Experts Say Reliance on Standardized Reporting Inadequate for Due Diligence

Posted by Andrew Borowiec on Oct 21, 2015 12:51:11 PM

​​​​​​​​In our ever competitive landscape, smaller and mid-sized companies are often seeking the shortest route, not always the smartest, in their growth strategies. Understanding operating risk of a company or transaction requires more than a cursory review of the company standardized reports. A process of critical and detailed analysis is essential to monitoring the growth of rapidly expanding companies or portfolios.   Why can't you simply rely on standardized reports? For starters, too seldom are standardized reports verified for accuracy, content or origin. I can't tell you how many times we have been provided standardized reports during due diligence, after a quick review we begin asking questions about the origin of the reports and its representations only to find no one in management can tell us why the reports are being used or oftentimes what the data fields represent. This is more common than not.

On occasion, just for fun, I ask whether a data point in the report is gross or net or includes unearned interest, only to get blank stares in return for my query quickly followed by the plausible deniability claim " I don't use that report, can't recall where it comes from". So if you can't rely solely on standardized reports then what? Should the due diligence efforts be augmented by the inclusion of a loan level file review of one hundred files? Will that get us there? Unfortunately, hundreds of millions, even billions of dollars in transactions are supported by these rudimentary and inadequate efforts to verify the integrity and veracity of borrower representations.

In our experience, investment banks are more thorough than hedge funds when it comes to due diligence. Most investment banks like Morgan Stanley, Goldman Sachs and Deutsche Bank have Credit Committees that require an independent third party perform due diligence. The Credit Committee also serve’s as a stop gap between eager bankers and loan being extended. The Credit Committee is generally a group of people responsible for assessing the credit standing and ability to repay debt of prospective borrowers. Other duties of the committee might include determining the institution's credit policy and spotting potential risks of various transactions and reputation risk assumed by the institution.

Hedge Funds tend to fancy themselves experts at anything that can be financially structured. And they're generally correct. If it can be structured into a lending instrument they can model and structure it. The trouble is deal structure alone and cash flow models are replete with assumptions. For these deals to work theses assumptions must necessarily prove to be true, else the outcome will differ from the forecast. In other words, a model is only a model. Basically anyone can calculate a basic deal structure based on the borrower's ability to repay the loan. Where the rubber meets the road is when the representations made by the borrower are not spot on. Think of it as the trajectory of an arrow if it lands 6’'ft left at 50' ft how far off will it be at 100' ft, How about 500' ft? Now convert feet to months, you get the picture. I will let you do the math. The same  is true of  financial models. Due diligence is necessarily the mechanism by which the basis for the assumptions can be tested and verified.

What about the relationship of the borrower and the lender. Think of it in terms of your relationship with your children. If you and your sibling were horsing around and broke one of mom's porcelain saucers on the end-table. First step: Do you glue it back together, leave it in place an looked surprised when mom brings it to your attention. Or do you call mom before she gets home and blame it on your sibling? Now you're beginning to understand the relationship between the borrower and the lender in a structured finance transaction. Trust but verify.

The legal side of the transaction can be daunting as well. All too often, the legal team may be experts at documenting transactions, but doesn't possess a deep knowledge of the underlying assets or industry.  The representations and warranties they draft may look good, but are they appropriate and fit the scope and complexity of the transaction.  A transactional law firm still needs to have the requisite expertise.  It's up to the in-house lawyers to staff the project effectively as well as efficiently.  I've seen lawyers with industry compliance and regulatory expertise brought in to bring the transaction lawyers up to speed on the business so they can effectively advise, document many transactions.

The "deal" lawyers need to be aware of and understand the due diligence process being conducted and not operate in a vacuum.  They should also understand the sensitive issues found during the due diligence process so that they can draft the corresponding deal documents to represent their client's best interest.  The goal isn't just to get the deal done, but to create a clear document that is understandable to the parties and enforceable down the road, should the need arise.  For instance, boilerplate language in many existing agreement may not be sufficient to protect the interests of the parties based on the latest regulatory changes. Trust but verify.

This article was co-authored by: Bobby Lazenby CFE and Steve Levine Esq. Lazenby & Levine represent the firm of Lazenby & associates. To learn more, visit  WWW.lazenbyassociates.com

Tags: Fund of Funds, Intermediaries, Mutual Funds, Valuation, Article, Asset Verification Tests, Fund Performance, Fund Structure, Hedge Funds, investment, Legal Due Diligence, Private Equity, Venture

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