China Business

"China Heavy" is Back and Due Diligence is Mandatory

International due diligence checklist

Jack Perkowski, who knows a ton about about China business recently wrote a piece for the Far Eastern Economic Review, entitled, The Return of China Heavy [link no longer exists].

By “China Heavy,” Perkowski is referring to what some call the “real China,”  — the China beyond the Westernized portions of cities like Shanghai and Beijing.

The economic downturn is hastening this return:

After experiencing “China Light,” it’s difficult to imagine that “China Heavy,” the darker, less economically and legally developed side of the country, still exists. However, a slowing economy and a dramatic decline in asset prices are demonstrating that China Heavy is alive and well, and investors should beware. Like rocks in a river that only become visible when the water-level drops, signs of China Heavy are now coming to the surface as the country’s economic waters recede. Recent articles on troubled investments in China, by foreign and domestic investors alike, are once again highlighting corporate governance and other legal issues that were the subjects of the China stories of the 1990s.

I completely agree as over the last three months or so, the China lawyers at my law firm have been working nearly non-stop with what Perkowski would call “China Heavy” work.

Six months ago, 99% of our work involved helping Western companies get into China and do deals in China. Now, about half our work involves helping Western companies extricate themselves from China joint ventures and other China deals gone bad and to help them collect on unpaid debts. Since the inception of this blog, we have been warning of days like these and now that they are here, all we can do is reiterate the things Western companies must do (these things have become even more critical) to reduce their risk of problems.

Perkowski does a fine job setting out the basic things of which Western companies must be vigilant:

What should investors pay particular attention to in today’s tougher economic environment? Following are a few due diligence items that warrant enhanced scrutiny:

Accounts Receivable have always been problematic.

Despite the substantial progress made by Chinese banks, the country still does not have an efficient system for distributing capital. When times are good and property and stock prices are rising, bank loans secured by real estate or shares are plentiful. When the markets turn, the banks are quick to demand repayment. As a result, customers that looked financially secure a year ago may now be problem accounts.

Understanding the true profitability of a company in China is often more art than science.

Rapid asset inflation has made it even more difficult. For example, historical profits of many Chinese companies have been bolstered by stock-market gains. Like individuals, companies in China flocked to a rising stock market and made money on the way up. Those profits cannot be counted on in the future, and there may even be hidden, unrecognized losses on the balance sheet.

Recent sharp declines in raw material prices mean that inventories may well be vastly overstated.

In a post 2005 world when raw-material prices seemed to rise ever higher on a monthly basis, the temptation to overbuy at current prices has been strong. Also, some companies have sought to lock in prices of raw materials by entering into futures contracts with suppliers. Prior to the economic crisis, that seemed like a safe bet. Today, it can represent a large off-balance-sheet liability and an overhang on future earnings.

Off-balance-sheet liabilities are especially difficult to find and quantify in China.

A recent example: the shareholders of a company made certain promises to its workers which they chose not to disclose to the new owner, a prominent Chinese businessman, when they sold him the company several years ago. As the factory’s fortunes turned down this year, the workers demanded payment and took the new owner hostage when he refused to pay.

Getting proper title to land use rights is challenging in China.

Furthermore, in a fast growing market where getting into production as quickly as possible is the prime concern, it is often put off until later. Rapidly escalating property prices have presented an ideal opportunity to sell off or pledge real-estate assets as a way to get cash. In the current environment, investors would be wise to clarify title early in the process to determine both true ownership and the nature of any outstanding claims.

All true, and all this can be summed up with the old adage of due diligence, due diligence, due diligence.

8 responses to “"China Heavy" is Back and Due Diligence is Mandatory”

  1. I agree that Perkowski’s advice here is sound, and agree that your advice on due diligence is sound. But I’m not sure that Perkowski knows as much about China business as anyone. If you read Tim Clissold’s memoir of how he and Perkowski managed to lose half a billion dollars in China (“Mr. China”), you will find that at no point do they ever seem to have consulted a lawyer who knew anything about the China business. (They were, for example, shocked to find that a Chinese company they were joint venturing with didn’t have good title to its land, something any lawyer with three months of China experience would have told them to look out for.) Perkowski seems to have been exactly the type of client you complain about in your blog, who shows up after the deal blows up his face because he couldn’t be bothered to spend a few bucks beforehand on good legal advice. Of course, maybe he’s now learned his lesson.

  2. How much of “Heavy China” will come back? Will important foreign companies in sectors like IT, GE (a sector unto itself) and the like find that the only foreign assets allowed to leave China are the foreigers?

  3. The comment about “economic waters receding” reminds me of an amusing analogy made by Warren Buffett about Wall Street:
    “I think I said one time that, you know, you only find out who’s been swimming naked when the tide goes out. Well, we found out that Wall Street has been kind of a nudist beach.”
    Skinny dipping in China?

  4. Anonymous,
    I’ve read Jack’s book, and I communicate with him every once in a while and I am certain he has learned his lesson. In fact, co-blogger Steve is always saying that our best/smartest clients are the ones who screwed up in China for their first few years, yet managed to thrive, and now know enough to know they need help to do things right and now have enough value in their business to warrant paying for that help.

  5. Audall,
    That’s a great quote (saw it somewhere before) and it certainly applies to China.
    One of the great things about being a lawyer (and one of the reasons everyone hates lawyers) is that we profit in both upswings and downswings and right now we are getting just a ton of calls from companies that were skinny-dipping in China, particularly in signing up for joint ventures….

  6. Dan,
    I think it has come close to happening when Microsoft made a big stink about pulling out of China completely due to piracy issues and possibly a message was passed to Redmond that only the foreign staff would be allowed to leave.
    I’ve had an offer for a JV but I don’t want to get bogged down there, just do 1-2 big deals and move on.

  7. If China’s economy has a down turn, the issue of India needs to be addressed by someone. 2009 might be an opportunity for American business, or American business might simply ignore India in 2009…

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