So many times, there is not enough due diligence done prior to doing a major deal in China and the cost of researching a potential supplier, acquisition, etc is small compared to the costs if there is fraud, or worse.
I wish I had written this insightful article but in fact it is from a marvellous company called Muddy Waters Research (www.muddywatersresearch.com) and was posted on their website. So many times, there is not enough due diligence done prior to doing a major deal in China and the cost of researching a potential supplier, acquisition, etc is small compared to the costs if there is fraud, or worse. Please go to the linkhttp://www.muddywatersresearch.com/2011/02/six-rules-china-due-diligence/ for the complete article but here are the highlights.
Rule #1 – Approach the company as a potential customer does.
You want to see what the China side customers see. Fraudulent companies have far less confidence that they can fool a Chinese company in their industry than they do about fooling a starched shirt analyst. Moreover, they’re usually less willing to take legal risks in their home market (China) than they are in the United States.
Rule #2 – Take all company-provided introductions with a grain of salt.
When companies set up meetings or conversations between you and their suppliers or customers, take them with a grain of salt. The people on the other side owe you no duty to be candid. You have no legal – or even social – recourse to them. In a country where a lot of managers earn less than $500 per month, it’s not hard for an unscrupulous company to buy someone’s loyalty for the duration of a meeting or phone call.
You should instead rely on your own networks to help you understand the company and industry. If you don’t have those networks, you unfortunately shouldn’t be making investment decisions in China by yourself.
Rule #3 – Try to construct your own fraud scenario.
At some point in evaluating every investment, you should stop and ask yourself how you could have staged everything you’ve been shown or done with the company. It’s good for American investors to practice this mentality because it makes us less credulous. More importantly, this kind of thinking makes clear how surprisingly simple measures (e.g., switching factory signs before you arrive, painting old machinery) can be so effective in fooling the credulous investor.
Rule #4 – Forget about the paper. Focus on the operations.
In today’s world where you can buy a competent colour printer for less than $200, it’s hard to understand why investors place so much faith in bank statements, invoices, and contracts. China’s deal making world abounds with stories of forged bank statements and other documents leading to disastrous deals. Unfortunately, most auditors apply the US audit playbook in China – reviewing and taking documents at face value.
Instead, you have to look at the operation itself. How much does the output seem to be, how much material is moving into and out of the factory, does the office seem to be a hive of activity, how many employees can you count, what is the square footage of the facilities? These are all basic questions one should concern themselves with during site visits. And it pays to visit two to three (or more) times – a good fraudster can put on a show, but they’re unlikely to be able to do it the same way each time. Watch for the subtle differences.
Rule #5 – Always speak with competitors.
Competitors with real businesses can usually tell you one of two things about a fraudulent competitor – either that it’s obscure (sometimes the “competitor” is hearing about the company for the first time); or, that they know it’s a fraud. Many competitors will be reluctant to speak openly at first about a fraudulent competitor if they know you’re a potential investor in the fraudulent company. However, if you’re a potential customer who is shopping around for a vendor, it can be a different story.
Rule #6 – Do not delegate.
A lot of experienced China investors have stories about subordinates who colluded with a target company to attempt (and sometimes succeed) to defraud the investor. Be attune to the dichotomy between the investment funds at stake and the income / wealth of the people on whom you rely for judgment.
Clearly the rules of the game are different in China than in the US. There are many solid companies and managements in China. However, unscrupulous people know that most US investors aren’t prepared to deal with a full-fledged attempt to defraud them in China. Above and beyond all else, ask questions and never accept an answer at face value.
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