The Cluster Of Due Diligence In China

The excellent folks at CALOBA recently held a very informative seminar on due diligence in China.  The dominant theme was the profound attention to detail required for US businesses that want to do business with Chinese partners.  I got way more than free Chinese food by attending.

Due diligence should have three main goals:  confirming an investment thesis; verifying representations and warranties; and determining the quality of a prospective company.  That's the legal framework that US attorneys schooled in the Anglo-Saxon common law model of jurisprudence understand.  This understanding may as well be flipped on its head when US businesses go to China in search of acquisition targets or joint venture partners.  US-based companies often need local Chinese counsel, an international accounting firm, and a local background investigation firm to understand a potential Chinese deal.

Caterpillar's US$580M write-down on a Chinese investment is the latest classic tale of what goes wrong with insufficient Chinese due diligence.  Discovering inventory, revenue, and even whole enterprises that are nonexistent is the hard result of good due diligence.  Leaving anything to "trust me" assurances is unacceptable.  Here are some uncomfortable truths about Chinese businesses.

Chinese businesses keep more than one set of books.  Don't be surprised to find three sets:  one for auditors, one for tax authorities, and one for the chairperson or primary owner.  Even the chair's set of books may not be completely accurate due to the weaknesses of middle management functions in China.  This weakness stems from the Chinese educational system's lack of emphasis on critical thinking and problem solving.  A solution will be at least a generation away if China chooses to reform its educational system.  Very little empirical work in the public domain has established a methodology for detecting Chinese financial frauds before they become problems.  This Princeton economic paper validates a model for detecting fraud based on data revealed in lawsuits.  The Hong Kong Institute of Science and Technology describes an approach to detecting false financial statements in both listed and non-listed companies.  Auditors examining small private Chinese companies need to go beyond these tools and reconstruct financial statements from scratch to meet US Sarbox standards.

Chinese theft of Western intellectual property is endemic.  The US's National Bureau of Asian Research published its IP Commission report in May 2013, noting that China steals US IP equivalent in value to the entire US trade balance with Asia.  Chinese companies value the prestige of listing on US stock exchanges.  The threat of delisting against prolific corporate IP thieves from China could be a good deterrent.

Chinese employees lie routinely.  China Labor Watch describes a cottage industry of Chinese consultants who will lie to help Chinese companies pass Western labor audits.  Other cottage industries will falsify customer invoices and bank statements.  They will even forge government documents.  Efforts to reform this cultural deficiency will go nowhere without regulatory reform, and that will go nowhere without breaking the Communist Party's corruption.

Chinese executives are a pain in the behind.  Anecdotes reveal that Chinese CEO-founders of publicly traded companies still think they own the company after listing.  They don't understand the US regulatory regime's emphasis on disclosure in financial statements.  They interfere with the investigations of US companies' hired lawyers and auditors as they reconstruct financial statements for Sarbox .  This culture of impunity would be untenable if Chinese investors could hold executives liable for misconduct.  I have met Chinese-American entrepreneurs and venture investors who think they can graft the American entrepreneurial culture onto China.  I will say right now that this will not happen without severe reforms to Chinese regulatory agencies and courts, and that won't happen as long as the Communist Party controls China.

Any US company that fails to perform competent due diligence of a prospective Chinese investment may run afoul of the Foreign Corrupt Practices Act. (FCPA).  Even China's state-owned enterprises (SOEs) fall under the FCPA regime.  The US DOJ and SEC have joint jurisdiction over FCPA enforcement.  US companies must insist that their non-US subsidiaries follow compliance programs to avoid sanctions because it is impossible to "quarantine" an FCPA violation in a foreign acquisition.  It is still possible to entice Chinese prospects to do the right thing under FCPA.  Non-US partners seek US relationships because the integrity and size of US capital markets gives them prestige.  Bureaucrats in other countries seek promotions in part by appearing more competent and prestigious, and access to the US gives them this cachet.  American multinationals can use the US's prestige as good currency for building trust with Chinese partners who will then comply with FCPA.

