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Hong Kong manufacturing SMEs have recently faced numerous challenges. They have encountered cost issues due to yuan appreciation, wage increases, and rising raw material and utility costs. They are operating in a more difficult and competitive environment and an increasingly complex global environment. In addition they have faced legal and regulatory changes on the mainland regarding export processing and export tax rebates, labour legislation and environmental and safety regulations. The list goes on.

In this context, there may be a number of businesses in distress which will either seek to raise funds via the sale of a proportion of equity, or even be forced to sell entirely. Avoiding business failure and successfully completing a "distressed transaction" is important for the society - helping maintain employment in the business and its supply chain.

In the midst of falling business valuations because of the above uncertainties and challenges, smart investors will identify and acquire "cash-thirst" SME businesses that are significantly undervalued.

We can expect to see some good examples of companies buying competitors, customers and suppliers as the liquidity problems bite. Now the question comes: If businesses can be acquired at comparatively low valuation, is it still worthwhile undertaking a formal due diligence process?

Due diligence is still crucial for three key reasons:

1. Time: The acquisition process uses the most valuable resource of all - time. If potential problems can be identified early, it prevents the buyer wasting time chasing a deal which will never be completed.

2. Money: Whilst an acquisition may be at a comparatively low valuation, it may also imply an underlying risk of unsustainable earnings.

3. Tax: Deal structure is still crucial - particularly from a tax perspective - and professional advice is necessary to devise a tax efficient structure.

The focus of distressed company acquisition differs from typical financial due diligence. There are a number of major risks to consider:

First, if you are buying a company, you inherit its assets and liabilities. Distressed companies inevitably have substantial liabilities, not all of which appear on the balance sheet. It is vital to be aware of the extent of these unrecorded commitments, guarantees and contingent liabilities.

Second, in terms of liquidity, it is particularly important to focus on cash and working capital requirements. The traditionally used method of looking at old balance sheets and payment terms will need to evolve to cover the effects of the current challenges facing Hong Kong manufacturing SMEs, particularly those with operations in the Pearl River Delta.

Third, a difficult global economic environment, particularly in the US and Europe, adversely affects the creditworthiness of overseas customers. It is therefore crucial that a buyer understands how profitable (or loss-making) different overseas customers are. The financial health of key customers should be assessed, and this can be extended to key suppliers as well.

All in all, due diligence on distressed transactions is as important as it has ever been, with an emphasis on the need for all advisers to move quickly.

The author is a Partner for Advisory Services at Grant Thornton Jingdu Tianhua, a member firm of tax consulting group Grant Thornton International in Hong Kong. The opinions expressed here are entirely his own.

(HK Edition 05/12/2011 page2)