The dirty truth about Due Diligence in China

| April 6, 2015

 

 

As a follow-up to my previous article titled The Mirage of Due Diligence in China, I thought it would be helpful to list some of the keys to effective Due Diligence in China.

There are hundreds or articles and books on the subject and there is no indication that a “cookie-cutter” method exists, rather, it is important to consider that common sense is the key ingredient.

 

Whether you are in the process of acquiring a company, forming a partnership or looking for a vendor / partner to manufacture your product, the basics are the same. The only thing that changes is the portion of the DD exercise you will focus on.

 

The old saying that Anything can happen in China certainly applies when it comes to understanding the hidden side of this often “dirty business”.

 

China does not have a monopoly on byzantine accounting standards or opaque regulatory systems but this is a major factor to be sure and should not be taken lightly.

It is also important to bear in mind that anything and everything can be faked in China. I have seen fake licenses, fake University Degrees, fake tax coupons, fake Identification Cards, fake cars, even fake eggs…   (I never managed to understand the economic justification for a fake egg…)

 

There are a few obvious rules to be followed:

 

  1. Insure you have a Mandarin speaking, trusted associate to help you with all transactions. Make sure this person is someone you know and not related in any way to local officials or targeted business partners.

 

  1. Insure the company your are dealing with is legitimate.

 

  • Ask for a business license. This is common in China and should not trigger any adverse reaction from the company, unless they have something to hide. This will allow you to ferret out potential middle men who may pose as a legitimate business.

 

 

  • Compare the company’s Chinese and English websites to detect any anomalies

 

  • Pay particular attention to the scope of the company as listed on its business license. An accounting firm cannot be in a position to offer precision instruments…

 

  • Pay an initial visit for innocuous reasons. This point is likely the most difficult and unsettling aspect of initial due diligence. You should arrive mid-afternoon for the visit and come back the next morning to complete the visit so that it covers two days. It is harder to maintain a “show” for consecutive days.

 

  • It is widely known that companies will put on a show for visitors, going as far as changing the name on the front sign, bringing in temp workers to spruce up the perceived capacity, borrow raw materials to increase stocks. I have actually been in situations where the entire organization was fake, down to the person posing as the factory owner.

 

  • Given how involved such a “set-up” really is, it is very difficult to replicate it repeatedly and accurately, therefore, repeated visits are required, particularly if something does not seem right on the first visit. Although facing a complete fake is rare, dressing up a factory for a visit is common, in fact it is automatic. When I ran my factories in China, we would always prepare for a visit and try to place our best foot forward. This can be as innocuous as cleaning up the factory and insuring that workers are wearing protective clothing, all the way to repainting old machinery to make it look new, borrow machinery that maybe required for the visitor’s job, staff up the laboratory that is usually unused, bring in additional workers to increase the ranks and project a capability that may not exist, etc.

 

  • Be prepared with questions that will allow you to deduce the actual capability and capacity of a company. Someone selling 5 million widgets a month, requiring the equivalent of 1000 workers will not be in a position to justify doing so with 100 workers. If they do, it implies the use of an elaborate sub-contracting operation and this will multiply your risks exponentially.

 

  1. Ask for a list of current and past customers and suppliers. Once you have the list, contact them and ask for their feedback. Speak to more than one person, particularly if you were given a contact name… collusion or some sort of Quid Pro Quo could be at play between the plant and the contact person.

 

 

Any reluctance or refusal with the initial points should be regarded as a major red flag and should lead you to walk away immediately.

 

 

Once the initial due diligence is completed, it is time to address more specific issues.

 

Before we identify these important points, it is necessary to understand there are no Anti-Trust laws in China or in Hong Kong. As a result, industry associations are free to collude on any subject. It is common practice for industry associations to allocate customers amongst themselves, compare and negotiate quoted prices to induce customers to chose one or the other vendor and in many cases, help prop-up an ailing friendly competitor.

 

While this may seem surprising to a Western operator, it is completely legal and can seriously affect the legitimacy of a competitive bid process.

 

This is important if your aim is to find comparable vendors in a specific region for competitive purposes. Chances are they know each other, have discussed your visit and already coordinated their answers. If you are looking for competitive bids on the same product(s), you would be well advised to do so in different regions or countries.

 

Here are specific and technical due diligence action points:

 

  1. Financial

 

  • Keep in mind that China GAAP practices are not the same as Western GAAP. Having a financial expert well versed in both systems is critical to any DD process.

