How much due diligence is enough?
Well, that depends. If things go wrong, then it’s very easy to say that “more should have been done”. However, the whole purpose of performing DD in the first place is to ensure that you’re never in a position where you have to make such a sheepish statement.
Due diligence means taking the appropriate levels of care and discretion before entering into a business transaction or legal contract. It means performing a thorough investigation of an investment opportunity – of the business(es) involved, the assets owned, the people concerned, the legalities of the documentation, and the security pledged. Indeed, when it comes to the lending of business funds – with which we are concerning ourselves here – there is no reason that an adequate due diligence procedure will not minimise a lender’s risk almost to zero.
I emphasise “almost” as part of my own due diligence in the writing of this article. In fact, an important part of DD is communicating both the opportunities and threats that exist in a particular deal. To say that performing due diligence results in the complete and absolute eradication of the risks involved within a deal would be misguiding and simply incorrect. Rather, DD shines a light into all of the nooks and crannies of a business, good and bad, not eliminating risk, but exposing it. There will always be risks – the purpose of DD is to assure the lender that these risks have been identified and meticulously considered, and that contingency plans are formalised and signed-off long before any money changes hands.
Performing due diligence naturally involves a lot of heavy lifting when it comes to conducting investigations into private businesses and individuals. Confirming the identity of the borrower and the borrowing company, who its investors are, its turnover, its growth projections (both with and without the loan being approved), the legal documents – none of this is straightforward, especially when approaching the task from the standpoint of leaving no stone unturned (as you must).
As such, a number of digital solutions have been developed to simplify some of these processes. There are now, for instance, platforms such as DueDil, which has grown to form one of the world’s largest databases of private company information. Access to this platform makes it much easier to dig into the specifics of a company, see its portfolio, look at its directors, and analyse its important documents.
Such resources are indeed extremely useful when it comes to doing the base work. But lending firms relying on these platforms alone to perform DD take a great risk of falling short of the mark in terms of the responsibility they have to the investors they represent.
Databases, software, algorithms – these things provide the basics; but when it comes to adequate due diligence, “the basics” are not nearly enough.
Let’s be clear – the scope of a DD database is a good place to start when familiarizing yourself with a potential borrower. However, in the end, due diligence is – and should be – a manual task.
What you’re essentially looking for is proof of the credibility of the whole project. And this means – further to confirming the identity of the borrowing party – drilling deep down into the business plan, finding out exactly to whom the money is going, where it’s going to be spent, and how the borrower intends to profit from the assets being funded.
What’s more, DD means assessing the market potential of the business plan (i.e. gathering evidence that there is indeed a market for the project at all), the track record of the borrower’s existing business(es), the exit plan, and, most importantly of all, the security. What are the assets that shall be mandated as security? Can they be sold? If so, what is the real value? Formal valuations of the security by third parties are often necessary to get this information.
Promises, promises will abound, and the documentation may very well confirm everything that the borrower claims.
However, just because everything appears present and correct on paper, is this level of due diligence still enough?
Thinking Outside of the Quantitative Analysis Box
Not everything can be confirmed by looking through a document and running predictive algorithms – even less by taking the word of even a “trusted” individual. Of course, financial analysis is critical, but it’s very important to take a step back – or perhaps rather a physical step closer – to see for yourself what’s driving the numbers. And the only way to do this is by conducting an up-front, first-hand evaluation of everything that’s being promised and proposed. In short, you need to see with your own eyes that everything is as-stated.
This is the Digital Age, and so the first contact that a borrower makes with a lending platform will often occur online. An initial application will be filled out, followed by a phone call and a number of email exchanges where details will begin to be discussed. How much money does the borrower need and for how long? What is the project being funded?
The business plan will be presented to the lender, together with accompanying documents that can confirm some of the claims and assumptions made within. The lender will be able to make an initial assessment with this information and, based on the potential strength of the project, a preliminary decision will be made.
