Due Diligence in China and other foreign markets
Date Added: 12th September 2016 from Control Risks
Due Diligence in China and other foreign Markets
De-risking your choice of PARTNER
One of the most important choices a company has to make when entering a foreign market is who to partner with. Whether the partnership is formal – such as acquisition or joint venture – or informal – such as an agent, distributor or manufacture, companies need to assess the suitability of a partner's experience, connections, track record and reputation. Control Risks recommends undertaking due diligence on partners before entering relationships, but what do we mean by due diligence?
Due diligence is the process of investigating the background of a company or individual before entering a business relationship. This traditionally focuses on financial, legal, and reputational aspects of the subject company and its principals. Reputational due diligence addresses questions about the subject's background and business track record, who controls the decision-making process, and how the company wins business. In China and many other emerging markets, the extent to which due diligence helps companies make better decisions and manage risk often depends on the quality and depth of answers to such questions.
The level of depth of due diligence conducted should be commensurate to the risk that the partner poses to your organisation – in simplistic terms – a joint venture partner in an emerging market requires a higher level of due diligence than a distributor in a developed market.
Initial due diligence can be conducted by the company itself or one of its advisors, however in-depth due diligence is most effective when a specialised political and regulatory risk team works in the local language, understands the local business culture, the political and regulatory environment and techniques to gather information beyond what is available on the public record.
This comprehensive approach addresses questions such as: What is the significance of any political connections identified? Do the subject and/or their connections have high-risk profiles, especially in terms of anticorruption targeting patterns in that sector or location? Are there any recent or potential policy changes that could substantially damage or boost the potential partner company's business prospects? For example, is the local government under pressure to reduce support and push consolidation in the sector? Or is it about to allow new entrants to the sector that could threaten the client's market position?
Understanding your partner
Understanding the ownership structure of an agent, distributor, client or partner – and any political and business relationships it might have – is crucial to determining whether your business is exposed to reputational risks. Having such an understanding also enables you to assure external stakeholders that your activities are both ethical and legal.
Control Risks has a record of assisting clients in identifying a shortlist of potential partners in emerging markets by using pre-agreed criteria. These criteria can include positive indicators, such as a company's track record and its experience of working with foreign entities, or negative indicators, such as risks relating to sanctions, political exposure and broader issues of integrity, including corruption.
Once potential partners have been shortlisted we can carry out investigative due diligence into their reputations, track records and perceived integrity. Due diligence also enables clients to see if a prospective partner has failed to comply with sanctions, or contravened laws proscribing terrorist financing or money laundering.
Evaluating country risk
Country risk due diligence seeks to understand the key challenges and obstacles specific to a particular nation that a business is required to address if its market entry is to succeed. Country risk due diligence should be specific to a business' profile and proposed operation, and is an important element in any broader due diligence. It can focus on the specific threats to your business in that market or on the political and regulatory environment. It is also recommended to conduct a stakeholder mapping exercise to understand the political and regulatory connections that you will need to cultivate for your business to succeed.
Control Risks has experience providing independent, expert views that have enabled clients to learn from other companies' experiences and thereby mitigate a wide range of risks. Control Risks is positioned to deliver tailored assessments of country risk and can provide case studies of multinationals' experiences to illustrate how country risk has affected other companies, deliver scenario analysis to assess how risks to clients are likely to develop over time, provide recommendations about how to manage risks identified, and answer our clients' questions about the country.
In the past three years, changes in China's economic, political, and regulatory environment have increased the importance of due diligence. These changes are also affecting how some companies think about the breadth of understanding necessary to make informed decisions regarding entry into the Chinese market. In particular, consideration of political risk can no longer end at obvious signs of exposure, and regulatory risk is no longer seen as just a legal issue.
Political exposure: For a country where state and business have historically been interwoven, investors in China had traditionally considered any political exposure of prospective business partners as an asset. However, since 2013, the scope and intensity of anti-corruption enforcement in China has transformed, and we've witnessed tens of thousands of officials from most regions and industries having been investigated and thousands removed. Investors are now aware that political connections can be a liability.
Regulatory exposure: Recent regulatory changes in China have resulted in a more complex environment with new risks and uncertainties while existing regulations are being enforced more actively, particularly in areas such as pricing, competition and anti-monopoly law. Foreign and domestic companies are now considered to be in the cross-hairs of Chinese regulators and it is difficult to predict exactly how regulations will be enforced. This is considered not purely a legal risk; rather, it is a political risk that must be factored into commercial risks when performing due diligence on a target company.
Situation 1: A leading food manufacturer planned a joint venture with a new Chinese partner. The client was concerned the partner relied on its chairman's government connections for its recent growth. Research established that the company had a solid industry track record, and demonstrated its competitiveness before the chairman developed high-level connections. It also flagged an increase in scrutiny from the local food safety regulator. Recommendations were made on requirements and policies to be built into the deal to address compliance concerns, and follow up work was undertaken to develop a strategy for engaging local government to manage related risks.
Situation 2: An international real estate group wanted to assess the risks of expanding their relationship with a developer in south China. It was also concerned by recent purchasing restrictions and corruption investigations in the local real estate industry. Research gave a mostly positive picture of the developer, but raised some questions about its capability to deliver on the envisaged project, and about management team stability. The client was able to seek clarity from the partner on these issues. Analysis helped the clients' decision makers outside China get perspective on the local real estate policy environment, and found the corruption probes were unlikely to spread through the industry.