
equately equip decision-makers to ensure a successful transaction or
avoid a costly mistake.
Diligencing the Logic of the Transaction
Prior to spending considerable resources on putting together a
meaningful due diligence, it is imperative to ask ourselves some
major questions regarding the decision under consideration. What,
explicitly, do we hope to achieve by the transaction? What is the end
game and what are the alternatives? Why is the deal better than a
greenfield operation or some other business arrangement? If the
transaction is to be a joint venture, are you merely paying tuition for
a formidable competitor?
It is also wise to explore all of the reasons why local management
recommends a certain approach in regard to a transaction. In our
experience, many transactions in China are ego-driven and under-
taken to build the resume of local country management: often,
foreign-educated local managers will recommend actions merely to
put an M&A feather in their hats, ultimately leaving the head office
10 Chamber Eye Guangdong
to send in a turnaround team to salvage residual value from a failing
operation that was ill-advised from the start.
After a sober review of these major issues, if the contemplated
transaction still looks like the best strategy, you are ready to begin
the due diligence process in earnest.
Target Search: Cast a Wide Net, Quickly Sharpen
Your Focus
Once it is determined to proceed with a transaction, it is important
to review all possible targets. Before revealing your intentions or
making a commitment, it is crucial to learn all the players and their
relative standings: many foreign firms take the easy route and pur-
sue a venture with their current supplier or even the first firm they
find in their business. Tying up with a weak partner at this stage,
however, not only threatens the success of the project—it can be a
potentially fatal blow for the parent itself.
This master list should be built mostly from a market research or
survey point of view: search engines, B2B sites and other databases
are a good way to get a general catalogue of who the players are.
Once all the players are known, a proper analysis can be made of the
relative strengths and weaknesses of each.
With a comprehensive list in hand, you can now move to cross most
of the firms off of it. Much of this will be easy to do, especially if the
process is properly structured so as to conserve your resources for
the main diligence effort. Many companies in China’s fragmented
market have no intrinsic value proposition and exist merely because
of local protectionism, some form of subsidy, or even a single re-
lationship. While this is certainly valuable for them, it limits their
growth perspectives and is unlikely to be transferable to the new
venture without tradeoffs that would be unacceptable to most out-
side investors. Depending on the industry and type of transaction,
there may be other obvious “deal-killers” that can be used to eas-
ily eliminate candidates at this stage. After this initial cull, you can
utilize simple SWOT analysis techniques to further pare down the
remainder to a few alternatives.
Cloak and Dagger: Covert Due Dil-
igence
The period of time between when you de-
cide to examine a certain company more
closely and when you actually contact them
represents a unique opportunity to catch
them off guard and collect data that you
may not be able to access once they know to
be on their best behavior. For instance, it is
often smart to have someone call the sales
office posing as a possible client.
If things still look promising, one should
visit the town of the target and confirm that
the physical operation exists. Many firms
are actually trading companies and do not
own the factories they claim. It is not un-
common to have signage changed on a facil-
ity the day before a client is to arrive for a
tour or signing ceremony.
While in town, have one of your team en-
joy a meal or two in nearby restaurants and
talk to the waitress about the company. The
meal is a very important part of Chinese
culture: often people drink too much and
company secrets become common knowl-
edge. Drunk, disgruntled or laid off work-
ers are usually forthcoming with pertinent
information.
We also recommend that you have back-
ground checks done on the principals of the
company. There are dedicated firms that
specialize in this type of diligence and it is
wise to use them. There have been numer-
ous incidences in the press of top manage-
ment in Chinese NASDAQ-listed companies
that have embezzled or diverted funds to
private projects or personal companies. It
is even more commonplace in the private
firms. The enforcement and concept of law
in China is not the same in the West and it
is very difficult to win any type of litigation.
Approaching the Target: The Let-
ter of Intent
Once the covert diligence is completed,
companies are again ranked and analyzed.
Usually, the selection from among the few
remaining suitable candidates becomes self-
evident. At this time, one should approach
the chosen firm with the proposition of a
deal.
Westerners are often in a hurry to complete
a transaction, but rushing the process can be
costly and even fatal for a company’s China
entry strategy. We recommend a methodical
1. A typical staged due diligence would start with commercial DD/ market research, then move to operational DD, legal review, moving finally to accounting compliance review and financial DD.
and deliberate approach. At this stage, it is
wise to sign a Letter of Intent or a Memo-
randum of Understanding. This a simple,
non-binding agreement used for the pur-
pose of giving each party comfort. Usually,
it states that a company will reveal certain
parts of its business to you in exchange for
you investing, acquiring or merging. Often a
nondisclosure provision is included.
Many PE firms have dedicated teams for
this sort of negotiation. If, however, they
have not completed a transaction in China,
we recommend that outside professionals
that have negotiated Chinese JVs or acqui-
sitions be retained.
An important provision that should be in-
cluded in the LOI/MOU should be a “No
Shop” clause. It is not uncommon for a Chi-
nese firm to begin side negotiations with
another PE firm or strategic player to drive
the price higher. Some of the smaller Chi-
nese PE firms will not conduct any due dili-
gence, but they have been known to pay off
low-level personnel in companies to learn
whom the foreign players are diligencing.
Although not strictly-enforceable, combin-
ing a No Shop clause with a binding offshore
arbitration stipulation will discourage most
such skullduggery.
Often the Chinese party will not agree to a
formal on-site due diligence team visiting
without a previously agreed-upon price.
Many firms do not grasp or believe the con-
cept of discounted future economic income
valuation methods such as discounted cash
flow (DCF), and prices are often termed in
multiples of sales or net assets. No matter
what terms are used to price a deal, it is wise
to put clawbacks into the agreement that
will reduce the price once full acquisition
costs are understood following the formal
due diligence exercise.
Overt Due Diligence: The Cross-
Functional Approach
Many diligence providers advocate a staged
approach, which usually involves an ex-
tended series of visits, each bringing a dif-
ferent perspective.1 While this is normally
the cheaper service, due to the option of
pulling the plug at any time, a series of
narrowly-focused task forces will not, in
practice, cross-verify information with each
other. As a result, the acquirer is frequently
left with disjointed data points rather than
a grasp of the dynamics that actually drive
the business, and the part of the diligence
that involves understanding the target on a
fundamental level is thus delayed until post-
transaction. Additionally, there is often a
negative effect on the relationship with the
target: the diligence process is inherently
disruptive and an unnecessarily long dili-
gence can cause anxiety in a company, gen-
erating tension in the deal.
We typically advocate a cross-functional ap-
proach to due diligence, employing a single
team of dedicated professionals from dif-
ferent disciplines to collaborate to arrive at
a holistic picture of the organization that
makes sense. A team of finance, operational,
HR, environmental and legal professionals,
for example, can each look at the company
through a different prism and, by compar-
ing notes, will uncover more information
than individual visits. The company can
thus be more thoroughly valued and under-
stood. In addition, the cross-functional ap-
proach is less disruptive, as the time it takes
to complete the diligence process is greatly
reduced.
Forensic Checking: Process Map-
ping and Modeling
In the West, the diligence team would typi-
cally sit in a war room and pore over piles of
documents. This will simply not work in Chi-
na, as much of the documented information
is intended to mislead the tax collector or,
in your case, the acquirer. Any meaningful
understanding of the target will come from
recreating a representation of the business
from scratch using process mapping and
modeling techniques based on trusted in-
formation. The operational-financial model
can then be used to guide your research ef-
forts, as it provides a reference point to cross
check with the information you are given by
the target directly. This requires a compre-
hensive and original information collection
effort, which begins by walking around,
observing processes and talking to people,
including lower-line staff.
Detailed and accurate process mapping
should allow a team to identify key bottle-
necks, assets that are not used, and ulti-
mately to accurately model the business. It
is not uncommon after a mapping session
to find that a company is not collecting all
of the accounting information. Mapping al-
lows the diligence team to quickly identify
and assess control weaknesses that would
be omitted from record keeping. A model
built on the basis of the process map allows
the analysis to go deeper, using the numbers
the team believes to be the true drivers al-
lows the team to focus on and quantify key
sensitivities and zero in on contradictory
information. It is not uncommon for a firm
11
 to falsify its records, and good modeling will easily identify whether
the current ledgers are reasonable. During the modeling phase, it is Additional Checklist Items: China-Specific Consider-
important that the team make sure that the full costs are accrued. ations
This would include the costs incurred from verbal barter agree-
ments, off-balance sheet liabilities and the commitments associated
with government favors and relationships or “guanxi”. ABOUT THE AUTHORS

Only by mapping and then financially modeling the business using
fraud and forensic techniques is it possible to confirm that the ac-
counting records are realistic. Letting the mapping process drive the
interviews and your site visit is the quickest way to get up to speed
on a business and forensically test whether the information that is
in the accounting system is in line with what you see on the shop
floor.
Arriving at a number: Business Valuation
While business valuation techniques employed at this stage are by
no means unique to China, some special points are worthy of note.
First and foremost, the valuation under any method should be driv-
en by the due diligence numbers themselves, including all the hid-
den and off-balance sheet costs.
James Boyle,“Jay,” is the Managing Partner of Expat-CFO Services,
a boutique financial consultancy providing transaction advisory
for pre- and post-acquisition. He is fluent in Mandarin and has
lived and worked in China since 1996 in numerous financial roles
for industry.
Matthew Winter is the Frontier Market Project Manger of Expat-
CFO Services. He speaks Mandarin, Uighur, Russian, Uzbek and
Turkish and has lived in Asia for 10 years.
For further info see http://www.expat-cfo.com or contact Jay at
jay.boyle@expat-cfo.com
© 2009, James Boyle; Expat-CFO Services LTD.All rights re-
served.

