Why you should do Due Diligence in China

In the last year, we have received enquiries about this more than ever. In this article, we analyze the reasons behind this increase, the most common types, and some final advice you can follow to minimize risks when doing business in China.

1 Reasons:

When things are stable, you have been working with a Chinese business partner for years, everything is going smoothly, and both parties are making a profit, there is no need to dig deeper unnecessarily. However, “when the tide goes out, you see who is swimming naked” said Warren Buffet.

In the last 2 years, international companies had to make significant changes: reduce personnel, change location, cut costs, adjust strategies, implement new policies, acquire or merge with other companies, and so on. In many cases, the foreign investor cannot travel to China, has been away for a long time, cannot visit suppliers, manufacturers and clients, or has decided to leave the country. As a result, the negotiation power and authority have been decreased and transmitted to the Chinese counterpart. Basically, they are losing control over their China business. At this moment, they find out that there have been irregularities with staff, financial statements, transactions, stock management, production, expenses and HR-related matters. How do they solve it?

2 Types of Due Diligence:

No matter if we are talking about a new potential partner or an existing one, a purely local company or our own subsidiary of the overseas headquarter, it is highly recommended to conduct an assessment of their current situation to guarantee they comply with regulations and business practices, before engaging in a close business relationship.

Some clients ask for a Financial Due Diligence, where we help them analyze their prospective partner´s financial statements, stability and other associated risks, make sure the accounting is done correctly, compliant according to the tax bureau, and combine it with an Audit. A few include a Tax analysis too, sometimes exporting companies can benefit from tax reductions they are not aware of. Another type is the Legal one, where we assess whether the target company has had any dispute, conflict, their corporate governance, meeting minutes, and so on. There is as well the HR focused, to check whether they are being compliant with Labour and Employment related regulations, contracts, agreements, compensations, terminations, handbooks, etc. Some industries need the Operational, to check their manufacturer´s production, stock, employees, assets, technology, equipment, etc.

The client can also decide how precise and accurate they want this report. It can be a very simple business check-up before starting a collaboration relation, to assess their basic information such as a legal representative, business scope, bank accounts, legal background, address, staff, etc., or it can be an extremely thorough one with all financial, tax and legal background from the last years together with a Feasibility Study Report for the new project. There are more types, depending on the industry, the company and the strategy. Ask your advisor which one would suit you the most.

3 Advice:

Do not assume anything: whenever there is a lack or gap of information, do not assume it works the same way as in the home country, things are done differently here and business practices are also different, because of industry-specific information, personal relationships, know-how, individual interests, connections and guanxi. The perfect sample of your ideal product will not mean the mass production will be the same, QC is key, especially on site, have a control system before, during and after production. Make the “violation of agreement” financially unbeneficial for your partner, in case things are not done correctly, implement a system that enforces the supplier or manufacturer not to think of breaking it. Find out which type of Due Diligence is the most helpful for your company and information you need to know before establishing a cooperation with a known or unknown partner.

Do the homework after the DD: the excuse “this is how we have been doing things for the last years” should not be a justification. Whatever it is that the experts find out, the irregularities need to be corrected. The next step should be to implement an internal control system and ensure this is being done in compliance from now on. It is the equivalent of going to a nutritionist, reading our health report, and then doing nothing and not changing our diet. Leaving everything until the end of the year for one audit report will mean little to everyday business. It would be like going to the gym on December 15th expecting to get a good fitness report on December 31st but not doing exercise the rest of the year.

Keep in mind the Chinese mianzi: in the business culture, some bosses might not like being audited or investigated by a third party, it might feel like there is no trust or they are losing face. Nobody likes to be seen that their credibility is being questioned. Even though this is being more open and widely accepted, the communication with the key people about conducting Due Diligence must be done correctly, in the best interest of both parties. Keep in mind the 4 steps: communicate how this process will be done, encourage transparency and collaboration when providing sensitive information and documents, explain how the internal control systems will be implemented, and finally, ensure there will be a follow-up to test the efficiency of the changes.

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