Transactions - Frequently asked questions on M&A in Asia 

Under existing rules and regulations, whenever State-owned assets/equities ("SOA") change hands, a statutory valuation is required for any contribution of assets, such as land use rights, buildings and machinery. The statutory requirements also apply to cases where state-owned equity interests in existing JVs are transferred to non-State-owned investment entities or vice versa.
 
Almost every transaction in China involving SOA requires a statutory valuation exercise. A statutory valuation means that it must be performed by an approved or licensed local valuation firm in accordance with generally accepted valuation practices in China, which to a certain extent differ from those commonly observed in other markets.
 
A foreign investor should obtain independent advice on the valuation process and the likely result of the valuation exercise, before becoming contractually bound by the valuation. The investor may also consider conducting its own assessment of value in accordance with international valuation standards, in order to calculate the inherent premium reflected in the statutory valuation.
 
For more information contact Nova Chan, Partner, Valuation & Strategy group in Shanghai.

The transaction screening process is a common concern among global corporations whose transaction failure rates are above average. During their initial target screening, such companies often focus on overall strategic fit, while overlooking critical closing and integration risks, which can lead to costly mistakes.
 
In addition to assessing the strategic fit of acquisition targets' competitive strength and compatibility with the acquirer's financial, operating and cultural profile. You should also look at transaction effectiveness to minimise risks during the screening process. Transaction effectiveness is the probability that the buyer and seller will be able to come to terms, survive due diligence, close and successfully integrate their operations. This is determined by correlating transaction closing and integration risk.
 
You can do a transaction closing risk assessment which involves uncovering and estimating the impact of several key factors that could affect a company's ability and willingness to close on a transaction and properly value the target. These include:

• Stakeholder, market and community perceptions of the transaction - both positive and negative
• Government relationships
• Target's internal controls and corporate governance practices
• Hidden HR and other liabilities
• Litigation risks for the buyer
• Target management's ethics, code of conduct and background
• Regulatory compliance issues

Companies that have a higher number of transactions that fail to close despite full financial diligence tend to under-invest in transaction closing risk assessment.
 
Assessing integration risk requires looking at factors that could impede the integration of a strategically desirable target into your company's operations. Questions to answer include:

• How well do our organisational structures, key processes and infrastructures match?
• Are our information, knowledge management and financial reporting systems and processes compatible?
• Do our corporate cultures, values and compensation philosophies mesh, and if not, can we realistically bridge the gaps?
• Companies that close transactions but have very limited success in integrating operations and realising synergies often underestimate integration risk.

By screening target companies for strategic attractiveness and transaction effectiveness, acquiring firms can create value by increasing their transaction success rate and allocating resources more effectively. In addition, they can execute their strategic goals faster and with less risk.
 
For more information contact David Brown, Partner.

The changes brought in by IFRS 3 affect all stages of the acquisition process - from planning to the presentation of post deal results. HKFRS 3 contains principally the same provisions as IFRS 3. The implications primarily involve giving greater transparency and insight into what has been acquired and allowing the market to evaluate management's explanations of the rationale behind a transaction.
 
Impact of IFRS 3 - at a glance:

• All business combinations are accounted for as acquisitions - no more merger accounting.
• An acquirer must be identified for every combination.
• More intangible assets will be identified and recognized on acquisition. The useful lives of these intangible assets will need to be assessed. Some of these intangible assets may have indefinite lives.
• Goodwill and other intangible assets with indefinite lives are not amortised but subject to continuing impairment tests - write offs from past deals could arise and this message needs careful communication to the market.
• Negative goodwill is recognised immediately in income.
• Restructuring costs are charged to income.
• Contingent liabilities are recognised at fair value.
• Detailed disclosures about transactions and impairment testing are required.

IFRS 3 is mandatory for all new transactions from 31 March 2004. First time adopters must apply IFRS 3 from day one of their IFRS track record and can choose to restate past deals. HKFRS 3 applies from 1 January 2005.
 
For more information contact Nova Chan, Partner, Valuation & Strategy group in Shanghai.

The Sarbanes-Oxley Act of 2002 ("the Act"), the United States' response to a number of high profile corporate scandals, is having a significant impact on the way US companies are run, and Mergers and Acquisitions ("M&A") have not escaped its effect. While M&A does not get a specific mention in the Act, the implications for deals are far reaching.
 
If management or the auditors become aware of a material weakness in a newly acquired entity, they have a responsibility to disclose that weakness. There is no option of hiding behind the one year exemption of the Act once a problem becomes known. In an acquisition scenario, this means that a significant amount of focus needs to be placed on internal controls and documentation thereof, in order to assess the financial and other implications of ensuring compliance with the Act.
 
