Risk Assessment for a De Novo Company in a Developing Country - Case Study Example

Contents Introduction 2 Risk Assessments 2 Operational 2 Asset Impairment 4 Competitive Risks 4 Franchise Risks 5 Mission for the New Business 5 Risk Appetite and Tolerance 6 Strategic Objective and Related Control Objectives 6 Required Control Activities Following the ERA Model 7 Monitoring Process Including Description of the Key Risk Indicators Using the ERA Model 8 Why (from a risk perspective) It is Worthwhile to Invest in this Plant Now 10 Bibliography 12 Introduction This paper is an assessment of the building of an automobile parts factory in China. It will analyze several risk factors, and establish a vision and goals for the enterprise. This is a joint venture with a regional government in China, which has the opportunity to develop automobiles in one of the fastest-growing automobile markets in the world[ CITATION Peo04 \l 1033 ]. The question that this paper seeks to answer is: is the opportunity worth the risks? Risk Assessments Operational China has been in the joint venture automobile business for only 26 years, from the time that the first Joint Venture law was promulgated by the government. The first joint venture, concluded between the Beijing Automobile Corporation and Jeep Motors (at the time, American Motors) took four years to conclude, and ended in failure after a loss of significant investment on Chrysler’s part. As a pioneering effort, both the Beijing government and automobile makers learned a good deal about what can go wrong, and how to do it differently[ CITATION Man97 \l 1033 ]. The second joint venture resulted in a significant success which continues to the present day. Volkswagen negotiated a joint venture with the regional government of Sha[ CITATION Cho98 \l 1033 ]nghai and Shanghai Auto Works to develop and manufacture the Santana for the Chinese market. Volkswagen had learned from the Jeep experience that allying itself with a regional, rather than a national, partner would help to shield it from the vagaries of change at the center, and insure a strong ally for growth. In the 1980’s, all the ground rules had to be established—legal, employment and investment. By this time, with 6 million vehicles per year being manufactured, the ground rules are much better-established. Indeed, one can argue that China is now in its 4th wave of automobile industry expansion: the decade of the ‘80s for the pioneers and the Japanese importers, the early 1990’s for the refining of the joint venture law, the late 1990’s for preparation for entry into the WTO (and gradual liberalization), and post-2002 for the fall of nearly all tariffs on autos and auto parts. With 6 million autos, trucks and busses manufactured per year, China now ranks in the top 5 nations in the world for automobile manufacturing. The operational risks are nevertheless major. Although the cost for labor is 5-10 times lower than in the developed West, there are a number of side expenses which can make costs higher than thought. Management is not yet developed, either in its people-management skills, or in its ability to profitably employ capital equipment and labor. The first risk, therefore, is finding proper operational management to build and operate the plant[ CITATION Dod95 \l 1033 ]. The second operational risk is the ever-changing nature of Chinese government law. Tax laws are changing rapidly, with the result that an operation that looked profitable last year could become less so in the next few years. Each region’s interpretation of federal tax and property law is different, which requires a significant understanding of the customs of the province in which one locates the factory. The third and most important operational difficulty is the need to bring on local managers. China operations through Guang Xi, or connections, as much as it does on rational Western notions of supply, labor and demand. Westerners just landed in China have little chance of breaking into the complex social networks developed in China. The operational risk, therefore, is to find the right, connected local managers, and to tie them to our joint venture in a way that insures that the company performs. Asset Impairment It is not usually possible to buy land for ownership in perpetuity in most Chinese regions. This means that the concept of “ownership” of land has a political dimension which can change with the whims of the central or regional government. Whereas terms were quite loose in the 1980’s and early 1990’s, the Chinese government has significantly hardened its negotiating stance, and made it more difficult for foreign companies to take assets from the country. One should count on any investment coming in to stay there. Secondly, China is developing a legal structure around property ownership, but history suggests that, if the central or regional government declares a plant, a piece of property or even capital equipment needed, the company can end up losing the asset. The most famous case was McDonalds in Beijing, which lost a prime site when the