"Study of facts is a powerful antidote to arrogance."
Why due diligence fails
With this note, we do not intend to judge any of people or firms, but rather share our thoughts on issues we have identified over the course of our long-term observations on the due diligence practice in China:
1 Stardardized and information gap
As due diligence products become increasingly standardized, professional service providers tend to add more exemption clauses in their disclaimers to cover a narrower scope of work. That may create huge gaps left uncovered by due diligence. The bigger the firms are, the more likely some areas are overlooked.
Every time when due diligence fails to find issue which broke, professional institutions tend to further narrow the scope of work, increase the scope of exemption, or add more procedures in order to prepare themselves for a defense in case of a complaint, i.e. creating more manuscripts or asking the target company to provide more disclaimers.
2 Inefficient and burdensome
Tedious and inefficient due diligence creates burdens to target companies. Most due diligence begins with super long lists of questions and documents along with jargons or lengthy definitions. Understanding the requests and preparing the documents are already painful enough, in particular for internet companies, as admin staff are less well trained and documentation is less perfect at most of these companies compared to well-established conventional firms. In addition, the fierce competition may lead to shorter execution time, and the due diligence may become a tragedy for the sell and buy side alike. Under this context, due diligence may, or has already, become the target of criticism or slighted by both investors and investees if it cannot produce meaningful results.
3 due diligence or endorsement
The due diligence made by professional institutions now serves more like an endorsement, rather than a true “investigation”. It is a paradox. Hiring a 3rd-party team to conduct due diligence means a lot of expenditures. Approvals for third party due diligence in most cases will be obtained after the term sheets or even later. It would be quite an embarrassment to withdraw after substantial efforts for documentation and internal pitch.
4 Other procedural issues
1) in a big professional firm, the on-site professionals are usually young and inexperienced. That means senior people would no longer check original documents or conduct first-hand interviews. Yet, it would take years for junior people to develop the sensitivity to the issues mined in the original documents or discovered in the interviews.
2) heavily rely on documents provided by the target company, and there is a lack of 3rd-party verifications. For instance, it would be difficult to detect systematic frauds when falsified vouchers provided and with full cooperation from upstream suppliers and downstream clients (when cash is verified), unless on site people are experienced enough to make judgement calls. Such cases are not uncommon according to our experience.
3) Transactions often need to be completed under a tight timeline. If the target company fails to provide certain documents or information, and the professional teams cannot determine the significance of these materials, these potential red flags would simply be tagged as “pending further documents or verifications.” As the transactions proceed, these potential risks would go unnoticed after being understated as repetitive and minor issues.
4) At the operational level, professionals do not have the time or motivation to voluntarily make judgement calls or dig more information when they have to follow complex protocols and comply with “perfect documentation” requirements while working under deadlines. Requesting “correct” documents seem to be the most effective way to satisfy all requirements.