Most Chinese factories are so poorly managed, there are real opportunities for savvy buyers who plan to restructure the company and boost profitability. At the same time, there are real dangers to avoid, and serious due diligence is necessary.

Looking at a factory from the perspective of a potential acquirer involves an analysis at many levels. I made the assumption that the due diligence process focuses on a Chinese-owned company.

1. Legal risks

The factory might not have the right scope of business, for example. Or they might be conducting a business that is illegal based on China’s law. Without a thorough review of their fundamentals by a local lawyer, you might buy a business that can crumble and disappear any day.

Sometimes it is more difficult to spot. The factory might be in an industry that has shady practices — for example, no VAT is paid in the construction industry and this practice, though illegal, is tolerated of local companies. It effectively prevents foreign companies to be part of that game. As soon as the local authorities realize the owner is non-Chinese, they will make it clear the business is operating illegally.

You can read about other examples in this article.

2. Compliance risks (in addition to strictly legal risks)

Do the factory’s operations have an environmental impact? What is the local government planning to do to this industry? For example, buying a ceramic factory in Foshan is probably a very bad idea — you will probably be forced to relocate to an inner province pretty soon.

Do production processes involve safety risks? In case an accident happens in the same industry, your factory might get closed for investigation. That’s what happened to 214 metal processing factories after the explosion in Kunshan this summer!

This type of risk is very industry-dependent and location-dependent, and is not always easy for industry outsiders to estimate.

3. Financial statements

Because of immature accounting systems and massive tax evasion, one can’t trust the level of profit declared to Chinese authorities. However, I would look at three indicators:

• Profit: if it is positive, the business is probably making more profit than declared.
• Assets: I would check whether their estimated value makes any sense.
• Debt: if millions are owed to suppliers, it will be very difficult to push them to do a better job.

Note that getting a Chinese business’ financials has gotten much harder recently. In some cities, specialized firms can still get their hands on this information without the target company being aware of it.

4. Manufacturing practices

How far away are they from best practices in their industry? Can capacity be doubled or tripled by elevating a few bottlenecks and without any investment?

A big red flag is high levels of inventory. It is a sure sign of a mismanaged factory. So the good thing is, it signals a lot of room for improvement. But the bad thing is, it increases the price of the acquisition because the owner has a rough idea of how many RMB he spent on that stock.

It takes one of our consultants a few minutes to have an idea about a manufacturer’s efficiency and about its systems’ maturity. But, to an untrained eye, all factories look practically the same.

5. Ability to satisfy customers

How good and consistent is product quality? Are there frequent shipment delays? As a consequence, are customers ready to switch to a competitor who is a few pennies cheaper?

If calling a few customers and asking them questions, or reading through a salesperson’s emails, is impossible, there are other solutions to evaluate this point. A good look at their processes, their quality system, and if possible their records, will result in a reasonably accurate estimate.

6. Exposure to local competition

Since one can’t trust a Chinese company’s accounting books, a good approximation of its margin is its ability to avoid local competition. As Jack Perkowski wrote in Managing The Dragon:

The China market is actually two distinct markets. For virtually every product, there is a ‘foreign/local’ market, characterized by higher technology and higher price, and a second purely ‘local’ market, which is characterized by lower technology and lower price.

So you definitely want to avoid being in the “local market”. But the ability to launch new products also plays a role in maintaining healthy margins, especially in electronics, mechanical products, and similar industries.

7. HR practices

I wouldn’t waste any time looking at HR records or asking for formal one-on-one interviews with random workers. These methods have severe limitations, as I wrote before.

The best is to ask shopkeepers and passersby in the neighborhood if the factory has a good reputation and why — for example bad food or horrendous working conditions. A factory with a bad reputation will have trouble attracting good elements for years to come.

Another method is to look at the working conditions and potential hazards to operators. If even the basics (e.g. the workers don’t have protective equipment and aren’t aware of the dangers to their health) aren’t done right, it means management doesn’t care about safety. And it translates into higher staff turnover.

8. “Face to face” due diligence

I would look at the key people and try to answer a few questions:

• Why does the boss want to sell out? Does he have another solid source of income (another business, some real estate investments…)? Or has he just lost a key account?
• Are department heads competent? How long have they been in place? Is there a certain harmony among them, or is communication difficult?
• How many members of the owner’s family have a position in the factory? The fewer the better.
• Who are the main suppliers? Are they part of the owner’s very close circle?
• If the factory sells a lot inside China: are there a few large accounts that do business “with the boss” rather than “with the company”?

9. What place for the owner in the future picture?

A Chinese “laoban” won’t act a professional general manager. In most cases, it is better for the boss to get out at the time of the sale. I would be extremely suspicious of a “laoban” who stays in a factory (whether he owns 0% or 50% of the business). I would suspect him of diverting money into his own pocket.

The touchy question is, who will act as legal representative? This position is often distinct from the owner or the general manager. The legal rep is the one who relates to government officials (in other words, who entertains them at night).

It is a key position, often held by a local employee who appears to be trustworthy. I won’t give general advice on this point… I’ll simply write that the acquirer should have a plan about how to deal with this issue.

10. Managing the switch from a Chinese-owned entity to a foreign-owned entity

What might employees do when they are told there is a change in ownership, and they are now part of a foreign enterprise? This is also a big question mark.

All of a sudden, all might ask for a raise, and might bring in the local labor bureau that might ask for retroactive payments of social security fees (as they did in last July with the Yuyuan shoe factory that employs 60,000 workers in Dongguan).

In theory, the proper way is to rent a building, start a new WFOE (foreign company), invest the capital required by the local AIC administration, hire staff, and so on. But this is not practical when acquiring a new factory. All I can advise is, talk to a lawyer and ask about the risks!

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Would you look at other aspects of the business?