Third-party due diligence: Process, benefits, and best practices

Businesses are increasingly reliant on suppliers, software providers,, and other third parties, with research showing that the average company shares confidential business information with about 583 third parties. At the same time, 59% of global companies admit they experienced at least one data breach caused by their vendors or third parties. This draws attention to the importance of third-party risk management, especially amid the increasing average cost of a data breach.

In this article, we’ll focus on third-party due diligence as a tool to mitigate risks associated with third parties. Keep reading to learn how to conduct third-party due diligence, why it is important for business, and what the main challenges of effective third-party due diligence are.

Key takeaways:

• Third-party due diligence is the process of a business’s investigation of its vendors, suppliers, distributors, and other third parties to ensure there are no red flags in their operations that could harm the business.
• The main benefits of third-party due diligence are risk mitigation, compliance assurance, legal protection, financial security, reputational protection, and operational efficiency.
• The third-party due diligence process is generally performed on three levels, which differ in the potential risk exposure.

What is a third-party due diligence (TPDD)?

Third-party due diligence (TPDD) is the process a business performs to investigate its distributors, suppliers, vendors, and other third parties to detect any red flags in its operations.

The key point about a third-party due diligence strategy is that it should be conducted not only when deciding whether to start working with a certain vendor and proceed with onboarding, but also as the part of a risk-mitigation approach in ongoing relationships cooperation with vendors and suppliers. 

This is especially relevant since 98% of companies have vendor relationships with at least one third party that experienced a data breach in the last two years. 

Benefits of third-party due diligence

The main advantages of conducting third-party due diligence include:

• Risk mitigation

Companies conducting third-party due diligence identify and assess potential risks associated with engaging a third party, such as legal, financial, reputational, or operational risks.

• Compliance assurance

TPDD helps to ensure compliance with regulatory requirements, industry standards, and internal policies, especially in industries such as finance, healthcare, and manufacturing where regulatory and compliance obligations are crucial.

• Legal protection

Thanks to TPDD, organizations can mitigate the risk of legal liabilities arising from the actions of third parties, such as bribery, corruption, fraud, or other unethical behavior.

• Reputational protection

With TPDD, an organization ensures that third parties adhere to ethical standards and do not engage in activities that could harm the company’s image or brand.

• Financial security

Third-party due diligence also helps to evaluate the financial stability and viability of third parties, including their ability to fulfill contractual obligations and overcome economic challenges.

• Operational efficiency

 TPDD is sometimes conducted to assess the capabilities and reliability of third parties to deliver goods or services on time and meet quality standards, ensuring operational efficiency and continuity.

Three levels of third-party due diligence

Regulators recommend companies take a risk-based approach to third-party due diligence. This means that high-risk third parties should be reviewed more thoroughly, while applying the same approach to low-risk third parties might be considered excessive. 

This approach is reflected in the three levels of a third-party risk management program:

• Level One

On the first level of due diligence, a company should check the third-party company’s management and owner names, as well as the company name in various global watch lists. Such a list may include the US Office of Foreign Assets Control (OFAC) Blocked Persons and Specially Designated Nationals (SDN) List or the United Nations Security Council (UNSC) Consolidated List. The measures on the first level of third-party due diligence are sufficient to investigate low-risk prospective third parties.

• Level Two

On the second level of the risk management program, a company conducts deeper research of third parties’ operations based on the Level One findings. This involves investigating internet resources, media, and newspapers to identify any corruption-related activities, for example. If a company finds no red flags during Level Two of third-party due diligence, this level is considered sufficient.

• Level Three

On the third risk level of third-party due diligence, an organization performs the deepest dive into a vendor’s operations. This stage is known as enhanced due diligence and involves on-site interviews, deep background checks of executives, and site visits. Based on previous stages of the risk assessment due diligence program, this stage focuses on uncovering any hidden issues that might put an organization at a high risk.

The six most important steps in a third-party due diligence process

There are typically six main steps in managing third-party risk due diligence.

1. Create a list of your current third-party vendors 

The first step in the third-party due diligence review process is to know your current vendors and supply chain third parties. 

Create a detailed list of all third-party vendors and service providers and include their contacts. It’s also recommended to initially assess and prioritize each third party based on their level of potential risk.

2. Define your current vendor risk

The next step of the third-party risk management due diligence workflow is to understand what risk exposure each vendor can bring to your organization. 

For instance, if the vendor was caught in money laundering, your company may find itself involved in a corruption risk which can negatively impact your reputation. 

