Grant Thornton – China: M&A Due Diligence Pitfalls

By Barry Tong, Partner, Advisory, Grant Thornton Hong Kong Limited

To acquire a business is a journey and in the words of Lao Tzu, “…a journey of a thousand miles begins with a single step.” One of the first steps that increases the chance of a successful merger or acquisition is thorough financial and tax due diligence. Investment decisions, mergers, acquisitions and joint ventures, if successful can propel a business to new heights, but if unsuccessful, can lead to ruin. When purchasing a business the greatest danger may lie below the surface. Due diligence gives you an understanding of the business and identifies the issues you need to know to make an informed decision and to get the valuation right.

At times we are asked, “Why is due diligence necessary?” Buyers may believe that as they have the seller’s audited financial statements, met with the seller’s management, who have confirmed their investment thesis and also visited the seller’s facilities and seen their equipment, that formal due diligence is unnecessary.

But an audit is not enough. Audits typically have a greater focus on the balance sheet than the income statement; they do not address the quality of earnings, business issues and trends, market share, customer or supplier concentrations, management, systems, or infrastructure. The standards can be quite different for due diligence as well. If the buyer is paying a multiple of earnings, adjustments to earnings and normalised revenue and expense items can have a material impact on purchase price.

Effective due diligence assesses the seller’s quality of earnings and determines the relative contribution of the various value drivers. It can corroborate the buyer’s investment thesis or provide the data required to support an adjustment to the valuation. Beyond this, due diligence assesses the seller’s personnel and systems, identifies issues to be addressed in the purchase agreement and gives the buyer a head-start on post-acquisition integration issues.

During due diligence various adjustments are made to earnings and adjusted earnings are often used as a proxy for cash flow. Cash flow, in turn, is often used to substantiate the valuation. Although the primary objective of due diligence is not valuation, due diligence establishes normalised earnings which is the “raw material” of valuations.

Given the importance of adjusted earnings, it merits looking at some of the most common adjustments to earnings.

Management proposed adjustments – If management’s proposed adjustments are not well documented or do not make sense, the buyer has no obligation to accept all or any portion of them. A ‘bridge’” can illustrate the magnitude and direction of the key factors that cause a change between two periods. These graphic pictures can be worth more than a thousand words in your understanding of what caused the difference in earnings or cash flow.

Management‘s accounting judgments – Management’s judgments impact earning. The judgments made about the adequacy of the bad debt reserve, warranties, inventory reserves, accruals, or allocations of expenses in carve-out situations can all have a significant impact on earnings and hence your conclusions about cash flow.

Accounting policies, procedures and practices – Revenue recognition, cutoffs, non-recurring items, one-time expenses (layoffs and discontinued operations), cash verses accrual accounting methods can, intentionally or unintentionally, mislead a buyer’s conclusions regarding operating cash flow. Any changes in accounting policies, procedures or practices during the periods being analysed can distort your conclusions, e.g. extending the useful life of depreciable assets between year one and two can improve earnings without any underlying economic impact.

Forecasts and run rates – Discontinuities between historical results and forecast assumptions that are unsupported or a recent significant change in run rate or the run rate assumptions require special attention and possibly due diligence adjustments. We find it useful to focus on backlog as a key short-term predictor of future revenues. The importance of backlog increases if run rates are being proposed as the basis of forecasts.

Let’s turn our attention to some specific risks that we commonly see in our due diligence work in China and some approaches for mitigating these risks.

Minority-interest and joint venture investments – Acquiring a minority interest in a business or entering into a joint venture are common ways to invest. In these cases, the scope of your due diligence should include background checks on the owners and managers. Spend time to get to know your partners over several meeting, both business and personal. The relationship with and trust in your business partner is vital to the success of your investment.

Multiple sets of books – It is common for Chinese private companies to have multiple sets of books and it is essential to understand why there are multiple sets and the differences between them. Frequently the “tax books” will understand income in order to reduce the tax liability, which may result in a potentially large contingent liability for a buyer.

Revenue recognition and cash reconciliations – We recommend reconciling cash deposits (from bank statements) to revenue. Although not perfect, it is an approach to corroborate revenue and develop and understanding of how and when key customers pay.

Owners’ compensation and personal expenses – These are probably the most common due diligence adjustment to earnings for smaller private companies. The owner’s post-close compensation arrangement must be understood and documented.

Related-party transactions – Are family members employees of the business? Do family members control businesses that are key customers or suppliers to the seller?  Relatives of the owners or managers may be on the company’s payroll, customers may include related or affiliated companies, and key suppliers may be related or affiliated by common ownership. The due diligence process needs to identify these relationships and determine if there is contractual employment, sales, or purchase agreements that will survive closing.

Transfer pricing – The seller may have sales or purchases that do not appear to be economically justified, but may be because related or affiliated companies are involved. Sometimes affiliated companies are used to move money into other jurisdictions. The ownership of Chinese companies is not always transparent and may be quite complex. Transfer pricing policies need to be understood and documented so they can be supported from a tax standpoint.

Contingencies – Adjustments here often arise from off-balance sheet obligations and can be significant surprise to a buyer. Contingencies can refer to a number of different off-balance sheet liabilities, such as leases, litigation, or third-party guarantees. Thorough due diligence is required to identify and quantify these risks. How the transaction is structured is also critical to who owns these liabilities post-close.

Management – Due diligence unveils the capabilities of the existing management team and what needs to be done if this needs to be upgraded. Is the business essentially honest? Is its administration competent? Are any problems with the financial information fixable? Will the buyer be able to engineer a higher standard of financial reporting in the target company? Management is always a key fixture in Chinese company and attention to detail needs to be placed upon it. Analysing the contents of the financial due diligence also gives the buyer an opportunity to examine cultural compatibility, as well as the level of competence that the buyer has to work with.

Professional advice – These are just some of many financial due diligence issues that need to be addressed – they may vary depending upon each specific case. A good professional adviser will be able to discuss all issues with you, assess what needs to be checked through, and allocate dedicated on the ground staff to look into and report back. Advisers who subcontract such work are not ideal, as they may not be able to manage the process directly, owing to a chance of an increased margin of error. Proven track record and sufficient resources in China should be taken into consideration.

Clearly, the process of acquiring a business is a journey with many risks, but in the words of another philosopher, “…any journey well begun is half finished.”

Grant Thornton Hong Kong Limited is a member firm of Grant Thornton International in Hong Kong. We are an integrated part of Grant Thornton China, offering a full range of assurance, tax and advisory services to privately held businesses and listed companies of all sizes.

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