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The Magnificent Seven Tips for Due Diligence

By Dr Brian Moretta Head of Tax Enhanced Services at Hardman & Co

Great British Investment Roadshow EIS/SEIS

November 2016

Agenda

Objectives 3

Introduction to Hardman & Co 4

Defining due diligence for today’s purpose 5

Magnificent Seven tips 7

Concluding remarks 17

Appendices 18

Disclaimer 27

Objectives

To reduce your business risk through better processes

To appreciate the FCA’s direction of travel regarding where the onus lies in the investment decision making process

To have better tools and concepts for due diligence

To feel professionally comfortable with EIS investments

Introduction

Hardman & Co

• Provider of independent research for over 20 years

• FCA Registered

• Entered tax enhanced space in 2015

Brian Moretta

• Fund manager and analyst for over 20 years

• Actuary

Defining due diligence for today’s purpose

Definition:

“Due diligence refers to the care a reasonable person should take before entering into an agreement

or transaction with or on behalf of another party”. Source: Investopedia

Background - Changing regulatory attitude towards due diligence

“…the poor quality of an advisory firm’s research and due diligence is one of the three root causes for poor consumer outcomes.”

What does the FCA see as key?

The nature of the investment

Its risk and benefits

The provider (can you entrust them with client assets?)

…Good news: FCA sees firms of all sizes capable of doing this

FCA Thematic Review TR16/1, February 2016:

“Assessing suitability: Research and due diligence of products and services”

https://www.fca.org.uk/publication/thematic-reviews/tr16-01.pdf

The Magnificent Seven Tips for Due Diligence

Source: World of Entertainment

Tax

Investment

Wider range of strategies

Shorter holding time for tax break

Loss relief

CGT deferral

BPR eligible

Advantages of VCT

For most products…

Advantages of EIS

Instant diversification

Greater diversification

Better corporate governance

Ongoing liquidity

Tax free income

Tip 1: Don’t let tax tail wag the investment dog

Tip 2 (1): Balance risk and return

Bank

~1%

Gilt

~2-3%

I.G. Bond

~4-5%

Equity

~6-8%

Derivative

~10%+

RISK

EIS

Tip 2 (2): Balance risk and return

What do target returns measure?

RISK!

Does the risk of the scheme match the target return?

Can a scheme promising a total of 10-20% over 4 years be risk appropriate?

Tip 3: Evaluate the investment process

Check there is an investment process

If so, what do you look at?

• What is the pedigree of those investing?

• Are there enough potential projects?

• How does the the manager filter opportunities?

• Is there independent scrutiny of decisions?

• How important is valuation?

Understand where the risks are.

Tip 4: Pay attention to what happens after investment

Understand how a manager supports and monitors their investments

Very few companies progress smoothly

Immaturity often means lack of internal systems and controls

Ensure you receive and read regular updates

Don’t forget about the exits

Tip 5: Greater skewness requires greater diversification

Probability of losing money

Compare two schemes

• (a) P(no return)=0.5, P(3x return)=0.5

• (b) P(no return)=0.8, P(7.5x return)=0.2

Both have same expected return i.e. 1.5x investment

But skewed one (b) needs greater diversification to get same probability of avoiding loss 0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1 2 5 10 15

(a) (b)

Two simple investments

Tip 6 (1): Understand how managers are rewarded

Rational people respond to their incentives

How are manager interests aligned with investors?

Annual fee

• Typically 2% per annum of initial investment

• Incentive – gather assets

• Where is incentive to exit?

Tip 6 (2): Understand how managers are rewarded

Performance fees

• Typically 20% of performance

• This is a call option on the assets

• Value to manager maximised by increasing return or risk (volatility)

Which is easier to change?

BUT only paid if there’s an exit

Tip 7: Validate your research

Good news – others have been doing this too

FCA says….

•…can rely on factual information provided by EEA-regulated firms

•…cannot rely on provider’s opinion

We say…

• Don’t rely on made up numbers!

Summary

FCA telling us that due diligence is not optional

Tip 1: Don’t let tax tail wag investment dog

Tip 2: Balance risk and return

Tip 3: Evaluate the investment process

Tip 4: Pay attention to what happens after investing

Tip 5: Greater skewness requires greater diversification

Tip 6: Understand how managers are rewarded

Tip 7: Validate your research

Appendices

I. Intro to Hardman & Co

II. The regulatory environment

III. The key steps to investment evaluation

IV. How Hardman & Co approaches reviews

I. Introduction to Hardman & Co

Who is Hardman & Co?

Founded in 1996, Hardman & Co is an FCA registered capital markets research and consultancy business providing a wide range of services to the UK corporate sector. Our expertise covers all major sectors of industry and commerce

Independent research and financial analysis are our core product offering, and combined with a deep understanding of our business and strategic focus, provides the ability to assess, value and advise our corporate clients

Our business is structured to address the ever-changing regulatory landscape and to help alleviate commercial challenges in the financial services industry

We entered the tax enhanced review business in 2015, having been encouraged to do so by industry participants, and after several months of due diligence

We are not a stockbroker. We are only retained by corporates or advisers. We do, however, have a significant network of contacts

I. Introduction to Hardman & Co

Speaker bio – Dr Brian Moretta

Head of Tax Enhanced Services at Hardman & Co since 2013

Actuary and examiner for the Faculty & Institute of Actuaries

Former fund manager

20 years experience in financial services

Contact details:

Telephone: 020 7929 3399

Email: [email protected]

Website: www.hardmanandco.com

mailto:[email protected]

http://www.hardmanandco.com/


What is ‘Research & Due Diligence’? (FCA’s view)

“Research and due diligence form part of a wider range of requirements which, together, combine to ensure firms deliver good client outcomes.”