I am unable to locate a sample due diligence checklist or budget plan in open source searches.  Multinational corporate law firms probably keep those details to themselves.  Their services are not cheap.  Such documents are probably good things to have if they come with triggers that will require prospective US investors to back away from a Chinese transaction when red flags appear.  Having mediation agreements in place with Chinese business partners and good relations with Chinese regulators are good risk management measures, but they just don't substitute for common sense.  Refusing to start a relationship with untrustworthy people is the unfortunate conclusion to a lot of Chinese due diligence.

China is still a developing economy because its weak regulations, questionable courts, unreliable economic statistics, and duplicitous middle managers pose enormous hazards to US businesses.  The due diligence process for a Chinese prospect can easily become a "cluster" if Americans aren't prepared to walk away from problems they can't solve.  American CEOs need to tone down their eagerness for headline-grabbing Chinese deals if they can't trust the people involved.  

Hints On Due Diligence In Rare Earth Mining

My genius readers have the chance to read my interview today with The Gold Report, which I've noted has also been picked up by other online media outlets.  I mentioned the logistics trifecta - water, power, roads - as something absolutely critical to a productive mine.  I also need to elaborate on the subject of production costs.

Investment banks and resource industry sources regularly publish information on the cost production curves for specific mining sectors.  Professional investors and analysts prefer to invest in projects whose cash costs of production are in the bottom quartile of their peer group.  I'm not sure how 25% became the threshold or whether it's been academically validated as a useful cutoff, but it's become an industry truism.  This business rule holds true for minerals, oil, natural gas, coal, potash, and any other resource that must be extracted from the earth's crust.  That's why junior miners whose executives have good business sense will tell you whether their cash costs place them in the cheapest 25% of their peer group. 

The problem with rare earths and other critical metals is that there are too few operating mines worldwide to construct statistically valid cost curves.  The rare earth sector is currently dominated by Chinese mines whose financial reporting may not be transparent.  The important point to remember is that investors must use factors besides the cost of production to evaluate new resource projects, especially those in the exploratory stage.  I'll recap some of those factors below.

Management experienced in the sector.  I get impatient whenever I sit through investment conferences and roadshow presentations and listen to a mining company CEO whose background was in investment banking, management consulting, financial brokerage, or something else unrelated to mining.  That tells me the insiders and founders are just looking to dress up a bad property and quickly flip it to the next round of suckers and bagholders.  Yes, folks, there really is some of that from time to time in resource investing.  Effective mining CEOs need to be operating geologists, without exception.  They should ideally have a career history encompassing an entire project lifecycle, from exploration to shut-down.  It's also nice to see other geologists and mining engineers on a junior resource company's management team. 

National Instrument 43-101 compliant report.  The SEC's rules for companies disclosing resource reserves are much more restrictive than Canadian securities rules.  The SEC requires disclosure of a company's resources that can be economically extracted.  Canada, with a more liberal bent to encourage development of its resource sector, requires companies preparing for production to publish what's commonly known as a 43-101 report.  The importance of the report for investors is its disclosure of a company's proven and probable reserves, aka "2P reserves."  This reserve category is the most useful estimate of what a company can economically extract, and does not include inferred or implied resources that may later be added to the 2P category after production begins.  The 2P number can be plugged into a valuation model to determine the company's worth. 

Burn rate.  This is the amount of money a junior company is spending monthly to operate.  Divide its annual net losses by twelve, then divide that monthly loss into its cash on the balance sheet.  I also like to subtract shot-term liabilities from the cash on hand just to see if the company will survive for a year.  Companies that run out of cash before their exploratory results are complete will need to return to investors hat in hand.  Raising more capital will dilute shareholders immediately (through common stock issuance) or eventually (through warrants and PIPEs). 

Logistics trifecta.  I've said it before and I'll say it again.  Water is for heap leaching a mineral deposit, which will also require plans for treatment and disposal of tailings (either in a pond or dry-stacked after baking) that retain traces of toxicity.  Electric power is for the equipment and base camp; the company must either be a mile or two away from a transmission line and have planned capex for a step-down transformer, or must have large volume diesel tanks on site.  Roads to the project site can be of the gravel and unimproved variety but they must at some point lead to a metals refinery by linking to other hardball roads or a port. 

There you have it, critical elements investors.  Please do your own homework while researching investment opportunities.  I can't do investors' homework for them because nobody pays me anything to do so.