For deals in which sales are highly uncertain and are dependent on Industry Classification: The PRC government classifies industries
one or a few major events, as: encouraged, neutral, discouraged, or forbidden. Policy dictates wheth-
including blockbuster R&D er and on which terms an industry can have outside investors.
Asset deals: The diligence projects and abstract, long-
exercise should dictate the type of term, strategic “we cannot Verbal agreements and hidden stakeholders: In the 90’s, verbal
deal that is feasible. In many cases afford not to establish a contracts became legally-binding, and there are often many people that
the risk of an equity deal is too beachhead in China” proj- are able to demand that it honor such agreements. It is also not uncom-
great, and an asset deal that allows ects, a valuation utilizing mon for local government officials to receive certain benefits from a firm
the acquirer to cherry-pick assets real option methodology that go unrecorded and for it to be expected that these services continue.
is a more viable solution. Note that may give a clearer picture
for an asset deal to be viable, your of the risk and opportunity. Shadow companies: This is when a JV partner sets up a mirror opera-
firm will need a registered legal en- tion following a transaction, especially if the foreign firm is a strategic in-
tity that is legally allowed to accept When using discounted vestor that upgrades knowhow. Management may open a second or third
the assets that will be transferred. cashflow methodology, shift, use company assets for an unrelated enterprise or run two payrolls
In some cases, assets are not trans- the discount rate must be through the company—one for the company itself and the other for the
ferrable at all under local law and, meticulously built-up by a shadow.
in any event, different taxes often party with China-specific
apply. micro- and macro-econom- Tax GAAP: Most private firms keep records in the old PRC GAAP, a mix-
ic acumen. One of the big- ture of cash and accrual methods currently referred to as tax GAAP. These
gest mistakes strategic buy- can severely misrepresent the company’s financial condition.
ers make is to determine that the discount rate is the same as their
company’s cost of capital. This is a very dangerous assumption as Land use right: In China, you cannot own land, but you can purchase
that rate, at best, does not reflect sovereign and currency risk. the land use right. It is mission-critical to confirm that the correct compa-
ny (not the parent or an affiliate) owns the land use right, that the right
As indicated above, use of sales and net assets multiples for the rel- has been transferred correctly and that the land is not zoned for farming
evant industry is one widely-accepted method in China. When using or something else.
multiples, it is useful to bear in mind that, if the existing market in
China is weak or non-existent relative to the comparables, then the Off-balance sheet liabilities: Off-balance sheet liabilities, such as
result will be an inflated number. unrecorded accounts payable and extra employees on payroll, are common
in China and can pose a problem.
Conclusion: Negotiating the Minefield
Contingent liabilities: It is important that all contracts are reviewed
While daunting, good China due diligence is rewarding, as it allows a by competent professionals knowledgeable in Chinese legal language.
company to snatch up bargains and back away from lemons—both Contracts can be very obtuse and interpreted differently by each party.
are abundant in Chinese M&A and PE deals. Having conducted It is best to err on the side of caution when identifying and quantifying
thoughtful analysis of the kind that the Chinese side might well these types of risk.
be unequipped to perform itself, quality diligence can be a source
of a powerful informational advantage. However, diligence of the
sort outlined here remains, above all, a necessary risk-mitigation
technique for an environment that lacks guarantees often taken for
granted in the West.

12 Chamber Eye Guangdong

WHY SO MANY CHINESE PRODUCTS ARE BORN TO BE BAD
THE recent scandals about poisoned baby milk, contaminated pet
food and dangerous toys from China have raised questions about
manufacturing standards in the country that has become factory
to the world. In China’s defence, it was probably inevitable that as
production grew so would the problems associated with it, at least
in the short term. Similarly, it could be argued that China is going
through the same quality cycle that occurred during Japan’s post-
war development or America’s manufacturing boom in the late 19th
century—but in an environment with infinitely more scrutiny.
A response to both these observations can be found in “Poorly Made
in China” by Paul Midler, a fluent Chinese speaker who in 2001
moved to China to work as a consultant to the growing numbers of
Western companies now replacing factories in Europe and America
with subcontracting relationships in the emerging industrial zone
surrounding Guangzhou. It was the perfect period to arrive. The
normal problems of starting a business, such as getting clients or
providing a value proposition, do not hinder Mr Midler, who had the
benefit of being in the right place at the right time.
Not only did he quickly, and seemingly effortlessly, find customers,
they were delighted with what they found in China. Factories will do
anything to please. Prices are famously low and production cycles
short. His clients returned from their initial trips to China stunned
by how quickly factories became proficient and puzzled by how
much could be done so well, so fast, so cheaply. They were right to
wonder.
Most of Mr Midler’s work is coping with what he calls “quality fade”
as the Chinese factories transform what were, in fact, profitless con-
tracts into lucrative relationships. The production cycle he sees is
the opposite of the theoretical model of continuous improvement.
After resolving teething problems and making products that match
specifications, innovation inside the factory turns to cutting costs,
often in ways that range from unsavoury to dangerous. Packaging is
cheapened, chemical formulations altered, sanitary standards cur-
tailed, and on and on, in a series of continual product debasements.
In a further effort to create a margin, clients from countries with
strong intellectual-property protection and innovative products are
given favourable pricing on manufacturing, but only because the
factory can then directly sell knock-offs to buyers in other countries
where patents and trademarks are ignored. It is, Mr Midler says, a
kind of factory arbitrage.
The first line of defence against compromised products are the fac-
tory’s clients, the importers. The moment they begin suspecting a
Chinese manufacturing “partner” and want to discover what might
be unfolding is the moment they become particularly eager to find
people in China like Mr Midler. That suggests they want informa-
tion. But, as Mr Midler discovers, they are finicky about what is
found. When suspicions turn out to be reality, all too often they
become unhappy—miserable about resolving something costly and
disruptive, yet terrified about being complicit in peddling a danger-
ous product. This is particularly true if the problems could go unde-
tected by customers. Better, to some extent, not to know.
Aware of these dynamics, Western retailers increasingly use outside
testing laboratories for Chinese products. But this too, Mr Midler
writes, is more form than function, since the tests are by their very
nature more limited than the ways to circumvent them. The process
resembles the hunt for performance enhancements used by ath-
letes, where a few get caught but the cleverer ones stay ahead by us-
ing products not yet on the prohibited list.
It would be unfair, of course, to see all Chinese companies in this
light. A few are gaining international recognition for quality, but in
contrast, say, to Japan or America, this recognition comes at a cost
to the firms themselves because it is accompanied by unpopular
scrutiny and compliance. This odd situation became apparent when
Mr Midler witnessed large, modern Chinese factories outsourcing
work to smaller, grittier, facilities even though this meant forgoing
the production benefits from economies of scale. The tiny outfits
were in a much better position to skirt environmental controls and
safety standards for products and workers.
The obvious way to clean up this mess—and to know whether it is
really as pervasive as this book suggests—is through broader disclo-
sure, but by whom? The Chinese press is sometimes revealing but
typically controlled, as are foreign reporters. Many production prob-
lems are well-known within local manufacturing circles, Mr Midler
says, but collusion is rampant and there are no rewards in China for
whistle-blowing. Most of the people in Mr Midler’s position would
not dream of disclosing what they see and many testing laborato-
ries protect their reputation by hiding, rather than revealing, what
they test. As a result, if Mr Midler’s perceptions are true, the pri-
mary source of discovery will come in the worst possible way—by
consumers who buy Chinese products, only to discover their flaws
themselves.
From the print edition of The Economist 16th May 2009 @
The Economist Newspaper Limited, London (2009)
13
 COMMERCIAL DUE DILIGENCE - AN ESSENTIAL
TOOL FOR EVERY TRANSACTION IN CHINA

As a whole, FIE expansion via M&A has increased substantially over the past three BY STEFAN KRACHT
years. This is partly due to consolidation in many industries and also because increas-
ingly, growth via acquisition is proving to be a faster and sometimes better method
to tap the China market. Against the background of lower transaction prices and
increased opportunities in China, we advise clients to continue this strategy in a more
focused manner.

