The widespread delisting of Chinese companies in recent months, in many cases because of fraudulent behaviour, has investors rethinking their due diligence options when it comes to Chinese firms and looking harder for clues that something is amiss.
In an article in McKinsey's Quarterly this month entitled "Due diligence in China: Art, science, and self-defence", David Cogman argues that overcoming investor concerns may mean going back to some investing basics. "Diligence is, after all, as much about developing a sense of trust in a company as it is an exercise in finding and checking facts," he writes.
The aggregate market capitalisation of US-listed Chinese companies fell in 2011 and 2012 by an incredible 72 per cent – and about one in five was delisted – even as the Nasdaq rose by 12 per cent. And it's not just in America – since 2008, about one in 10 Chinese companies listed in Singapore has also been delisted or suspended.
False documentation
Among the high-profile cases were Longtop Financial Technologies, a China-based software company charged with fraud in 2011, and Sino-Forest, a forest-plantation operator that announced plans to liquidate itself last year after allegations of fraud.
The extent of the damage to investor confidence is hard to measure, but this slide in market capitalisation suggests investors are lumping bad and good companies in together.
In many cases, the problem was fraud, and often involved false or misleading documentation that would not have been discovered by a regular audit – since such audits rely on documentation supplied by the company itself, Cogman writes.
He said financial, portfolio, and corporate investors need to revive the habit of looking beyond the usual statutory and regulatory disclosures for less direct indicators of trouble.
“Such indicators are not conclusive in themselves. Nor are they a replacement for the other aspects of diligence. But they can be valuable clues that something unpleasant is hiding under the surface, even when everything looks healthy on paper,” he adds.
