Discover more from Jamaal’s Letter
How NOT to Do Diligence
J.P. Morgan is suing the founder of a company that it bought for $175 million, claiming it was a scam. But how did one of world's largest banks fumble its due diligence so badly?
I recently predicted that 2023 would be a record-high year for corporate scandals, as a looming recession exposes a decade's worth of poor governance at private companies.
But, I didn’t expect the year to start with the headline-grabbing scandal playing out between a seemingly high-flying startup and one of the world’s largest financial institutions. As the NYTimes describes:
When JPMorgan Chase paid $175 million to acquire a college financial planning company called Frank in September 2021, it heralded the “unique opportunity for deeper engagement” with the five million students Frank worked with at more than 6,000 American institutions of higher education.
Then last month, the biggest bank in the country did something extraordinary: It said it had been conned.
In a lawsuit, JPMorgan claimed that Frank’s young founder, Charlie Javice, had engaged in an elaborate scheme to stuff that list of five million customers with fakery.
“To cash in, Javice decided to lie,” the suit said. “Including lying about Frank’s success, Frank’s size and the depth of Frank’s market penetration.” Ms. Javice, through her lawyer, has said the bank’s claims are untrue.
JPMorgan’s legal filing reads like pulp nonfiction, with jaw-dropping accusations. Among them: that Ms. Javice and Olivier Amar, Frank’s chief growth and acquisition officer, faked their customer list and hired a data science professor to help pull the wool over the eyes of the bank’s due-diligence team.
As expected, much of the press focus on this case is on how Frank’s 30-year-old founder Charlie Javice, with her gilded credentials, executed this alleged fraud.
But what I find the most interesting is how J.P. Morgan -- a company that makes more than $13 billion in fees every year advising other companies on these types of transactions -- so badly fumbled its due diligence of Frank.
I’ve worked on more than $80 billion of acquisitions and investment deals in my career. (Much of that early in my career working in J.P. Morgan’s investment bank.) That includes advising and working for companies on both sides of acquisitions and working for firms that are investing significant sums in new and established companies.
There are consulting and law firms that one can hire to conduct due diligence entirely or partially. Anyone experienced in this work can produce a long list of things that are part of due diligence that include everything from confirming that the business is a registered legal entity to verifying that the company works with its biggest stated customers.
But here are a few things unlikely to be on these lists and a few things that many poorly-diligenced transactions -- and in this case, J.P. Morgan -- miss.
Talk to More Customers and Market Experts
Talking to customers is a standard part of diligence, but it’s more art than science for large, consumer-facing businesses. Depending on the product or service, there may be millions of customers.
When the company in question has a large customer base, the goal should be to develop an intuitive sense of the customers and the market
Diligence should include talking to people who know the market so well that they can easily tell when something is out of place.
In the case of Frank, even a low-level expert in college financial aid should have been able to spot the red flags. The NYTimes reports that Frank’s stated 5 million customers would have represented an overwhelming share of the market of students who apply for financial aid:
Mr. Salisbury, a former director of institutional research and assessment at Augustana College, estimates that two million students start college each year for the first time. Having done the FAFSA once, he figured, most families wouldn’t seek help from a company like Frank the second time they needed to and beyond. So if Frank had served five million people in just half a decade, it would have captured a sizable share of new college students who needed financial aid.
Experts aside, J.P. Morgan should have talked to enough customers to understand that Frank’s brand recognition among financial aid applicants was too low for the reported number of customers. They needed someone to go out into the world organically, find where student loan borrowers congregate, find who among them are customers of Frank, and talk to those people. That would have surely given them a sense that the actual size of Frank’s customer base was smaller than what they were claiming.
This information alone wouldn’t have revealed the fraud, but it would have made it clear that J.P. Morgan needed to dig deeper.
Talking to customers and experts may sound obvious, but you’d be surprised how often this missed step lies at the root of an eventual fraud.
Lack of market and product expertise allowed Theranos’ fraud to elude its board of directors. Lack of market intuition helped Ozy Media, the now defunct media startup, to overstate the size of its audience for years.
Properly Incentivize the People Working on the Deal
There is a team of mergers and acquisitions professionals inside J.P. Morgan that made this deal happen. They were responsible for doing the diligence themselves or hiring someone. Either way, they failed.
I bet these people were poorly incentivized to get this acquisition correct. Too often, investment and corporate development people are incentivized to get deals done, not necessarily get them right.
If I’m correct, the people in charge of the diligence process were faced with bigger bonuses if the deal closed or its outcome had no bearing on their pay.
In either case, rather than taking a sober, impartial look at this company and its claims, they were likely looking for reasons to complete the acquisition, not reasons to kill it. That leads to minimal diligence. Rather than aiming to understand Frank’s business, customers, and market, they were looking for signs to affirm their overly-simplistic beliefs about the company.
A compensation scheme where the people working on the acquisition were aligned with its outcome -- doing well for themselves if the acquisition did well for the company, and vice versa -- would have likely improved the rigor of the diligence process.
There is no law against J.P. Morgan conducting lazy due diligence. But Frank, which has been shut down, is essentially worthless. The $175 million it paid for a now worthless company represents the annual salary of more than 1,700 JPMorgan employees.*