 

  • The large majority of companies operating in China keep multiple sets of books. At the very least, they have one set for the tax authorities, one for the Customs authorities and one “true” book that is used internally and with partners. In addition, companies that are foreign subsidiaries will have additional sets, covering their country of origin and possibly one to cover their shell company requirements if they are domiciled in places such as Hong Kong or the Virgin Islands.

 

  • Sorting out true financial results maybe out of the reach of the most experienced financial experts, with the possible exception of Chinese companies that are listed overseas, although even that is tenuous, given the number of frauds uncovered at that level. Here is a great article from McKinsey on this particular issue.

 

  • Examining the books of a Western (or HK) parent company maybe more important then the local books.

 

  • Local books may not reflect internal fraud such as bribes, payouts, fantom workers, partial social security payments, inflated prices paid to suppliers to be kicked back to individuals, and the list goes on.

 

  • It maybe more useful to examine “material-in” records versus payable records, count the actual number of workers present and compare with time sheets, shipment records vs customs records, etc…

 

  • The most effective way to understand a factory’s financial position is through its suppliers. If the factory is using third and fourth tear vendors, or worse middlemen, in order to maintain an acceptable level of supplies, it is likely that first tear suppliers are no longer willing to extend credit and the factory is not in a position to pay cash for deliveries. This is when they turn to local loan sharks who act as a middle men to supply material and charge an exorbitant premium for their service. Their behavior is straight out of a bad mob movie and they often enjoy the protection of local authorities. In many cases, they are directly linked to corrupt local officials who push the company over the edge to deposit them in the arms of these “facilitators”. Without a clear understanding of a factory’s position in relation to their vendors, you expose your business to inevitable disaster.

 

 

  1. Operational

 

  • Obtain an Org Chart. This is not only good DD practice but it will give you a road-map to middle and lower management staff who are often more aware of potential issues. Compare the org chart to actual payroll records.

 

  • Obtain an accurate count of workers. Phantom workers are a recurrent issue in trying to determine accurate capacity. We once discovered that an HR mid-level manager had managed to circumvent the system and issued dozens of fictitious company ID cards, linked to his bank account. He distributed those cards to actual workers who were taping these cards on their forearm, under their sleeve, and all they had to do was to swipe the entire arm for the machine to read all the cards. We placed a 2 second delay on the machine to avoid such a problem in the future, but this is a good illustration of what can happen.

 

  • Look at the equipment and evidence of maintenance records. If there are no records covering months of maintenance activity, it is likely the factory poses a safety and operational risk or worse, that the machinery is borrowed for the purpose of the visit. Don’t be fooled by how difficult it may seem to you to borrow and install heavy or complex machinery, it is common place in China.

 

  • Inquire about the source of electricity and how many scheduled brownouts the factory is subject to. Double check this information with local authorities. Although most factories have diesel generators as back-up, this is historically a good source of excuse for late shipments. Electricity is usually a great pressure point for local authorities who are intent on leaning upon a particular business. Blocking diesel trucks from entering a facility is also common place and can place a factory in a very precarious position.

 

  • A major source of challenges for seasonal operations in China (industries that are heavily dependent on a specific selling season) is the high turnover of workers. The toy industry for example suffers from an average turn over that far exceeds 50% yearly and poses a serious challenge for factory operators when it comes to employee retention, initial training, on-going training and ramp-up lead-times. As a result, many factories turn to Labor agents who control a pool of workers they can move from location to location. They usually charge a percentage of the wages paid to the workers and act as surrogate in terms of filing all adequate regulatory documents. This is a very grey area of the labor law in China and can often produce major problems if the agent receives a juicy offer from a competing factory and decides to pull his workers. Another murky source of workers is the “vocational schools” renting out workers and designating it as “internship” which under the law, allows these “schools” to offer minimal curriculum and use their students as virtual indentured laborers. The students actually pay a fee for joining the school with the promise of a degree at the end. Soon, they realize that the majority of the curriculum consists of assembly line work at the local gadget factory, where a good portion of their meager wages are taken by the school. These potential challenges cannot be overlooked and pose a serious threat to the customers. Interviewing workers, without the presence of management minders is the only way to eventually discover the truth, although most workers are well coached on what to say. Many factories spend more time coaching workers on dealing with inspectors then they do on training.

 

  • Asset tracking within a business in China is virtually impossible. Due to the restrictions related to the transfer of assets between entities, machinery and equipment is often devoid of traceable elements. Book values are inflated and the number of assets fluctuates depending on the need to meet one or another audit.

