Japanese and Chinese companies are always particularly interested in acquiring assets in the United States. But before committing to transactions, buyers need to know exactly what they are buying, including the nature and extent of the target company’s third-party risks.

The Red Flag Group® underlines how recurring due diligence can benefit acquiring and target companies, and why it is a vital component of an overall ongoing monitoring strategy around managing third-party risks.

Why recurring third party due diligence matters

In April 2015, Japanese building-materials conglomerate Lixil received a letter from a Chinese bank informing that its new acquisition Joyou – a Chinese subsidiary of German bathroom-fittings group Grohe – had failed to repay a small loan. By May, Joyou announced that it was filing for insolvency, leaving Lixil’s management to explain to investors how a €3.1 billion (US$3.37 billion) acquisition had led to US$560 million in losses.

It turned out that, in an effort to raise funds from multiple lenders, Joyou had collateralised its Chinese factories several times over. It then lent some of that money into China’s shadowbanking sector, and that loan, combined with the subsequent collapse of a lending pyramid in southeastern China, caused irreparable damage.

As Lixil’s merger with Grohe moved to the integration stage, slow growth hit Chinese manufacturers hard. According to the Financial Times, banks called in loans from those who had re-lent into the shadow market, causing defaults to soar.

While Lixil chief executive Yoshiaki Fujimori defended his company’s auditing and due diligence procedures, by December he was gone.

This case study is notable insofar as it highlights some of the perils of a major foreign acquisition involving an emerging market such as China. But it also comes at a time when Japanese corporates are embarking on oversees spending sprees to rival those at the height of the 1980s Japanese economic bubble.

In 2018, Japan surpassed China in outbound deals. Data from Dealogic revealed that Japanese deals accounted for US$184.2 billion while those of China deals at US$105.4 billion.

Japanese and Chinese buyers are increasingly targeting assets in developed markets, where prices tend to be lower and target companies are of better quality. And they face increasing pressure from stakeholders to improve their target due diligence, with some advisers warning that the race to secure headline-grabbing deals results in sloppy diligence such as that seen in the Joyou acquisition.

By way of example, investors took Japan Tobacco to task towards during the end of 2015 when the company agreed to pay US$5 billion to purchase the cigarette assets of United States rival Reynolds American without fully explaining its rationale. Shares in Japan Tobacco dropped nine percent on news of the deal, with Credit Suisse estimating that the company had paid 65 times earnings before interest, tax, depreciation and amortisation.

The importance of renewals

In a 2014 Foreign Corrupt Practices Act (FCPA) Opinion Release, the United States Department of Justice (DOJ) encouraged companies engaging in mergers and acquisitions to take the following five steps to ensure FCPA compliance:

  1. Conduct thorough risk-based FCPA and anti-corruption due diligence
  2. Implement the acquiring company’s code of conduct and anti-corruption policies as quickly as practicable
  3. Conduct FCPA and other relevant training for the acquired entity’s directors and employees as well as third-party agents and partners
  4. Conduct an FCPA-specific audit of the acquired entity as quickly as practicable
  5. Disclose to the DOJ any corrupt payments discovered during the due diligence process

According to statistics from Dealogic, companies in the United States represent by far the most attractive targets for Japanese and Chinese acquirers. But potential targets need to ensure that they have a compliance programme that is effectively managing their third-party integrity and compliance risks if they wish to be considered as attractive assets.

Remaining attractive to a potential acquirer is just one of several reasons why renewing due diligence is a good idea. In addition to mitigating integrity and compliance risks, renewals enable companies to know more about their third parties, such as each third party’s operations, financial status, integrity profile and possible areas for improvement. Given that initial due diligence reports are immediately dated (in the sense that the information is useful but covers only a snapshot in time), renewals enable companies to keep their materials updated.

Renewals also give companies the opportunity to let their third parties know that they are watching them and keeping an eye on their activities, which can only encourage ethical conduct. And renewals offer the significant benefit of providing companies with an effective defense in the event of third party misconduct. Read more