Credit Due Diligence Meets Loan Review:

In today’s banking environment, mergers and acquisitions (M&A) are once again gaining momentum. But while strategic deals can unlock growth opportunities, they can also introduce heightened risk – particularly on the credit side with a target portfolio underwritten and managed by another organization. Credit risk is elevated compared with the past decade and is influenced by industry stressors, such as changing interest rate dynamics, economic slowdowns in some pockets, challenges in the agricultural sector, and broader market instability.

For leaders preparing to evaluate potential acquisitions, credit due diligence should not be a check-the-box exercise. Robust, data-driven credit due diligence offers a more complete picture of risk exposure before a deal closes. Many of the concepts also apply to reverse due diligence, an exercise that has become increasingly common as sellers look to assess the risk of any looming credit concerns in the acquirer’s portfolio that could affect the value of the acquirer’s stock that sellers often receive in deal consideration. Our banking M&A team presents critical areas of focus to consider when building a full credit diligence approach.

Uncover hidden risks with advanced analytics

Traditional approaches for credit file diligence often emphasize larger loans or those already flagged as problem credits. While useful, this approach can miss deeper risk pockets. Applying advanced analytics allows organizations to:

• Detect anomalies that wouldn’t be visible in spreadsheets alone. For example, by combining product types, vintage, geography, and average risk ratings, banks can quickly visualize concentrations or outliers that warrant deeper review.
• Identify product type or borrower industry concentrations and pair them with geographic and macroeconomic data to reveal higher-risk pockets. A geographic region might show risk across different loan products, such as apartments and office properties, that share similar performance concerns. Borrower industry and geographic concentrations paired with granular macroeconomic forecasts, like those from ITR Economics, a subsidiary of Crowe, can surface pockets of the portfolio that might be susceptible to underperforming in the near future. When revealed, these patterns can direct diligence teams to focus attention where it matters most.
• Review growth trends and upcoming maturities of lower rate vintages across portfolios. Instead of just reviewing problem loans or larger loans, banks can get more granular to identify the pockets of risks.
• Evaluate the target’s portfolio in conjunction with the acquiring organization’s. This evaluation can reveal a variety of challenges and opportunities, including bringing banks to other concentration limits, aligning the portfolio to current expected credit losses segmentation and modeling, and determining how the target’s product types, structures, risk tolerance, or geographies differ.

By surfacing these risk themes, advanced analytics can direct attention to the areas that might affect the target portfolio’s performance in the future. Many smaller banks lack the in-house tools or expertise to perform this level of analysis. Even when they do, necessary confidentiality regarding potential transactions often limits who can be involved. In these cases, it can be helpful to engage an outside specialist to provide the necessary data and analysis without compromising confidentiality.

Develop solid communication with strong, thematic risk reports

Identifying themes is only part of the equation. Communicating them effectively is equally critical. Thematic risk reports help translate loan review findings into insights about portfolio stability. These reports might spotlight exposures by geography, borrower industry, or collateral type. Additionally, investor filings at deal announcements typically highlight details regarding credit due diligence coverage and analysis.

The foundation of effective reporting is strong, reliable data. Often, credit diligence starts with inconsistent or incomplete information from the target bank. As file reviews progress, new and more reliable data can emerge. Incorporating these findings back into reporting allows decision-makers to assess risk with greater confidence.

Best practices also call for clarity of purpose. Organizations should define upfront what they want their risk reports to achieve, whether it’s assessing geographic concentrations, evaluating collateral quality, or understanding borrower-level trends. Using analytics platforms can turn these objectives into near real-time insights rather than static, manual reports.

Create a feedback loop between credit diligence and valuation teams

Credit diligence is not an isolated exercise. Its findings directly shape the valuation of the loan portfolio, particularly when it comes to loss expectations for purchase accounting as well as deal pricing and negotiations. A strong feedback loop between credit diligence and valuation teams allows organizations to identify issues, risks, and trends and act on them quickly. If early loan reviews uncover significant weaknesses – whether on individual loans or whole segments of the portfolio – that insight should flow quickly to valuation teams to reflect the impact in the loan portfolio valuation and then to acquirer management, which can sometimes prompt hard decisions about whether to move forward or deploy strategies to proactively manage the risk.

Additionally, identifying data issues and structural weaknesses or abnormalities, such as loans with long, interest-only periods, incorrect product types, or lengthy periods for repricing on variable rate loans, enables acquirers to consider those factors in the valuation.

Capture credit process and practice insights

Beyond data and risk in the current portfolio, credit diligence should capture process and practice issues that affect risk. These can include:

• How a target bank manages covenant compliance and the actions it takes to manage violations
• Timeliness of annual reviews and data collection for regulatory compliance
• Rigorous oversight of credit administration, credit monitoring, and the problem loan management process
• Focus on reporting requirements, including how information is collected and what types of monitoring systems are used
• Loan structure, specifically if there are weaknesses or unapproved terms
• Integration risk, especially as it relates to underwriting, loan structure, and processes
• Product types and geographies, as they might pose a risk that requires divestment

Identifying structural or operational weaknesses helps acquirers anticipate integration challenges and factor them into their deal planning.

Anticipate future integration needs

While diligence focuses primarily on risk at the point of acquisition, it also offers a window into future integration. Loan structures, portfolio management practices, and monitoring systems all influence how smoothly portfolios might blend after closing. Proactively understanding not only the credit quality and composition of the portfolio but also the people, processes, and technology relating to the lending and credit functions can prepare acquirers for cultural and operational integration. As part of integration, lending teams should perform an analysis on the acquired portfolio, product types, and overall credit function to bring together credit policies, underwriting standards, lending systems, teams, and processes.

Integration risk also extends to how acquired portfolios align with the acquiring bank’s existing exposure. For instance, unfamiliar loan types or concentrations outside the acquirer’s experience might warrant heightened scrutiny or even divestiture to avoid adding unexpected risk.

Apply a sharper lens

The banking industry is navigating a period of elevated credit risk. For chief financial officers, chief credit officers, and loan review leaders, integrating credit due diligence with loan review provides a sharper lens on hidden risks that could affect transaction value. By using advanced analytics to uncover patterns, producing clear thematic reports, and maintaining a strong feedback loop with valuation teams, organizations can approach deals with greater clarity and confidence.

Credit diligence has evolved from reviewing past loan issues to anticipating the themes and trends that can define a combined organization’s future. For financial leaders evaluating M&A opportunities, this integrated approach could be the difference between a successful transaction and a costly surprise.