People take risks to get to the top.

Some China risks keep repeating themselves - but still manage to surprise people. I reviewed the history of a number of cases as part of the research for my forthcoming book, “Risky Business In China”, and found that there are typically red warning flags, and burnt-out wrecks on the road to the risk event, but that they are usually ignored as all eyes are fixed on the prize (deal / bonus / promotion / glory / retention of job etc.).

Big, headline cases, such as GSK’s bribery scandal and Caterpillar’s investment write-down, highlight very real (and often-repeated) China risks such as accounting fraud and bribery. In Caterpillar’s case, the company is reported to have spent US$677 million on its purchase of the Chinese firm ERA Mining Machinery (the owner of Siwei Mechanical & Electrical Equipment Manufacturing Co Ltd., “Siwei”). According to a Reuters report, Caterpillar discovered "deliberate, multi-year, coordinated accounting misconduct" at Siwei soon after the deal was completed. The Reuters investigation noted: “…it has become a case study in how a foreign company with decades of experience in China can still flounder in that market. It also shows how willing some multinationals are to accept risks they might otherwise avoid to establish themselves in the world's second-largest economy”.

But accounting misconduct was not new in China (or anywhere else). The existence of multiple sets of accounts is so open that it can hardly be called a secret. And the warning signs had been provided publicly too, not least by the actions of short sellers such as Muddy Waters who uncovered accounting frauds at overseas-listed Chinese companies.

I will look at accounting fraud and financial due diligence in a later post, but some of the due diligence lessons from these accounting cases include:

Box-ticking and a narrow focus on accounts is a recipe for disaster.
Information provided by the target should be independently verified.
Operations need to be a focus of due diligence, and site visits are essential.
Due diligence processes need to account for local reality (hidden loans, fake receipts, connected parties and more).

Many losses result from a lack of proper, localised due diligence, a lack of awareness of changing conditions and policies, a failure to maintain risk awareness beyond the start of the process, and business and reward structures that may incentivise inappropriate risk-taking. They may also result from a belief that bad things only happen to other people, and that historic horror stories are of academic interest only. But China risk is real and, like history, it often repeats itself. So it is best to be prepared, and to learn the expensive lessons for which others have already paid.

For more news and discussion on risk issues in China, join the Risky Business In China LinkedIn Group, and follow the @RiskyBizChina feed on Twitter.

“Risky Business In China. A Guide To Due Diligence” will be published by Palgrave Macmillan in September 2014.

Photo: Huashan, 1998 © Jeremy Gordon