How investors can avoid due diligence pitfalls in China

While institutional investors were still recovering from the shocks of some accounting scandals involving Chinese companies listed on U.S. exchanges through reverse merger, Caterpillar’s $580 million write-down due to fraudulent accounting practices of its Chinese subsidiary cast yet another chill on future transactions U.S. companies and/or investors are considering.

In the reverse merger examples or Caterpillar’s fumbled acquisition, the ultimate problem lies in the lack of quality due diligence. Standard due diligence, including validation of documents, materials and interviews of the management team, has proven far from sufficient in a market like China’s.

The biggest challenges come from prevailing business and transaction practices in China, which are dramatically different from those in the United States. One of the most common practices by Chinese companies is the conducting of their business in cash without providing VAT Fa Piao (which means official receipt used by Chinese tax authorities to calculate and collect VAT taxes) to purchasers of goods or services.

There are three primary taxes a Chinese company pays to tax authorities, Corporate Income Tax (CIT), Value Added Tax (VAT), a tax collected each time a business purchases products in the supply chain, and business tax. Standard CIT rate is 25% and 17% for VAT. Business tax, imposed on businesses other than manufacturing, varies from 3% to 5%, depending on the type of business.

However, some Chinese companies tend not to play by the rules. For example, when a vendor which makes steel sells its products to its customer, such as a refrigerator manufacturer, instead of collecting VAT tax from the customer, the vendor may offer a cheaper price of steel to the manufacturer if VAT Fa Piao is not required, which means the vendor does not collect VAT from the refrigerator manufacturer, the buyer. In this way, the vendor can report lower sales, which will lead to less VAT, CIT and other related taxes, while the manufacturer pays less for its steel. This practice may well run throughout the whole supply chain.

When a company prepares to go public or to be acquired by a third party it has to restore all the VAT and CIT owed to tax authorities. It is a challenging task and many issues may arise. The first issue is to what degree the restoration will extend, which dictates the revenue and income the company will reflect on the financials it may present to investors/buyers. If the revenue and income are restored to a level that is slightly below or up to the actual level, it is acceptable. But if the revenue and income are inflated throughout the process in order to attract investment, this obviously becomes very problematic.

How does a company restore its VAT and CIT? First, the company has to work closely with their suppliers and vendors to locate the uncollected VAT. The company may have to absorb any costs and expenses incurred by the restoration. Second, they have to go to the local tax authority and relay the truth. Both parties have to negotiate terms and conditions and reach an agreement. A large number of local governments in China provide incentives, including tax benefits, to companies to encourage them to go public. The local authority for example, may allow the company to pay the tax it evaded in past years through installments after the company goes public while some may even agree to forego the tax the company owed in the past and agree not to penalize the company. In return, once the company goes public it will file their tax returns truthfully and therefore bring more tax revenue to the local government.

It is widely known that some Chinese private companies keep multiple books. The discrepancy between the revenue and tax a Chinese company reports with China’s SAIC (State Administration of Industry and Commerce) and to the tax authority has been used by short-sellers to accuse a Chinese company of accounting fraud. In most cases, it is misleading. Most companies treat the annual filing with SAIC as routine and often outsource the work to a third-party service provider. Even with the tax authority the company does not report the full amount of income. Tax evasion is a prevailing practice in China. Some people blame it on the high tax imposed on corporations by the government.

Thus the question, is there an efficient way to find out a realistic and accurate picture of a company’s revenue? The answer is yes. However, an investor should be prepared to pursue multiple avenues to piece the puzzle together. One reliable information source is the company’s bank(s). Most private companies obtain loans from local banks. While applying for a loan, companies are typically asked for a lot of information by a bank, especially if it is a private company. Secondly, visit and speak with the company’s major distributors to evaluate the business. Distributors have first-hand knowledge of how the company’s products are performing in the marketplace. Thirdly, conversations with major vendors should shed light on the company’s business. For example, a soft drink manufacturer’s container supplier will tell you how many containers they have sold to the manufacturer. Finally, do not forget the company owner should hold the best answers to your questions. Most business owners are willing to share more information if they believe you are sincerely interested in helping their business. We suggest having a conversation with the owner in a private and discrete manner ensuring him/her that you will keep what you learn from your conversations confidential.

We observe that some service providers mislead Chinese business owners by setting an unrealistic IPO date or minimum amount of net income that the service providers believe will be attractive to investors. Because of that, these service providers offer to help business owners re-engineer their financials to meet the desired criteria. It is critical to qualify thoroughly the credentials of the service providers who work with the business owner.

On the other hand, some investors want to strike rich fast without putting forward too much effort, and, therefore, setting unrealistic criteria for their investment targets. The reality is that there are not many companies that are ready to go IPO within a short period of time in China. Most of them need a lot of help, capital and time to meet IPO criteria. Until investors set their expectations correctly, Chinese companies will continue to try to “re-create” themselves to please investors.

Unlike the U.S., China lacks sophisticated background check infrastructure. Thus, how does one conduct the essential background check? Online via a search engine is a reasonable starting point. Since Google is blocked by the Chinese government, Baidu is the best option in China. Secondly, ask for detailed resumes from the senior management and do due diligence on each of them and the companies they worked for previously to assess what kind of people they are and whether they potentially have any issues of concern, such as dishonesty or fraud, that may raise a red flag. Additionally, one should also try to learn about the business owners’ family members. In China, wives often control the finances of a family and, therefore, they may have considerable impact on their husband’s behavior, values and business decisions.

Sometimes, you may have to rely on and trust your instincts. If someone does not look or behave like a decent person, you may well be right. A company that owned and operated a dredging business once approached my colleagues and me. After meeting with the two owners one of our team members from China expressed her concerns for the seemingly ridiculous reason that one of the owners had a “bad” guy’s face. We did not brush off her doubt; instead we started looking into the situation. The routine background check did not come back with helpful findings. We continued to talk to people who knew this owner. In the end, we discovered that this owner with ‘bad” guy face was deported from the U.S. more than 10 years prior for involvement in illegal business activities. Never be afraid to trust your instincts.

China has a very different business environment and practices than the U.S. Being well aware of the differences will allow investors to understand that standard due diligence practices will likely not work very well in China. Some of the guerilla techniques, or irregular techniques, we have discussed are essential to the conducting of adequate due diligence there. Institutional investors have to spend the time and money in the trenches kicking the tires and cannot rely solely on the big four accounting firms or large law firms to do the work. It is not harmful and often it is prudent to be skeptical about what you see. Keep asking questions and dig deeper. Always be willing to walk away from a potential deal that seems too good to be true, especially in China. But with proper, thorough due diligence, investors have and will continue to identify and profit from the many excellent investment opportunities that exist in the dynamic and rapidly growing Chinese economy.

Coco Kee is Managing Partner of Kee Global Advisors LLC (KGA), a corporate development advisory firm based in New York. KGA advises companies on cross-border expansion between China and the U.S., specializing in market entry and customer acquisition, growth capital raising and M&A.

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