In our work with GMs, Business Unit Leaders, Strategy Heads and
CFOs, two reasons arise for failed acquisitions: lack of information
and failure to build relationships. Negotiations often break down in
the early stages when decision-makers of both parties fail to agree
on basic issues such as business plan feasibility and valuation meth-
ods. This is because validating the deal rationale and building deep
relationships during the financial and legal due diligences is impos-
sible.
Our clients confirm that the best way to achieve sufficient infor-
mation and to build the necessary relationships is via discussions
within the target and with third-parties such as industry observers,
suppliers and customers. The fast-changing environment both in-
side and outside of China is a further reason why commercial due
diligence has become essential. Finally, deals here are much more
about creating mutually beneficial partnerships than about pure fi-
nancial transactions.
What is commercial due diligence (CDD)?
CDD is a complete process of investigating a target in terms of its
strategic, commercial and organisational capabilities relative to its
market. It allows the buyer to gain a deep insight of the target’s busi-
ness model, success factors and competitive position in order to
validate future investments. Specifically, a CDD assesses the target’s
commercial situation in three main respects:
• What drives growth in the target’s market?
• How is the target positioned and perceived to grow in its market?
• How will revenues and profits from the target’s core operations
support its ambitions?
• Confirms basic interest on both sides and further strengthens the
partnership with the target
• Optimises buyer’s tactics and negotiation power
• Reduces transaction risk and limits liabilities
• Results in a practical and realistic plan for post-acquisition integra-
tion including agreement on complementarity and synergies
For which cases does CDD apply?
This approach is widely used in M&A both for strategic investments
by corporate and for financial investments by private equity. In ad-
dition, many clients have engaged us to conduct such diligence when
making strategic supplier decisions.
How does it fit with other DD?
(Chart 1)
How does it differ from FDD?
Due to the broad nature of commercial issues, a CDD often also in-
cludes a basic legal and financial analysis. Below is an outline of the
main differences:
(Table 1)
What are the successful deal ingredients in China and
how does CDD play a role?
1. Define deal breakers before beginning the CDD or negotiations,
and be firm on them
• This will clarify your thinking in terms of when to drop the deal.
• In case you decide not to proceed, you can use your funds to invest in
alternatives.

Why does it pay off? As an example, for a specialty metal manufacturing client, the rela-
Our clients have found that such insight: tionship with local residents turned out to be a deal breaker since

MARKET MAPPING COMMERCIAL DEAL FINANCIAL &

BUYER AND
& TARGET SEARCH DUE STRUCTURING & LEGAL DUE CLOSURE
SELLER MEETING
DILIGENCE NEGOTIATION DILIGENCE

NDA LOI PURCHASE

KEY BUYER AGREEMENT
DOCUMENTS

Chart 1 – Example Deal Process in China

14 Chamber Eye Guangdong

 CDD FDD

Internal (Owner, Management Team And Staffs)

Internal (Owner, Management Team And Financial
INTERVIEWS External (Customers, Competitors, Suppliers, Staffs)
Distributors, Regulators, Industry Observers)

FOCUS Projections And Future Potentials Based On Historical Result

The Status Quo Facts

Both Qualitative And Quantitative (E.G. Critical

TYPE OF Soft Strengths Such As In-house Technical
Mainly Quantitative
INFORMATION Know-how, Strong Local Government
Relationships)

Table 1 – How CDD differs from FDD

the manufacturing process currently used by the target had a large tion.
negative influence on the local community. As an aside, this high- • Example: qualitative inputs from workers on assembly line, engineers
lighted how important win-win solutions between targets and lo- from QA and production departments are important facts to identify the
cals are. potential for cost optimisation.

2. Fix a schedule
• Clear communication on the project schedule can convince Chinese own-
ers, who are often inexperienced, of your seriousness, and can assure that
they will cooperate with the CDD team efficiently throughout the process
including interviews and data room set-up.
• This schedule should include key communication windows during the
project in order to save time committed by the target.
• Such a timeline can also contribute to smoothing the process of internal
approval, for example from a board of investors.
As an example, for most of our clients engaging in mid-market
transactions, a 3-4 week CDD is necessary in order to enable closing
within less than 6 months. Without clear communication and regu-
lar updates on the working schedule, the target may lose interest
throughout the process.
3. Agree on rules
• Legal documentation and repeated commitment of confidentiality is
paramount since Chinese owners lack deal experience and the awareness
of the importance of confidentiality.
• Explain the nature and reasoning of the investigation and highlight the
danger of manipulating information.
• Assure the mutual benefit of conducting CDD as it provides an ideal
platform to confirm post-acquisition synergies and potential operational
changes.
As an example, a local target was heavily influenced after talking
with their competitors who were also conducting negotiations with
our client. Without repeated reminders of confidentiality, this talk
amongst targets could have created complications for all the clients’
projects at once.
5. Use the process to familiarise yourself with the relevant people
• Get to understand the working style and personality of the decision
makers.
• Better understand who the influencers are (including shareholders,
management team, local government officials, relatives or partner com-
panies).
As an example, we dealt with a Chinese entrepreneur who owned
20 companies involving different types of businesses, using them to
evade tax and enable other ”flexible arrangements” between the en-
tities. The shareholders of the 20 companies were friends and rela-
tives who had significant influence over the target even though they
had no direct investment relationship under the legal framework.
In closing, carrying out a CDD is not only essential in providing in-
formation for successful transactions, but also highly beneficial to
the long-term post-acquisition relationship. By applying some or
all of the elements mentioned above, you can ensure the success of
both the buyer and seller.
Stefan Kracht is Executive Director of Fidu-
cia’s China Consulting Practice. Established
in 1982, Fiducia Management Consultants
provide a wide range of services to assist inter-
national companies in implementing, expand-
ing or optimising their business activities in
China and Hong Kong. He can be contacted at
skracht@fiducia-china.com.

4. Ensure your discussions encompass all levels of the target

• Map your negotiation team; assign them different roles during negotia-
tions.
• Communicate at different levels in the target company. It’s a good way
to triangulate the data to identify inconsistencies during the investiga-

15
 TECHNICAL DUE DILIGENCE
In today’s challenging business environment organisations are increasingly exposed
to complex, interconnected risks; if you are planning a Joint Venture, merger, or an
acquisition it is essential that you employ the services of a reliable TDD partner to
provide Technical Due Diligence assessments.
What is Technical Due Diligence
What is Technical Due Diligence (TDD) and how does it differ from
other types of Due Diligence? It’s the independent examination of
the science and technology within a potential asset, from an en-
gineering perspective. Whether your deal is for real estate, wind
farms, hotel management, buildings, or an industrial facility sector,
Technical Due Diligence has a vital role. It’s important to note that
it’s not a substitute for other forms of Due Diligence, rather it’s an
essential part of the whole Due Diligence family.
An assessment tries to identify:
i) potential liabilities
ii) risks
iii) deficiencies associated with the technical aspect of a project
iv) added value opportunities
Anyone can walk on to a site and say whether or not a standby
generator is fitted, but you’ll need an engineering expert to decide
whether the genset is serviceable or whether it has suffered from
deferred maintenance. Will you need to replace it next week? Does
it have the potential to be converted to use alternative fuel? Can it
be converted for use in a cogeneration plant? These are engineering
questions that Technical Due Diligence assessments try to address.
Let’s take an example, imagine you plan to acquire an existing in-
dustrial biofuel facility, financially it may appear to be an attractive
proposition. However, your legal adviser cannot assess the techni-
cal side of the coin. What is the condition of the existing mixing
and treatment plant, is it state of the art technology? Any deferred
maintenance noted? Any code violations that require immediate
repair? One engineering deficiency could cause serious operational
headaches. Call for a Technical Due Diligence assessment to fill that
information gap early in the process.
In the good old days, not so long ago in fact, Due Diligence involved
16 Chamber Eye Guangdong
BY JOHN A. HERBERT
finance, legal and related regulatory matters and usually examined
a limited range of risk exposures, critical engineering related risk,
many of them deal breakers were overlooked.
Whether we like it or not society is becoming more litigious, and ex-
posing your stakeholders and shareholders to a critical risk is simply
not an option these days if you want to stay in business. Increasingly
individuals are being singled out, and made publicly accountable for
failing to demonstrate adequate risk management. It all rests on the
cornerstone - credible risk management. Technical Due Diligence
ensures that your decisions are well-informed.
Technical risk exposures are the most important for immediate op-
erations. You would like to know whether your operations manager
will require US$1 million spend to improve energy efficiency, and
comply with current codes before your acquisition, not after it. A
good TDD firm will not only highlight and assess those risks before
the transaction, but also stand ready to rollout solutions for each
deficiency uncovered.
Carbon Risk
We can no longer ignore Climate change, and it’s implications for
business. Governments around the world are busy implementing
different types of carbon taxation schemes which will impact facil-
ity operations. Australia and the USA amongst others are mulling
schemes to cap emissions at a building level. The risk is real, and an
imperative for the future, but often overlooked.
Depending on the business sector, the total cost of energy is nor-
mally the first or second largest cost centre. Imagine acquiring a
facility only to find aged steam boilers suffer from low energy effi-
ciency. A smart assessment could look past the pile of rust, and help
clients identify opportunities to upgrade, lower fuel costs, and even
monetise carbon credits. During one assessment we found a very
poorly designed steam system, without condensate return, a carbon sioning tests. For example, considering the critical nature of standby
nightmare for the next owner. power, it is surprising how many standby power generators over the
years have not started automatically under test conditions.

Approach 5) Post Transaction -- Once the transaction is complete a good TDD

An assessment approach is divided into stages covering:
1) Document Review -- Checking the documentation available, it
is no surprise to find a modern facility lacking drawings or missing
them entirely. For major items of capital equipment its history and
MTBF track record is evaluated. Reviewing maintenance records,
spares, and repairs carried out would be verified against the manu-
facturers approved maintenance manual where available.
firm should be able to manage all outstanding technical issues. For
example, remediation projects to achieve compliance with the local
fire or electrical codes, and attending to deferred maintenance. Such
matters need to be dealt with swiftly and effectively for a smooth
transition. Therefore recommendations should be pragmatic, to
help guide the new owner to the most cost effective repairs in cases
of non-compliance, clients will also benefit from step-by-step guid-
ance throughout the process.

