By Control Risks

Due diligence is the process of investigating the background of a company or individual before entering a formal business relationship. This traditionally focuses on financial, legal, and reputational aspects of the subject company and its principals. Reputational (or integrity) due diligence addresses questions about the subject’s background and business track record, who controls the  decisionmaking 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.

When the standard approach is not enough

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. 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 are so interwoven, investors in China have traditionally had little fear about the political exposure of prospective partners or M&A targets. Political connections were seen as an asset, and corruption crackdowns were relatively rare and short-lived. But, this changed due to the scope and intensity of anticorruption enforcement since 2013. Tens of thousands of officials from most regions and industries have been investigated and thousands removed. Most were not known political rivals of the president, and few were top-level leaders. Private firms and tycoons have also been affected, often in real estate and resources sectors. Investors are now aware that political connections can be a liability and that political exposure is more likely.  
  • Regulatory exposure: While some processes and approval procedures (such as starting new businesses) have eased, most regulatory changes resulted in a more complex environment with new risks and uncertainties. New and dormant regulations are being enforced more actively, particularly in areas such as pricing, competition and anti-monopoly law. Foreign and domestic companies have come into the crosshairs of Chinese regulators and it is difficult to predict exactly how regulations will be enforced. This is 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.

During the double-digit growth decades, integrity, political, and regulatory risks were often seen as secondary concerns and left to a last-minute “red flag” check before finalizing a deal. Today, they are often core determinants of the long-term success of an investment, requiring investors to adjust the depth and breadth of an approach. The savviest investors think about integrity, political, and regulatory factors earlier and give them a central position in their strategic thinking about investments.

A more comprehensive, calibrated view of risk

Routine due diligence can’t delve into political and regulatory risk. Instead,investors must balance the extent and cost of such work, and ensure it is appropriate for a deal’s size and its perceived risk. When political or regulatory issues are particularly important, they usually require separate, more extensive consideration before the due diligence stage. However, if they have not already been identified and assessed, a comprehensive approach to due diligence can address these issues.

Due diligence requires a specialized political and regulatory risk team that works in the local language. Ideally, the team should be integrated with a business intelligence team doing the “traditional” due diligence. 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? How might these political connections impact the execution and operation of the deal?
  • Are there any recent or potential policy changes that could substantially damage or boost the target 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 target’s market position?
  • Is the company a potential target for aggressive regulatory scrutiny or constraints? For example, is it in an industry targeted locally by tough environmental or pricing enforcement? Are there indicators that the company or the prospective investment could be controversial? What are the likely attitudes of key stakeholders at various levels?

While this is not a substitute for more thorough types of work to understand and manage political and regulatory risk, this can be a good first-level check to establish whether further work is necessary. For example, an investor might need a deeper understanding of a particular individual who appears politically exposed; a detailed assessment of how new policies in a particular industry or location will impact a target company’s business; or development of strategy to engage government stakeholders on a key regulatory issue affecting an investment.

Recent examples of ‘Level 1’ in action

Situation 1: A major Western banking group considered partnering with a state-owned Chinese bank. It wanted enhanced due diligence into the Chinese bank, but also identified anticorruption investigations in the banking sector and recent regulatory debates as potential risks. Investigations into the state-owned bank showed that the concerns were not a show-stopper for the partnership.

Situation 2: 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 3: 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’ decisionmakers outside China get perspective on the local real estate policy environment, and found the corruption probes were unlikely to spread through the industry.

 

About the Author:

Control Risks is an independent, global risk consultancy specialising in political, integrity, and security risk. They help some of the most influential organisations in the world to understand and manage the risks and opportunities of operating in complex or hostile environments. For questions or further information, please contact [email protected] or [email protected]

 

Posted by Control Risks