Note: All names, places, companies, newspapers, and relevant financial figures have been modified for this article. No reference is made to a real transaction, occurrence, or case, and this article is for educational purposes only. The following should not be taken as legal advice, nor considered a comprehensive study of due diligence in China. Always consult a legal professional before any M&A transaction.

Introduction

By all accounts Mr. Ma was another one of China’s fast-rising multimillionaire businessmen. With billions (CNY) of assets under management through his PRC private investment group, he controlled stakes in music companies, real estate developers, new tech, and much more.

More than a successful investor and businessman, Mr. Ma was a celebrity in his own right. His corporate website frequently added to that legend by posting interviews with Forbes, Bloomberg, the Wall Street Journal, and many Chinese mainland newspapers. He sought to develop a new culture of “conscientious investing” and would proudly espouse this philosophy wherever he went. Moreover, he had recently taken a several million USD stake in a foreign company. Although these days that amount is not an eyebrow-raising figure from a Chinese investor, he was clearly intent on building a globally recognized portfolio and brand.

He then approached our client for a new overseas investment and possible China joint venture, and our client in turn looked to R&P to conduct a formal due diligence investigation of Mr. Ma and his investment group.

Clearing the Smoke and Mirrors

The narrative of Mr. Ma proved hard to verify. Our lawyers’ due diligence revealed over 40 shell companies and funds, but very little real investment and trading activities. Calls to the HQ inquiry number on its website were met with vague responses like “Mr. Ma is very busy” or “we have many companies so it is hard to keep track”. How could a company that supposedly had thousands of workers, billions under management, and a high-profile CEO not generate more news?

We also met a road block looking into Mr. Ma himself. For whatever reason, we were not able to verify a single piece of information on Mr. Ma through online searches as they only redirected to his own company’s website and LinkedIn pages. We reached out to the international newspapers referenced on his company’s website and found that they had no record of the supposed interviews with Mr. Ma having ever taken place.

Moreover, digging into his company structure and investment portfolio raised even more red flags. Instead of an “Investment Group”, his companies resembled a spider web of personal interests and investments, with Mr. Ma and his family members owning each fund individually, and no tangible corporate structure linking the various firms. The companies appeared to have all been formed in the past few years, and the limited information available in regards to their finances painted a far less rosy picture than he had initially implied.

Ultimately, our client felt that Mr. Ma’s unwillingness to share more detailed financial information, and the red flags uncovered by our investigation, were enough to call off further discussions on any sort of cooperation.

Due Diligence Explained

At times, Chinese firms’ “speed dating” style of business combined with foreign firms’ eagerness to find a suitable partner to expand overseas, can lead to basic lapses of due diligence and good judgment. The foreign partner may discover that the target they sought to do business with has either overstated their ability to uphold part of an agreement, or may not be a suitable partner at all. Lawyers or other qualified personnel can pull up detailed company information from a local AIC, which may be all the due diligence required for smaller transactions. The AIC files will include the registered address of the company, shareholder information, business scope, etc. We have seen cases where an individual representing a factory as the “owner” was neither shareholder nor director or general manager, and other cases where the company in question does not have the required business scope covering the activities it intends to engage in.

A more in depth approach requires a full legal audit, including confirmation of legal licensing, verification of real estate certificates, review of commercial practices and employment systems, checking of IP owned by the company, etc. Our general checklist focuses on the following:

–          Focus the investigation on the partner / investor’s contribution. If in the case of a new JV the Chinese partner is contributing machinery or land, then ownership of these assets must be confirmed beyond a doubt. If the foreign investor plans to take a stake in the target company, then the client will require a comprehensive investigation;

–          For long term partnerships such as purchase or sale, agency or joint-development, the financial wellbeing of the partner is placed at the forefront. By reviewing detailed financial information, a foreign party shows prudence and will better understand the capability of their target;

–          Finally, an effort should be made to understand the target company’s organizational structure. Chinese companies have very opaque inner workings, and an extra effort must be made to find who will ultimately be exerting control over its operations.

–          More information can be found in my colleague’s excellent piece Due Diligence the Chinese Way

It was only through this kind of thorough investigation that serious questions surrounding Mr. Ma and his finance group began to emerge. Although basic due diligence is better than nothing, foreign investors and businesses should apply an appropriate amount of diligence and risk assessment according to the size of the project, and their own risk appetite.

Conclusion

China is still a developing country, and information asymmetries can create “success” stories like Mr. Ma out of thin air. Perhaps he was a fairly wealthy man trying to “fake it until he made it” in elite and international circles. Perhaps his connections to the music industry meant he moved in China government circles, which could explain the vague origins of his investment funds. Perhaps he did have all the employees and assets he described, but just needed a better marketing department and telephone hotline…

The bottom line for foreign investors and businesses is that due diligence is more important in a slowing China economy than ever before. If enough red flags are raised during a professional firm’s inquiries then there is no need to ask “why”; the best solution may well be to walk away from the deal entirely, and focus time and energy on more fruitful opportunities.