2) Fieldwork -- Just because a turbine is spinning today does not
mean it will spin for the next thirty years. A TDD inspector will
walkthrough the site to check all major items of plant and equip-
ment, check the monitoring system, and identify any deferred
maintenance, all of which would have risk and cost implications for
future operations. Another point often overlooked is the availability
of spare parts. Without adequate spares bespoke equipment could
be just one breakdown away from complete replacement.
3) Value -- Identifying opportunities for improvement. For example
an inspector can identify potential energy efficiency improvements
or carbon management opportunities.
A Technical Due Diligence assessment is essentially the creation of a
methodical step by step shopping list of technical risks, coupled with
matched solutions deliberately designed to avoid the unexpected.
John Herbert is Managing Director at Kelcroft E&M Limited, an envi-
ronmental consultancy he founded in 1999. John has more than twenty
five years international engineering experience gained on three conti-
nents in commercial, healthcare, hospitality, and industrial sectors. He
can be contacted at john@kelcroft.com.hk

4) Further Investigation -- Based on the findings, and the deficien-

cies uncovered further investigation maybe warranted. An inspec-
tor might call for additional evidence such as witnessing re-commis-

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17
 LEGAL DUE DILIGENCE
Doing your legal due diligence in China is just like making a regular visit to the doctor. BY JAMES ZENG AND JAMES
Not long ago, companies doing regular legal compliance audits were unheard of in China, ROWLAND
although the reason for maintaining high legal standards is generally well-understood.
Now, in light of increasing regulation and safety concerns, the need for private enforce-
ment of legal compliance standards is more pressing than ever. Like taking a regular
medical check-up, the need to keep operations legal can be addressed using due diligence
strategies more familiar in the world of M&A.

Typically, DD tasks are grouped by scope tion, or the “target”. engineers.

into familiar categories such as commercial,
legal, technical and tax. Commercial due dil-
igence focuses on the value of the company’s
operations, its revenues and finances. Tech-
nical DD looks at whether operations con-
form to relevant scientific or other physical
specifications. And tax due diligence looks
at the existence or absence of documenta-
tion to support the company’s tax filings
and the existence of outstanding tax liabili-
ties or possible back claims.
It is sometimes said that doing legal due dili-
gence is like going to the doctor for a medical
check-up. You go to the clinic yourself for a
routine medical inspection just to make sure
that your health is normal. If a third party,
such as a potential employer, asks you to
submit to a medical examination, you do,
if you want the job, and the duration and
intensity of testing might differ, depending
on whether you are applying for a job as an
office executive or an astronaut. One day,
you will go to the doctor for specific tests in
preparation for a journey to an exotic coun-
try. Prior to departure, and as well as doing
other research, you will commit to obtain-
ing vaccinations and medical certifications
without which you know you will be refused
entry to your chosen destination.
The same logic applies when doing legal due
diligence. It can be a way of ensuring that
all the right conditions are in place before
proceeding with a significant or demand-
ing activity. Or it can be completely un-
event driven: just a routine business process
which you do to prevent a serious but treat-
able problem from going undiscovered until
it’s beyond your control.
Although the specific enquiries can vary,
the general order of legal DD follows a logi-
cal sequence. It is a cumulative process that
starts by establishing the most basic infor-
mation about the subject of the investiga-
The starting point, given the target’s exact
legal name and registered address is to de-
termine the legal scope of its operations. If
the target takes the form of a company reg-
istered in China, then this information will
be printed on its business license, the origi-
nal of which Chinese law requires to be kept
at its registered office. The business license
is a fundamental document which the com-
pany must display to relevant governmental
authorities (and usually to trading partners
too) as proof of its identity and registration.
Without this document, the company can’t
do business.
The target’s business scope, and the nature
and scope of the investigation are taken
into account when preparing an initial DD
checklist. The accompanying list [see text
box 1] contains a list of the broad classifica-
tions in China into which DD questions are
usually grouped.
Often several of these classifications con-
verge into one and not all of them will apply
in every situation. For example, not every
company needs to be checked against anti-
trust criteria and some business activities
require government authorization at local,
provincial as well as central level while oth-
ers require no specific authorization at all.
In China, the type of industry to which an
operation belongs is the single factor which
most strongly influences decisions about
the content of a legal due diligence investi-
gation.
It is usually advisable to get local legal advice
when preparing the checklist for DD over a
Chinese target. Usually, most of the legal
due diligence process is conducted by quali-
fied lawyers, just as you would expect finan-
cial due diligence to be conducted by accoun-
tants trained in PRC GAAP or for technical
due diligence to be delegated to qualified
There is usually at least some degree of co-
operation between the party commission-
CHINA DD CHECKLIST
1 Company business licence and registrations
2 Historical changes to the company
3 Shareholder information
4 Financing arrangements
5 Investments, loans and security interests
6 Tax registration and records
7 Staff and employment records
8 Environmental records
9 Material contracts
10 Disputes existing and potential
11 Government permits and authorisations
12 Land and buildings
13 Intellectual property
14 Other long term assets
15 Insurance
16 Product liability
17 Antitrust
18 Other Non-compliance
19 Other relevant issues
TEXT BOX 1
ing a DD investigation and the target. In
the UK, Europe and the US the requirement
for investors to do due diligence is so insti-
tutionalized that target companies will nor-
mally be prepared to undergo an audit or in-
vestigation of any matter which is material
to the transaction. It is usually understood
in those jurisdictions that a decision not to
submit to reasonable DD enquiries will put-

18 Chamber Eye Guangdong

off potential buyers or business partners.
To some extent, the need to undergo DD is also understood, if not
institutionalized, in Chinese business circles. Where it is agreed
that completion of due diligence will be a pre-condition to the clos-
ing of a particular acquisition, the target will be obliged to cooperate
although the scope of due diligence may still be debated. Existing
shareholders can also sometimes negotiate that a subsidiary agrees
to undergo a legal compliance audit or routinely scheduled legal
compliance audits.
When the target agrees to undergo due diligence, it should be given
a copy of an initial DD checklist and invited to respond to it. The
checklist will typically include requests for information and copies
of supporting documents. Usually, copies of this documentation
are gathered together by the target and supplied to the commis-
sioning party’s legal advisors who will take appropriate measures to
preserve its confidentiality, disclosing it only to their client and its
financial and other advisers or by agreement with the target. It is
just as common for the target to make copies of the documentation
available in a “data room” where it can be accessed only subject to
certain conditions.
Sometimes, access to the data room is segregated so that, for in-
stance, those responsible for conducting legal due diligence will not
be permitted access to detailed financial or technical documents
and vice versa. This is common in a well-organized due diligence,
particularly where information containing important trade secrets
is being scrutinized or where certain aspects of the proposed trans-
action are market sensitive, for whatever reason. The terms and
conditions of access to the DD documents / data room are usually
controlled by the target in an M&A scenario and the same thing can
be expected if a legal audit is requested in a hostile shareholder/sub-
sidiary relationship. Agreeing not to remove or copy any documents
may help to encourage access to information, and doesn’t necessary
limit the effectiveness of the due diligence process.
Requiring the target to voluntarily provide documents and infor-
mation responsive to the DD checklist makes the most efficient
use of information already in the target’s possession. A preliminary
review of this information by the requesting party’s legal advisors
or in-house counsel is done to identify any obvious deficiencies in
the target’s responses as well as any legal compliance issues that are
already apparent.
Sometimes the target’s initial responses demonstrate a lack of un-
derstanding of or a failure to cooperate fully with the due diligence
investigation. This can be because the target is not sophisticated
enough to know what the investigators are looking for, for instance
if it is evidence of a permit or authorization that the target was not
aware the law required, or reports in a format which the target is not
capable of producing.
Sometimes foreign investors are required, by the laws of their home
jurisdiction, to meet a very high standard of diligence but the Chi-
nese target insists that certain material information is confidential
or company private property and cannot be the subject of any in-
vestigation. These situations are common and can be addressed if
patience is used and good channels of communication have already
been established by the party initiating the due diligence or its pro-
fessional advisors.
In addition to supplying information, it is usually necessary for due
diligence investigators to obtain a copy of the target’s business li-
cense (if it is a company) and a power of attorney or other relevant
authority from the company. This entitles them to conduct back-
ground investigations with the government departments who have
jurisdiction over any relevant aspects of the target’s operations. The
purpose of these background investigations is to gain access to doc-
uments and records held by public authorities which are off-limits to
all but the target and the government authority itself.
Sometimes, depending on the circumstances of the investigation, it
will not be possible to obtain such authorizations from the target,
for example where the target believes that the investigation will in-
terfere with a relationship it controls. The party commissioning the
DD may feel that obtaining certain information will help to justify
or inform its decisions about whether to continue with an invest-
ment while knowing that a request for the information is too sensi-
tive to raise with the target directly.
Whether it is possible to obtain such information informally de-
pends on the skill and resourcefulness of those engaged to perform
the DD investigation. For example, a government office which will
only provide certain documents to the company or its authorized
agents may verbally provide information about the content of the
documents to anyone who can provide a good-enough reason for
making their enquiry. Sometimes it is a matter of sufficiency of au-
thority and a government official may be willing to grant access to
certain information to an attorney upon sighting a copy of his or her
practicing license. If this is unsuccessful, enquiries placed with dif-
ferent departments of the same government office may finally yield
a reliable verbal response [see text box 2].
The deficiencies and legal compliance issues thus revealed are then
summarized and compiled into a “preliminary due diligence report”
which is submitted to the party who requested the investigation.
This report will be cross referenced against all relevant documen-
RESULTS OF ANONYMOUS INVESTIGATION
The target is a Chinese company drawing water for its
operations from a municipal water source. A shareholder
wants to know if a permit is required for this activity to be legal.
Published laws say that a permit is required. However, the
target has never obtained a permit and its Chairman insists that
none is needed - what is going on?
Has the water resources bureau officially waived the permit
requirement?
Do the target’s good relations with the bureau mean that it
will be able to obtain a permit without penalty or delay in the
future?
Several calls placed to technical staff in the local water resources
bureau confirm that a permit is required, legally. A discussion
with the target’s operational staff reveals that the question of
permits is always dealt with between the Chairman and the
Chief of the Bureau. The Bureau Chief is known to have no
understanding of applicable law. Independent enquiries permit
this complicated situation to be understood and will pave the
way for a reasonably skillful and diligent response, if remedial
action is needed.
TEXT BOX 2
tary materials, against the target’s own responses and against any
responses provided by relevant authorities noting whether they are
written, verbal, formal or informal.
19

