Executive Summary: Strong due diligence processes are critical to success in financial services. These processes need to be both redefined and more effectively applied to loans, acquisitions, investments, and people. Too often, the desire to do a deal undercuts this process and harms a company.
“When underwriters refused to approve dubious loans, they were punished.” This comment from a Sunday New York Times article on WaMu underscores the importance of a strong and independent due diligence process (in this case tied to underwriting) and suggests how frequently managers abandon rigor. Strong due diligence frequently loses out to the desire to complete a transaction and the pressures of the marketplace. However, the current volatile operating environment places a premium on a return to the type and level of due diligence that used to be standard but, remarkably, no longer is.
Due Diligence 101
What do we mean by due diligence? It entails a process of investigation and analysis related to evaluating almost any significant decision, meaning everything from evaluating an acquisition (the traditional use of the term) to a technology purchase to hiring a new exec. While it is usually tied to acquisition and acquisition integration, the process needs to be applied more broadly. Examples help to underscore its use and the negative impact of compromise in this area.
Example: One client, acquired by another financial services player, told me: “They had no idea what they bought [this comment from the acquired company no less]. They wanted to buy us and never really evaluated us at all until the papers were signed.” In this case, the buyer was lucky in its decision, but luck is not a strategy.
Example: In a recent conference on Private Equity in Banking, much conversation occurred concerning TPG’s investment in WaMu. While the keynote speaker from Carlyle refused to comment on the quality of TPG’s due diligence process, the clear indication was that it was insufficient. Certainly, the end result indicates that was the situation. In this case, apparently, the investors were hit by the double whammy of insufficient due diligence related to the acquisition and insufficient due diligence and discipline related to managing the bank’s loan book.
Example: We have been involved in the due diligence process many times. Several years ago, one client that had positioned itself as a fast growth company (dangerous in financial services) asked us to evaluate a potential purchase to determine the target’s market reputation, competitive position, and platform for growth. For multiple reasons we suggested that the deal be abandoned, and it was due not only to our but work but also resulting from company-led analysis.
However, the head of this company wanted and, he believed, needed to do a significant deal to fuel growth. When the next opportunity came along, we were not invited in and the level of internal due diligence was much reduced. As you can guess, the deal was done and soon blew up.
Example: At the same Private Equity conference mentioned above, the head of Boston Private, a bank and wealth management firm, discussed the process his company used to assess potential investors as well as the due diligence process that others conducted on them. They selected Carlyle as a partner in part because of the depth of Carlyle’s due diligence process, which included visiting all the company’s subsidiaries and “confirming the underlying business strategy and business model.” The investment group took the time to diagnose the target in detail and in doing so showed its commitment and ability to add value to the target. Too often speed replaces depth of analysis.
Example: Just weeks ago, Citibank was going to acquire Wachovia. As reported, Wells Fargo had dropped out of the bid process leaving the field to Citi. It did so because it did not have sufficient time to become comfortable with the deal and it was not desperate to do a transaction. Its discipline resulted in it walking away from that deal. However, its analytic strength and that same discipline also allowed it to re-enter the deal and win it.
Applying Due Diligence
Rigorous due diligence has never been more important that it is now. Due diligence needs to include a level and type of stress testing that previously was viewed as unnecessary. And, while modeling is of value, it has been proven to be insufficient in the current environment. So, what to do:
- Make sure the team doing the due diligence is truly independent. Internal team members sometimes have hidden agendas. Outsiders provide an important balance to employees and should bring a broader set of experiences to the analytic task.
- Go beyond the numbers. Private equity and investment banking analysts are great at crunching numbers and they know industry dynamics but they seldom look behind the numbers. Some of the most valuable work we have done for clients relates to assessing reputations and providing the “low down” on people.
- Due diligence continues beyond acquisition. We know of businesses that were bought years ago that still need a good due diligence process. Units that are technical or outside the comfort zone of the owner’s top management often avoid the type of critical analysis they merit. Again, an outsider’s perspective and independence are critical.
Concluding Thought
This newsletter highlights some fundamentals of doing business intelligently. However, too often in recent years, these fundamentals have been ignored by the overly aggressive, the self-assured, or the lazy. The market will no longer bail out poor deals; intense and rigorous and painstaking due diligence should become the norm.