China due diligence: Suspicious minds?

The crisis of confidence in overseas listed Chinese companies began with a phone call in November 2010. Sitting in her office in California, Susan Woo, Asian services partner at accounting firm Frazer Frost, contacted Zou Dejun, CEO of Rino International Corp., an environmental equipment manufacturer based in Dalian. The question was simple: Had Rino fabricated six customer relationships and overstated its 2009 revenues, as short sellers were alleging? Woo established that two of the six contracts didn't exist, and that there might be problems with 20-40% of Rino's other commercial agreements.

The company quickly crumbled, slipping from NASDAQ to the pink sheets, while Frazer Frost, now known as Frazer, was left with a shattered reputation. It represented the first clear-cut vindication of a short-seller attack on a Chinese firm that had listed in the US through a reverse takeover.

Reverse takeovers were popular among Chinese companies because they are cheaper and easier than a full IPO and involve less regulatory oversight - 159 took place between 2007 and the first quarter of 2010 alone, according to the US Public Company Accounting Oversight Board. The Rino case gave fresh impetus to a host of short-sellers and hedge funds to scour the operations of companies and identify those who had misrepresented themselves to public investors.

The rot focused on the US bourses but wasn't restricted to it. Mid-cap Chinese firms trading in Toronto to Hong Kong were implicated and prices took a hit, regardless of whether they were guilty of fraud or simply tainted by association. China Agritech and China Forestry Holdings, both of which are backed by The Carlyle Group's Asia Growth funds, are the highest-profile of a raft of cases involving private equity firms. Anecdotal evidence suggests that problems also exist at plenty of other, as yet unlisted, portfolio companies.

Under the spotlight

The situation has put pre-investment due diligence in China firmly in the spotlight. Is the pressure to close deals so intense that private equity firms are cutting corners? Established players claim their oversight processes are suitably entrenched and their deal-sourcing sufficiently proprietary that the quality of due diligence hasn't suffered. Head into the mid-market, though, and it is a different story.

"Competitive pressure has forced people to do less due diligence," says Frank Tang, CEO of FountainVest. "Some of these domestic funds will say they won't collect a management fee until they make an investment. It seems great for the LPs - they're only paying based on the amount invested instead of the amount managed - but it's not. The GPs have no money to hire quality professionals or external consultants to carry out due diligence."

It is a refrain echoed, in slightly different keys, by many in the industry: Private equity funds have grown too big in China and teams struggle to find the time and resources to deploy capital; competition for deals has shortened the closing period, resulting in oversights; the growth capital space is overpopulated and opportunistic, with firms pursuing deals across dozens of sectors.

While some of these problems are systemic and will take time to fade away, recent concerns over due diligence have at least reminded some industry participants of the risks. As one China-based GP puts it, the likelihood of investing in an outright fraud in China is now somewhat lower than it was 3-5 years ago.

"We are seeing a more substantive being taken by foreign investors in Chinese companies," says Doug Ferguson, transactions and restructuring partner at KPMG China. "People are taking less for granted and looking at a lot more transaction-level detail and carrying out more sample tests."

Areas in which other Chinese companies have found to be weak are now subject to specifically directed due diligence. Invoices are scrutinized and representatives visit banks to verify key information from source documentation. Income statements are taken to pieces and cash, receivables, inventory and fixed asset information parsed for suspiciously large or small entries that might indicate falsification. Site visits are conducted to ensure that financial statements make sense based on what is seen on the ground and key customers and suppliers are often interviewed to verify trading relationships.

Ferguson adds that investors are also paying more attention to social welfare obligations - whether the target company is making the correct payments for the correct number of employees - and potential liability under the US Foreign Corrupt Practices Act.

Commercial and investigative due diligence specialists agree that there has been an uptick in business. Kent Kedl, managing director for Greater China and North Asia at Control Risks, which looks into the market reputation and track record of companies and their founders, notes that hedge funds and investment banks in particular are more willing to hire external consultants. Matt Fish, managing director at New Pacific Consulting, is more circumspect. There is greater demand for the commercial intelligence his firm provides, but it is concentrated among the major players, with most mid-cap private equity houses still opting to do the work themselves.

"Due diligence is being done in most funds on a subpar standard because there is so much competition," Fish says. "Doing 8-9 term sheets anywhere else would get one deal across the line, but in China its 15-20. Funds don't have the resources to cope."

This has two immediate implications: quality and time. If an external consulting firm is hired for a due diligence project it has limited control over how the end product is used. A 200-page report on a target company's market position is unlikely to be slotted directly into the investment proposal; the deal team will select certain elements for inclusion in documents that are presented for consideration.

