January/February 2011

The Due Diligence Factor — The Importance of Doing Your Homework

Whether you perform your due diligence internally or outsource it, it is important that you do your due diligence before you enter into any lending or factoring agreement. A little homework on the front end will result in a healthy portfolio that is easily managed. More importantly, it will reduce your exposure to unnecessary risk.

Some of the best potential deals can be the worst in the long run, and the only way to ensure you are entering into a profitable transaction is to perform the necessary due diligence. Due diligence is like homework. If you do your homework, you will be prepared for any tests to come. However, if you are not sure what to study, all the homework in the world won’t help you pass the test.

While the foregoing homework analogy may be simplistic, it holds true for all financial transactions. Asset-based lenders, private equity groups, and even factors have some criteria that the borrower must meet to qualify for funding. The borrower must provide financial information on the company, as well as, tax returns and personal credit information from the guarantors. They must also disclose any other loans or liabilities to the potential lender to be considered for a loan or factoring agreement. This information is usually provided by the borrower and then given to the lender for consideration. The cliché believe none of what you hear and half of what you see may be cynical, but very appropriate when it comes to prepared documentation. It is the lender that must confirm, investigate and analyze the borrower’s ability to repay the loan, honor their terms and conditions of the loan or factoring agreement.

Most asset-based lenders outsource some, if not all, of their due diligence to ensure that the borrower doesn’t have any derogatory history that would lend itself to a potential risk. Underwriters are usually quite savvy when analyzing information and drawing a financial portrait of the potential borrower. They profile the borrowers to determine a pattern of behavior, which they then can use to make certain assumptions as to the borrowers integrity and ability to repay the loan. Integrity becomes a component when the business experiences financial stress. Will the borrower honor the covenants of their agreement in difficult times, or will the borrower be more likely to default? The history of the company and guarantors can many times predict the future behavior of the borrower.

What is important to know about your potential borrower can be challenging for lenders and factors alike. There are the obvious facts such as corporate status, internal management structure, UCC filings, judgments and tax liens, and vendor payment trends. Sometimes, the vendor payment trends will say a lot about a borrower. There is a reason the borrower needs funding. Some need funding because of expansion, some to take on a new contract, and others because of cash flow problems. The borrower that has cash-flow problems often seeks financial assistance from a factor because the qualification process is easier and faster than other options. How a borrower pays vendors should be very important to a factor. Does the borrower run up bills with suppliers and then finds new suppliers, leaving the original suppliers unpaid? If that is a pattern it speaks to the integrity of the borrower. Perhaps the borrower will attempt to do the same with the factor. When suppliers are not paid, there is a potential for litigation, which can have a negative impact on the borrowers stability. Legal expenses will be incurred by the borrower, and this can certainly impede the borrower’s ability to make payments to the lender, and more frightening, it can create a desperate financial situation with the borrower. Desperation can motivate even the most honest borrowers to cut corners, take risks or even attempt to work around their factor. Now, take that same scenario and apply it to a borrower who has a history of avoiding suppliers or vendors. This is a recipe for fraud. Payment trends are a small, but important part of the profile of a borrower.

Many factors have very strong in-house policies in place to properly vet potential new clients. By implementing a due diligence procedure, they protect themselves from borrowers that would attempt to defraud the factor. The attractiveness of factoring is that it is easy and usually doesn’t require a tremendous amount of documentation from the borrower. This is extremely attractive to a struggling business.

The advances from a factor to the client business, many times is the very life blood of that business with cash-flow problems. This cash-flow solution is exactly what attracts the fraudster to factoring companies. Add to that the very minimal paperwork required by a factor, results in the perfect opportunity for fraud. So, with all of the factors that are competing for a share of the borrowing market, some factors attempt to make the approval process quick and easy. This practice unfortunately, can result in disaster for the factor.

There is a way to perform the necessary due diligence to protect yourself, without delaying or making the application process too arduous. Having a simple check list in place and taking a few steps to verify the qualification of the borrower on the front end will eliminate a lot of headache and losses down the road.

Your check list should look for previous factoring relationships. If there were previous relationships, did the borrower deal fairly with the factor? Or did the borrower leave the relationship owing the factor? How does the borrower pay their vendors? Are there any judgments or more importantly, any pending civil suits? Are the receivables already pledged as collateral on an existing UCC Filing? Is the borrower grounded in the community, or has the borrower moved from state to state? You may wonder why this would be important, but when you think of that one borrower that skipped out on you and you still can’t find him, you will understand why this is important as well.

Personal references are still important and can help locate a debtor who has skipped on you. Ask for personal references. Personal credit reports can be extremely helpful in profiling a potential borrower. And, of course, perform a criminal background check. Don’t limit that search to a single county. Search the entire state or wherever the borrower has lived for criminal records. People have a tendency to run from their past. If a borrower has a long history in one area and then has moved to another area, ask why. The move could have been for a good reason such as work, or marriage, or worse, from a criminal record.

Once you have this check list of loan criteria determined, how do you gather this information? You can do the investigations yourself, which can be quite time consuming, but will save you a little money on outsourcing. Or you can outsource the investigation, which will save you time and more importantly, put the responsibility of accuracy on a company that specializes in investigation that is licensed, and insured. If the information you receive from a company you selected to outsource your due diligence procedure provides incorrect information to you and you experience a loss because of their information, you have recourse through their insurance. If you do elect to perform your due diligence internally, make sure the person who is responsible for this task has experience in underwriting, investigations, or is an actual licensed private investigator that specializes in financial investigations. While adding personnel to perform this function may not seem financially feasible, imagine the cost of a default.

If you are a smaller factor that wants to perform the proper due diligence yourself, you just need to know where to go to get the answers to your check list. The first stop is the Secretary of States office to confirm corporate status, and to determine if there are any UCC filings. Then you will want to call the county clerks office to see what kind of information they can provide to you. Ask questions such as: “Where can I get criminal record information?” Or ask, “Is this where I can find judgment filings.” You will find that the clerk will direct you who to speak to, or which department to call for this information. The county tax assessor’s office will also be helpful. They can tell you if the borrower owns their property and what the assessed value of that property is on record.

Ideally, if you choose to perform your own due diligence, it is best to subscribe to a database that provides that sort of information. I don’t want to sway you on which database is the best or worst, but I can tell you that most databases will offer you a free trial so that you can make that determination yourself. The best way to do that is to perform a search on yourself. You know what should be found. You will be surprised what information has been gathered and is available to subscribers of the database.

Whether you perform your due diligence internally or outsource it, it is important that you do your due diligence before you enter into any lending or factoring agreement. A little homework on the front end will result in a healthy portfolio that is easily managed. More importantly, it will reduce your exposure to unnecessary risk.