A ROUTINE COMPLIANCE AUDIT
The shareholders in a Chinese food processing company want to
do routine due diligence on local operations. A legal advisor to
the shareholders makes an enquiry at the local environmental
authority presenting herself as “a potential business partner”.
Similar enquiries are made at the local trade registry where the
investigator’s Chinese ID card is sufficient to obtain a full extract
of the company’s record. But why go to the effort of conducting
due diligence anonymously when relations with the target are
friendly?
The target of a due diligence investigation will often see
itself as fully compliant as long as it is trading without any
complaint from local authorities. Lawyers engaged to conduct
due diligence will form an independent view and owe a duty to
the shareholders who instructed them to disclose any non-
compliance that is identified after reasonable enquiry, whether
the target is trading without complaint from the authorities or
not.
TEXT BOX 3
This preliminary information enables the investigators to iden-
tify issues and suggest items to be added to any supplemental DD
checklist. In an M&A or IPO scenario, all of these suggestions are
contained in the preliminary DD report. The preliminary DD report
normally does not contain detailed legal analysis of any issues iden-
tified – it is just a documentary record of the investigation. More
detailed analysis can then be requested and provided in a final DD
report which is produced after several rounds of supplemental ques-
20 Chamber Eye Guangdong
tions have been asked and answered by the target, or other investi-
gations conducted.
Often, after the preliminary DD report is submitted, some items re-
quire no further analysis or elaboration and the party commission-
ing the DD may instruct its investigators to focus their enquiries on
a more limited number of issues perceived to be of key importance.
The final due diligence report is often voluminous because its read-
ers may be relying on its contents in order to reach a final decision,
whether that is a decision to purchase an individual asset, to proceed
with an IPO or to commit resources to taking corrective action (or
not) in the case of a legal compliance audit.
One of the most important objectives of due diligence is to identify
the potentially harmful aspects of an operation in time to prevent
harm to the investors. However, the primary objective, whether it is
a typical M&A investigation, pre-IPO due diligence or a routine legal
compliance audit, is to gather information that leads to an objective
and intelligent assessment of the operation overall. All businesses
have good and bad aspects - the point is identifying the bad aspects
while their impact is still within your control.
James Zeng is a partner and James Rowland a consultant at King &
Wood PRC Lawyers in Guangzhou, a Beijing based Chinese Corporate
law firm. They can be contacted at james.zeng@kingandwood.com and
james.rowland@kingandwood.com respectively
DUE DILIGENCE
IN A CAUTIOUS M&A MARKET
Merger and acquisition activity in China has slowed markedly in recent months, as BY WARREN PHILIPS
the economic downturn has widened an expectation gap that already existed between
buyers and sellers. Companies with sound business models and demonstrated earn-
ings growth are sticking to the valuations they agreed 12 months ago, while prospec-
tive buyers have taken a wait-and-see attitude. The number of deals completed in
China on a quarterly basis has fallen steadily over the past 18 months, from 261 deals
in the final quarter of 2007, to 116 deals in the first quarter of 2009.1

For many investors, China still offers strong growth potential and
many attractive M&A targets. Global funds and strategic investors
continue to allocate capital, even if the sense of urgency is not as
high as it was one or two years ago.
However, with buyers becoming more cautious, negotiations are
more protracted and companies have more time to devote to due
diligence. In a recent Asia Pacific survey conducted by KPMG, 64
percent of respondents said that due diligence was taking slightly
longer on average since the onset of the financial crisis. Over 70
percent of respondents said they had become more cautious about
making acquisitions and, consequently, over 60 percent believed
due diligence was becoming more detailed.2
The downturn brings an extra dimension to the challenges of con-
ducting M&A. The old horror stories about companies having mul-
tiple sets of books do not reflect the reality of M&A in China today.
Over the past decade, companies have grown dramatically and their
financial profiles have become increasingly complex. Many compa-
nies have become more transparent in their financial reporting and
corporate governance, but more complex risks need to be identified
and due diligence needs to keep up.
Due diligence needs to be more substantive in terms of underlying
issues and understanding key trends and indicators. That means it
needs to be more than simply a snapshot of a moment in time. It
can also aim to develop a more in-depth understanding as to why
margins have declined or risen over time, or how the target has per-
formed relative to its competitors.
Buyers, particularly with a US focus and in large or buy-out situa-
tions, are additionally demanding investigations into potentially
improper financial transactions, as a result of an increasing focus
on implications from the Foreign Corrupt Practices Act. Any issues
uncovered can affect the valuation to a greater extent in a bear mar-
ket environment and also impact the buyer’s and seller’s reputations
and their ability to conduct future business.
Cash flows and working capital, and in some cases where financing
is still being raised, the ability to service debt, are naturally receiving

Due diligence check list

In a recent KPMG survey, more than half of respondents (63 percent) agreed that a comprehensive due diligence process can alleviate
many of the risks associated with conducting an M&A transaction in Asia. Some key matters to focus on in the current economic
environment are:
Conducting more detailed work on current market conditions and the time to turn-around
Conducting more detailed work on the target’s competitive positioning
Understanding that current trading performance is not a reliable predictor of future performance
Gaining a closer understanding of operational performance
Performing detailed risk assessment
Examining financing arrangements and ability to service any debt, including working capital, loan arrangements, head room on cash flows
and derivative arrangements.

21
 VALUE

300 50,000

261 45,000
250
40,000

35,000
200
NUMBER OF DEALS

173 178 30,000

169

150 25,000
137

116 20,000
100
15,000

10,000
50

5,000

Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009

VALUE volume
Source: MERGERMARKET value(usd m)

greater attention in the current climate. Vendors or borrowers need
to invest time and resources to these aspects within their finance
function, while acquirers will look to this as an area in which they
can implement change and realise greater value. When acquiring a
distressed asset, the general approach to due diligence may not alter,
but there are greater timeframe pressures. This means that the due
diligence process needs to be well-planned, to anticipate next steps
and identify potential shortfalls in information or other hurdles.
ers will have to come to terms with the shortage of funding options
and the new market reality. At the same time, due diligence will have
an important role to play in restoring confidence to the market, by
helping support the completion of good-quality deals that allow ac-
quirers to realise their strategic objectives and create lasting value.
Warren Philips is a Partner in KPMG China’s advisory practice.
He can be contacted at warren.phillips@kpmg.com.hk

Apart from taking more time to assess a deal, there is also an in-
creasing focus on the identification and mitigation of post-deal is-
sues. When the global economy was expanding and financing was
readily available, the risk of overpaying for a deal was mitigated by
the likelihood that strong economic growth would add to sharehold-
er value over a relatively short period of time. This is no longer the
case.

As the market recovers, the approach to due diligence in China is

likely to become more similar to that adopted in more developed
markets. China can still be viewed as an emerging market in some
respects, but the sheer volume of foreign strategic and private eq-
uity investors that have set up in China in recent years means that 1
mergermarket M&A data
Chinese companies have already adapted to the expectations of for-
eign buyers. 2
KPMG International: Due diligence in uncertain times, March 2009,
see www.kpmg.com.hk
Deal activity should pick up later in 2009 and during 2010 as the ex-
pectation gap between buyers and sellers narrows. Eventually, sell-

22 Chamber Eye Guangdong

HR INVOLVEMENT CRITICAL TO M&A
SUCCESS
In mergers and acquisitions (M&A), due diligence forms the base upon which virtually BY JASON CHAN
all key decisions – both strategic and operational – are made. Those involved in such
transactions understand the importance of due diligence in identifying potential “deal
breakers” and any items that may have a material impact on the negotiations or the
purchase price. Once this has been accomplished, however, it is not uncommon for due
diligence activity and intensity to wane. This cuts short a process that could be benefi-
cial in other ways and may leave other critical information on the table – particularly
employee/human resources (HR)-related information that could influence integration
decisions and enable a smooth integration process.

