Important issues in automotive parts enterprise acquisition

By Du Guoping, East & Concord Partners
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The automotive parts industry serves as an important complement to automotive original equipment manufacturers (OEMs). With China experiencing a large annual growth of vehicle sales in recent years, sales in the automotive parts industry have also grown impressively. Joint venture (JV) automobile enterprises dominate in China, and the majority of the corresponding automotive parts enterprises are also wholly foreign-owned enterprises or JVs. With the rise in domestic automotive brands, a number of excellent wholly Chinese-owned automotive parts companies have also begun to appear.

Du Guoping Partner East & Concord Partners
Du Guoping
Partner
East & Concord Partners

When a potential acquirer proposes acquiring an automotive parts enterprise, the principal motivation for doing so is usually vertical integration. For example, an OEM may acquire an upstream automotive parts enterprise and convert it into its supply department. Such acquisitions are mainly to reduce procurement costs.

Among similar automotive parts enterprises, for example, the logistical cost advantages arising from an automotive parts enterprise being within the support radius of an OEM support enterprise are relatively clear. It is thus possible for the OEM to successfully enter a certain regional market through cross-regional acquisition. As another example, an automotive parts enterprise of certain prominence may consider acquiring another such enterprise to enter a certain highly stratified automotive parts market or attain cross-regional development.

General acquisition procedure

Given that an automotive parts enterprise is established pursuant to the Company Law, an acquirer is usually required to conduct several investigations of the target enterprise before proceeding to acquisition. These investigations can include legal due diligence, financial due diligence (an audit also where necessary) and asset appraisal. Where the acquisition is based on a profit forecast, instead of obtaining an independent asset appraisal, the accountants will usually be asked to pay special attention to the state of the relevant assets in the course of the financial due diligence.

If problems are found in the course of the due diligence, the acquirer will, after deliberating on a solution, discuss the transaction plan, determine the transaction consideration, conduct negotiations and, finally, execute the transaction documents and amend the business registration.

Furthermore, there is a possibility that the acquisition procedure may entail the original target being required to continue to perform certain obligations after completion of the business registration amendment. Such matters will, on the whole, be largely identical to those involved in the procedure for acquiring an ordinary company. The legal due diligence report will also usually be a standard report. As inspections are launched at the outset of due diligence, the lawyers representing the acquirer will usually pay special attention to those issues that have drawn the attention of the acquirer.

Flawed assets

Automotive parts manufacturers own a large quantity of relatively expensive fixed assets and equipment such as robots and high precision machinery. The acquirers counsel will closely consider the state of the target enterprises material assets during due diligence, such as land use rights, real property ownership and the relatively expensive fixed assets and equipment. The lawyers will generally conduct a detailed investigation to verify the title to the assets.

The independence and integrity of such material assets are of great importance to the acquirer. As an automotive parts enterprise generally supports an OEMs production, its moulds, equipment, and other such items may in turn only complement specific OEMs or vehicle models. Accordingly, certain material fixed assets and equipment will have lost their normal use value due to a generational change or product upgrade, which, in practice, are indicated as being idle.

In financial terms, such assets still retain a corresponding book value after depreciation but, in fact, will have no realizable economic value for the acquirer after completion of the acquisition. Even if title to such assets is free and clear, they are nonetheless flawed assets for the acquirer. Accordingly, attention should be paid to such flawed assets during the due diligence.

An effective due diligence device is to conduct their verification based on the manner that the target company complements the OEM’s product line. The lawyers must conduct an onsite inspection of the place where the target company’s equipment is located to verify the state of use of the equipment and fully disclose it.

Material sales contracts status

When conducting due diligence, the lawyers representing the acquirer will usually verify the material claims and debts of the enterprise, e.g. its bank loans, security provided for third parties or other material debts. The acquirer’s lawyers will also conduct a full verification of the enterprise’s main suppliers and customers in recent years.

For a production enterprise, its major customers during the most recent three years are an important metric for judging the enterprise’s sales and future revenues, and the sales contracts between the company and its major customers constitute its main revenue source and the foundation for its claims. The sales contracts of ordinary enterprises are usually executed in the year in question and their performance is completed in the same year. As for relatively stable customers, a framework agreement may be executed in the year in question and sales carried out by way of orders.

In contrast, the main sales basis of an automotive parts enterprise lies in its OEM support. Further, parts required for certain models of the OEM’s vehicles are subject to a stringent certification procedure. Once the relevant parts produced by an automotive parts enterprise for the purposes of developing a certain model have been certified, they will continue to be supplied to the OEM until such time as the OEM’s vehicle model is upgraded or undergoes a generational change.

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This determines that the term of performance of a sales contract executed between a parts enterprise and an OEM at the current point in time will be for a few years into the future. This is because the supply of the parts will match the lifecycle of certain of the OEM’s vehicle models. Accordingly, lawyers need to pay particular attention to the “execute now, perform in future” nature of the target company’s sales contracts.

Du Guoping is a partner at East & Concord Partners

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E-mail: duguoping@east-concord.com

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