Some institutional investors, from Caterpillar to John Paulson's hedge fund, have fumbled in their investment in China. The lesson learned: standard due diligence by big fours and large law firms is far from sufficient because China has a dramatically different business environment from that in the U.S. Investors have to get into the trenches on their own and kicking the tires. meanwhile, do not be afraid to adopt guerrilla techniques in the process.

1. How
Ins(tu(onal
Investors
May
Avoid
Due
Diligence
Pi9alls
in
China
Presented
by
Kee
Global
Advisors
LLC
(KGA)
March
2013

2. Investors’
FrustraBon
with
China
Due
to
due
diligence
failure
on
the
acquisiBon
target
ERA
Mining
Machinery
Ltd.,
a
Chinese
maker
of
roof
supports
for
coal
mines,
Caterpillar
announced
the
write-­‐down
of
$580million
earlier
February
2013
in
the
value
of
ERA,
which
was
acquired
last
June
for
about
$700
million.

3. Investors’
FrustraBon
with
China
John
Paulson’s
bet
on
Sino-­‐Forest
cost
him
$460million.
Investors
are
suing
him
for
failing
to
conduct
proper
due
diligence
on
this
Chinese
forestry
company.

4. Investors’
FrustraBon
with
China
More
than
a
dozen
Chinese
companies
listed
in
U.S.
exchanges
through
reverse
merger
were
accused
of
fraudulent
accounBng
conducts
and
delisted
from
exchanges.

5. What
Went
Wrong?
Lack
of
quality
due
diligence
on
Chinese
companies.
Standard
due
diligence
proven
far
from
sufficient
in
China
Prevailing
businesses
and
transacBon
pracBces
in
China
differ
dramaBcally
from
those
in
the
U.S.

6. Challenges
(1)
–
Cash
Business
•
Evasion
of
VAT
(value-­‐added
tax)
causes
missing
of
tax
receipts
(fa
piao)
and
makes
it
challenging
to
find
out
a
company’s
actual
revenue
•
Prevailing
pracBce
that
companies
do
not
report
full
amount
revenues
•
Inflated
revenue
and
net
income
during
the
process
of
restoring
owed
VAT
and
CIT
to
aeract
investors
or
acquirers

7. Challenges
(2)
–
MulBple
BooKs
•
Most
companies
keep
mulBple
accounBng
books
•
There
are
ways
to
get
to
the
real
book

Talk
to
the
bank
that
loans
to
the
company

Speak
with
the
company’s
distributors
and
vendors

Don’t
forget
the
business
owner,
who
holds
the
answer

8. Challenges
(3)
–
UnrealisBc
ExpectaBon
•
Investors
set
unrealisBc
expectaBon
of
their
prospects
•
Service
providers
re-­‐engineer
companies
to
meet
investors’
criteria
•
There
are
not
that
many
IPO
ready
Chinese
companies;
most
of
them
need
Bme
and
capital
to
grow

9. Challenges
(4)
–
Background
Check
•
Do
not
solely
rely
on
internet
or
standard
background
check
•
Talk
to
the
owner’s
previous
employers
and
co-­‐workers
•
Speak
with
owner’s
friends
and
relaBves
•
Get
to
know
the
owner’s
spouse

10. Big
Fours
vs.
Guerilla
Techniques
•
Investors
should
get
into
trenches
and
kicking
Bres
•
Always
ready
to
walk
away
from
deals
that
seem
too
good
to
be
true
•
Trust
your
insBnct
•
Don’t
be
afraid
to
turn
to
irregular
techniques
and
avenues
in
a
due
diligence
–
be
creaBve
Standard
due
diligence
is
not
sufficient
and
does
not
work
well
in
China

11. Contact
•
For
the
full
arBcle,
please
visit
hep://keeglobaladvisors.typepad.com/kga/
•
KGA’s
website:
www.keeglobaladvisors.com
•
For
quesBons
or
suggesBons,
please
email
info@keeglobaladvisors.com