This is particularly relevant to HR professionals since they are re- ing points or the purchase price
sponsible for the integration of “people”-related issues such as the • Uncover and understand the information that will influence inte-
integration of compensation and benefits programs, workforce re- gration and transaction strategy decisions
structuring, labor contracts/agreements and their administration,
and the management of issues such as leadership, organizational We’ll now consider how due diligence plays an important role over
culture, and employment practices. However, HR professionals the various stages of a deal, then address what can and should be
are not usually provided access to the vital information surround- changed from an HR perspective to obtain better results.
ing these “people” or “human capital” issues until late into the M&A
process. They are often not included in the early stage discussions Stages of the deal
and due diligence with their counterparts in functional areas such
as accounting and finance, operations, and legal. In many cases, Mercer broadly categorizes the M&A transaction process into three
“people” issues are not valued as highly as financial/legal issues and stages: 1) Pre-deal, 2) Doing the deal, and 3) Post-deal.
HR teams may lack credibility as a contributing strategic member of
the executive deal team.
PRE-DEAL
Managing the due diligence process effectively can yield more im-
pactful and faster results from an integration standpoint. While a
smooth transition is an important goal, it should also be accompa-
Strategy And Planning
nied by a speedy close of the transaction, in order for the organiza-
tions affected to begin to realize the full value of the deal as quickly
as possible. Figure 1 illustrates this point.

DOING THE DEAL

Achieving M&A success
Detailed Due Diligence
There are three key factors that help an organization achieve merger & Do-by-close
success and “people” issues play an important part in each:

• Business logic – Why is the transaction being done and what needs
to occur for it to be considered a success?
• Price paid – What is the economic baseline and what improve-
ments in post-transaction performance are expected in order to pay POST-DEAL
any premium in price?
• Integration – How is the strategy to merge or acquire translated Immediate And
into real value? Extended Integration
Due diligence is intended to uncover the answers to these three
questions. It prevents organizations from overlooking key issues
and can significantly improve the chances of the deal’s success. Spe- The “Pre-deal” stage of an M&A transaction is where the acquiring
cifically, due diligence is performed to: or merging companies define business strategy and transaction
criteria. Companies will develop a high level understanding of the
• Discover issues that could be “red flags” or “deal breakers” target company and potential transaction, which may include deter-
• Find and investigate material issues that might affect the negotiat- mining the:

23
 CROSSOVER
POINT
VALUE
VALUE DESTRUCTION
Current Value
Figure 1: Accelerating M&A value creation
- Business drivers behind the deal
- Organizational strategy for the deal
- Expected outcomes and risks of the deal
Due diligence at this stage usually can uncover some qualitative is-
sues that would stop the deal, which may be as basic as whether the
leaders can actually work together. It can also uncover major finan-
cial issues that would materially affect the price.
During this stage, companies may begin to plan for HR’s involve-
ment by understanding the value of human capital and the factors
and strategies that influence it and by building organizational and
HR function readiness through:
- Assessing and understanding the leadership culture of the compa-
nies in consideration
- Assessing the HR transaction team’s skills and capabilities/con-
duct training as needed
- Understanding the key “people” factors affecting business perfor-
mance
This stage typically ends with an agreement to move forward to the
more formal and rigorous “Doing the Deal” stage.
The second stage is typically conducted, at first, at a high level with
24 Chamber Eye Guangdong
VALUE CREATION
TIME
Post-transaction Value
limited information provided by the target company, usually select
summary financial and operational information. Most often the fo-
cus is on critical financial issues since access is limited from a time
and content perspective. The purpose of this stage of the due dili-
gence is to unearth those issues that may influence whether the deal
can proceed to the next stage and what pricing adjustments need to
be made.
In the event that discussions at this stage cease and both parties
revert to being competitors, they will want to have divulged as lit-
tle information as possible. As the transaction progresses and the
interest from both parties to continue remains (or if the deal was
friendly from the outset), more and in-depth information will be
disclosed to the buyer for further analysis and consideration. This
more comprehensive information typically contributes to integra-
tion planning, in addition to the decision to proceed with the deal
and the pricing considerations. It is not unusual, however, for the
information necessary to make informed decisions not to be avail-
able until after the formal close of the transaction. In this case, it is
necessary to make certain assumptions and base certain decisions
on those assumptions. Once the missing information becomes
available to the buyer, it is prudent for the buyer to confirm previous
assumptions or make amendments to certain decisions. While this
step may seem perfectly logical, it often is not carried out.
It is important to note that during the due diligence stage:
1. the parties still can get out of the deal;
2. the parties still can affect the price; and
3. the parties have the ability to plan the integration to get the max-
imum value out of the deal in the shortest timeframe.
 ISSUE IMPACT DOCUMENTS
TO EXAMINE

Excessive problems discovered around HR policies and

Employee lawsuits
practices on the surface can portend to much more
EMPLOYMENT significant problems underneath. The number and type of Employee surveys
employee lawsuits (both closed and active), grievances, work Retention/turnover statistics
PRACTICES
stoppages, and negative audit results all can be indictors of
much deeper problems. Grievance reports

The currency of insurance premiums; accruals for medical, Plan documents

HEALTH AND dental, sick pay, vacation, etc.; and reserves for incurred but
Financial reports from third-party
WELFARE BENEFITS unpaid claims (medical, dental, short-term disability, and
administrators or providers
other self-funded plans) can have a material financial impact.

Unfunded obligations of current, frozen, or terminated Defined benefit plan document

defined benefit retirement promises can be significant; in
some cases the retirement plan financial obligations exceed Most recent actuarial valuation(s)
RETIREMENT
the value of the deal. Forfeited (unvested) amounts from Benefit plan contribution schedules
BENEFITS defined contribution plans that are being used to offset
employer contributions may also distort the financial Breakdown of employer
position shown in the target’s accounts. contributions

In certain countries in Asia (e.g. Hong Kong, Taiwan, and Financial statements (according to
Korea), companies are required to make payments upon country-specific GAAP and U.S.
TERMINATION retirement or involuntary resignation, and sometimes GAAP accounting standards)
INDEMNITIES voluntary resignation as well. Companies must therefore
Analysis of cash flows relating to
establish accounting reserves for such potential payments.
such programs

It is important to quantify existing and future

compensation commitments. Expenses for commissions,
incentives, bonuses, etc., can be both significant and
Variable pay and retention
unpredictable. In some countries in Asia (e.g. China),
program plan documents and
salary paid to employees may not meet the local
COMPENSATION associated communications
minimum salary requirements; individual income tax may
COMMITMENTS be underpaid by excluding bonus or incentives; and social Governing employment legislation
AND COMPLIANCE security contributions may be underpaid. As such, buyers Labour agency policy manuals
should be aware of such practices and account for
normalized compensation expenses. Violations can result Social security payment receipts
in significant back pay and fines for both employers and
employees.

Significant or excessive severance/change-in-control Deferred compensation plan

(CIC) payments could trigger excessive costs. In some documents
circumstances, the magnitude of CIC payments may stop Executive contracts
EXECUTIVE the deal.
CHANGE-IN-CONTROL Change-in-control agreements
PROVISIONS Broad-based severance plans
Stock option plan/agreements and
data

