What is “due diligence”?
The term is used constantly in the investment business. We are told that we should do our due diligence before investing in something, and often, when presenting an idea, someone will say, “I’ve done my due diligence.”
We hire advisors and consultants and gatekeepers of all kinds because we expect them to perform due diligence. Their pitch books have a page or two about what they say they do in that regard, usually showing a filtering process of some sort that is rooted in “rigorous due diligence,” or some similar phrase.
But what is due diligence, anyway?
One definition: “Reasonable steps taken by a person in order to satisfy a legal requirement, especially in buying or selling something.”Oxford Dictionaries | The definition comes from the online cousin of the OED. Notice the legal aspect. Recently, someone said to me that much of the investment business is based “not on giving advice but on giving fiduciary protection.” Is a due diligence process designed to produce good ideas or to provide an evidence of process in order to check a fiduciary box?
Before going further, it’s important to note that there are many kinds of due diligence. A stock analyst investigating a company is doing due diligence. An individual interviewing prospective investment advisors is doing due diligence. And those involved in mergers and acquisitions work are doing it — in fact, almost all of the books you’ll find on “due diligence” relate to M&A. In comparison, there has been relatively little written about due diligence on asset managers, which is not to say that you can’t find quite a bit on “manager selection.”
It seems to me that there’s a difference. Manager selection is literally that: The way in which managers are selected. On the other hand, due diligence is an investigatory journey, what I call “an adaptive process of discovery.”
Current practices for the evaluation and selection of managers are dominated by the quantitative analysis of performance information. A few gatekeepers position themselves as being focused exclusively on such metrics in their selection process. Some even offer types of analyses that are different from those of the crowd. We can debate whether the numbers alone are sufficient to understand whether future performance will be in the same zip code as past performance, but at least the philosophy of those who proceed in that fashion is clear.
That’s not true for most involved in manager selection. They tend to talk about the integration of their quantitative evaluations with their qualitative assessments of managers, but if you look closely at what they do, the performance information usually overwhelms everything else in the end.
For those who remain tethered to the numbers on the page (or the screen) even as qualitative information is being recorded, then “due diligence” as I speak of it may be just a waste of time, except for its value as a marketing device (“I talked to the manager and . . .”) or as evidence of fiduciary activity “for the file.”
Let’s go back to the two words found in my short definition:
~ The process should be adaptive. For example, a checklist can be a helpful tool, but following a checklist does not equal doing due diligence; it needs to be abandoned at times to pull on a thread of inquiry. (Sometimes it should be discarded for the remainder of the encounter and left for another day.) A due diligence report filed on time is not the goal.
~ Discovery is. Everything about the process should be focused on building an understanding that goes beyond the narrative found in pitch books, presentations, and the due diligence reports available from third parties. If the questions you ask don’t reveal new information — if the answers come easily to those on the other side of the table — you probably aren’t likely to discover much. (However, there are times to get someone “on the record,” like a good trial lawyer would do, even though you know the answer, in order to set up other questions.)
The objective is to surface differential information and therefore the design of the due diligence process in general and its implementation in a specific case should reflect that quest. One requirement for success is a healthy skepticism that never waivers (in practice it tends to ebb and flow with performance). The benefits of due diligence compound over time, as the deep issues are illuminated by new events, but if you are focused on the same topical material as everyone else, you’ll likely miss the signs amidst the noise.
My definition of due diligence equates to finding relevant information wherever it is. It could be from “outside” a manager (think of a background check, for example) or from “inside” (whether it is the standard fare that everyone gets or something unique that you’ve dug up yourself). But doing “due diligence from a distance”Advisor Perspectives | That was the title of an article I did in 2009. is extremely difficult, in that generating differential information is much tougher in that fashion than if you can be on site. Unfortunately, much manager selection proceeds with the assumption that due diligence has been done, when what has been done is a summation and interpretation of information that is widely available.
Of course, what matters is not my definition of due diligence, but yours.
If you are charged with doing due diligence, how do you define it? How do you add value? What differential information is produced and what causes it to be produced?
If you are relying on due diligence performed by others, how much do you really understand about their approach?
As a term, “due diligence” is tossed around pretty loosely. In practice, for you, what is it? What should it be?
Due diligence is at the heart of my consulting work; I help organizations analyze and improve their due diligence practices.tjb research | This is a brief PDF that describes my services.