Down and Dirty Due Diligence

The title for this posting comes from two articles in the Journal of Private Equity, the first appearing in 1998 and the second in 2001.  They were written by a pseudonymous author, Allan Smithee (paying homage to those in the film industry who had used similar names).

Private equity and the investment world in general have changed markedly in the last quarter century, but the articles are a reminder that patterns repeat, especially those involving human behavior (and therefore organizational behavior and investor behavior).

Smithee described his approach in the 1998 piece:

I don’t carry a badge or a gun.  I carry an unhealthy dose of cynicism.

I treat everything as a hair-brained scheme that must be proven otherwise.  I trust no one’s convictions to be honest or competent.  Credentials mean nothing.  Facts?  What facts?  Faulty misguided assumptions are masquerading as facts.

The examples that he provided were regarding company due diligence of the kind that is done for private equity (and venture capital, etc.), but the lessons apply to the investigation of asset managers as well.  Being “boondoggled by [an] orchestrated demo” of a new product is similar to being boondoggled by a pretty summary of an unpretty investment process — or by a theatrical investment committee meeting without the true theater that can play out within a real one.

Smithee wrote of the president of a firm who “had crossed the Rubicon of objectivity” regarding its prospects, noting that “sometimes the will to believe becomes the belief itself.”  The same thing can happen to those charged with doing due diligence.  One of his lessons to avoid the slippery slope of belief:

Never, ever be intimidated by anyone, anywhere, anytime.  Never be so intimidated by someone’s credentials and convictions that you fail to question and verify their claims.  Respect everyone, be intimidated by no one.

Another:  “Don’t let anything pass by your eyes and ears that doesn’t make sense.”  Instead, you need to “look for the loose thread and yank it.”  You don’t know what’s going to matter, so you should “challenge everything that doesn’t fit.”  Those whom you question:

will either learn to tell you the truth, decide there are dumber investors available and quit talking to you, or you will decide there are more intelligent, honest managers and quit talking to them.

Columbo on the case

Smithee used the TV detective Columbo to suggest effective ways to approach interviewing, writing that “little is served by presenting a capable image.”  Columbo turned his unassuming manner, frumpy appearance, and willingness to appear confused into assets.

The subjects of due diligence are more knowledgeable about technical matters than those doing the investigations, so it’s a mistake to try to impress them in meetings:

If I went into a project with a big head, I might worry about looking stupid by questioning a fundamental fact or asking for a down-to-earth explanation that everyone else might see as obvious or trite.  I might want to avoid potential embarrassment.  But, I am not going to the target company to show the managers how smart and successful I am.

There is no reason to tell them much, if anything, about my own credentials and experience.  There is no reason to present a capable image in either dress or speech.

In my experience, the exact opposite image can be useful.  If you appear helpless and confused, it is amazing how much people will want to help you.

Tactics

The first article closed with ten “down and dirty tactics” for onsite visits.  Here are a few of them.

Smithee said that you shouldn’t challenge “the honchos” in an initial meeting (although that may not be the best approach in situations where there won’t be a series of such meetings).  His rationale:  “Feeding their ego will make them feel comfortable and will increase your access.  Get out of the executive suite silently skeptical and talk to the staff.  They know what is really doing on.”

He repeatedly stressed the importance of interacting with the staff:

Why is it that employees say the darndest things?  Why would they tell you something that is not in the best interest of their company?  Lots of reasons:

~ They may not know what management has told you.

~ They may assume you have already been told.

~ They haven’t been coached on what to say, how to say it, or what data to provide.

~ No one may have asked for their opinion before, including management.  Now they have someone to talk to, and you’re the lucky one.

~ They may assume it is a done deal, so why shouldn’t they talk to you?

~ They want to get off on the right foot with the new owner.

While the last couple apply to situations where a change in control is the endpoint of the due diligence work, the broader principle applies in any situation.  The best information often comes from those who aren’t on the interview lists of due diligence analysts.

When evaluating an operating company, you should “speak with the engineers and technical people.  They don’t know how to lie, they’re too analytical.”  (And they are not fluent in the narrative.)

Like Columbo, you should “make the fog your best friend”:

Never tell anyone you are skeptical and doubting.  Explain it as confusion.  “I’m way over my head on this assignment.  Sorry, I’m such a bother.  I really appreciate your patience with me.”  People will try to help you.  Give them enough rope to hang themselves.

Narrative framing

As in his first article, Smithee’s second piece used examples (with fake names) of due diligence projects that he had worked on.  Many emphasized the narrative-creation activities of those he investigated.  In one case, he was impressed with the initial information he saw, “even allowing for investment banker-inspired spin and presentation mastery” — a discount that should always be applied to those carefully crafted narratives.

He wrote that investment bankers “have several functions”:

~ To keep you focused on the trees rather than the forest (or vice versa, if need be).

~ To keep you from getting too close to reality by presenting you with pretty, edited, and slanted information bundled in a way that’s a real task to untangle.

~ To control where you go and who you see.

~ To keep you away from people who might slip up and give you the real story.

~ To eliminate impromptu questions and answers.

Some asset management firms are experts at doing the same sorts of things; evaluating the degree to which those barriers are being erected and creating strategies to break through them are fundamental skills in due diligence.

Also, he stressed avoiding the written-questions trap:

I hate putting questions in writing because it gives the respondent too much time to spin a fudged answer.  It allows the seller the opportunity to get everyone on board as to what the story is.  Getting one-on-one with the target managers and asking the same questions of each [doesn’t happen in a group meeting].  The one who had the best spiel would offer an answer and no one else would say anything contradictory.

Other lessons

“Feigned stupidity, which I talked about so much in my first article, goes only so far.”  Eventually, you have to be willing to press the issues, to ask the uncomfortable questions, and to make sure that you get all of the information that you have been promised.

“Don’t let others manage the process, but it’s OK if they think they are.”  This is one of the most-violated precepts in due diligence practice.  Those to be evaluated should never control the agenda.

“Don’t be shy of walking away.”  This should be a bedrock principle, although walking away from a business deal is easier than walking away from a meeting with an investment manager that your firm expects to cover for years to come.

Due diligence analysts can benefit from investment knowledge and technical expertise, but they are hollow without the kind of mindset and tactics that Smithee espouses.  (That’s why the Investment Ecosystem Academy due diligence course and customized training for organizations take a similar approach — and identify important topics where an analyst’s expertise can exceed that of the people being interviewed.)