Methods of avoiding tax, such as keeping two sets of books, and a lack of reliable historic financial information, are often encountered. There can often be a lack of transparency caused by related party relationships and transactions not being fully disclosed, and a mixture of corporate and personal assets being reflected in company accounts. Typically many companies rely on a far greater proportion of manual controls due to the relative lack of sophisticated IT systems, and traditionally many Chinese companies have been controlled through the close involvement of the owner in day to day business matters, rather than a code of formal and documented (and testable) controls.
 
Issues faced by the large State Owned Enterprises, in particular, can include poor corporate governance, caused by the lack of an independent management board, an ineffective audit committee, the lack of a formal risk management process and ineffective financial reporting.
 
To access the global survey and find more in-depth commentary, analysis and advice, visit our Global Sarbanes-Oxley site and our cfodirect.com website.

A tax due diligence review plays a critical role in any M&A transaction. A proper tax due diligence is a key ingredient in assessing whether to proceed with a deal, and if the deal proceeds, how to maximise the overall return achieved.
 
The vast majority of deals fail to achieve targeted returns by not capturing or maximising upside benefits and or by not identifying hidden liabilities and downside risks. A well conducted tax due diligence, in conjunction with legal and financial reviews, should expose these issues and opportunities and help achieve a successful investment. Tax can be a large cost, but also a rich source of cash flow savings if managed properly.
 
For more information contact Nick Dignan, Regional Tax M&A Leader.

There is no single universal valuation method that provides an appropriate value in every case as each target has unique characteristics that need to be considered. In practice it is usually better to apply several different techniques and then compare the results as this will usually reveal the factors which are adding or destroying value. In addition to valuing a target on a stand alone basis it is also necessary to consider how much the target will be worth to the acquirer as a whole after the transaction is completed. Since most M&A transactions are expected to deliver synergies, a discounted cash flow method is often used as it takes into account future benefits to the acquirer. However, this valuation method would normally be supplemented with other valuation techniques to obtain an appropriate range of values for the target company. Other valuation techniques utilised may include an analysis of comparable transactions in a similar industry to obtain earnings or revenue multiples, an asset valuation focussed on replacement cost or perhaps a Greenfield analysis which would assess the cost to start from scratch a business similar to the target. The actual price paid for the target business is often a function of the negotiating skill of the acquirer and the perceived risks and rewards of the investment which varies significantly for each potential investor.
 
A key focus of financial due diligence, for the buyer and by implication the seller, is to identify issues which will have a direct impact on the valuation drivers and therefore, the valuation of the target company. For example, if the pricing agreed with the seller is based on a discounted cash flow model, then the financial due diligence should assess the assumptions used in the target's projected cash flows and identify key risk areas and appropriate adjustments in light of historical performance. Alternatively, if the pricing is to be determined using an earnings multiple, then the financial due diligence should seek to identify adjustments to the target's reported earnings to arrive at sustainable earnings against which the earnings multiple would be applied. In both examples, financial due diligence seeks to validate the underlying valuation assumptions of the target and therefore has a direct impact on the valuation.
 
For more information contact Nova Chan, Partner, Valuation & Strategy group in Shanghai.

The valuations performed by authorised appraisers are primarily to prevent the loss of state-owned assets at an undervalued price to a foreign investor and frequently do not reflect the true economic value of the entity even though it may be used to price the potential transaction. A potential acquirer of a state-owned enterprise ("SOE") would still perform its own valuation of the business to establish the price range which they are willing to pay for the target business. This is important as the most commonly used asset valuation methods used for SOE assets by official appraisers often produces inflated valuations and the acquirer will need to compare the appraiser's valuation against its own to ensure the deal is still economically feasible. Financial due diligence should still be performed in this type of transaction and it should be done prior to the appraiser's valuation as it will play a key role in identifying factors impacting the acquirer's valuation model as well as identifying opportunities to present evidence to the authorised appraiser which may influence the appraiser's valuation before it is finalised.
 
Financial due diligence will identify other factors impacting the decision whether or not to go ahead with a deal besides valuation. For example, understanding the true quality of earnings is a primary concern for most acquirers. It is not uncommon that state owned enterprises have extensive interests in other business entities with whom they transact. Ensuring that all such related party transactions and relationships are identified is crucial in the financial due diligence as these are often conducted on non-arms length terms and there can be significant changes to the financial performance and the financial position of the target business once these related party transactions are either excluded or restated in arms-length terms.
 
For more information contact Nova Chan, Partner, Valuation & Strategy group in Shanghai.

An effective due diligence investigation will be a coordinated team effort involving the acquirer and all of the specialist advisors working together towards a common goal. In our experience, the most efficient approach is to identify one person from the acquirer's team to act as project manager, responsible for coordinating the due diligence and ensuring that responsibility for the due diligence work is appropriately assigned with minimal overlap. However, care must be taken to avoid excessive restrictions on each advisor's scope of work. In practice, there are certain key areas, such as reviews for contingencies, where both a legal and accounting perspective are valuable because the differing approaches often yield different findings. For certain review areas, assigning primary and secondary responsibility to the accounting and legal advisors is an effective way to minimize overlap while at the same time retaining the benefit of different perspectives in a particular area. Advisors should also ensure that key findings are communicated to the team promptly as issues identified from the financial due diligence review may require further follow-up in the legal due diligence or vice versa.
 