Figure 2: Critical HR issues to examine during HR due diligence

25
 This stage typically ends with the negotiation of final terms and con-
ditions into a formal agreement that addresses all of the relevant
information regarding the deal.
The closing of the transaction marks the beginning of the final “Post-
deal” stage. Typically, the closing is consummated by the signing of
a Sales and Purchase Agreement (SPA) or a Definitive Merger Agree-
ment (DMA). Theoretically, this stage should reflect the execution
of the integration plan with no further due diligence required. How-
ever, as mentioned earlier, as not all information will be available or
disclosed earlier in the process, it may be prudent for the buyer to
conduct further due diligence to confirm assumptions made earlier,
with appropriate adjustments made to integration plans.
What to do differently
There are three things companies can do differently during the M&A
process that will yield significant improvements in the speed and
success of the integration and overall transaction:
(1) Get HR involved earlier. A significant amount of activity – both
decision-making and due diligence – takes place in Stage 1 and 2.
Much of this activity has direct relevance to “people” issues and
will affect the eventual integration process and success of the deal.
However, it is still relatively uncommon to have HR representatives
participate in Stage 1 and 2 activities. Those involved at this stage
tend to be M&A/corporate development, legal, finance, accounting,
and operations staff, along with senior leadership. Senior leadership
needs to be educated about the importance of HR’s role in M&A suc-
cess, and HR professionals need to aggressively secure a role early in
the process.
(2) Compile and examine different types of information. The due
diligence process has almost always focused on the financial side
of the transaction and typically involves items such as finances, as-
sets and liabilities, and contractual agreements. In addition, due
diligence during Stage 2 too often only focuses on searches for “deal
stoppers” and items that may require purchase price adjustments.
This results in insufficient attention to critical issues that have a
26 Chamber Eye Guangdong
significant impact on integration, including the broader “people” is-
sues. Figure 2 provides examples of several critical HR areas that
should be examined as part of the due diligence process, but that are
often overlooked.
(3) Move HR due diligence to earlier stages. In addition to it be-
ing crucial to involve HR professionals earlier in the M&A process,
it is also important to begin collecting the relevant data early. This
will expedite the M&A process with regards to HR due diligence, and
contribute to a smoother integration.
Conclusion
As M&A activity continues to occur, companies involved in transac-
tions have the opportunity to increase the speed and value of the
transaction through the increased involvement of HR profession-
als and using early data to formulate integration strategies. Given
more and earlier involvement in due diligence, HR professionals can
provide a valuable perspective about leadership, organizational cul-
ture, employment laws and practices, and potential HR costs/liabili-
ties that could have a significant impact on a deal’s success.
Jason Chan is an M&A Engagement Manager in Mercer’s Global M&A
Consulting Services business in Hong Kong, which advises clients on
transactions, including mergers, acquisitions, joint ventures, initial pub-
lic offerings, spin-offs, divestitures, start-ups, and business transforma-
tions. Mercer is a leading global provider of human resource consulting,
outsourcing, and investment services and serves more than 25,000 cli-
ents globally. Jason Chan can be contacted at jason.chan@mercer.com or
+852 2115 3386.
EXAMINING THE FINANCIAL HEALTH OF
YOUR DEAL - FINANCIAL DUE DILIGENCE
As China transitions ever faster towards a market economy, M&A activity has
exploded over the last decade; from foreign companies looking for a foothold in a
market with double digit growth, to local enterprises eager to strengthen their
competitiveness
What is due diligence
Due diligence is a coherent and focused review exercise carried out
by the investor to evaluate the target business and ultimately maxi-
mize the return on a deal. Among the family of due diligence ac-
tivities, financial due diligence is often considered one of the most
important areas to cover mainly because it can provide the required
information and solid basis for a proper valuation and estimation of
investment return.
Some investors underestimate the importance of due diligence,
whilst others rely only on a statutory audit report in lieu of a proper
financial due diligence. Financial due diligence is fundamentally dif-
ferent from an audit and should not be confused with one. A statu-
tory audit seeks to verify whether the financial statements give a
true and fair view under the specific accounting standards, governed
by the auditing standard. Whereas a financial due diligence is tai-
lored to the investors needs and looks to explain the financial num-
bers in order to understand the entity’s financial performance and
highlight potential deal breakers and other critical issues that the
investor needs to pay attention to. This will then allow the inves-
tor to ascertain whether the perceived potential realizable values of
the target actually exit, what kinds of risks and exposures they may
have to face and to formulate an appropriate pricing and negotia-
tion strategy.
The key objectives of a due diligence are therefore to maximize the
return on a deal, focusing on issues impacting the deal valuation and
pricing, deal structure and approach, terms and conditions required
in the Sale and Purchase Agreement (“SPA”), the potential synergies
generated or exposure inherited, and any other post deal operation-
al and management concerns. These issues should not be restricted
to the risks and exposure but may also include opportunities and
potential upside one may get from the deal.
Importance of financial due diligence
Reported financial information does not always present a true
picture of the company, especially in countries like China, where
maintaining two sets of books is common practice. Manipulated
accounting records will distort reported financial statements, num-
bers are either deflated or inflated to minimize tax liabilities or ob-
tain funding that would otherwise be out of reach. Due diligence
will look to uncover these irregularities and hence assist the investor
in whether to go ahead with the investment and pricing.
BY PY CHUI
More importantly, in a deal where the investor is buying an equity
interest in the target business (i.e. equity deals), as he will be inherit-
ing the liabilities, the investor will want to identify the material his-
torical potential risks and exposures which have not been reflected
in the reported financial statements.
Even in an asset deal (a deal where the buyer only acquires the assets
of the target business instead of buying the shares), although the in-
vestor will not inherit the historical liabilities and risks, as the seller
will likely walk away post-deal, enforcing warranties and indemni-
ties agreed in the SPA may not be possible in practice, therefore a
financial due diligence before the purchase will help the investor un-
derstand what he is in for.
In the event that an investor only acquires a minority stake, it may
be difficult to obtain quality information post deal, therefore car-
rying out a proper financial due diligence upfront is important to
understand the risks and exposure of the target business and seek
appropriate protection. This is particularly important if the target’s
operation covers numerous countries and jurisdictions. In this case,
the target’s performance may not be transparent and potential
transfer pricing issues and related party transactions will often ex-
ist.
Owing to the complexity of doing a deal, rushing to close a deal with
insufficient understanding of the target will easily lead to failure in
realizing the value of the deal. Carrying out a proper due diligence in
a professional manner is considered vital.
The scope of financial due diligence
It is up to the investor to determine the scope of the financial due
diligence, but it will normally be based on how the deal is priced, its
structure, complexity, the target business operations, and the nego-
tiation process.
Pricing may be based on a multiple of earnings, turnover or net as-
set value etc, the results of the financial due diligence will be used
to determine the valuation of the deal. Based on the results of a
financial due diligence, the most appropriate deal structure may be
determined, based on mitigating risks, facilitating cash repatriation
and exiting the deal at a future date.
Financial due diligence will also help uncover potential defects of
land, property title and unpaid liabilities in property deals, employ-
ee related liabilities in State-Owned Enterprises (“SOE”), standalone
27
 cost issues in carving out the target operation from a larger group;
and loan book quality and credit underwriting control weaknesses
in bank deals.
Due diligence should be carried out by investors to examine the
value perceived in the target or created in the deal and to identify
any potential risks in doing a deal. However, often sellers will try to
dictate the process and restrict the flow of information, meaning it
will be up to the buyer to formulate appropriate negotiation strate-
gies to ensure a due diligence appropriate to his needs.
A typical scope of financial due diligence will often include the ex-
amination of the integrity of the financial information, assessment
of the quality of historical earnings, the sustainability of the profit-
ability, working capital and cash flow trends and the quality of the
target’s assets. Results will facilitate the investor’s ability to evaluate
his financial modeling and valuation, which will include reviewing
the projection of future performance and assessment of potential
synergies benefited from the deal.
Typical common issues identified in financial due dili-
gence
The issues identified in financial due diligence may vary from target
to target depending on the type of the target (private companies vs
SOE) and the deal structure (asset deal vs equity deal). In China, the
typical issues are often inappropriate revenue and cost recognition,
tax exposure due to two sets of books, distortion under significant
related party transactions, off book transactions, non compliance
with regulatory requirements and poor reporting quality with lim-
ited transparency. The following is a summary of the common issues
identified in financial due diligence.
Value
Other
Upside
Synergies
Improvement
in Profit
Enterprise
Value Of The
Target
28 Chamber Eye Guangdong
(1) Many Chinese companies adopt cash accounting and recognise
revenue and cost based on actual cash receipt and payment, which is
not compliant with the accrual principle in accounting. The reported
financial performance of a company may change significantly if the
inappropriate revenue and cost recognition practice is rectified.
(2) The financial statements of most Chinese private companies are
often tax driven. External books often understate sales and contain
invalid costs with a view to minimizing tax liabilities. The practice
not only distorts the true profitability of the target business but also
gives rise to significant tax exposure.
(3) Significant related party transactions are common in many Chi-
nese companies, normally because of non-rationalized or informal
group structure, or for obtaining financing beyond the facility’s lim-
it, or to cover up the ultimate ownership of the entity. If the target
company is an SOE, related party transactions may occur under the
instruction of local government , perhaps to provide financial sup-
port to other companies to avoid redundancy, or to provide cross
guarantees. Owing to their non commercial basis, these related par-
ty transactions may not only distort the profitability of the target
business, but also give rise to potential contingent liabilities (such as
guarantees) and carve out issues (i.e. separating the target business
from the seller’s group activities). If a company is over reliant on the
support from related parties, significant costs may be required for
it to operate on a standalone basis. Potential competition / threats
from related parties may also exist post transaction.
(4) Off book transactions are common practices in China. As men-
tioned before, many private companies may not record certain sales
transactions and manipulate the cost of sales and expenses in order
to present a “reasonable” profit margin with understated sales. The
actual cash inflow from off book sales transactions will usually be
handled and deposited in the owners’ personal bank accounts. The
Standalone
Costs
Other
Downside
NEGOTIATION
RANGE
FOR
Value To The
Buyer
cash generated from these off book sales may be subsequently used
by the business to purchase raw materials and capital equipment.
These transactions will have to be treated off book accordingly. In
many cases, off book transactions may also be arranged to facilitate
informal rebates, discounts or other under-the-table arrangements.
The most common informal rebate is the cash rebate offered to the
customer’s purchasing officers. Since these are unofficial payments
and are inappropriate, some companies will make the rebate pay-
ments by cash out of the owners’ personal account and treat them
off book. The practice of off book transactions not only distorts the
true profitability of the target but will also give rise to potential cor-
porate governance issues which have to be rectified post deal (espe-
cially for investors which are listed companies).
(5) Non compliance with local regulatory requirements is also a
common feature of many Chinese companies. Other than the en-
terprise income tax mentioned above, many local private compa-
nies do not properly report their liabilities on individual income tax
and social security contribution by under-reporting the number of
employees and their salary level. In some cases, many companies in
China may conduct certain non permitted business activities which
are either beyond their business scope or are prohibited under local
regulations, these might include borrowing/ lending money from/
to other companies without a banking license, improper or non dec-
laration of custom duties on importing goods (or even smuggling),
cash transfers via informal channels without going through the of-
ficial foreign exchange bureau, and violation of environmental and
safety regulations. Again such practices may potentially lead to sig-
nificant actual liabilities or continent exposures.
(6) One of the key concerns for many foreign investors doing deals
in China is the poor quality of financial information and integrity
issues of the management team. As mentioned before, practices
such as inappropriate revenue and cost recognition, off book trans-
80
60
% of respondents
40
20
0
Liability Quality of Matters
Black-Holes Management affecting deal
Control price & terms
PricewaterhouseCoopers
actions and two sets of books have led to unreliable management
accounts. In addition, the unsophisticated monthly management of
accounts without detailed breakdowns and explanations to the vari-
ances between different financial periods also impairs the trust and
confidence in the management team.
Conclusion
In summary, there is no standard review scope in a financial due
diligence, it usually very much depends on the objectives and the
value an acquirer sees in the deal. It is therefore important for one
to understand the deal background, including the motives of both
parties, the drivers of the transaction and the deal structure before
one can decide what should be covered in a financial due diligence.
Investors, with the help from their financial advisors, will have to
prioritise the areas of review and focus on deal breaker issues and
matters which will materially impact the proposed transaction. A
financial due diligence is not just to identify the issues and exposure,
but should stay focused on the deal value and provide details for the
investors to evaluate the target and facilitate a deal negotiation,
including forming the optimal deal structure and seeking appropri-
ate terms and conditions. At the end, a good financial due diligence
should also assist a buyer to capture the core value of the deal after
it has been agreed.
PY Chui is a Partner in PwC’s Guangzhou M&A transaction services
practice. He can be contacted at py.chui@cn.pwc.com
Profit Post deal Commercial
sustainability issues viability
29
 THE BRITISH CONSULATE-
GENERAL GUANGZHOU

