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Regulatory breaches can turn an otherwise attractive deal sour. Wonga’s demise earlier this year is a stark reminder of how important specialist regulatory due diligence on private equity and venture capital deals can be.
Over the summer, payday loans provider Wonga went into administration, buckling under the weight of compensation claims from customers and regulatory pressures on its business model. Until its demise, Wonga had raised over £100 million in venture capital funding from a number of well-known venture capital houses, many of whom got burnt as a result.
Wonga’s troubles began in 2014 when it entered into an agreement with the FCA to pay £2.6 million in compensation to around 45,000 customers in arrears who had received letters from fictitious law firms, invented by Wonga, which threatened legal action to enforce the debts. A few months later the firm was forced to write off £220 million worth of debt for 330,000 customers, forego interest on a further 45,000 loans and subject itself to a section 166 review after the FCA found that the firm had been providing high cost credit to customers who had no prospect of being able to pay it back.
Compounding these regulatory costs, the FCA introduced new rules for high cost short term credit providers. These changes included restrictions on the ability of payday lenders to roll over existing loans and, later, a cap on the daily interest rate and fees that could be charged to customers. Both changes significantly undermined Wonga’s business model and ultimately led to its failure, with sales at Wonga falling from over £300m in 2012 to just £77m by 2016.
Regulatory due diligence is more than a checklist
Thorough regulatory due diligence is vital for private equity and venture capital firms – and indeed any investor – when acquiring FCA-regulated financial services businesses. This is particularly true for consumer-focused financial services firms where the regulator perceives the potential for harm to retail customers. Wholesale firms have also been subject to large fines in recent years, so are not risk free.
Regulatory issues unearthed as part of due diligence need not always spoil a deal – but a thorough regulatory due diligence report can tell you if remediation needs to be part of your 100 day plan and can provide leverage in negotiations.
What should regulatory due diligence cover?
Skeletons in the closet
Wonga’s initial compensation claims stemmed from activity that took place before its series B and C funding rounds. These should have been picked up and quantified at the due diligence stage. Investors should be able to enter a deal with full knowledge of any skeletons in the closet.
Things that go bump in the night
Due diligence should also encompass the regulatory environment and any risks arising from proposed or possible rule changes that could be made by the regulator during the holding period. Just as important as Wonga’s legacy issues was the regulatory horizon and the regulator’s plans for the high-cost credit sector. The caps on costs and charged introduced by the FCA hit the profitability of all payday lenders and led to a dramatic reduction in the number of payday lenders operating in the UK.
Rickety frameworks
As well as risks arising from legacy issues and regulatory change, the systems, controls, governance, and culture a prospective portfolio company has in place at the time of acquisition can cause new problems during the holding period. In the case of Wonga, its inadequate affordability checks prior to autumn 2014 led to large amounts of debt being written off at the FCA’s insistence.
How we can help
Bovill is a specialist provider of regulatory due diligence. We have carried out regulatory and operational due diligence on prospective portfolio companies and acquisition targets across a wide range of sectors, as well as in the wider M&A market. As part of this, we identify:
- Legacy issues that could lead to regulatory fines in the future
- Weaknesses in existing systems, controls, governance and culture that could create new problems after completion
- Future issues to the target’s business model arising from planned or likely regulatory changes imposed by the regulator.
These findings can form the basis of a post-deal plan, which we can work with you to draft and implement, to proactively address issues that could lead to regulatory action.
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