Doing Due Diligence when investing in China Raymond Woo Managing - - PowerPoint PPT Presentation

Doing Due Diligence when investing in China

Raymond Woo Managing Partner, Greater China Operations Ernst & Young

22 May 2012

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China remains a hotspot for inbound FDI

► China’s GDP reached USD7.3 billion in 2011, second only to the US. ► Financial crises reduced 2009 FDI to China to USD90 billion, not because of lower market prospects, but because of financial problems of the investors. ► Rising income and demand for luxury goods will continue to attract FDI to China in 2011 and 2012, as inbound FDI reached USD105 billion in 2010.

Source: UNCTAD (United Nations Conference on Trade and Development), 24 October 2011

USD’billion

80 60 40 20 20 40 60 80 100 120 2006 2007 2008 2009 2010

FDI Outbound FDI Inbound

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E&Y is active in China’s M&A market

Typical M&A deals in China

Type of Target Company Business Company Deal stake ► Shandong Lingong Wheel Loader POE Majority ► Tianhe Chemicals Specialty Chemical POE Minority ► Golden Jaquar Restaurant Chain POE Majority ► POVOS Electric Appliance Kitchen Appliance POE Majority ► Dabao Cosmetics SOE Majority ► Fujian Sedrin/ KK Brewery Breweries SOE Majority and Huaneng Debier/ Yangji Nuobao Minority Harbin Brewery/ Tsingtao Brewery Zhejiang Shiliang ► Yashili Dairy products POE Minority ► Web Education POE Minority

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Due Diligence issues varies from transaction to transaction

Typical DD objectives ► Identify deal breakers early ► Gather relevant information for informed decisions

► Valuation ► Deal structure ► Liabilities exposure ► Funding requirements ► Representation & warranties

Typical DD issues

► Accounting errors and

differences

► Quality of earnings ► Liability exposure ► Fraud and unscrupulous

business practices

► Valuation gap ► Other transaction issues ► Representation &

warranties

► Price adjustments

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Typical due diligence issues

► Accounting errors and differences

► Revenue recognition ► Cash vs accrual basis of accounting ► Accounting estimates ► Doubtful debts ► Obsolete stocks ► Warranties ► Staff benefits ► Other GAAP differences ► Not uncommon to see profits reduced by 20+% after DD adjustments

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Typical due diligence issues

► Quality of earnings - sustainability

► Cost structure ► Product mix and profit margins ► Cost-to-income ratio ► Sensitivity analysis ► One-off adjustments ► Stand alone adjustments ► Related party transactions

► Analysis is limited by

► Free access to people and information ► Use of manual accounting system ► Design of chart of accounts

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Typical due diligence issues

► Liability exposure

► Contingent and off balance sheet liabilities ► Cross-guarantees ► Onerous contracts ► Commitments ► Land use rights ► Tax exposure ► Multi-sets of books ► Negotiated tax rebates ► Improper CIT/ BT tax adjustments ► Customs duty – under-declare import price and misuse of bonded materials ► Under-reporting of IIT ► Penalty: up to 5 times (with no statutory bar) ► Share deal or asset deal? Transaction tax rates

Asset deal

► VAT @ 2 or 17% on fixed

assets (pre or post 2009)

► BT @ 5% on intangibles ► RPGT @ 30-60% on gains ► CIT @ 25% on profits

Share deal

► Stamp duty @ 0.05% on

value

► Capital gain tax @ 25% for

domestic seller, @ 10% for foreign seller.

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Typical due diligence issues

► Fraud and unscrupulous business practices

► Inflated sales ► Fictitious transactions and assets ► Complex distribution channels ► Undisclosed liabilities ► Kick-back and bribery ► US: FCPA; UK: Commercial bribery

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Typical due diligence issues

► Valuation gap

► Acquisition is expensive: average PE multiple 25 X to 50X ► SOEs can’t sell below 90% of prescribed valuation ► Need to have deep understanding of assumptions underlining projections and valuation model

Average PE of major stock indices

PE PE of Shenzhen zhen Composite

• site is higher

er than Hang Seng’s and S&P 500’s and has rebounded

• unded faster

er

0.0 0.0 5.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0

Dec 31, 2008 Dec 31, 2009 Dec 31, 2010 Dow Jones S&P 500 Hang Seng Shenzhen-A Shanghai-A

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Key take away……………

► China is a developing market, transaction issues not peculiar to China ► China is big – one size doesn’t fit all ► Diverse in geography and demographic ► 56 minorities, 200 dialects, in 22 provinces ► Internal alignment is important ► China vs HQ team ► Division, finance and legal teams ► Involve advisers early ► Don’t limit scope of DD ► Don’t get “trapped” in the “This is how it’s done in China” syndrome ► Doing transaction in China takes time (can take 3X+ longer) ► Patience, patience, patience ………