Due diligence on an off-market deal: what to check before investingDue diligence on an off-market deal: what to check before investing

Key answer. Before money moves on an off-market deal, five things should be verifiable on paper: the legal entity that signs, holds the assets and repays; the documents that create the obligation; the security and who can enforce it; the route the money takes from the investor to its use; and how, when and on whose decision the investment ends. Anything described verbally but not written into a signed document should be treated as missing.

An off-market deal, in practice often a private placement, is one that is not marketed through a prospectus, a listing or a public offer. It reaches investors through introductions, which removes the filters a public offer comes with and leaves more of the checking to the investor and the investor's own advisers. The checks below are mechanical, and they show up a weak deal run by honest people as readily as anything worse.

That is the angle here. The story of a deal, the asset, the sector and the projected outcome, is rarely where it goes wrong. The paper is. Each check below can be done from documents and public registers, before anyone is asked to transfer money. The table below is the short version of that due diligence checklist, and the sections after it explain each line.

Who is the counterparty, and is it the entity that signs, holds and repays?

The counterparty is the legal entity that owes the investor the obligation, and it should be the same entity that signs the documents, holds the assets and receives the funds. In practice the three are often different companies, and the gap between them is where an investor's position weakens.

Start with the public record. The Companies House register shows when the company was incorporated, who the directors are, who the persons with significant control are, what it has filed and whether it has charges registered against it. The FCA Register shows whether a firm that claims to be authorised is, and for what. The Gazette shows insolvency notices.

Then ask what the entity actually owns. A special-purpose vehicle created for the deal can be perfectly sound, but it has no history, so the check moves to what is inside it and who stands behind it. A strong parent that only gives a guarantee, while the borrower is an empty company, is a different position from the parent borrowing directly. The names should match everywhere: the term sheet, the agreement, the bank account and the registered company. A trading name where a legal name should be is a question to ask, not a detail to wave through.

Which documents should exist before money moves?

The obligation, the security and the payment instructions should each sit in a signed document, and the investor should read the final versions, not a summary of them. A term sheet is an outline of intent. The agreement is what binds, and the differences between the two are where the real terms are.

A working set for most private deals includes:

• The agreement that creates the obligation: a loan agreement, a subscription agreement or an investment agreement.
• The security documents and any guarantee, where the deal is secured.
• The information memorandum or equivalent, with the latest accounts and any independent valuation.
• The investor confirmation, where the offer relies on an exemption from the financial promotion rules.

On that last point, read what you are asked to sign. For the high net worth and self-certified sophisticated investor exemptions, the statement the investor signs is set out in Schedule 5 to the Financial Promotion Order. It says that promotions may not comply with FCA rules, that the investor can expect no protection from the FCA, the Financial Ombudsman Service or the Financial Services Compensation Scheme, and that they could lose all of the money they invest. The statement is about the investor's status and the protections that are absent. It is not a formality.

Compare the documents against each other. Names, amounts, dates, governing law and the courts that hear disputes should be identical across all of them. Look for the terms that decide what happens when something goes wrong: events of default, what the borrower may not do without consent, and what information the investor is entitled to during the holding period.

What does the security cover, and who can enforce it?

Security is worth what it attaches to, where it ranks against other claims, and who has the right to act on it. A document headed "security" says little until those three are answered.

• What it covers. A fixed charge over a named asset, such as a property or a receivable, is a different thing from a floating charge over the company's changing assets. State which one the deal has.
• Whether it is registered. In England and Wales a charge created by a company has to be registered at Companies House within 21 days, counted from the day after it is created, and a late registration needs a court order, according to the government's guidance. The same register shows whether an earlier charge already ranks ahead. For property, check the title and the registered charge at the Land Registry.
• What it is worth. A recent, independent valuation, with the loan-to-value stated, is a document. An asking price quoted in conversation is not.
• Who holds it and enforces it. Security held by a trustee or agent for all lenders works differently from security held by the borrower's own group. A guarantee is worth the guarantor's assets outside the borrowing group, not the guarantor's name.

Secured lending and real asset deals rest on this section more than any other. The same questions apply to the kinds of deals covered on our Short Term Lending and Real Estate & Infrastructure pages.

Where does the money go between the investor's account and its use?

Funds should go to an account held for that purpose and be released against a stated event, not paid into the issuer's operating account on signing. The name on the receiving account should be the counterparty named in the agreement, and the account should sit with a regulated bank or a regulated client account.

The release conditions should be written down: for example, that the security has been registered, that a valuation has been delivered, or that goods have been inspected. Holding the money in a lawyer's client account or with an escrow agent until those conditions are met moves the risk of delay from the investor to the deal.

Then follow the money out. The use of proceeds clause says where the funds go next. For repayment, check which account receives the borrower's cash: in a trade, the buyer's payment should land in an account the lender can see or control, not in the seller's own. Where the deal is built around physical goods, as in the trade-based deals covered on our Commodities page, the question is whether payment is tied to documents of title, inspection and storage, rather than to a promise.

One rule has no exceptions. A late change to the bank details, or a request to pay a different party, is a reason to stop and confirm by telephone, using a number taken from the signed documents rather than from the message asking for the change.

How does the investment end, and who controls that?

An investment has an exit only if the documents name the date, the source of repayment and who can change either. A target exit date in a presentation is a hope. A maturity clause is an exit.

• The date. Is there a fixed maturity, a redemption window or no date at all? Who can extend it, and does the investor have a say?
• The source of repayment. The sale of an asset, a refinancing, trading cash flow, a listing or a buyer for the shares are different routes with different risks. The route should be named.
• Early exit. Can the position be sold or transferred, to whom, and with whose consent? Are there fees for leaving early?
• Default. What happens if repayment does not arrive: who steps in, on what notice, and how long enforcement takes.

Equity routes depend on an event the investor does not control. The same questions apply to a Private Equity position, a Pre IPO holding or an EIS/SEIS investment, where the exit is a sale or a listing that depends on the company and the market. How long such events take in practice is covered in our piece on UK private equity exits and portfolio duration.

What do these checks not tell the investor?

They show whether the paper supports the description of the deal. They do not predict performance, and a deal can pass all five checks and still lose money. The checks are the investor's to carry out, and they are best carried out with independent professionals.

Beyond the simplest deal, bringing in an expert is part of doing the diligence properly, not an optional extra. A solicitor can read the agreements and the security documents and say what they do and do not give the investor. An accountant can review the accounts and the tax position. For property or other assets, an independent valuer can test the value on which the security rests. The cost belongs to the investment. And a deal that cannot be examined by a professional before money moves is telling the investor something.

HBRD is an introducer. It is not authorised by the FCA, and it does not advise on investments. For how the firm sits between investors and the parties behind an opportunity, see How We Operate.