Window dressing is nothing unusual in private equity and the investment committee's job is to cut through any embellishment and make an objective decision. The issue in China is misrepresentation.

A standard due diligence effort from a Big Four accounting firm typically takes 2-6 weeks. It involves an assessment of the target company's underlying business position and often results in the prospective investor adjusting performance metrics. But it is not an audit. Industry participants note that uncovering structural and deliberate misrepresentation can be incredibly difficult in a short period of time.

"In the growth sector we see the whole spectrum of due diligence, from those that are very thorough to those that are light touch," says David Brown, Greater China private equity group leader at PricewaterhouseCoopers.

"For example, they might only ask us to check the bank balances and we would then issue a report saying that was all we were asked to do. You really couldn't describe such limited work as ‘due diligence' as the term is commonly understood, but in some cases it may be that they are telling LPs that they always get a Big Four firm to do due diligence and point to the name in the report."

With their reputations at stake, Big Four firms claim they are increasingly careful in taking on new clients in China.

Time is a factor when several private equity players are competing for the same deal. Given a choice between one investor that wants to devote four months to deep analysis before signing anything and another who is willing to reach an agreement on the spot, most Chinese entrepreneurs take the money. As a result, closing periods have been squeezed, particularly in the venture space. Group-purchasing website Lashou.com, for example, raised $166 million in three rounds of funding within 13 months of its launch early last year.

In China, a country not known for the breadth and accuracy of its publication information sources, the inherent risk is that problems will go ignored. It also threatens to reduce the due diligence process to a box-ticking exercise, with little time spent on the ground getting to know company management.

"Time gives you the luxury of just observing, kicking the tires and bringing in experts - there's no substitute for that," says Derek Sulger, founding partner at Lunar Capital Management. "No one should be making investments based on little more than 3-4 interviews with analysts."

Lunar Capital usually spends three months to one year engaging with a target company. Sulger says the process is part science and part art - the science is the background checks and legal and financial consultancy work and the art is making judgment calls on senior management. "One approach I have found effective is to ask the same question 100 times in different ways throughout the management team," he says. "It's very hard to perpetrate a falsehood because you need everybody to be consistent."

Other industry participants outline a similar approach. Investment professionals sit in on a company chairman's meetings, observing him in 30-40 situations a day over the course of 3-4 months. About two months in, consultants are usually hired to conduct due diligence in specific areas, supplementing intelligence already gathered. An expert in the target industry, whether in-house or external, is expected to come out of meetings with company management having noted down 100 follow-up questions and highlighted 25 inconsistencies.

"Spending a lot of time with an entrepreneur in different contexts and iterating into greater depth on the business is naturally a baseline in getting to know a potential partner," says Homer Sun, a partner at Morgan Stanley Private Equity Asia. "Comfort level with an entrepreneur is the core issue in minority investing in China and so all our diligence ultimately goes towards developing a comprehensive view."

Too big, too fast

The question is whether this kind of rigor is employed widely enough. China is perceived as one giant deal shop, with venture and growth capital firms pursuing four times the number of transactions that would be attempted by a Western outfit with comparable resources. It is a consequence of too much capital chasing too few deals, and can be traced back to ever-expanding fund sizes.

Sequoia China Capital Partners Fund I closed at $200 million in 2005, and AVCJ Research has records of 12 investments. Based on transaction values for 11 of the 12 (one wasn't disclosed), the average deal size was $12.5 million. Less than one year later Sequoia was back in the market raising two more vehicles, worth $250 million and $500 million, respectively. AVCJ has 10 recorded deals and the average transaction size for the nine disclosed was $67.2 million.

Investors have confidence in Sequoia and, in Neil Shen, the firm has a leader who is a well established dealmaker. Much the same can be said of Andy Yan, managing partner of SAIF Partners. SAIF closed its second fund at $650 million and then attracted $1.1 billion and $1.3 billion for its third and fourth vehicles in 2007 and 2010.

One fund-of-funds LP who has put money into the private equity firm's funds and plans to continue doing so nevertheless warns of the dangers of pursuing size above all else. "A fund of $1.3 billion is too large but they have managed it," the LP says. "If I were Andy Yan I would go out and raise a $750 million fund next time. You have to ask why Chinese firms feel the need to raise more and more when GPs in Europe and the US come back with the same size fund on each occasion."

No one AVCJ spoke to could recall a China fund returning money to LPs, having decided more money had been raised than it could realistically deploy.

