Who needs enhanced due diligence procedures and why

More than $3 trillion of illicit funds streamed through the global financial system in 2023. At the same time, terrorist financing accounts for 33% of current financing crime threats. 

Such statistics reflect the scale of global financial crime and call for better regulatory controls to fight it. Identifying effective measures is especially crucial for organizations entering new business relationships through mergers, acquisitions, or similar transactions.

Enhanced due diligence (EDD) is what helps mitigate risks here. 

This article explores enhanced due diligence, describes the triggers when it’s required, and lists its main components. Additionally, we show how EDD can be improved with the help of a virtual data room (VDR).

Highlights:

• Enhanced due diligence is a thorough investigation of high-risk customers, businesses, relationships, or transactions.
• Enhanced due diligence is required when a business deals with companies or clients from high-risk countries, politically exposed persons, cross-border transactions, new or unfamiliar clients, high-risk industries, complex ownership structures, or unusual transactions.
• The main components of the EDD process include deep background checks, source of funds verification, analysis of business relationships, geographical risk assessment, compliance with regulations, reputational risk review, and ongoing monitoring. 

What is enhanced due diligence?

Enhanced due diligence is a meticulous investigation process used to assess high-risk customers, transactions, or business relationships. Unlike traditional due diligence, enhanced due diligence goes much deeper to ensure compliance with anti-money laundering (AML) and combating the financing of terrorism (CFT) rules. 

The main goal of enhanced due diligence is to define and mitigate potential risks when entering a new business relationship. 

This is how it works. Imagine a global manufacturing company planning to acquire a supplier based in a high-risk country. During the enhanced due diligence process, they discovered that one of the supplier’s executives was previously linked to corruption charges, and several large transactions were routed through offshore accounts with little transparency. To mitigate risks, the buyer reduces the offer price, requires stricter compliance measures, and insists on ongoing audits. 

This way, by rolling out the EDD process, the acquiring company avoids potential legal penalties, financial losses, and reputational harm.

Enhanced due diligence vs. customer due diligence

Just like enhanced due diligence, customer due diligence (CDD) is also performed to verify a customer’s identity and assess their risk level to prevent fraud and financial crimes. However, unlike EDD, which is used to review high-risk customers, CDD reviews medium-risk customers. 

Here’s how these two types of due diligence differ: 

When is enhanced due diligence required? 

Enhanced due diligence procedures should be implemented in any situation where a risk-based approach is needed. For instance, EDD is required when a business deals with:

• Companies or clients from high-risk countries
  Businesses or individuals from countries with weak financial regulations, high corruption rates, or a history of financial crimes require extra scrutiny. These regions may have poor enforcement of AML laws, increasing the risk of illegal activities.
• Politically exposed persons (PEPs)
  These include government officials, diplomats, and their close associates, who may be more vulnerable to bribery or corruption. Since their positions give them access to public funds and influence over financial decisions, they require stricter monitoring.
• Cross-border transactions
  International deals, especially those involving tax havens or regions with loose regulations, pose a higher fraud or money laundering risk. Differences in legal frameworks may make it easier to hide suspicious activities, requiring deeper investigation.
• New or unfamiliar clients
  When dealing with first-time clients, especially those with limited online presence or unclear business histories, businesses must verify their legitimacy. Without a proven track record, there is a higher chance of fraud, identity theft, or other hidden risks.
• Complex beneficial ownership structure
  Companies with multiple layers of ownership or offshore accounts can be used to hide the true owners and sources of funds. Enhanced due diligence helps determine a beneficial owner and uncover whether these structures are legitimate or designed to evade taxes, launder money, or conceal criminal activities.
• High-risk industries
  Certain sectors are more vulnerable to financial crime. These include gambling, cryptocurrency, real estate, luxury goods, and correspondence banking, where financial institutions establish relationships with foreign banks. These industries often involve large cash transactions or rapid fund movements, making it easier for criminals to exploit them.
• Unusual transactions
  Unexpected financial activities, such as sudden large deposits, inconsistent payment patterns, or fund transfers to unrelated entities, may indicate illegal dealings. Investigating these transactions helps prevent fraud, money laundering, and regulatory violations.

