Chinese investments: Trust but verify – PwC China Compass

69 % is the amount by which yearly Chinese investments in Europe fell from 2016 to 2019

The volume of investment may continue to fall, but Chinese companies are still some of the most important investors worldwide. There are certain steps Chinese players can take to mitigate the risk that a transaction will fail or end in a lengthy dispute.

Many reasons exist why the participating parties, who have gone the extra mile to make things work, might not be able to reach an agreement, causing the transaction to fail. And even if a deal has been closed, it still does not mean it is a success – since, after closure, the buyer may be disappointed with the acquired asset.

The PwC forensic dispute team has observed many cases when, after the transaction has closed and the cork has been popped on the celebratory champagne, the Chinese buyer learns more about the entity in question and ends up dissatisfied.

We have also seen that Chinese business players rely more on factors like good relationships, the seller’s verbal presentations, and trust between the parties than on robust due diligence.

Chinese players rely more on factors like good relationships and trust than on robust due diligence

The failure to carry out proper due diligence can prevent the buyer from recognizing certain financial, tax, legal or even environmental risks, which can cause significant problems afterwards. Suing the seller is one possibility, but it is a difficult case to win without adequate due diligence. Our experience shows that the typical reasons for post-M&A disputes are disagreements over completion accounts and claims of breach of warranty.

Completion accounts

Used to adjust the contractual transaction price based on the entity’s performance, completion accounts have a substantial effect on the final purchase price. The seller will try to increase the price and the buyer, in turn, will find ways to reduce it when the completion accounts are being finalized. We have often seen cases where specific provisions and accruals are the source of disagreement.

A standard clause in the sale and purchase agreement (SPA) covers representations and warranties. This is where the seller attests, for example, that the entity has no tax arrears. This clause allows the buyer to pursue claims against the seller for any potential breach of warranty. Typically, the seller guarantees that the annual financial statements are a true and fair accounting of the entity’s performance. The guarantee is then breached if the buyer makes an investment based on incorrectly prepared statements. Typical areas of disagreement are the valuation of assets (whether they were overstated), the underprovision (overstatement) of debtors or inventory, and the misrepresentation during due diligence of the entity’s future performance. Breaches of this sort can lead to complex and lengthy disputes.

Prevention is better than cure

Preventing problems is of course better than having to fix them afterwards. The following steps can be taken during due diligence to avoid conflict: 

• During negotiations, the participating parties can include clear instructions in the SPA on how the completion accounts are to be prepared. 
• Instead of completion accounts, the parties can use the “locked box mechanism.” In this case, they negotiate the purchase price based on a balance sheet current at the signing of the SPA, under the condition that the seller, who is still running the day-to-day business, can only extract value from the entity for purposes set out in the agreement. The purchase price cannot be adjusted after closing, but the seller is liable for facilitating any cash leakage before the completion date. 
• Warranty & Indemnity insurance can be used to address breaches of warranty. These policies usually cover an agreed sum of the entity’s value or purchase price. The insured amount includes provision for legal costs, but not purchase price adjustments and leakage, or known and future risks.