We’ve been told many times throughout the years that change is the only constant. Success often times can be determined by the ability to create or adapt to change, and failure often is determined by those that cannot. The due diligence business, specifically the collateral field examination business, is no different. Our firm, Lender’s Consulting Group, Inc., provides outsourced due diligence for banks, commercial finance companies and investment funds throughout the country. Over the last ten years, we have seen many changes in the industry and we are providing our services to institutions that five years ago did not know what a collateral field examination was, or had never read one.
Technology and Security
I believe it is safe to say that throughout most industries over the last 10 to 15 years, the biggest impact on businesses has been technology. The collateral field examination industry is certainly no different. For example, ten years ago an examiner proficient in the Microsoft Office products, specifically Excel, was a plus. Now it is a requirement. Similarly the use of data mining software has gone from being a rare skill set to something that nearly all field examiners are trained on these days.
We are also seeing a significant increase in security requirements. There is no doubt that the advent of recent technologies has made many lives a whole lot easier. However those new technologies bring a new level of security breaches, hacking and cyber fraud. As a result, many institutions have been forced by regulators to develop comprehensive security programs that include e-mail encryption, hard drive encryption, secured servers, document retention/destruction procedures and countless other requirements.
Years ago, password protecting a computer might have been a sufficient security measure. Today, many vendor agreements require outsource firms to be in compliance with legislation instituted by the government to protect privacy and information flow, such as the Gramm-Leach-Bliley Act (GLBA). These measures historically had been required only from vendors that have access to individual consumer information, such as mortgage processing firms or loan brokers. This language is typical in more and more agreements these days, and that trend is expected to continue.
Service Organization Control reports (SOC) and other measures ensuring vendor compliance will be more prevalent in the very near future as data integrity becomes a top priority for lenders. This prioritization in compliance is also causing many lenders to reevaluate vendor relationships to ensure their outsource partners can meet their requirements or have proven they are on the right track to do so.
Another significant change to our industry that has affected due diligence groups (specifically collateral field exam groups, whether they are in-house or outsourced) has been the sheer volume of collateral field examinations being ordered these days. We’ve always had consistent work flow from the traditional asset based lenders (bank owned or independent); however, now there is a significant increase from commercial banks that have been instructed by regulators to beef up their risk mitigation measures, as well as to diversify their real estate credits by booking more commercial & industrial (C&I) loans.
We are now seeing what was at one time a very fragmented approach to requiring field examinations to evolve into a more structured, streamlined approach. For example, several of the larger banks in the U.S. now have dedicated groups that monitor the non-ABL group collateral field examination process. In the past we saw much more of a shotgun approach where the requirements were determined on a case by case basis by the individual loan officer. In addition, we are seeing significantly more field examinations performed on smaller deals. The regulators were observing the intent of the lender to monitor these credits commonly known as “ABL-light;” however, there were material deficiencies in monitoring beyond the exercise of checking the box when the borrowing base certificate was being submitted.
As the recession hit, those monitoring deficiencies resulted in many borrowing bases being out of formula due to fraudulent reporting. Many of these smaller companies were forced to “manufacture” availability on their borrowing bases, as they typically had nowhere else to go for working capital. They had no sponsor to put in additional equity, and the life savings of the owners were usually already tied up in the company. The results in many instances, unfortunately, were significant variances between the reported availability calculated by the borrower and the actual availability calculated by the field examiner.
In many cases, the company was too far gone by the time all of this was uncovered. The common theme among many of these ABL-light field examinations is that it is usually the first time the borrower had ever had a field examination performed, and it had very little understanding of the borrowing base certificate beyond receivables aged over 90 days.
As many of the commercial banks are educating themselves on the field examination process, we are seeing more acceptance and less pushback. The volume from these commercial deals, primarily due to regulators, has certainly moved the needle for most field examination groups.
Also as a result of the recession, we saw significant activity from the banks re-rating credits and moving them from one group (such as middle market) to another (such as ABL or even special assets). Therefore, monitoring increased, field examinations were no longer waived and field examination frequency was accelerated. The re-rating has normalized somewhat over the past year as many of these companies have stabilized; however, some level of monitoring remains in place. We also saw many lenders reorganizing their own internal lending criteria, creating size and profitability thresholds. In many cases, the “run-off” due to those thresholds created opportunities for other lenders that typically increased the monitoring levels, thereby creating an increase in field examination frequency.
Changes in Testing
Another significant change within the industry is the actual collateral field examination itself. The scopes of field examinations in general have increased over the past five to ten years. Limited scope field examinations with reduced A/R, inventory, cash and A/P testing are few and far between, where these were more common years ago. In the past, it was common for a lender to waive certain testing such as A/R phone verifications, credit memo testing, cash application testing, etc. Currently, these items are almost always included in standard survey and recurring field examination scopes.
The same can be said for inventory testing. In prior years, inventory testing was one of the first sections to be removed from the field examination scope for budget and time constraints. Now it is a key area of concern for many lenders. Inventory has been an extremely hot topic over the past few years with regard to value and movement. These are logical concerns during any recession as the inventory is only worth what the market dictates … if indeed there is still a market. More time and concern have been spent quantifying inventory movement than in the past, and inventory advance rates and ineligibles have been adjusted accordingly.
In addition, the overall level of analysis and comprehensive nature of field examination templates in general have evolved quite a bit over the years. There is more financial and covenant analysis than ever before, and an advanced understanding of accounting procedures and financial statements is a requirement. In depth narratives regarding credit policies, billing procedures, and other general policies and procedures of the borrower are now required, where in the past a few bullet points may have sufficed. The increase in testing and the robust nature of most field examination templates these days is having a direct impact on timing, and, therefore, costs.