Competence – the advisory firm must ensure its advisers are adequately competent on the subject of the product or service concerned. Advisers are required to be competent in the regulated activities they undertake, such as advising on investments

Research and due diligence – the process carried out by the firm to assess: (a) the nature of the investment, (b) its risks and benefits, and (c) the provider. The firm needs to understand these factors in order to judge whether the solution is suitable

Assessing suitability – once advisers are competent in the nature of the investments and understand the individual product or service, they should be able to judge for each client if the solution is suitable

Conclusion: “What constitutes a reasonable level of research and due diligence will differ depending on the adviser’s recommendation and the needs of the client.”


So…what does TR16/1 have to do with me?

The FCA findings & observations included the following comments:

Many firms did not show consistently good practice across all products and services

“We were disappointed to identify issues relating to platform research and due diligence, particularly having previously published our expectations around this topic.”

The better firms had either in-built challenge in the process and/or individuals who were knowledgeable, enthusiastic and challenged the firm’s approach

File reviews should involve a genuine assessment of the recommendation rather than simply checking the presence of research and due diligence, irrespective of its quality or relevance to the client

Many firms demonstrated inconsistent and insufficient research and due diligence in the selection of platforms. We believe this was caused in some cases by status quo bias and an ‘if it isn’t broke, don’t fix it’ attitude. We also saw evidence of some firms retro-fitting due diligence to justify the outcome the firm had already previously decided upon

When firms have CIPs, they should ensure individual advisers understand the benefits and risks


…And there is more to come from the FCA soon

“We will be publishing a second consultation paper on the implementation of the Markets in Financial

Instruments Directive (MiFID II) later this year (2016). Based on ESMA’s Technical Advice to the Commission of

December 2014, we anticipate that this will include requirements in relation to research on products.”


Where will the buck stop?

An intelligent observer might deduce that the onus regarding the investment responsibility (as opposed to tax planning) is being pushed increasingly onto the adviser, as they are best placed to understand the needs of their client.

An Adviser might be asking questions such as:

What do I need to know?

What do I need to do?

Who else, if anyone, can I rely on?

General words of advice:

Ignorance is no defence, nor will “just going with the flow” be an acceptable practice

Acting like a reasonable person is a good sense-check

Get informed help in cases of uncertainty


The appropriate mindset to adopt

The general rules to any investment commitment include:

Appreciate the key drivers to risk and reward

Identify the investment processes that are applied to decision-making

Adopt a constructive approach; and do not accept weak answers to questions and enquiries

Understand the business proposition and importantly the current valuation

Consider management record, contribution and reward structure

Identify any conflicts of interest

Division of reward - who stands to benefit?

Absorption of losses - who takes the hit?

Assess financial resources to accomplish aims – scale of future fundings and timing

Obtaining additional comfort whenever necessary

IV. How Hardman & Co approaches reviews

What we look for…does it all make sense?

Clarity of fund objectives

Robustness of business case that underpins objectives

Investment process – needs to be clear and consistent

Management experience and credibility; case studies

Valuation calculations; on what basis are these prepared

Corporate governance standards – management of conflicts

Risk management

Monitoring of progress; life is not static

Results of stress testing the business model

Disclaimer

Hardman & Co provides professional independent research services. Whilst every reasonable effort has been made to ensure that the information in the research is correct, this cannot be guaranteed.

The research reflects the objective views of the analysts named on the front page. However, the companies or funds covered in this research may pay us a fee, commission or other remuneration in order for this research to be made available. A full list of companies or funds that have paid us for coverage within the past 12 months can be viewed at http://www.hardmanandco.com/

Hardman & Co has a personal dealing policy which debars staff and consultants from dealing in shares, bonds or other related instruments of companies which pay Hardman for any services, including research. They may be allowed to hold such securities if they were owned prior to joining Hardman or if they were held before the company appointed Hardman. In such cases sales will only be allowed in limited circumstances, generally in the two weeks following publication of figures.

Hardman & Co does not buy or sell shares, either for its own account or for other parties and neither does it undertake investment business. We may provide investment banking services to corporate clients.

Hardman & Co does not make recommendations. Accordingly, we do not publish records of our past recommendations. Where a Fair Value price is given in a research note this is the theoretical result of a study of a range of possible outcomes, and not a forecast of a likely share price. Hardman & Co may publish further notes on these securities/companies but has no scheduled commitment and may cease to follow these securities/companies without notice.

Nothing in this report should be construed as an offer, or the solicitation of an offer, to buy or sell securities by us.

This information is not tailored to your individual situation and the investment(s) covered may not be suitable for you. You should not make any investment decision without consulting a fully qualified financial adviser.

This report may not be reproduced in whole or in part without prior permission from Hardman &Co.

Hardman Research Ltd, trading as Hardman & Co, is an appointed representative of Capital Markets Strategy Ltd and is authorised and regulated by the Financial Conduct Authority (FCA) under registration number 600843. Hardman Research Ltd is registered at Companies House with number 8256259. However, the information in this research report is not FCA regulated because it does not constitute investment advice (as defined in the Financial Services and Markets Act 2000) and is provided for general information only. Hardman & Co Research Limited (trading as Hardman & Co) 11/12 Tokenhouse Yard London EC2R 7AS T +44 (0) 207 929 3399 Follow us on Twitter @HardmanandCo (Disclaimer Version 2 – Effective from August 2015)


How to contact us Hardman & Co Richard Angus (Head of Business Development) 11/12 Tokenhouse Yard London EC2R 7AS Tel: +44 20 7929 3399 [email protected] www.hardmanandco.com


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