The ultimate goal of all due diligence whether you are a first-time or experienced investor is to validate the assumptions made in determining to go ahead with your investment. Quite simply put, are you buying what you think you are buying? Key questions to be addressed in the financial due diligence include:
- How has the target company really performed in the past and what are its true earnings prospects?
- Does the company have cash flow adequate to support its growth and day-to-day needs?
- What's not being reported on the balance sheet and are there any skeletons in the closet that result in contingent liabilities?
Getting to the bottom of these questions often means going beyond the publicly available information and speaking directly with management. At this level of access, the picture presented by management often is not nearly as straightforward as it appears on the surface. Even for listed companies in certain Asian markets where the corporate governance systems are considered to be relatively strong, such as Hong Kong and Singapore, the common financial due diligence issues outlined below are still equally applicable.
From marble quarries in Northern China to cable TV content providers in Taiwan, the common deal issues arising from financial due diligence undertaken in Asia can be categorised into seven key areas - the Seven Deadly Sins.
Sin 1: Non-sustainable historical earnings
When presented with the target's income statement on which a true and fair audit opinion has been issued, a common misconception is to assume that the reported earnings represent the maintainable earnings of the business you intend to acquire. More often than not this is not the case. Audited financial statements are prepared only to comply with local statutory and tax requirements, or for a general purpose use rather than for your specific transaction and earnings-based valuation model.
To understand the reality behind the reported numbers and the true quality of earnings, an in-depth review of the business and detailed management accounts must be performed. Adjustments need to be made to reflect the business you intend to acquire as it stands currently. Common adjustments include stripping out the impact of one-off events, lost customers, discontinued products or businesses, changes in cost structure and bookkeeping errors. While these types of adjustments are found in markets outside Asia, the net impact of adjustments on reported earnings in Asia is comparatively greater.
Differences between the target's and your accounting policies must also be adjusted to ensure like for like comparisons. This is particularly important in Asia where the local accepted accounting practices may be substantially different from International Accounting Standards or US GAAP particularly with respect to revenue recognition, capitalisation and off-balance sheet financing policies.
Sin 2: Poor quality forecasting
Within Asia, forecast information is seldom prepared on a regular basis if prepared at all. When a forecast is prepared, the target is usually completing it as a special exercise for the sole purpose of the financial due diligence exercise with limited or no input from sales, marketing and operations management. Accordingly, the forecast is prepared on a high level basis with oversimplified assumptions and no clear plan as to how the forecast will be achieved. Assumptions may be internally inconsistent and difficult to reconcile to historical results. The classic "hockey stick" forecast where a period of declining results is followed by a blue-sky forecast is a common occurrence.
Usually, a forecast will focus exclusively on earnings with no consideration of the opening net assets position or the cash flow required to support the projected earnings. Overall, the forecast prepared is often limited in its usefulness and normally would not be relied upon, particularly in a forecast earnings based valuation model.
Figure 1: "hockey stick" forecast
Sin 3: Poor quality of reported assets
Many of the businesses in Asia are family-run and it is common to find assets without a business purpose on the books as the owner-manager does not separate business and personal assets. Common examples with a strong "personal" element include club memberships, vehicles and housing for directors. Conversely, of the assets used in the business, certain assets may be legally held by the owner personally or another external entity. In China, it is not surprising to find that the target is not the owner on record for its offices and factories.
As part of the deal negotiations, it should be made clear which assets are to be included or excluded from the transfer of the business and the appropriate transfers made prior to completion. In addition, appropriate representations and warranties as to title should be sought.
Frequently, write-offs for aged receivables, directors' current accounts, intercompany balances, obsolete inventory, idle production assets and inappropriately capitalized costs need to be made. Agreement between the principals should be reached over the valuation of key assets as this may have a direct impact on how the deal is priced, particularly if a price-adjustment mechanism based on a minimum net asset or working capital level is adopted.
Sin 4: Undisclosed off-balance sheet liabilities
Companies in Asia commonly utilize imaginative ways to minimize tax liabilities that contravene taxation regulations. Common examples include under-reporting of income for tax purposes, dubious classifications of income as off-shore, fake VAT invoices (in China) and inappropriate transfer pricing practices. With an increasing trend of taxation audits, there is a risk that pursuit by the relevant taxation authorities could result in substantial hidden liabilities, penalties and exposures. In some cases, the quantum of the exposure combined with the risk of crystallisation may result in a deal breaker particularly when the seller is unwilling to provide an indemnity for the potential exposure or the amount of the indemnity becomes very significant when compared to the deal proceeds.
Sin 5: Distortion of trading performance through related party transactions and other undisclosed arrangements
Asian companies often rely on related parties to conduct business to a greater extent than their counterparts in the West. The importance of understanding the nature and extent of related party transactions cannot be underestimated as such transactions will often be conducted under special pricing terms. In a carve-out situation where only a portion of a company is being sold, it is common to find that certain infrastructure services provided on a company-wide basis, such as finance, human resources and legal, have not been charged to the target business at all and adjustments will need to be made to reflect the business as a stand-alone entity.
For all related party transactions identified, the impact on the business of a change in ownership structure should be assessed and it will often be necessary to adjust those transactions to reflect normal commercial terms. Identifying all the related party transactions in a business may not be straightforward as it is not uncommon for key management to have undisclosed competing business interests.
Sin 6: Weak controls and reporting processes
Investors from the US or Europe often mistakenly assume that due diligence in Asia can be undertaken as easily as in their home countries. However, Asian companies typically under-invest in their financial reporting systems. Primitive handwritten manual ledgers are often kept and the financial controller typically has little or no formal training. As the bookkeeping system is error prone and labour intensive, basic analytics on the numbers such as sales by product line and by customer are inherently more difficult to perform. Investors should be wary of automatically assuming audited accounts are prepared to an international standard, particularly if a local auditor has been used. All of these factors result in a lengthier due diligence process.
A weak reporting and control environment by itself will not be a deal breaker, particularly when the commercial due diligence results are favourable. However, the lack of high quality timely information does mean that an additional investment in a new system including skilled accounting personnel may be needed to obtain the quality of information needed to properly monitor your investment's performance. Such changes do not happen overnight and there may be a need for agreement early on as to what can be reasonably achieved and a timetable which local management commits to.
And the Seventh Sin?
If you've gone through the six sins above and identified issues in each of the areas, don't despair -- it's not all bad news. The six sins aren't deal killers by default. The issues identified are often used to negotiate a better price and structure a better deal for yourself. The seventh sin is failing to look past the issues to take a balanced view by weighing the risks against the upside potential in your deal. These could range anywhere from hidden value on the balance sheet, cost reduction opportunities, efficiency improvements, synergistic savings, strength of the management team and access to new markets to name just a few. The upside potential and downside risks of a deal should always be viewed together rather than in isolation. While good due diligence should help protect you from making a bad decision, it should not stop you from closing a good deal.
* Noreen Tai is a senior manager in the Transaction Services group of PricewaterhouseCoopers Hong Kong, specialising in financial due diligence and related M&A advisory services.