Effective due diligence deploys a structured methodology and trained personnel to review key components of a financial transaction, and communicate in a timely manner related results for decision-making with regard to structuring and/or monitoring the proposed or existing extension of credit. This can be through a warehouse line of credit, term loan, securitization, servicing platform or other means. Information obtained via objective and independent due diligence is a critical component of the lending process, and such efforts directly affect the confidence that key parties – including lenders, issuers and investors – have in the credit markets.
There is growing concern, publicly and privately, about the depth, quality and timeliness of due diligence performed by financial institutions. Several questions need critical attention, such as:
- What should the scope of procedures include?
- How large should the sample sizes be?
- Who should execute the procedures?
- How often should the procedures be performed?
- What should the reporting of results consist of?
- How can we work efficiently with the borrower?
Relying on a weak methodology, unqualified or inexperienced resources, or a poorly defined project plan to conduct due diligence magnifies the risk associated with these questions. This also results in a cumbersome, untimely and ineffective process that does not produce the key information needed for effective decision-making.
Challenges and Opportunities
There are numerous challenges in the due diligence process, including:
- The scope of procedures may not be well-defined, leaving key credit committee questions unanswered.
- Information requested may be poorly communicated; the borrower may have to spend extra time gathering new or different data than expected.
- Transaction responsibilities and timelines may not be well-understood; critical matters uncovered during due diligence may not be communicated to the appropriate people.
At the same time, there are many benefits to employing effective due diligence:
- Fewer unanswered questions by credit committees; higher confidence in credit granting
- Improved relationships and more open communication among the due diligence participants
- Reduced effort on behalf of all parties in the due diligence process, allowing for lower overall costs or increased coverage
- Reduced regulatory findings, as a strong, repeatable due diligence process demonstrates commitment to sound credit risk governance
Effective due diligence carries the added benefit of improving confidence levels in the capital markets.
Our Point of View
Effective due diligence helps interested parties:
- Objectively understand the assets and their underlying historical performance, including deviations from historical and recent trends.
- Identify key risks faced by the lender and establish a communication framework to address these risks, including potential risk mitigation efforts. This could also result in deal-structuring alternatives such as pricing considerations, collateral requirements or enhancements to required periodic reporting.
- Develop an understanding of critical policies and procedures used to prepare information used for decision-making and identify potential areas of information weakness.
- Provide a framework to address questions and concerns, allowing each party to focus on making sound business decisions.
Although not specifically designed to identify fraud, effective due diligence may also reveal key indicators of potential fraudulent activity, such as:
- Unusual transactions
- Discrepancies in accounting records
- Missing/conflicting evidential matter
- Activities/transactions outside the normal course of business
- Changes in important credit and underwriting policies and procedures
Market confidence relies on and will improve with more effective and frequent due diligence. Today’s environment requires world-class due diligence service providers that can provide powerful insights on potential weaknesses or other transaction variances that ultimately could lead to a nonperforming asset.
How We Help Companies Succeed
Protiviti is a leader in providing credit risk due diligence services. We have worked with dozens of leading global financial institutions, focusing on the needs of the originators, investors and other market participants. We bring deep competency in asset-backed commercial paper and securitization conduit markets, as well as asset-backed lending.
Protiviti provides comprehensive due diligence and collateral monitoring services that help address key risks and concerns within financial institutions and/or financial buyers. Our due diligence teams assist structuring and lending organizations by providing timely and relevant information about the target company and its assets. We perform procedures that cover not only the particular assets being evaluated, but also the processes, reporting capabilities and quality of data associated with those assets. We also help clients gather critical insights and focus on key deal structuring risks. These “best practice” services help reduce potential losses to financial institutions by significantly improving the understanding of their customers and the underlying assets included in each transaction.
- During a review of an equipment leasing company, a model error was uncovered in which one of the covenant ratios was not calculated in accordance with the legal agreements between the financial institution and its client. When the ratio was recalculated in accordance with the legal agreements, the company was out of compliance and a required pay down was initiated.
- During the review of a manufacturing company seeking a lending facility with our client, multiple reporting errors were discovered in the financial data. The target company was netting dilutive activity within sales, reducing the impact of dilution on its asset pool. Once this activity was reported properly, the financial institution had to revise its models and reconsider the structure of the transaction to account for the significantly increased dilution over information provided for original approval of the deal. The methodology was adjusted to provide additional reserves to cover the expected increase in dilution going forward. Additionally, the following year, the company focused a significant amount of effort to reduce its dilutive activity, resulting in a reduction of its dilution reserve and a 10 percent improvement in its borrowing capacity.