Due Diligence in China

Beyond the Checklists

Kwek Ping Yong

• Publisher: Wiley
• Year: 2013
• ISBN:
  9781118469057
• Edition: 1
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

A plain-English guide that demystifies the business landscape in China from a due diligence point of view

Due diligence is crucial to any business deal, and, thankfully, due diligence research has come a long way over the years. What used to be a cumbersome, time-consuming process has been standardized and systemized with generally accepted auditing frameworks and tools, such as the all-important auditing "checklists." But when it comes to doing due diligence in China, with its opaque regulatory system and byzantine accounting standards, all bets are off. In this book an acknowledged expert in the field takes you beyond the checklists to arm you with China-specific due diligence strategies, tools and techniques that go beyond what is typically part of the process.

• Gives a detailed account of why conventional frameworks used in the west simply don't work in China
• Provides first-hand accounts based on the author's years of experience as a private equity professional doing deals in China
• Reviews, in-depth, the unique differences between corporations and businesses in China and those in the West and their implications for the due diligence process
• Uses numerous case studies to guide the reader through an entire due diligence process for a firm in China

Chapter 1

The Business Landscape in China

This chapter is designed to provide a broad overview of the business landscape in China. Without a fundamental understanding of the key components that make up the business landscape, readers may find it hard to understand the intricacies of doing business in China and how it relates to the core topic of conducting due diligence in China.

Conducting due diligence in China requires an intimate understanding of the business landscape in China and understanding how these various factors interact together to pose challenges. An in-depth due diligence is critical in helping potential buyers to identify the workings of a company and its strategy, and to uncover any hidden issues.

In this chapter, we discuss the characteristics of Chinese political, business, and social landscapes and their relevance and impacts to the due diligence process. The three landscapes are inherently wide in scope and cannot easily be exhaustively covered as they are also dynamic and changing with the times. The purpose is to inform readers to pay attention to the context and unique circumstances that surround Chinese due diligence. The landscapes described may share some similarities with other regions or countries, but, seen as a whole, the Chinese characteristics of these landscapes are unique to China.

First, we cover the macro and structural domains that include a discussion on the macroeconomic conditions and system of rules and laws in China. We also cover the level of corruption in China and the significant number of fraud cases that plague business dealings in China.

Second, we cover company-specific issues such as the lack of internal controls of Chinese companies that have made it more susceptible to corruption, backroom dealings, and dubious related-party transactions. We would also discuss the current state of how Chinese businesses operate in general, which is to say that they rely heavily on manually intensive record keeping. Moreover, we discuss the cultural and social aspects of the Chinese businesses, which include the corporate culture and environment, the powerful influence of Chinese founders, and their peculiar characteristics that shape their own corporate landscapes.

The aspects discussed in this section are merely snapshots and highlights of the highly complex business landscape in China. As such, readers may find many other peculiar aspects of doing business in China that may complicate the due diligence process that are not covered here. Nevertheless, the purpose of describing the business landscape in China is to provide readers with a contextual understanding and appreciation of the complexities of doing business in China. These insights will provide readers with a good background and allow them to understand and appreciate the importance of conducting a full diligence prior to any deal making in China.

MACRO AND STRUCTURAL DOMAINS

This section covers selected macroeconomic conditions in China that have contributed to the challenges that one may encounter when doing due diligence in China. Some of these conditions, such as the systemic low-compensation schemes, may have exacerbated the level of corruption and fraud cases in China.

From Planned Economy to Market Economy

China has advanced tremendously economically ever since Deng Xiaoping’s economic reform that began in 1978. That reform was accelerated by China’s accession into the World Trade Organization in 2001. Since then, China has been transitioning from a planned economy to a market economy (Figure 1.1). China’s economic growth has been so tremendous that it had surpassed Japan as the world’s second largest economy, and it is poised to surpass the United States by 2027, according to Jim O’Neill, the head of Goldman Sachs Asset Management.1

FIGURE 1.1 The Transition from Planned to Market Economy in China

Source: Illustration by Kenny Ng.

China had been known as a cheap manufacturing haven among investors and businesses looking to leverage the country’s cheap factors of production, such as labor, and government policies. As China’s economy embarks onto the next stage of growth, since its identity as a manufacturing hub, it is gradually evolving into an economy that is more service centric and higher up in the supply chain. The Chinese government has embarked on deliberate measures in the form of strategic economic goal setting using the Five-Year Plans that outline its economic development initiatives. These Five-Year Plans serve as critical benchmarks that the Chinese government strives to achieve, and these changes present great opportunities to investors and businesses.

China’s economic reforms and open-door policy has provided a conducive investment environment for business and investors. Foreign investments into the country were seen as an important source of injection of capital and technology to enable economic growth. China’s investment attraction strategy comprises the liberalization of trade with its key partners using free trade agreements (FTAs) to reduce supply chain costs and to enhance price competitiveness. In addition to the FTAs, China has signed various partnership agreements that seek to mirror the benefits of an FTA such as the Economic Cooperation Framework Agreement with Taiwan.

