The Imbalance in Due Diligence
As of late, I’ve been thinking about the term “due diligence.” As investors move into esoteric sorts of investments, there’s more and more emphasis placed on due diligence. What do pension officials or financial advisors mean when say that it’s critical to perform thorough due diligence before investing in private equity, real estate, or hedge funds? After rummaging through the policies and procedures of several pension plans, looking at websites for a few fund of funds, and browsing a couple of conference agendas on the subject of due diligence, I’ve come to the conclusion that most due diligence processes don’t provide much comfort to investors.
Due diligence is of course the research and analysis that is supposed to proceed any investment. And indeed most investment organizations conduct large amounts of due diligence. They have the file cabinets and hard drives to prove that they’ve “kicked the tires” before making an investment. However, what’s in those files?
In my experience, most of the due diligence material is of the “check the box” variety. If anyone asks a money manager or pension plan if they conducted due diligence, they will open file drawers filled with copies of track records, organizational charts, audits, financials, contracts, etc. During my career as a money manager and a CIO for North Carolina, I spent innumerable days poring through reams of this material. Every now and again, I found a salient item that raised an important question. However, the box checking exercise never told me whether the prospective investment was a good one or not.
Clearly, operational due diligence is necessary. After all, it’s important to cover one’s backside. However, the valuable due diligence – meeting with key decision-makers – usually gets short shrift. In fact, I know all too many money management firms who insist on detailed meetings with key professionals when they make investments, such as buying a company. However, the money manager usually limits access when institutional investors seek that sort of access. In my experience, it is usually extremely limited and very scripted.
Knowing the people you are going to entrust with your money is the most important part of the due diligence process. Nonetheless, less than five percent of due diligence time is spent on getting to know the manager. If you ask senior pension officials or fund of funds executives (and if they are being honest), I’ll bet that most of their face-to-face contact is with the marketer and client service personnel of hedge funds and private equity firms. If you have any hope of figuring out in advance whether a manager is any good, you need to spend some serious time with the key folks and get your nose out of the documents.