If the plan, the documents and the project all appear to give positive signals, it’s time to meet the borrower in-person – and this should be done sooner rather than later. No matter how strong a business plan may appear, a lender must be able to trust the person to whom a substantial amount of capital is potentially being forwarded. Confidence is everything, and until you’ve shaken hands with someone, and sat down for a face-to-face discussion, it’s very difficult to determine the real trustworthiness of an individual.
At this meeting, the lender will be able to unearth the personal and business-related history of the borrower. What past successes has he or she had? What were the failures, why did they occur, and what has been learned from them? And what about personal loan and debt history? Any county court judgements? These are all quite difficult questions to put to a person, and many of the quantifiable answers can of course be gleaned from DD databases and financial analyses. But the purpose here is to see for yourself how the borrower handles a personal interview. Indeed, how well acquainted is he or she with the figures? The borrower should be forthcoming, able and willing to tell you everything you need to know.
Government issued photo IDs must also be provided to confirm the identifications of all parties.
The overall purpose here is to establish the borrower as a sound and bona fide individual or group of individuals. And it’s a process that demands facetime.
Perhaps the borrower owns some property that has been put forward as collateral. On paper, this could be worth, say, £300,000. But how true does this valuation really hold? Just how “independent” and indeed qualified was the individual who performed the valuation? Was it a chartered surveyor, or did an estate agent acquaintance of the property owner provide an informal valuation?
This can all be determined by adequate scrutiny of the paperwork, and lenders should not be surprised to discover that a borrower may not have been as thorough in the valuation of his/her security assets as is required. And this, indeed, is an example of an identified risk that DD will uncover.
So how does the lender determine a true valuation of the property? Well, first, a valuer completely independent of the borrower needs to be appointed. When it’s land or property involved, this valuer should be a member of the Royal Institution of Chartered Surveyors (RICS) and perform the valuation on a Red Book basis.
The surveyor will inspect the condition of the property to make a qualified, reasoned and informed judgement of its most accurate value should the property need to be sold. He or she will make a number of assessments of the property’s general condition: if there are any major faults in the building that may affect its value; any urgent problems that may require specialist inspection; test for damp in the walls and damage to the timbers; the condition of any insulation and damp-proofing; compare the property with similar properties on the open market; assess the overall stability and likely trajectory of the local property market.
These assessments cannot be performed by a piece of software or an algorithm – it’s a hands-on job from start to finish.
But even with a RICS assessment, it’s still imperative that the lender personally visits the property, takes time to speak to the neighbours and walk around the local area in order to determine first-hand if this property is saleable even at the most accurate valuation.
The Project Itself
How good is the business plan? On paper, again, no doubt excellent. But what no amount of documentation can tell you is just how realistic the forecasting of a project’s success might be.
Learning the intricacies that a particular market presents is by no means simple. It is important to obtain localised information. Where will revenue come from – the locals, visitors or online channels? If the business relies on its physical presence, does the area attract the amount of footfall required to meet the figures in the business plan? Indeed, does the premises itself appear inviting and ship-shape, or is it dilapidated and grim? These are all things that can only be truly determined by an in-person visit to the business itself and the surrounding area.
Furthermore, are there any local objections to the project? To what extent are these likely to cause problems with the projected success of the venture?
Speaking to real people at the heart of a business’s community will enable a proper assessment of any problematic external factors that may not be present in a business plan.
You can’t kick the tyres without an in-person inspection – and neither can you shake the borrower’s hand, look them in the eye and get to understand the person with whom you are entrusting your money, and the money of the investors you represent.
The Route – Finance’s Approach to Due Diligence
Accompanied site visits provide invaluable facetime opportunity, and are where the real nitty-gritty of the risks involved with a deal will be exposed. The Route – Finance believes that DD is not complete until a personal investigation and inspection of all aspects tied into the forwarding of a loan has been done. Investor protection forms the core value of The Route – Finance’s due diligence procedures. All investments carry inherent risks, and returns can never be fully guaranteed. As such, The Route – Finance’s processes are designed to thoroughly expose all of these risks, provide confidence in investment opportunities, and independently confirm all written documentation, as well as the assumptions that have been used in the financial analyses of borrowers, securities, and business plans.
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