Beijing government realized that it had not driven a hard-enough bargain, and McDonald’s retail site turned out to be the highest-volume retail site in the world for the restaurant chain. The Beijing government took back the property. Competitive Risks Auto parts are a two-edged sword in China. The world auto parts industry has discovered that, for those parts that have a medium- to high labor cost component, China is an endless supply of inexperienced and relatively skilled labor that can produce their parts. If our joint venture establishes itself, there may be several competitors who follow in quickly behind us. There are no barriers to entry. On the plus side, by creating a low-cost parts manufacturing center, our company can anticipate the competition and derive some benefit from lower-cost parts on the world market. On the other hand, local companies are quite aggressive about developing parts to compete with our company. As in Japan in the 1950’s and 1960’s, reverse engineering is rampant, and can cause problems for our joint venture before it achieves a profitable level of volume. Franchise Risks Franchise value would allow our company to charge a premium over generic auto parts suppliers for the perceived quality of our products. This is our guarantee that foreign and domestic Chinese automobile manufacturers would like to use our product in preference to a commodity-type supplier. There is a danger of copying in China, which is greater than other parts of the world. As in developing countries such as India, copyright laws and enforcement are relatively weak. If an erstwhile competitor would like to copy our product, and even put our name on that product, it may take some time before we would be successful in closing down that company’s copycat products. If we choose to franchise a brand from a third-party, well-known licensee, we should be prepared in their contract to enforce that company’s trademarks and patents in China. Since the courts are relatively slow and inefficient (Guang Xi helps), it may be difficult to guarantee such enforcement over time. Mission for the New Business The company has an opportunity to produce parts for the domestic Chinese market, supplying both foreign-owned and locally-owned ventures. As one of the fastest-growing vehicle markets in the world, China offers significant growth opportunities. Since autos account for only 1/3rd of total Chinese vehicle manufacturing, and roads are being built rapidly, our company can expect to increase auto-related parts sales at a par with or in excess of underlying auto manufacturing growth[ CITATION Xin99 \l 1033 ]. Risk Appetite and Tolerance Our company is relatively risk-averse. We had looked at China as early as 1985, when Chrysler/Jeep (then American Motors) concluded its joint venture agreement. Although China had a joint venture law, it appeared that too many things were still up in the air. Even as late as 2000, when China was producing 2 million vehicles, some major manufacturers, such as Ford, were new entrants. It is only now, as a rapidly-maturing business, that our company feels comfortable to assess the risk. Strategic Objective and Related Control Objectives It appears that the regional governments which control investment and joint ventures are less willing now than in the past to support wholly-owned subsidiaries of foreign companies. Recent changes allow for majority foreign-owned joint ventures, which is preferable to our company. In the longer term, we expect China to become the largest auto manufacturer in the world, both to satisfy domestic demand and to start major exports. At that time, we would like to deepen our investment and involvement in this market. Although the initial plan is to manufacture parts designed elsewhere, we would like to quickly develop local design capabilities, and eventually integrate Chinese engineering staff with the rest of our design staffs in order to (1) improve our design efficiency (design output per dollar, and (2) internationalize our attitude towards parts manufacturing and procurement. Inherent Risks The company’s risks are primarily operational, with some risks on the legal side. Those companies which have engaged in joint ventures and lost money or pulled out have done so generally due to misunderstandings on the part of the Chinese joint-venture partner about the goals of the project. Since many of the JV partners are related to regional governments, it is important to preserve goodwill between the partners. Required Control Activities Following the ERA Model Management at headquarters needs to ensure that the relationship is established at top levels, and monitor the ‘temperature’ of the relationship over time. In order to do so, the company needs to send over two or three managers who will be in top positions, and who have the day-to-day interaction responsibilities with local partners. These positions should include: CEO of the JV and CFO, who will insure that the funds invested and profits are properly accounted-for and sent to the appropriate shareholders. Since China