A new approach to due diligence on trust company acquisitions

Nowadays, detailed due diligence on client files and on risk and regulatory compliance is a key requirement of most potential buyers of trust company businesses, and of their bank funders.  This is because there is a heightened awareness of the potential dangers and difficulties associated with buying trust companies where work standards have been poor, or where compliance has not had the prominence it should have had over the years.  There have been some notable and high profile cases where buyers have suffered the consequences of not having paid enough attention to these aspects, and as a consequence bought trust companies only to find themselves embroiled in client litigation, problems with the regulators, and huge back-logs of remediation work to undertake.  The quality of work done on a file and the approach taken to risk and compliance has a direct and very tangible link to the value of these businesses, and the brand damage associated with regulatory action and client litigation can be enormous.

The usual way of doing due diligence on the client files is for each potential buyer of a company to undertake its own file reviews, often at a second round stage where there may be 3 or 4 potential bidders remaining in the process.  The difficulty with this approach from the Vendor’s perspective is that each potential buyer will approach the task in a slightly different way, may wish to review a different selection of files (or to duplicate work already done by another interested party), and will want to spend time not only with the physical files but also with staff members who are involved in running them.  In my experience (having seen both sides of the fence – from the perspective both of being the vendor and the buyer), the file reviews are usually very time consuming for the business and can often be the most disruptive element of an investment or sale process (not least because of the need to remove the physical files from the fee earners for a brief period).  The reviews are also always an area of particular sensitivity regarding client confidentiality, and the findings may be contentious as they inevitably involve a degree of subjective judgment.  Given that the file reviews are usually done only in the second or third rounds of bidding, it can be disastrous to the Vendor to be presented with negative findings late in the day, as these can result in price chips or the deal itself being aborted.

In light of all these difficulties, it seems to me that a better approach would be to have the file reviews done as part of the Vendor due diligence.  That way, there is only one team of people looking at the files, who is engaged by the Vendor.  The work can be done at a slightly more measured timescale, to try to minimise disruption to the business.  Furthermore, by doing the work up front, then it lessens the opportunity for investors to chip away at their commercial terms as the process evolves, as there should be no surprises.   If there are weaknesses identified, then these can be remediated and addressed in advance.  Provided the organisation carrying out the diligence is demonstrably capable and experienced in the field, then many private equity houses and their bankers appear to be comfortable with this approach.

Of course, the obvious downside of file reviews being done as part of Vendor due diligence is that the Vendor is then paying for the work rather than potential investors.  However, the costs involved are likely to be offset by the saving in fee-earning time by not having to repeat the process with a multiplicity of possible buyers/investors, and the invoices can in some cases be passed to the buyers as part of a successful acquisition.

Financial and commercial vendor due diligence has been an accepted part of the sales and investment process for a long time.  In my view, there is much to be said for dealing with regulatory and compliance due diligence in the same way.