As China increasingly moves closer to become a capitalistic society, there is a need to implement structural reforms to strengthen the foundations for a market-based economy. China’s economic growth had been propelled primarily through fixed-asset investments. There is a prevailing recognition that China will have to rebalance its economy by shifting into a consumption-driven economy. However, the general consensus is that China will find it challenging to shift into this mode and will rely on investment spending, which it has heavily relied on for its rapid progress. China has sufficient resources to support this move into a consumption-based economy. According to Jefferies projections, consumption in China is expected to reach 73 percent of GDP by expenditure by 2025, up from 49 percent in 2012. In terms of GDP by output, tertiary industries (services) are projected to reach 67 percent of GDP, up from 44 percent in 2012. Secondary industries (manufacturing and construction) are expected to fall to 27 percent of GDP, down from 47 percent in 2012.

China’s massive state-owned enterprises (SOEs) have dominated the economy since its economic reforms and the massive earnings have been crucial in funding China’s investment-led growth. The revenues from SOEs account for approximately half of China’s economy. Jefferies estimated that listed blue chip SOEs could pay out dividends of up to 35 percent. However, SOEs have only paid a portion of it, at around 5 to 10 percent. The large retention in earnings of the SOEs has led them to look for other sources of investments and even led to speculation in the real estate and stock markets. The Chinese government has started to look deeply into the reform of the SOE sector in order to curb excessive speculation and to redeploy capital into the other national objectives such as economic rebalancing and improvement of social welfare. Government revenues can be significantly increased if SOEs are forced to pay proper dividends, which could result in an additional 692 billion yuan ($111 billion). Apart from raising dividend payout ratios, China may embark on a privatization drive for SOEs or increase the public float.

Rising Income Inequality

There is growing social tension and political risk in Chinese society. Chinese officials had not published the country’s Gini coefficient since 2000 when it was 0.412. A score of 0 would represent perfect equality; a score of 1 would mean one individual controlled 100 percent of income. The Gini coefficient measures income distribution on a scale of zero to one. A Gini index between 0.3 and 0.4 indicates a relatively reasonable income gap. A Gini index between 0.4 and 0.5 indicates a large income gap. The Chinese government has claimed that there is insufficient and inaccurate data on high-income groups, which may skew the results. China’s wealth gap raised concerns about China’s development path. The income gap between urban and rural areas, between communities, and the lack of a middle class are factors that could affect social stability. A growing divide between the haves and the have-nots has far-reaching implications for China’s future growth. In addition to the difficulties of narrowing income gaps, the Chinese government also has to contend with the immense task of creating sufficient jobs. In order to maintain the employment rate and to absorb the large numbers of people coming into the labor force, the Chinese government has targeted an economic growth rate of 8 percent. Chinese leaders have prioritized building a “harmonious society” to ease social and political tension. In January 2013, the chief of China’s National Bureau of Statistics revealed that China’s Gini coefficient stood at 0.474 in 2012, down from 0.477 in 2011. The peak was 0.491 in 2008. The large income disparity is a contributing factor to the large number of corruption and cheating cases in China.

Compensation Schemes in China

Low civil service pay has been widely accepted as an important contributing factor for corruption. This is especially so in less developed nations. The assumption is that when salaries are low but expectations for service remains high, government officials may demand more compensation from informal or even illegal channels than what is officially sanctioned; hence, corruption arises.2

In China, civil servants refer to public employees in people’s governments, people’s congresses, people’s political consultative conferences, and courts at various levels. In recent years, the number of people in China’s civil service has grown fast. By the end of 2011, the total number of public servants had reached 7.02 million, according to Wang Jingqing, deputy head of the Organization Department of the Communist Party of China (CPC) Central Committee.

The civil service in China is quite lowly paid as compared to more developed countries. Currently, the country’s civil servants receive a basic salary, bonuses, subsidies, and allowances. According to the National Bureau of Statistics (NBS), civil servants enjoyed, on average, an annual salary of 33,869 yuan ($5,435.97) in 2008, higher than the 29,758 yuan average earned by those working in state-owned enterprises and the national average of 28,359 yuan for all urban workers. In total, the regular pay received by civil servants, combined with their annual bonuses—which typically range from 21,000 to 40,000 yuan—costs the state between 404.26 billion and 537.67 billion yuan per year.3

Due to the relatively low official compensation scheme of civil servants and public officials, there is a higher propensity for officials to seek alternative forms of compensation in order to make up for their pay and to sustain their lifestyles. These additional forms of compensation could come from many sources, and it is not surprisingly that many officials have many unofficial sources of income other than their official salary from the government.

Although there may be a higher propensity to accept bribes, this in no way suggests that all officials are corrupt or susceptible to these additional compensatory temptations. However, the critical thing is to acknowledge and accept that corruption and bribery is not uncommon in China.

Seen in this context, the due diligence process will have to factor these facts of life into the calculation and process. As such, it should not be surprising that, during the due diligence process, there may be challenges and obstacles presented by officials who purposely put up roadblocks to slow down or inhibit the process.

CORRUPTION IN CHINA

It is widely known that China suffers from widespread corruption. According to Transparency International’s Corruption Perception Index, China was ranked 80th out of 176 countries. China scored 39 out of a possible 100 points, behind countries like South Africa and Italy. Corruption cases extend acro...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Preface
• Acknowledgments
• Chapter 1: The Business Landscape in China
• Chapter 2: Due Diligence in China
• Chapter 3: Financial Due Diligence
• Chapter 4: Operational, Commercial, Legal, and Other Due Diligence
• Chapter 5: Beyond the Checklists: Founder and Management
• Chapter 6: Beyond the Checklists: Hard Facts
• Chapter 7: Implementing a Due Diligence Workflow
• Chapter 8: Post Due Diligence and Case Studies
• About the Website
• About the Author
• Index