Contrasts are drawn with US and European investors in terms of fund scope as well as size. Private equity firms build a reputation for excellence in certain sectors and retain that focus. While most China-based fund managers accept that specialization is the long-term objective, they are resolutely sector agnostic for now, arguing that the industry isn't mature enough for more nuanced strategies.

But even where attempts are made to limit investment scope, the range of companies that come under consideration is dizzying. Sulger offers a snapshot of Lunar Capital's deal log for one week in October. It included a gas recovery supply specialist, an oil-drilling tubes manufacturer, an air conditioning retailer, a packaged foods producer, a copper miner and a ball bearing company. "We have a strategic focus and still we field deals that come from all over the place," Sulger says. "The typical renminbi fund would look at all of them and raise more money."

An unsustainable approach

Strong returns can hide a multitude of sins, but the concern is that the prevailing growth capital strategy is simply unsustainable. A well-run venture capital firm might have made small investments in 40 portfolio companies and 8-10 underperform, but this is more than made up by the two companies that deliver returns of 20x or more. Taking the same approach to growth capital doesn't add up, industry participants say. Larger investments are made in a smaller number of firms and unless IPO exit multiples match the highs achieved on China's small-cap boards last year, the margins are much lower.

"In the growth cap model you cannot afford too many mess ups - a 2.5-3x return on a fund level is pretty hard if you have a couple of big zeros," says Doug Coulter, head of Asia Pacific private equity at LGT Capital Partners. "It's no different from fund-of-funds. The thing that will kill you is backing a manager who cuts corners and doesn't return capital."

The problems concerning reverse takeovers are temporary and the lessons public markets investors have learned about backing an overseas-listed Chinese company on talk of emerging consumer classes alone may yet become ingrained. But will growth capital firms reassess their attitudes towards due diligence in the long term? The issue appears to rest on a rationalization of investor sentiment, which would be helped by the removal of multiple arbitrage and other systemic problems.

"There are some very selective memories out there," warns Kedl of Control Risks. "People might end up saying they spotted suspect companies a mile away and weren't the suckers who got drawn into the deal. That level of hubris is very dangerous in China."

 

SIDEBAR: Anatomy of a fraud - the telltale signs

Few chairmen of Chinese companies turn up to work one day with the intent of perpetrating a fraud. Many indiscretions arise from ignorance of the regulations - such as failing to understand US GAAP accounting requirements - or ingrained bad habits. For years, it has been standard practice among smaller private firms to keep multiple sets of books, one to show the tax authorities, another to show investors, and a third internal use.

The problems often begin as creeping fraud as executives discover loopholes. Telltale signs of a fraud fall into four categories: excessive reliance on related-party transactions; exaggeration of market position; inflated revenue figures; and cash problems.

According to Doug Ferguson, transactions and restructuring partner at KPMG China, the first step is to analyze the company's financial statements and identify key related party balances on balance sheet and transactions in the income and cash flow statements. Large related party assets and liabilities may reflect non-market related trading relationships, asset ownership and recoverability problems which can distort the true performance and position of the target company.

Unrecorded liabilities is another major but common challenge in due diligence.

David Brown, Greater China private equity group leader at PricewaterhouseCoopers, recalls examining a capital intensive business with strong sales growth that seemed unusually profitable. The company had been adding more and more fixed assets to expand capacity, but it emerged that the party from whom it acquired the assets was the same in each case. They were told he was nothing more than a middleman.

"We looked into the middle man and found that he was an old school friend of the company chairman working out of a tiny office," Brown says. "We guessed it was a parallel business."

Further investigations suggested that the company was overstating what it paid for the assets and the difference was siphoned back into the main business from the parallel operation and used to cover expenses. In this way the company could shift expenses out of the profit and loss account and instead record the cost as assets on the balance sheet. The private equity firm considering an investment pulled out but the company managed to go to IPO two months later.

Matt Fish, managing director of New Pacific Consulting, adds that much can be established through basic channel checking. He recalls carrying out due diligence on a proposed deal involving the consolidation of three companies producing related construction vehicle components. The entrepreneur who was promoting the deal claimed the company had a backlog of thousands of orders, but New Pacific Consulting discovered the reverse was true.

"We spoke to 14 major distributors and 12 were trying to cancel their contracts because of quality problems," Fish says.

 

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• Topics
• Greater China
• Investments
• Advisory
• China
• professional services
• Industry best practice
• GPs
• Morgan Stanley Private Equity Asia
• Lunar Capital Management
• KPMG
• PwC