Common mistakes when buying a state-owned enterprise or other chinese company
It’s the Government so everything is OK. Actually this is not necessarily true, and in our experience, additional, not less, attention to detail needs to be put into effect when dealing with State Owned Enterprises (SOEs). Although the management of the enterprise may well stress “government connections”, thus implying some sort of favored status, the role of the government typically ceases at the level of shareholders. It does not really extend far into management, except for businesses of extreme national importance, such as in energy or in the manufacturing of certain key commodities and supplies. For non-essential SOE’s involved in various normal manufacturing and trading sectors in which the government has no particular vested interest, although the government will have a seat on the board, there is no guarantee that this actually manifests itself into anything meaningful within the operations of the business.
Cronyism within SOEs
As mentioned, although the government may be shareholders in an SOE, the management of the venture have often placed themselves in positions to cement a regular income and to position themselves personally, rather than the government as shareholders, in taking advantage of any business opportunities that arise because of the existence of the business. The Chinese government has in fact had to go to extraordinary lengths over the past two decades to instill a sense of nationalism across the country (the 2008 Olympics being the pinnacle of this) but in reality, most Chinese nationals still see the State as a provider and will exploit any business the state has for their own ends rather than for the good of the shareholders. Consequently, with the government paying the bills in any event, the following scenarios are likely :
- Sales/Distribution relationships totally reliant on non-commercial activities, including the deliberate non-payment for goods or services received, or relationships that have been put in place on purely personal relationships first with any economic considerations being secondary;
- Management in place that are ineffective and inefficient, with their sole interest being what they can take, rather than contribute to the business – and that includes your investment;
- Other necessary operational issues such as sub-contractors, suppliers, distribution channels, and sales, that may exist within a framework that may not be included as part of the entity you imagine you are purchasing – thus ensuring you continue to be reliant on them even though you have purchased the manufacturing division.
When “Government” Ownership is not Government Controlled.
As mentioned, we wish to be very clear on the point of SOEs and Government connections. If mentioned, are these tangible or just being “sold” to you as a sort of assurance ‘everything will be OK” ? It is wise to remember that many of China’s largest fraud cases have been where management of SOE’s have deliberately sold out the company assets – buying them effectively from their own government – at a knock down price only to set up as a new, private firm, one month later, free of all liabilities and with millions of dollars of assets held privately that the State now does not possess. Yes, if uncovered, the Government can and does sue. But when SOE management are fully capable of ripping off the State – what chance they’ll view your investment acquisition funding in a similar lamb to the slaughter fashion ? And with local regulations and connections on their side, what chance of success if you counter-attack and sue ?
Due Diligence Issues
Consequently, thorough due diligence needs to be conducted on SOEs way beyond the normal legal and financial standards to establish that what you think you are buying is actually what you are getting. These include:
- Logistics, Supply Chain, Customers and Sales Team
Are you sure these are properly identified and included in the package ? - Land and Other Utilities
Have you properly identified all land use rights (see also page 7) and are satisfied that future access and the provision of utilities meet your expectations and are fully under your control ? - Environmental Issues
In China, the concept of “polluter pays” is in its infancy. If you inherit land that is polluted, you may face a clean-up bill later on from the very same people who sold you the land in the first place. Although you’ll need to go through the process of having core samples taken, and an expense will be incurred here, laboratories are close by in Hong Kong – and any pollutants found can be used to negotiate the price of the land downwards. - Intellectual Property
Does the sale include the China IP, patents and trademarks of the business you are purchasing ? Many Chinese brands are very valuable.
