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When credit staff joins due diligence team

No one wants to buy pigs in a portfolio

When credit staff joins due diligence team

There’s been a lot of interest focused in the last couple of years on whether or not a community bank’s ownership should sell. We hear, over and over, things like “It’s not fun anymore” and of the heavy regulatory burdens imposed by Dodd-Frank.

But it’s also a question of the ability to compete in a crowded and overbanked market place. Competing in the face of the large capital investments required in technology and systems. And the ability to achieve an attractive and sustainable return on equity.

As a member of the credit administration staff at Florida’s largest bank holding company several years ago, I had the opportunity to participate in several due diligence investigations of the acquisition of small- to medium-sized community banks around the state. This was in Florida’s “unit banking” days, so for a holding company seeking to expand its franchise, the only options for geographic expansion were to acquire an existing bank or to obtain a de novo charter.

Each due diligence team worked like a crew of safety and soundness examiners, usually in the boardroom or in a large conference room plowing through stacks of credit and collateral files. And our manner of proceeding with our task was very similar to that of the examiners. 

While we were ferreting out the level of risk we perceived in the bank’s credit assets, we were ultimately attempting to incorporate this assessment into the price that we would be willing to pay.

Today, due diligence isn’t only for acquirers, I understand. Sellers will sometimes choose to do due diligence on the purchaser if it is anticipated that the selling shareholders will be paid at least partially in stock. After all, shareholders will want to have their bank “kick the tires” in their stead, looking beyond publicly available documents.

5 steps to better due diligence

If you as a community banker find yourself part of a due diligence team, here are tips that my experience suggests that you and colleagues should consider. It’s hardly exhaustive. But it’s what comes immediately to mind as I reflect back on all of those due diligence examinations. I should also note that not all of these projects produced offers to acquire the targeted banks. After all, the idea of due diligence, in part, is to know when to walk away, or at least, re-negotiate.

1. Read the credit policy carefully and any supporting procedural statements.

Do you agree with the policy, in the sense of whether it contains the usual sorts of provisions both of a positive and an exclusionary nature?

Does it make sense? 

Does it provide guidance in the nature of “principles”? Or is it more of a proscriptive cookbook? 

I prefer a principles-based policy. Such a document usually supports the lender in being creative with the specific circumstances of a credit request, yet provides guidance on acceptability of an underwriting conclusion as a whole.

2. Carefully review the exceptions lists.

Most banks track exceptions by dollar and by number and whether the exceptions are of a credit or a collateral nature. A buyer’s objective should be to see if the lenders understand the policy and are required to follow it.

Exceptions to policy are to be expected periodically. But you should formulate an opinion on whether they are routine or based on a sensible rationale. This can also be a window on how effective account servicing is over time.

3. Can you make sense of the underwriting of each credit, particularly its structure?

In a surprisingly frequent number of cases, both by bank and by a credit-by-credit review, our teams often couldn’t make heads nor tails out of the information in the file.

The bank examiners probably had the same sorts of comments or concerns. But this experience taught us that not all examiners are created equal (in the skill or experience sense). And we would simply not take reports of examination at face value.

4. Create an historical scorecard of key items of information.

This should include such items as exceptions by dollar and number; dollars of potential loans in the “pipeline”; an aging of the past dues by 5, 10, 30, and 90 day delinquencies; chargeoffs and recoveries for several trailing calendar quarters. Some of the trends were very revealing of the state of the quality of the portfolio, particularly when they suggested a gentle deterioration collectively over the last two or three years.

We were also sensitive to how “service intensive” the portfolio appeared to be. Some credits are naturally more work-intensive than others and that’s not necessarily whether they are criticized assets. It’s more often a reflection on the age and maturity of the borrower’s business, including the skill of the lender in firming up what might be a less than pristine credit into something easier to administer and manage in terms of both time and risk.

5. Thoroughly review the bank’s Uniform Bank Performance Report.

Form an opinion on any credit-related peer group comparison that is below the 50th percentile.

Is it a problem? 

Is there a trend or a pattern of behavior that contributes to the negative comparison? 

Does it appear to be readily fixable?  

The UBPR is probably the best place to start your due diligence and you should do so before you arrive on site or before you go into files remotely via electronics, these days. That way you can be alert to items that relate to the negative comparisons as a byproduct of what you’ll otherwise be doing. It’s also a good idea to look at the very favorable comparisons and form an opinion on the sustainability of such results.

There are many other critical inputs in developing a decision to submit a purchase offer on a particular bank and an appropriate price. I’ve listed the credit related inputs to the process that my experience taught me were useful. While these are listed in the form of a “to do” list for acquirers, they can also form a preparatory checklist for sellers.

Takes a lender to weigh a lender

Each of us who participated on these teams was a career lender or a professional credit administration staffer. We could sense the “snow jobs” as well as the diamonds in the rough.

We weren’t just looking at loans. We were learning about people. We formed opinions on the lending staffs that were a formal part of our record of the process.

And here’s an important caveat: It’s not just the individual underwriting decisions that are important. It’s the context of the loan and how professionally the lender presents his work as evidenced by the contents of the file. I acquired a lifelong appreciation for the calls that safety and soundness examiners have to make in their day-to-day work.

We are all very transparent to the skillful inquirer. That should be top of mind for the management of each selling bank. There very likely will be significantly fewer banks in the years to come, meaning that there will be a continuing stream of consolidations.

For sellers, it’s not too soon to start to shine up the portfolio for the ultimate purchase due diligence. And to decide who will be looking at the buyer, if that’s an option.

Ed O’Leary

Banking Exchange Contributing Editor Ed O'Leary, a veteran lender and workout expert, spent nearly 50 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. His last job before retiring was as the CEO of a regional bank headquartered in Alburquerque, N.M. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending. O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools. Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses. You can e-mail him at [email protected]. O'Leary's website can be found at

In mid-2016 O'Leary's "Talking Credit" blog received a bronze excellence award for the Northeastern Region from the American Society of Business Publication Editors.

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