Key components of enhanced due diligence

Enhanced due diligence measures typically include the following main stages:

• Meticulous background checks
  Review the company’s history, key executives, and financial activities. This includes checking for past legal issues, regulatory violations, or involvement in fraud. Such background checks help identify potential risks before entering into a business relationship.
• Source of funds verification
  Investigate where the money comes from to ensure it is earned legally. Review bank statements, tax records, and financial reports to confirm a clean source of income. This step helps prevent money laundering and other financial crimes.
• Business relationship analysis
  Examine the company’s structure, ownership, and key stakeholders. Identify business partners and third-party connections to detect high-risk associations. Understanding these relationships helps assess overall risk exposure.
• Geographic risk assessment
  Identify risks associated with doing business in certain regions. Some countries have weak regulations, corruption, or political instability, which increases business risks. Checking these factors helps to avoid problematic locations.
• Compliance with regulations
  Ensure all activities follow local and international laws and regulatory requirements, such as anti-money laundering and counter-terrorist financing rules. Companies that fail to comply face heavy fines or legal action.
• Reputational risk review
  Look at news reports, social media, and legal records to see if the person or company has been involved in scandals or controversies. A bad reputation harms a company’s brand, which leads to financial losses.
• Ongoing monitoring and reporting
  Keep track of financial transactions and activities after the initial review. Set up alerts or automated tools to detect unusual behavior, such as large or unexpected transfers. It helps to ensure that possible risks are identified and addressed quickly.

Enhanced due diligence in M&A and business transactions

Enhanced due diligence is especially relevant during complex financial transactions such as M&A. For a buyer, getting involved in a business relationship with a company that has certain hidden issues can result in reputational damage at best and huge financial losses and legal implications at worst.  

Such an advanced risk assessment process is notably important while world economic uncertainty persists, with geopolitical risks being at the core.

Enhanced due diligence procedures during M&A help dealmakers to:

• Identify hidden risks
  Enhanced due diligence uncovers hidden risks such as unreported liabilities, operational weaknesses, or compliance issues that may not be visible in standard due diligence. By identifying these early, companies can address them before they affect the business post-acquisition, minimizing surprises​.
• Prevent legal issues
  Enhanced due diligence helps detect potential legal violations, including past regulatory breaches or connections to high-risk entities. Identifying these legal concerns early ensures that the acquiring company can avoid legal disputes, fines, and compliance violations that could arise from the target company​.
• Protect financial investments
  Through comprehensive financial checks, EDD ensures that the acquirer is not investing in a company with hidden debts, inflated asset values, or financial instability. This provides a clearer picture of the target’s true financial health, protecting the acquirer’s investment​.
• Strengthen negotiation power
  Armed with detailed findings from EDD that are reflected in a due diligence report, buyers gain better leverage in negotiations. By knowing the target’s weaknesses and risks, buyers can request better deal terms, such as a lower price, risk-mitigation clauses, or additional guarantees from the seller​.
• Avoid reputation damage
  Enhanced due diligence reveals any past scandals, unethical behavior, or negative public perceptions associated with the target company. Avoiding these risks helps protect the acquirer from potential damage to their own reputation, ensuring that the deal does not negatively impact public trust​.
• Ensure transparency
  Enhanced due diligence ensures complete transparency by thoroughly investigating the target company’s financials, operations, and compliance records. This level of scrutiny allows the buyer to make an informed decision about the acquisition, based on clear and honest data.
• Reduce integration risks
  Enhanced due diligence helps uncover operational challenges, such as incompatible systems, cultural mismatches, or supply chain vulnerabilities. Identifying these issues early on allows the acquiring company to plan and mitigate integration risks, leading to a smoother transition post-merger​.

Using Ideals for enhanced due diligence

Ideals’ virtual data room offers dedicated functionality aimed at making the process of enhanced due diligence faster and more efficient. 

Here’s what you get by employing Ideals VDR: 

• Secure storage for sensitive data
  Confidential and sensitive documents such as financial contracts, legal records, and private stakeholder information are stored in the cloud and secured with a variety of dedicated security features. Features that ensure data privacy include redaction, two-factor authentication, IP address restriction, and eight levels of granular access permissions.
• Effective collaboration tools
  All the participants of the due diligence process can effectively communicate in the Q&A section. They can post questions to certain files and get prompt answers from assigned experts.
• Intuitive interface
  Ease of use is what Ideals’ clients especially like, according to G2 reviews. Both desktop and mobile versions have a pleasant user interface (UI) and are intuitive for all users regardless of their tech background.
• Due diligence checklist features
  Ideals makes the process of due diligence checklist management straightforward. You can upload your existing XMSL checklists into the VDR without conversion and make real-time edits directly with the VDR.
• Real-time reporting
  Thanks to detailed audit trails, you can monitor data room activity, including who viewed what documents and when.

Final thoughts

Enhanced due diligence helps businesses identify hidden risks, ensure compliance, and protect against financial crime. It strengthens decision-making in mergers, acquisitions, and high-risk transactions by providing deeper insights through background checks, financial verification, and ongoing monitoring. 

For even more effective results, use tools like virtual data rooms. They enhance the security and efficiency of the EDD process while establishing collaboration among all parties involved.

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