TIME EVENT LOCATION LEAD OFFICER

September

6-8 UKTI mission to China International Optoelectronic Exposition (CIOE) Shenzhen Kevin Liang
8-12 UK mission to China International Fair for Investment & Trade (CIFIT) Xiamen Vivian Zheng TBC
UK Food event Cities in Guangdong Jessie Zhang TBC
October

Regional city mission Foshan Vivian Zheng TBC

November
UK Mobile Data Association to MobileExpo China Shenzhen Kevin Liang
Regional city mission Zhuhai Vivian Zheng TBC
‘Enabling Innovation’ ICT mission Shenzhen, Dongguan, Xiamen Kevin Liang
South West England and South East England outward missions Guangzhou Chris Butland

The British Consulate-General Guangzhou’s Trade & Investment team supports British businesses entering the Chinese market through
missions, seminars, trade shows, research and ongoing advice. They also foster positive bilateral trade and investment conditions through
their contacts with the Chinese Government.

For more information please visit their website at

www.uk.cn/gz

30 Chamber Eye Guangdong

UK/CHINA RESPONSE TO THE
GLOBAL ECONOMIC CRISIS
There is no doubt that the global economic downturn, with shrinking demand
for goods/services and the resulting export credit squeeze, has had a negative
impact on our respective economies. Both the UK and China rely on exports in
support of their economies.
The G20 meeting in London in April saw constructive agreement, on
the part of the UK and China amongst others, that protectionism,
although viewed as a tempting prospect for some countries, would
offer “false” short-term hope. This would simply result in a lack of
international competition in the domestic industry, with the result
of restricting the ability to export to such markets. Inevitably this
would have a particularly adverse impact on trading nations such as
the UK and China who rely on the openness of other markets.
The current situation offers an opportunity for countries to review
their positions on Doha and attach a higher priority to concluding
the round. Clearly such a scenario would reduce the length of time
various countries’ economies spend in low, zero or negative growth
as a result of the current crisis.
It is all the more encouraging to tell you that in the midst of this
global economic downturn, the UK and China continue to focus on
the importance of strengthening our trade and investment relation-
ship.
We have seen high level visits in both directions so far this year to
build on strengthening the trade and investment relationship to the
mutual benefit of both countries. Of particular note was the visit of
Premier Wen Jiabao to the UK at the beginning of February 2009.
During this visit, Prime Minister Gordon Brown and Premier Wen
Jiabao jointly reconfirmed the bilateral trade target of US$60 billion
by 2010. Premier Wen’s visit was closely followed by a visit to the
UK by Commerce Minister Chen Deming later that same month. He
was accompanied by a trade delegation of 150 Chinese companies
keen to identify cooperative opportunities with UK counterparts. A
number of activities were planned during the visit, bringing the Chi-
nese and UK businesses together, which resulted in contracts valued
at US$2.2 billion being signed. UK Trade & Investment (UKTI) is
following up with a number of interested UK companies.
Further emphasis has been placed by our respective governments
on identifying linkages that play to our respective needs and
strengths. This has been backed up by implementation of a num-
ber of initiatives to realise those ambitions. For example, “China
Tomorrow”, launched in March 2009, aims to rapidly identify and
introduce 50 UK companies with particularly innovative products
or services to China/Chinese institutions with the hope that mu-
tually beneficial commercial relationships can be established. The
BY DAVID BROWN
“Sustainable Cities” and “Regional Cities” initiatives also play to UK
industry strengths in climate change/low carbon, and aim to assist
the Chinese government with policy implementation for sustain-
able regional economic development in the Central, Western and
North East regions of China. Additionally, we continue to alert UK
business to other cities outside the main centres within China where
opportunities for cooperation with local companies exist.
These are only some of the initiatives being realised to contribute
to a continued and flourishing trade and investment relationship
between the UK and China. This is in addition to the existing UK
government support, through UKTI and our partner organisation,
the China Britain Business Council, provided to UK companies with
an interest in China.
By the time this edition of the publication appears, the UK will
have hosted the UK-China Economic & Financial Dialogue taking
place in May 2009 and preparations for the Joint Economic Trade
Commission annual meeting will be well underway. Both are well-
established government-to-government mechanisms to take stock
of our bilateral relationship with a view to deepening those ties for
the benefit of both countries.
In conclusion, I am keen to remind you of my UKTI colleagues based
locally within the British Consulate-General in Guangzhou as well
as the CBBC in Shenzhen. They stand ready to assist you as appro-
priate in your business endeavours and will be more than happy to
hear from you.
Contact +86 20 8314 3000 or
guangzhou.commercial@fco.gov.uk
David Brown is Deputy Head of China Markets Unit, UK Trade & Invest-
ment. He can be contacted at david.brown@ukti.gsi.gov.uk
31
 UK-GUANGDONG COOPERATION
ON CLIMATE CHANGE
Ed Miliband, Secretary of State for Energy and Climate Change, visited
Guangzhou in early May as part of a China-wide programme to deepen United
Kingdom-China co-operation on climate change ahead of important interna-
tional negotiations in Copenhagen in December this year.
The primary focus of his visit to Guangdong, China’s export manu-
facturing base and largest Provincial economy, was to promote low
carbon economic development and to explore new opportunities for
UK-Guangdong co-operation on these issues.
His visit programme included high-level exchanges with Guangdong
Governor Huang Huahua, a keynote speech at a business luncheon
at the Grand Hyatt Hotel, a press conference and a fact-finding visit
to the Guangzhou Paper Mill, one of China’s Top 1000 Energy Con-
suming Enterprises that is successfully meeting national energy ef-
ficiency targets.
In discussions with Governor Huang, Mr Miliband outlined the
domestic measures that the UK is undertaking to reduce the UK’s
greenhouse gas emissions by 80% by 2050, and spoke of the impor-
tance of Guangdong to the global response to climate change.
Mr Miliband said the UK was keen to deepen its co-operation with
Guangdong on practical measures to address climate change and
proposed a UK-Guangdong Memorandum of Understanding to
take this forward. Areas of possible co-operation included policy ex-
changes with government planners, capacity building for officials,
the development of low carbon demonstration zones, scientific
exchanges on the impacts of climate change, studies to explore the
potential for Carbon Capture and Sequestration (CCS), the develop-
ment of innovative low carbon technologies and greater engage-
ment with the business sector on energy efficiency and carbon
management strategies.
32 Chamber Eye Guangdong
BY TIM HANSON
Governor Huang said he welcomed the support that the UK is
providing to China and shared Mr Miliband’s wish for greater co-
operation. He spoke of the challenges that climate change posed
for the world and of the importance that Guangdong attached to
building a resource efficient, environmentally friendly, low carbon
society. Some of the measures already being undertaken in the Prov-
ince included industrial restructuring, greater use of clean energy,
reforestation, the promotion of energy efficiency technologies and
processes and public awareness.
In his speech to business leaders, including members of the British
Chamber of Commerce Guangdong, Mr Miliband further outlined
the need for action by the business community and spoke of the op-
portunities that arise from a global shift to a low carbon society.
“The actions that you take will affect the world. Business in China
has the chance to inspire other countries and to show leadership
that will be followed around the world” Mr Miliband said. “I wanted
to meet businesses in Guangdong because tackling climate change
is not just the right thing to do, it is the profitable thing to do. The
low carbon economy presents huge opportunities for businesses”.
Mr Miliband’s three day visit to China also included meetings with
senior leaders in Beijing in preparation for the international climate
change negotiations in Copenhagen in December, and a visit to a
rural community in Gansu Province that is experiencing the impacts
of climate change.
The British Government’s work with China on energy and climate
change is undertaken by a network of Embassy and Consulate staff
in Beijing, Guangzhou, Shanghai, Chongqing and Hong Kong. Fur-
ther details available at www.ukinchina.fco.gov.uk
Tim Hanson is Head of Climate Change, British Consulate-General
Guangzhou. He can be contacted at Tim.Hanson@fco.gov.uk
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33
 NEW MEMBERS
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34 Chamber Eye Guangdong

 EVENTS

Downsizing and Termination of Employment Contracts

11 March, GZ
Graham Webb Live - 26th June 2009 JSAssociates

Graham Webb Live - 26th June 2009

Jeremy Sargent, Graham Webb

Quiz Night - 23rd Apr 2009

Winning teams

Selling in Hard Times - 25th Mar 2009

Huthwaite Greater China

United Kingdom Border Agency Visa Presentation - 6th May 2009

BCGG

Supply Contract Seminar - June 2nd 2009 Sectoral Round Table Event - 30th June 2009
Wragge & Co LLP In Association with UKTI

35