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Due diligence - getting at the telling details

In the world of finance, the phrase ‘due diligence' pops up everywhere…but what does it mean when you're talking about investments in Asian companies? Brian McLeod of the AVCJ discusses the issues that must be addressed by investors.

The legal landscape
First comes ‘legal' due diligence. The specifics vary; they include checking to ensure that basics such as proper incorporation of the target company pass muster, and that the contracts that underpin the business have been properly signed off. The concern is that the business, regardless of how attractive its earnings, may be being conducted on the back of unenforceable agreements, says Robert Ashworth, a Partner with Freshfields Bruckhaus Deringer in Hong Kong.

There's also, he tells AVCJ, an increasing focus on areas such as intellectual property rights, traditionally not well documented in Asia. Tough protection for these can be critical in places such as China - justifiably famous as the land of 10,000 counterfeiters.

‘First, you've got to be organised in your approach,' says Ashworth. ‘And often that means effectively educating the key parties within the target Asian business, selling this decidedly foreign procedure [to them] on the basis that it's the sine qua non of getting the deal done, and them getting their money.'

As well, cross-checking is essential. One of the trickier bits here, in Ashworth's experience, is the simple absence of supporting documents: ‘Sometimes the trail just goes cold. And then it's not always clear how to proceed. It may be that they were lost, or just never put in place. But just occasionally, their lack is due to a specific party not wishing you to see them.”

Corporate management
Another element in a cogent due diligence exercise is the corporate - or at least corporate-directed - aspect. Parts of this process can be handled in-house by the would-be acquirer, say a private equity investor who wished to remain unnamed. By tapping internal management staff with expertise in a particular business (or perhaps retaining an outside expert in the field with a view to adding this expert to the target's management team downstream), professionals can be assigned to interview customers, suppliers, employees and marketing people, walk the assembly line and so on. In other words, to dissect the business as it really is.

It's also not uncommon for such investors to negotiate the right to appoint slected managers to the target company's management team, even if they are only taking a minority shareholding in the company.

The mutable faces behind the paper
Cultural factors add up to a big complication, says Anthony Root, Managing Partner for Milbank Tweed Hadley and McCloy LLC (Hong Kong). Root has been advising clients on major deals in the region since the early 1990s. It's a tricky landscape.

‘Asia just doesn't have a disclosure culture,' muses Root. ‘It takes time for people here to get comfortable telling you the whole story. You can go to an Asian issuer and ask a question once, and ask it two or three times over the course of a month or two and you'll get the same answer. Then finally, just when you're ready to do the deal, you'll ask once more and get a different answer.'

Not surprisingly, all this triangulating toward the truth can lengthen the due diligence time frame, by as much as two or three times. Quite naturally, the apparent laggardness spurs the potential buyers initiating the exercise to try and speed things up. But doing so, beyond a certain point, Root explains, may well put them in peril down the road. To be fair, target companies generally have very good reasons - apart from mythical Oriental inscrutability - to be chary about handing over crucial corporate information to outsiders. Call it ingrained survival reflexes.

‘Such information can be so fundamental to the business that the seller isn't going to hand it over to anyone other than a near-assured buyer,' explains Ashworth. ‘Which is why it's often held back until the very end of the process. It's frequently customer-sensitive information, or a reveal of what the “secret formula” is, the actual revenues from specific customers, where the key relationships are. The crux, in other words, of what the buyer needs to know.'

So how to test the strength of the target business during this dance of the veils? Newbridge Capital director Emerson Yip, suggests tracking a company's performance figures, versus its budget, during the due diligence period can be useful. Keeping an eye and ear open helps too. ‘Due diligence in Asian deals is complicated by family/ political/regulatory factors, which tend to be especially difficult to circumnavigate,' says Emerson Yip. ‘The trick is in finding the right channels. Most of the time, we can get at an answer. If we don't, we walk away - unless we can agree on a deal structure as a solution.'

Closing the information gap
Vis-à-vis M&A/private-equity transactions, Root adds another thought. ‘On average, across-the-board, you expect to find many more accounting issues, control issues, information and best practices gaps in Asia than you would in the United States. There, for example, you wouldn't be worrying about the US Foreign Corrupt Practices Act. And you wouldn't be likely to find that there'd been a complete misrepresentation as to the target company's compliance with some key regulatory requirement. In Asia, you have to assume that you're going to find some challenging due diligence issues with every investment that you make.'

Root's prescription for coping? ‘First, you anticipate them. With experience, you get to know where the hot buttons are, the big issues that really matter. Second, you work very closely with the accountants. And on a private-equity transaction, you make sure the accounting firm has been hired just to do the due diligence.'

In the lion's share of cases, that's likely to mean one of the big international firms. According to Jim Woods, PricewaterhouseCoopers Hong Kong-based transaction services partner, the essence of this part of the exercise in Asia must tag a number of points:

• Assessing the target's management team, not just in terms of the team's business acumen but also its suitability for entering into a ‘partnership' with a venture capital or private-equity investor

• Getting comfortable with a sustainable level of earnings for the business going forward, and what that means for the likely exit value, whether via an IPO or a trade sale

• Getting a detailed understanding of off-sheet commitments, arrangements and exposures

Be persistent… and skeptical
‘You have to have a skeptical mindset leavened by prior experience,' advises Woods. ‘You can't expect to undertake due diligence in an Asian country for the first time and think you're going to be able to identify all the possible issues that someone with specific experience of that jurisdiction could. ‘Many people fall into the trap of looking at Asia as a whole, whereas the reality is that each territory within it has its own unique issues that require local country-specific expertise to truly understand - and solve.'

Be persistent, whilst viewing issues from a number of different angles. In particular, Woods says trying to get to the sometimes murky bottom of related party transactions or other off-balance sheet arrangements will require more than simply questioning the target company's management and/ or perusing the financial information provided. In Asia, the due diligence net must be cast much wider. The process might well include talks with industry experts augmented by Internet research, background checks, inputs from collegial professionals, even IT forensics consultants.

Both legal and financial advisors stress that although most of their work, obviously, is generated by mid- to mega-sized deals, it needn't be. Stripped down but still very strategic due diligence can be done surprisingly affordably. The caveat is that much more of the planning and preparation - identifying specifically what issues are key to a particular deal - must be done by the client before he flips the advisor's meter on.

An ounce of prevention can be worth a pound of cure, especially in Asia.

Copyright © 2002 AVCJ

Brian McLeod is a senior writer at the AVCJ.

This article first appeared in the Asian Venture Capital Journal, December 2002.

The Asian Venture Capital Journal is the region's leading publication on private equity and venture capital. With readers worldwide, AVCJ provides monthly coverage of fund raising, investments, exits and the people behind them. For more information please visit www.asianfn.com