When I went to Shanghai with the NUS Overseas College programme, we were learning how research and innovation could become businesses. The examples we had studied came from the United States. In Shanghai, some of the most interesting businesses were in industries we might have overlooked. We learned from meetings, conversations with colleagues and the ordinary work of finding an apartment.
I think about that experience when someone describes a market as too risky to invest in. A view about the country can tell you where to start asking questions. What matters for the deal is how those risks reach the business and what the company can do about them.
Follow the risk into the business
Suppose we are looking at a Chinese manufacturer of testing equipment. It sells to local factories and relies on one overseas distributor for much of its export business. Management sees that relationship as a source of stability. The distributor has been buying from the company for years.
I would start with the contract, the order history and what the distributor actually paid. Does it commit to a minimum volume? Can it switch suppliers at short notice? How much stock is sitting in its warehouses? A distributor that still has six months of stock may have little reason to place another order, even if the relationship is good.
Then ask what happens if the distributor stops ordering or needs new documentation before it can import the equipment. Which products and orders are exposed? Can local customers use the same equipment, or would they need a different specification and months of testing? The answers tell us how long cash could be tied up in stock and whether the business could finance a change of course.
Find out what the investment gives you
Which company signs the contracts, owns the equipment and receives the money? Which company would issue the shares we are buying? If they are different entities, I would ask local advisers to verify how they are connected. I would also want to know who can commit the company to major spending or a new loan, and what information minority shareholders can see.
I would test the exit in the same way. If the plan depends on selling to a larger manufacturer, who might buy, what would they want to own and whose consent would be needed? If the investor expects dividends along the way, trace how cash would get from the operating company to the shareholder. Have advisers check the route against the proposed structure and the rules that apply to it.
Let the evidence change the deal
Good diligence can change the price, the amount we commit upfront or the evidence we need before investing. If the manufacturer says local buyers can replace lost export orders, I would want to see a buyer qualify the product and place a paid order before relying on that assumption. And if an important agreement cannot be verified, a lower price may do little to solve the problem.
What stayed with me from Shanghai was the value of checking assumptions against how people and companies actually work. In a deal, that means knowing which order, approval or cash flow could fail, and what we would do if it did.
Adapted and expanded for IJK Capital Partners from Un-investable on Kenny Ng’s personal blog.