Blog » 2016 » September » Due Diligence Assessments - The Important First Step in Investing

Posted on Sep 12, 2016 2:53pm PDT

Given the current environment of the financial industry, extra care must be taken when analyzing potential investment opportunities in the consumer and small business lending sectors. In addition to standard financial assessments, credit, operational, and compliance risk assessments are important due diligence focus areas. While each investment firm has its own methods and preferences when it comes to due diligence, we outline some critical elements to consider for inclusion in every investment opportunity assessment.

Credit Risk

Many of the newer players in the financial industry have yet to see how their underwriting models will perform in an economic downturn. Hence, there are several factors that should be analyzed while performing credit risk due diligence to ensure a well-rounded view of a company's lending capabilities. Investors should conduct a review of all underwriting models, scores, and related practices. Such testing should ensure that all loan origination and underwriting are performed in a sound and consistent manner that is well documented and monitored. This review should also examine exception reports to underwriting standards, noting reason stratification, approval process and frequency. To understand the effectiveness of underwriting practices, it is important to compare actual credit performance to expectations based on scorecard parameters and decisions. Pricing logic, including risk adjusted margin strategies, should also be examined in a similar way by comparing actual losses to anticipated results. If the credit is secured by assets (car, real estate, etc.), a due diligence audit should be conducted to confirm that the assets exist and the value assigned to them at loan close is still relevant.

TIP: Meeting minutes from the company's Credit Risk Committee should be requested (assuming these exist) which may also be useful in understanding any potential concerns, opportunities, and outstanding orders of business. Focus areas would ideally encompass acquisition/ underwriting, portfolio management, collections & recovery, and compliance.

Operations/ Risk Technology

Most diligence activities naturally focus very heavily on financials, however overlaying the operational diligence is not to be underestimated. It is often here where lack of appropriate diligence can present missed opportunities or become problematic. For example, inefficient and/or ineffective operations and the ability to execute on the business model can often result in increased expenses. On the upside, understanding the exact short-comings as well as strengths to build on can unearth untapped potential that may optimize returns. Investors are encouraged to make this a robust part of the diligence exercise. Typical Ops/ Tech diligence includes review of all operational policies and procedures (including third party vendor agreements) and testing to ensure adherence to these procedures. Robust operational due diligence includes mapping of all touch-points (both human and systematic) for customer and data flow to understand the end-to-end customer journeys and overall customer experience.

Overall Operational Risk and Compliance

With the ever evolving regulatory and compliance environments, vetting the Compliance Management Systems (CMS) that a company has defined and implemented to ensure compliance is paramount. This goes beyond simple “check the box” lists and obtaining essential policies and procedures. Ideally, this includes the presence of a robust CMS, which is more like an eco-system than a typical technology-based solution. Additionally, a review of the complete inventory of applicable regulations and the mapping of all operational interactions and touchpoints (e.g. leads to booked loans) with the related control points are encouraged. It is important to review all audit findings, any known open compliance matters or concerns, related corrective action plans and progress made against them. The goal is to achieve an overall comfort level that current audit functions are operating optimally or, at a minimum, well enough to sufficiently self-identify, correct, and monitor these items in a timely way.

In addition to the standard financial modeling and stress testing of an investment opportunity, investing a little more time, energy, and focus on credit, operational, and compliance risk upfront can potentially pay even bigger dividends in the future.