Another example is when a vendor experienced at least one data breach in the past. In instances like this, cybersecurity risk investigation should be a part of due diligence efforts.

3. Determine the location of your vendors and assess the risks associated with it

It’s also essential to know where your vendors’ operations are located, especially in cross-border business relationships.

For instance, some countries may be susceptible to sanctions, which can have a huge impact on your business and reputation. What’s more, some territories suffer from ongoing conflicts and wars, which inevitably influence the local economy. As a result, this can also be reflected in your financial operations. For example, Russia’s war in Ukraine already cost the global economy $2.8 trillion.

4. Gather documentation

After the preparatory stages are completed, you can proceed with initiating the third-party business due diligence. 

For this, ask for third-party data such as articles of incorporation or key stakeholders’ information. In cases relating to an individual, ask for proof of their identification or any information about the disclosed conflicts of interest.

5. Perform third-party vendor due diligence

After the preliminary check, the third-party compliance investigation starts. 

Start with the background checks and then proceed with the compliance screening, contract review, financial due diligence, site visits and interviews, and legal due diligence. 

For an effective review, implement a level-based approach.

6. Analyze the findings and develop risk mitigation strategies

The final step is to develop risk mitigation strategies based on the findings of the due diligence process. 

This may involve implementing additional controls, monitoring mechanisms, or establishing contingency plans.

Challenges of third-party due diligence

During the third-party risk management process, certain challenges may occur, potentially impacting the effectiveness of the due diligence efforts. These include:

• Limited information
  Often, third parties don’t readily disclose all relevant information. They might hide critical details or provide incomplete or inaccurate information, making it challenging to assess their true risk profile.
  
• Complex corporate structures
  Some third parties have complex corporate structures involving subsidiaries, affiliates, or offshore entities. Understanding these structures and identifying ultimate beneficial ownership and control can be difficult, especially if transparency is lacking.
  
• Geographic and cultural differences
  Dealing with third parties operating in different geographic regions can challenge understanding local regulations and business practices. Misinterpretation or lack of awareness of these factors can lead to oversight of crucial risk indicators.
  
• Resource constraints
  Conducting comprehensive due diligence requires significant time, expertise, and resources. Organizations may face challenges in allocating adequate resources to thoroughly investigate third parties, especially when dealing with numerous vendors or when operating with limited budgets.
  
• Fraud and corruption
  Third-party relationships can be exploited for fraudulent activities or corrupt practices. Detecting red flags indicating potential fraud, such as conflicts of interest, questionable financial transactions, or suspicious relationships with government officials, requires diligent investigation and vigilance.

Third-party due diligence best practices

Consider some of these risk-based due diligence best practices:

• Create a third-party due diligence questionnaire or checklist
  A third-party due diligence questionnaire is a formal document that lists all the questions and issues to clarify during the investigation process. With it, you can ensure no area or aspect of investigation is missed. 

• Centralize the data
  It’s a great idea to store all the third-party data for review in one secure place, a virtual data room, for example. This way, you can significantly streamline the process and ensure no unsolicited parties have access to confidential data.

• Mind employees
  While investigating an executive’s background is paramount, ignoring other employees is a mistake. Especially because 74% of data breach incidents involve a human element.

• Involve experts
  Engage internal and external experts, including legal advisors, compliance specialists, and industry professionals, to provide specialized knowledge and insights.

• Stay updated
  Continuously monitor changes in the third party’s risk profile, such as financial status, legal issues, and regulatory compliance, to ensure ongoing diligence.

How iDeals can improve your third-party due diligence process

For effective TPDD, modern companies often use third-party due diligence solutions, such as virtual data rooms. Using iDeals data room for due diligence during your TPDD, you benefit from the following:

• Ease of use

iDeals is extremely easy to use, regardless of the user’s technical background. What’s more, iDeals offers mobile access, which allows parties to efficiently work on due diligence documents from anywhere and at any time.

• Enhanced security

iDeals prioritizes data security, offering such features as two-factor authentication, in-built redaction, dynamic watermarking, IP address restriction, eight levels of access controls, and many more.

• Customizable workflows

iDeals understands that every due diligence process is unique and offers customizable workflows, allowing clients to tailor the system to their specific requirements. 

• Advanced collaboration tools

With the help of an advanced Q&A section, the third-party due diligence team can proactively collaborate with the vendor in case any extra questions arise.

• Dedicated customer service

Customer service is what iDeals clients appreciate the most. They can access live training with an expert, a dedicated project manager, in-app live chat support 24/7, and more.

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