Ninety percent of problems when setting up business in China can be avoided by the deployment of due diligence at the front end of the investment planning. Here we point out some of the areas that can hinder a sensible approach to due diligence, the hidden risks and basic checks. The process does not have to be expensive.

Purchasing product from China

Quality control is one issue of course your responsibility as a buyer to ensure that the product you are purchasing meets the legal requirements of your own nation's legal standards. But there are other issues that can and do affect the purchasing process and if understood and rectified, can reduce the risk.

Profit margins

With China joining the WTO, one effect has been to introduce increased competition into domestic industry. The Chinese tend to have a knee-jerk reaction to this and automatically reduce prices. It is also true to say that many international buyers perform highly aggressive negotiating and purchasing policies that are intended to get the best possible financial deal for the buying entity. Some indeed, are utterly rapacious. There is a link between aggressive purchasing and quality risks, and it has largely been ignored. But squeeze the manufacturers too much, with wafer thin or even no profit margin capabilities, and the pressure and incentive arise for the manufacturer or their supply chain to cut corners. I see it essentially as a moral issue--you need to allow your supplier to make a reasonable dollar out of your business. If you do, it will keep them honest and more committed to you.

If not, there is a risk of the following equation occurring:

A: Aggressive Pricing x Reduced Profit Margins = Cost Cutting by Supplier

B: Reduction in Quality + Minimal Quality Control Checks = Risk of Contamination

A+B = C + Substandard Products

C = Risk of Litigation

Due diligence here can also be measured financially: The cost of litigation and award payouts set against purchasing costs.

Operational due diligence overview

Chinese enterprises often lack useful and reliable operational information and some transactions have not lived up to acquirers' expectations after the discovery of operational surprises or weaknesses. The likelihood of buyers being disappointed by the performance of the target company can be reduced by conducting operational due diligence (ODD).

ODD can be a highly effective tool in helping the buyer understand exactly how the target company works, which in turn leads to a trouble free transition after the consummation of the acquisition. It is also proved effective at assisting the buyer in evaluating how well the target's current operations support the future strategic objectives. ODD should include a detailed assessment of: the functional operations of the target and the processes and systems supporting it, the interconnectedness of these operations and the likely impact of operations on the future financial value of the company.

ODD can be used at variety of stages in the acquisition process, but is typically used to achieve one or more of the following outcomes:

- Target assessment

Identifying potential operational enhancement upside opportunities, along with the key commercial issues associated with the deal. The unforeseen opportunities that might deliver say, an extra $10 million to the bottom line. When factored into a valuation of say, 10 times cash flow, and such an uplift translates into a sizeable $100 million of additional value. That can be the edge a buyer needs to place a deal winning bid in a competitive bidding process.

- Bid evaluation

Reviewing management structures and controls and providing an assessment of operational effectiveness and benchmarking the business against other similar businesses.

Identification and validation of any assumed operational improvement initiatives that underpin the target's business plan and assessment of the business's capability to deliver each initiative. ODD will identify the deal killers-aggressive management plans that simply won't fly.

- Post deal

Highlight operational areas where improvements can be made to enhance productivity and profitability and work with the management team to accelerate the improvement process.

- Key operational functions

A company's operational capabilities can be the basis of a deal and specific auditing tests must be devised to measure the value chain. The steps involved in this will vary dependent upon the company being considered for investment, but should involve an on-site of the target's daily business processes and of the systems supporting the business' operations. This analysis should involve an evaluation of production capacity, raw material flows, inventory levels and all other factors that are necessary for the business to conduct normal operations.

- The key to value

ODD completes the view of the target company in areas not fully addressed by financial due diligence and can often be a very important tool in identifying the real value of the transaction. Financial due diligence typically merely verifies the target company's financial statement and attempts to opine on the potential future sales and profitability, but chiefly using historic patterns and trends as its base point. ODD goes much deeper to assess the target company's functional operations and the interactions between them. The insights gained in this process can often determine a significant amount of the transaction's value, or lack of it.

The author is with Dezan Shira & Associates. www.dezshira.com

In Issue No. 51 we will continue discussing due diligence procedures in China