For more information contact David Brown, Partner.

Hidden liabilities and exposures are a key area of concern in most M&A transactions and this is also one of the most difficult areas on which to obtain comfort. Certainly, there is no single prescribed set of procedures which guarantees that all hidden liabilities and potential exposures will be identified. However, as a starting point, specific characteristics of the target need to be considered to identify key risk areas on which the financial due diligence should focus. Although not an exhaustive list, this would include the nature of the industry, recent major events in the business, operating history, location of operations, the control environment, characteristics of key management and the extent of use of professional advisors in the past.
 
As an example, a family controlled or owner-managed business will sometimes utilise means to reduce tax that may contravene tax regulations. This is particularly common if the target business has operations in the PRC and it is not unusual that significant exposures would arise from a review of PRC tax matters during the financial due diligence.
 
Once the key areas are identified, the financial due diligence will focus on discussion with key management involved in all aspects of the business (not just the finance and accounting department) and analyses of information received from the target. However, in the end, identification of potential exposures often comes down to asking the right person the right question and knowing the warning signs. Therefore, in selecting advisors, it is very important to inquire about previous experience on M&A transactions as most acquirers place significant reliance on their advisors for expertise in the area of undisclosed exposures.
 
For more information contact David Brown, Partner.

There are often situations where one firm of accountants is appointed for due diligence for two or more clients with competing interests on a particular transaction. In these situations, client confidentiality is a primary consideration which can be appropriately managed if certain controls are in place. Such controls include robust structures to reduce the risk of confidential information being inappropriately used to benefit clients with competing interests. In these situations, subject to any other confidentiality considerations, it would be usual to inform the clients of the potential conflict of interest and also take steps to erect effective Ethical Walls, acting as a protective barrier, to ensure that adequate safeguards are in place to prevent access to information related to an engagement other than by the members of the relevant engagement team.
 
The procedures that might commonly be utilised in constructing Ethical Walls include the use of separate teams at all levels (including specialist consultation and secretarial support), use of code names in carrying out work, strict physical separation of teams and areas of work, restricted access to confidential information including computerised files and perhaps written confirmations from each team member of their compliance with all Ethical Wall procedures, with a particular emphasis on confidentiality.
 
For more information contact David Brown, Partner.

In almost every transaction, the vendor must strike a balance between the risks and rewards of providing commercially sensitive information to a potential purchaser. From a purchaser's perspective, obtaining adequate information is essential to evaluate and prepare a bid for the target company. From a vendor's perspective, while providing sensitive information may be detrimental commercially in the event the transaction does not proceed, it does assist in maximising the selling price if the transaction does proceed. The vendor will therefore usually control the release of information with access to the most sensitive commercial information and people only being provided at the later stages when exclusivity has been granted to a potential acquirer and a deal is considered likely. While conflicts can arise, in general if the reasons for the confidentiality are appropriately communicated, purchasers will understand. After all, if the confidential information is disseminated to all potential purchasers the value of the franchise will be diminished to whoever ends up owning it.
 
For more information contact David Brown, Partner.

Doing business in Asia and China specific differs from the way business is done in western countries. Cultural norms and attitudes in Asia (e.g. China) are different. Asian business heavily relies upon relationships and building these relationships is a way of life. Building and retaining the relationship will often involve gifts/entertainment/gratuities and "facilitation" payments are common in many countries. Examples of such payments are: Direct payments to customers, payments to customers via agents and payments to customs and tax officials.
 
The US Foreign Corrupt Practices Act (FCPA) seeks to control the activities of US nationals, US corporations and other US-listed entities - and their affiliates - operating anywhere in the world. The Act imposes significant civil and criminal sanctions for any bribery or attempted bribery of foreign officials. Entities covered by the Act may also be held responsible for inappropriate behaviour on the part of third party agents and consultants retained by them.
 
Inappropriate activity is not restricted to gifts involving cash: it includes anything of value, such as gifts, inappropriate or excessive entertainment and the provision of employment that may be considered to influence them for the purpose of obtaining a business advantage.
 
There are still many State Owned Enterprises in China and therefore trade with government owned and operated entities may be inevitable. State Owned Enterprise employees are included in the definition of a government official.
 
For Chinese businesses "facilitation" payments could be a way to retain business or preferential treatments and terminating this practice after the transaction may result in loss of customers, lower revenue and decrease of profitability.
 
The anti-corruption regulations don't need to withhold you from doing a transaction in China however awareness and steps financial due diligence performed by PricewaterhouseCoopers' dedicated team of specialists will be able to identify some of the practices a business may have to build and retain their business relationships. An in depth analysis of the potential target's compliance with the regulations could be performed by PricewaterhouseCoopers' Forensic Services team.