The cost of a field examination has always been an issue in the past; however, the additional testing requirements and procedures mentioned above have taken the issue to another level. This is a struggle not only with outsource firms, but just as big of an issue with the lender’s internal field examination groups as well. Many of the lenders mentioned above that were exposed to field examinations possibly for the first time were largely thankful for the clarity that these field examinations provided to them, yet were surprised at the costs involved. In these instances, the deal size is typically smaller and the borrower’s financial reporting is not always very sophisticated … and that is being polite.
Unfortunately, what some lenders and borrowers alike have been learning is that there is little correlation between the field examination costs for a borrower with one division doing $1 million in revenue to one doing $100 million. In fact, the company with revenues of $100 million typically has a CFO that is familiar with the field examination process and is capable of providing reliable information. The positive that came out of this “sticker shock” is that it forced field examination groups to ensure the lines of communication with the client were clear and to properly manage expectations. It made everyone better communicators.
Another direct contributor to a rise in field examination fees is the increase in costs a lender or an outsource firm incurs to employ an individual with the aforementioned analytical skills necessary to be a successful field examiner. Examinations are so robust, and emphasis on insightful analysis (as opposed to simply displaying test results in a chart) is a requirement, which it should be. However, to meet those standards, field examiners must possess a unique ability to consistently deliver a superior product and withstand the rigors that come with the job, such as Sunday afternoon and Friday evening flights, significant time away from the family, and of course, deadlines.
The Talent Pool
In the past, professionals used field examination divisions as a stepping stone to other areas of lending. This has historically created a challenging environment for managers, as finding talented examiners is never easy, yet the learning curve today is significantly steeper than it was years ago. The field examination industry will most likely face a severe shortage of qualified professionals in the future. We will see many of today’s field examiners with 20-plus years of experience retire, and there will be a tremendous gap between the capabilities of those professionals and those of the next generation. This has been exacerbated by the lack of new hires in the industry eight to 12 years ago and the difficulty in hiring recent graduates and getting them trained in a reasonable period of time.
This is particularly true for large institutions, where the deals were high dollar with large exposure, contained multiple divisions or locations and could be extremely complex. As such, it was very difficult to train those new to the industry without a comprehensive training program, which were eliminated from many of those larger institutions. There was also a surplus of experienced ABL examiners on the market, so the need to delve into campus recruiting was not required at the time. This has resulted in a shift from the days when most examiners were hired right out of college. There are some institutions with specific field examination training and recruiting programs; however, they would certainly be considered the exception at this point.
So one question that needs to be addressed is how can we do a better job of keeping field examiners from leaving the industry? We can do that a few ways. As with any profession, compensation is always a good starting point. Fair compensation and earning potential is something that everyone is looking for. We’ve seen field examiner salaries steadily rise over the years. Unfortunately, in many instances, they have been rising much faster than field exam costs. This is creating tremendous pressures on outsource firms and internal field examination groups to maintain manageable margins and forcing them to diversify their practice into other more lucrative services, thereby further diluting the talent base.
Another way to keep our people is by appropriately managing the field examination process. As mentioned above, the templates have grown quite a bit over the years; however, the allocation of time has not equally grown. So what we end up with in many instances will be a lot of very early mornings, late nights and working on the weekend. Combine all of that with the travel away from the family on a regular basis, and the quality of life can deteriorate rather quickly. Our goal has to be to ensure that time allocation and field examination scopes are directly correlated so we can avoid what is known in the industry as “the burnout factor.”
One way to successfully avoid this issue is through the proper training of communication, which was referred to above but cannot be mentioned too much. Much of this can be avoided when the field examiner ensures that all parties involved are fully aware of the progress (or lack thereof) and adjustments to timing or scopes are requested. Over the years we have been extremely fortunate enough to work with many institutions that have embraced this communication and view us more as partners rather than vendors (this also applies to the internal field examination groups of the banks as well). The result has been a more rested examiner that has a better work/life balance that ultimately produces a much better product and is compensated fairly for it.
The Future of Field Exams
Given the additional requirements we are experiencing now, such as technology, insurance and rising labor costs, we think the barriers of entry into the field examination business will rise to another level. Gone are the days when all someone needs is a laptop computer and an e-mail address and they are in business. We will see shorter approved vendor lists and more compliance reviews. In many instances, vendor management groups within banks have been established, taking a portion of the approval authority away from the field examination group managers.
In addition, due to the projected talent that will be available in the next ten years, and the estimated cost of that talent, the return of comprehensive training programs and college recruiting will be a necessity. Lenders and outsource firms alike will need to make training and development a high priority. Fortunately, we have more tools available to train now through the use of some of the technology previously mentioned. We will see more oversight from managers with the use of software that allows collaboration on exams from different locations, real-time reviewing of workpapers and the shift from source documents being paper to electronic.
There are certainly challenges that are facing the field examination industry; however’ many of these challenges are faced by countless other service industries throughout the world. These challenges will create opportunity for some and demise for others. Opportunities for those that can adapt and maintain high standards for quality and communication while growing responsibly, and demise for those that are unable to keep their quality ahead of their growth. As mentioned above, the only constant is change.
Paul Epstein is the co-founder and managing partner of Lender’s Consulting Group, Inc. (LCG), which provides outsourced due diligence and transaction advisory services for lenders and institutional investors throughout the country. He received his Bachelor’s degree in Finance from the University of Tampa.
John Dendrinos recently joined LCG as a managing director. Prior to LCG, he spent the last 20 years with Bank of America Business Capital most recently as an SVP and regional field examination manager. Dendrinos, a licensed CPA, received his Master’s degree in Administrative Management from John Hopkins University and earned his Bachelor’s degree in Accounting from Loyola University.