has just adopted GAAP-like international accounting procedures, there is a risk that the entity may not fully conform to the company’s overall accounting practices. It is important for the Board’s audit committee to therefore assure that an outside (i.e. non-Chinese) accounting firm verify reporting as well as audit results afterwards. Monitoring Process Including Description of the Key Risk Indicators Using the ERA Model It is important that the audit function is not simply an “after-the-fact” exercise. The company needs to put policies and procedures in place which conform to SEC disclosure rules and US laws about foreign practices. The Board should create a separate China subcommittee, and review on a regular (perhaps quarterly) basis the conformance to these requirements. In addition, the outside auditing firm can recommend additional ‘safety’ measures to insure that the JV complies. Thus the risk assessment and mitigation will be at two levels: local Chinese JV and Headquarters, verified by an external accounting firm (both process and results), and reported independently to the company. The primary concerns in this process design and monitoring are the following: Growth-related: Errors of omission or commission Culture-related: Incomplete management information Information Management: Inefficiencies and breakdowns As American Motors found in the 1980’s, it is important to have one’s objectives clear at the outset of the negotiations. Since there is a good deal of expertise in negotiating auto parts joint ventures with Chinese companies, it would behoove our company to work with a group of consultants to derive a checklist of items which we can insist on and ‘must have’ in order to complete the agreement and make the investment. This group can also help us with the due diligence on the right groups with which to do business, and experiences with those groups in the past in other business ventures. These items should include the following: Ability to hire and fire at will Ownership of the property: either outright or for a very long period of time Ability to buy out the minority joint venture partner; ability to obtain operating and management control of the venture Ability to have access to the foreign capital needed during and after building Ensure that the local venture partner has ‘skin in the game,’ and will benefit from a profitable venture in the same way that our company will do In addition, the agreement must preserve our ability to generate and repatriate profits, to go public on the local stock exchanges (Shenzhen or Shanghai, as well as Hong Kong), to not pay confiscatory taxes, and to engage in additional joint ventures or wholly-owned ventures where desired. Finally, the agreement should foresee the opportunity to sell all or part of our venture to a third party. In particular, the spate of acquisitions which continues to consolidate companies in our business needs to be provided for. If, for example, we receive an unsolicited offer from another auto parts manufacturer, the region and local JV partner need to agree to the merger, or we should at least have terms that allow for their approval, “not to be unreasonably withheld.” Once the plant is built and our company starts to sell on the local market, there is relatively little that we can do to mitigate risk, other than to monitor the commercial state of the market and trends in taxation and regulation on our industry and our company. In these respects, risk monitoring and mitigation is similar to any OECD country. Why (from a risk perspective) It is Worthwhile to Invest in this Plant Now As mentioned previously, this is a relatively late time for our company to invest in China. Although not all laws and customs are well-known, the risks of failure are significantly lower in China than they have been in the past, and may be significantly lower than other large, developing countries like India where the legal and cultural infrastructure is not as developed. With our company’s long-term strategic objective of growing its parts business in all important automobile markets in the world, we have three key reasons for building a JV plant in China now: 1. China’s domestic market is in the top 5 already, and will grow to number one before 2020. The domestic market alone makes China a valuable market. 2. China’s low costs of production make it a good country platform for export of auto parts from our factory there to other countries. 3. China’s low costs of development, hard-working people and high skills level give our company the longer-term advantage of developing not only manufacturing from foreign-developed designs, but to create a fully-integrated and cost-effective business system in China which, when integrated with the rest of our worldwide network, will result in improved efficiency and product output. Bibliography CITATION Peo04 \l 1033 : , (People's Daily 2004), CITATION Man97 \l 1033 : , (Mann 1997), CITATION Cho98 \l 1033 : , (Chow 1998), CITATION Dod95 \l 1033 : , (Dodds 1995), CITATION Xin99 \l 1033 : , (Xinhua 1999), Read More