The standard approach to due diligence

Due diligence tries to understand the background of a company or individual before entering a formal business relationship. This traditionally focuses on financial, legal and reputational aspects of the subject company and its principals. Reputational (or integrity) due diligence usually addresses questions about key areas such as the subject’s background and business track record, where real control and decision-making lie, and how the company wins business. In China and many other emerging markets, the extent to which due diligence helps companies make better decisions and manage risk often depends on the quality and depth of answers to such questions. Information constraints mean that desktop ‘box-ticking’ often misses major warning signs beneath the surface.

When the standard approach is not enough

In the past three years, changes in China’s economic, political and regulatory environment have put a premium on ensuring adequate depth of due diligence. These changes are also affecting how some companies think about the breadth of understanding they need to really make informed decisions. In particular, consideration of political risk can no longer stop at checking a politically exposed persons list, and regulatory risk is no longer seen as just a legal issue.

Political exposure: For a country where state and business are so interwoven, investors in China have traditionally had relatively little fear about the political exposure of prospective partners or M&A targets. Political connections were seen as an asset, and corruption crackdowns were relatively rare and short-lived. But since 2013 the scope and intensity of anti-corruption enforcement has been unprecedented. Tens of thousands of officials have been investigated and thousands removed. Most were not top-level leaders or were known political rivals of the President. Most regions and industries have been hit. Beyond the state sector, private firms and tycoons have been affected, sometimes severely, notably in real estate and resources. Investors are now more aware that political connections can be a liability as well as an asset, and that political exposure has become a more likely, higher-cost scenario.

Regulatory exposure: Regulatory change in China has been dynamic in the past few years. While some processes and approval procedures (such as for starting new businesses) have eased, most changes have resulted in a more complex environment with new risks and uncertainties. Both new and dormant regulations are being enforced much more actively, particularly in areas such as pricing, competition and anti-monopoly law. Both foreign and Chinese companies have come into the crosshairs of Chinese regulators and it is difficult to predict exactly how regulations will be enforced. This is not purely a legal risk; rather it is a political risk that must be factored into the commercial risks when doing due diligence on a target company.

During the double-digit growth decades, integrity, political and regulatory risks were often seen as secondary concerns and left to a last-minute ‘red flag’ check just before finalising a deal. Today, they are often core determinants of the long-term success of an investment, requiring investors to adjust both the depth and breadth of an approach to due diligence in China. The savviest investors are often thinking about integrity, political and regulatory factors much earlier and giving them a more central position in their strategic thinking about investments – recognising them as key factors in identifying the best opportunities as well as managing risks.

A more comprehensive, calibrated view of risk

Clearly not every routine due diligence can delve into political and regulatory risk – investors always have to balance the extent and cost of such work, and ensure it is appropriate for a deal’s size and its perceived risk. Where political or regulatory issues look particularly important they usually require separate, more extensive consideration before the due diligence stage. However, if they have not already been identified and assessed, these issues can be addressed with a more comprehensive approach to due diligence.

This needn’t be rocket science, but requires a dedicated, specialised political and regulatory risk team working in the local language on the ground, ideally integrated with the business intelligence team doing the ‘traditional’ due diligence, and tapping into industry and policymaking networks. This comprehensive approach addresses questions such as:

What is the significance of any political connections identified? Do the subject and/or their connections have high-risk profiles, especially in terms of anti-corruption targeting patterns in that sector or location? How might these political connections impact execution of the deal and operation once it is completed?

Are there any recent or likely policy changes that could substantially damage or boost the target company’s business prospects? For example, is the local government under pressure to reduce support and push consolidation in the sector? Or is it about to allow new entrants to the sector that could threaten the target’s market position?

Is the company a potential target for aggressive regulatory scrutiny or constraints? For example, is it in an industry targeted locally by tough environmental or pricing enforcement? Are there indicators that the company or the prospective investment could be controversial? What are the likely attitudes of key stakeholders at various levels?

This is not a substitute for more thorough types of work to understand and manage political and regulatory risk, but can often be a good ‘Level 1’ check to establish whether further work is necessary, and what it should achieve. For example, an investor might need a deeper understanding of a particular individual who appears politically exposed; a detailed assessment of how new policies in a particular industry or location will impact a target company’s business; or development of strategy to engage government stakeholders on a key regulatory issue affecting an investment.

Some recent examples of ‘Level 1’ in action

Situation 1: A major Western banking group was considering partnering with a state-owned Chinese bank. It wanted enhanced due diligence into the Chinese bank, but had also identified that anti-corruption investigations in the banking sector and recent regulatory debates might also pose unforeseen risks. We provided an independent, expert assessment of recent investigations, how the bank in question had been affected, and why these issues were not a show-stopper for the particular partnership being considered. We also analysed changing regulation on overseas remittances and capital outflows, and provided an initial assessment of how this might impact the partnership.

Situation 2: A leading food manufacturer planned a JV with a new Chinese partner. The client was concerned that the partner had relied on its chairman’s government connections for its recent strong growth. Research established that the company had a solid industry track record, and had demonstrated its competitiveness before the chairman developed high-level connections. It also flagged an increase in scrutiny from the local food safety regulator. Recommendations were made on requirements and policies to be built into the deal to address compliance concerns, and follow-up work was undertaken to develop a strategy for engaging local government to manage related risks.

Situation 3: An international real estate group wanted to assess the risks of expanding their relationship with a developer in south China. It was also concerned by recent purchasing restrictions and corruption investigations in the local real estate industry. Research gave a mostly positive picture of the developer but raised some questions over its capability to deliver on the envisaged project, and about management team stability. The client was able to seek clarity from the partner on these issues. Analysis helped the clients’ decision-makers outside China get perspective on the local real estate policy environment, and found the corruption probes were unlikely to spread through the industry.