 

  1. Regulatory

 

  • Obtain all certificates, including Business License, Tax License, Customs Certificate. Check their authenticity against these administrations website.

 

 

  • Request a statement on the status of Social Security payments. Many companies obtain waivers from local governments, allowing them to skirt Federal Laws and only cover a portion of the work force. This is a grey area and many companies have found themselves in trouble with Federal authorities, once their “local protection” There is also a significant risk related to CSR (Corporate Social Responsibility) requirements from customers.

 

  • Many industries run CSR programs, requiring their factories to abide by certain well-defined criteria covering business, health & Safety, hiring practices, the age of employees, etc.. Since many major retailers have signed on to these programs, a factory lacking the proper accreditation maybe prevented from shipping goods to the intended customers. These so-called accreditation are themselves subject to a high level of corruption; it is therefore prudent to verify certificates for authenticity directly with the issuing organization. It is also smart to use common sense during the exploratory visit. If a particular industry requires all workers to be 18 and older and you encounter many workers that appear to be very young, it is a red flag that a problem may exist. If the factory is playing with fire, you will eventually burn with them.

 

  • Worker fraud is the number one concern of HR departments in China. Obtaining a fake ID is easy and cheap. Most factories are equipped with electronic readers that allow them to identify fake ideas, although this implies that the HR staff is not cooperating with fraudsters. Workers that do not have valid residency permits will undoubtedly resort to fraud in order to maintain their employment in a particular industry. This is prevalent in regions that employ a large amount of migrant workers, such as the Guangdong province. Migrant workers must obtain a permit from their home-based police department to relocate to another region; it is a form of internal work visa. Since China operates with a number of different rules and regulations depending on location, the intent is to prevent large migrations to economic zones that are more advantageous then others. For example, minimum wage in the Shenzhen Special Economic Region is significantly higher then that in the rest of the Guangdong province and it is every worker’s dream to move there. Without this internal visa, the imbalance would present a significant challenge for the authorities.

 

  • Sanitary, Health and Safety regulations are administered by local authorities and this is a significant pressure point when it comes to fraud and corruption. It is necessary to hire third party inspectors (or your own staff if that’s an option) to conduct independent audits in these areas. A visit to the kitchens, dormitories and common areas will quickly determine if a problem exists. Insist on complete access and do not allow your minders to steer you to well prepared areas of the facility. Again, factories are happy to dress-up the situation with showcase facilities, props and often temp workers (read actors) that are brought in solely for the purpose of your visit.

 

  1. Quality

 

  • We can all agree that product quality is central to a brand’s identity and credibility. Controlling quality in China requires a set of skills ranging from technical knowledge to investigative technics. In the context of a Due Diligence exercise, it is necessary to assess a factory’s internal systems, its quality culture and feedback from past and existing customers. Certain industries operate under strict quality and safety requirements that are codified by their governments or regulatory agencies. In China, the prevailing culture is about money, finding the shortest route to a problem and covering issues by all means necessary. Although there are plenty of anecdotal stories to support this assertion, I recognize that there are organizations in China who have managed, through hard work and years of education, to bring those issues under control.

 

  • Most organizations rely on the idea of setting a standard for a product by requiring the factory to deliver a production sample. Said sample is then approved by the client and serves as the standard by which all production is measured, either for internal purposes or for visiting inspectors. Very often, these samples are either specifically manufactured to the desired standard or altered to reflect a more lenient standard desired by the factory, or lost altogether. The practice of manufacturing a standard sample, either for initial sample or for subsequent inspections is called “The Golden Sample”.

 

  • Insuring that you are in fact looking at a true Production Sample (representative of what is coming off the assembly line) requires for the client to keep a vigilant eye on the process, either through its own employees or through a trusted third party inspector, bearing in mind that factories are very adept at dealing with inspectors to insure that they see things their way.

 

  • The most effective way I know to deal with doubts is for management to visit the factory during the production process and personally pick product coming off the line for further tests and analysis.

 

We have covered here some of the more salient points related to due diligence in China (and many similarly positioned countries). Although this article does not suggest that this is an exhaustive list, it is nevertheless a good start and should allow you to ferret out some of the most blatant practices designed to obfuscate your attempts to obtain reliable information.

 

Having someone at your side, that has gone through this process many times and has learned from both their mistakes and successes is a must, if you are to avoid filling the ranks of the many who have failed.

AUTHOR - Richard S Ellert