How Did I Get Here?

"And you may ask yourself: well, how did I get here?"
Talking Heads, Once in a Lifetime, 1980

Nobody asks that question on the way in.

You ask it four years later, staring at a line on the balance sheet that stopped paying, in a vehicle whose manager stopped writing, secured by assets nobody has seen. The honest answer is usually pretty simple. You got here because the due diligence that would have caught it was skipped.

It wasn't skipped out of laziness, but from one of four reasonable-sounding reasons:

The four excuses

The cheque was small. Two hundred thousand didn't feel worth a proper review, so it got a phone call and a glance at the deck. Small positions go wrong at the same rate as large ones.  They just take up far more of your attention per dollar when they do. The position you keep avoiding is rarely the biggest one you own.

You knew the person. This is the expensive one. Familiarity feels like information.  It isn't. Knowing someone socially tells you how they behave when things are going well.  This is probably the only environment you've seen the person. We wrote about where that ends up in When the Borrower Is a Friend.

The deal was moving. Allocation closing Friday, three others circling, room for one more. Urgency is the oldest diligence-suppression technique there is.  Sometimes it's true and sometimes it isn't.  You rush because somebody else may take the allocation. That doesn't always make the allocation good.

Someone else had already done it. A name-brand fund led the round, so you assumed the work was done. It might have been. It also could have been done for a different position, at a different price, with different rights, by someone whose downside is a rounding error on a portfolio of ninety names. Their diligence was for them, not you.

What actually gets checked

Proper diligence isn't reading a longer version of the deck. It's a different activity, and most of it happens outside the data room.

The counterparty's behaviour in a prior downturn. Not their track record. Their behaviour. Did they fund the follow-on, honour the guarantee, take the write-down early, or did they litigate, stall, and move assets? The current cycle tells you almost nothing. A bad year is the best evidence.

Litigation history in every jurisdiction they operate in. Not the one on the letterhead. People who use the courts as a delay strategy do it repeatedly, and it's a matter of public record in most places, in the local language, under a spelling of the name that isn't the one on the term sheet.

Previous investors. Actually call them. Both kinds. The ones who exited, and the ones who wanted to and couldn't. The second group is harder to find and worth ten times more.

Who controls the entity that signs. Not the brand on the letterhead. The specific legal person taking your money, who owns it, what else it owes, and whether it has any assets other than yours. A guarantee from a shell is decoration.

Whether the assets exist and are where they say. A registry search, a site visit, a title check. Not a Zoom or an appendix in a deck. This step gets skipped more often than any other and it's the one that turns a bad investment into a total loss.

The boring clauses, before the economics. Transfer restrictions, consent rights, the dispute clause, the governing law, the forum. Everyone reads the fee section twice and the exit mechanics never. Then they discover a right of first refusal eight weeks into a sale that was never going to close.

Where the last round's money went. If a business has raised three times and can't tell you clearly what the previous two rounds bought, that's the finding. You don't need a forensic accountant to notice an unclear answer.  Vague answers are massive red flags, do not ignore them.

Penny wise, pound foolish

Due diligence gets treated as a cost against the deal. It isn't. It's an option premium against the loss.

Twenty thousand of real work on a two hundred thousand position is ten percent, which sounds outrageous right up until you compare it to the alternative. The alternative isn't losing the two hundred thousand. It's losing the two hundred thousand, then spending four years and some multiple of that in attention, legal fees and goodwill trying to get part of it back, and finishing with a position we would buy from you for a dollar.

Compared to that, the diligence cost is cheap. It's always cheap. It's just cheap at a moment when the loss is still hypothetical and the fee is real.  That is why it loses the argument.

One more thing about the math. A review that stops you writing a cheque produces a full return.  It just never shows up as a line item. Nobody celebrates it, when in fact, it's usually the best work anyone does for you all year.

What we do before you commit

Most of our work arrives too late. Somebody has a position that's gone quiet and wants to know what's left. We're good at that, and we'd rather do less of it.

So we run the same plays in the other direction, before the money moves. You send the documents and the name. We look at the structure, the counterparty, the entity that signs, the exit mechanics, and what happens to you specifically if this goes sideways. Fixed fees, always agreed up front. Days, not weeks, because a live deal doesn't wait and we'd rather be useful than thorough after the fact.

What you get back is a short document that says what the position actually is, where the risk is concentrated, which terms to change before signing, and whether we'd put our own money in it. If the answer is don't, we say don't, and that's the end of the engagement.

The same review works on something you already own. Later is worse than earlier, but it's still much better than never.

The honest floor

Due diligence doesn't make a bad deal good. It tells you which one you're holding.  Sometimes, the answer is that a good business, with a solid hypothesis, clean documents and an honest counterparty simply didn't work out. The hypothesis failed - and that happens.

Also, due diligence doesn't always catch everything. Determined fraud is often well constructed and can even survive a competent review. We will be spending more time on fraud and how to recognise it early in future Insights. 

What diligence reliably catches is the ordinary stuff: the guarantee from an empty company, the asset that was pledged twice, the manager who has done this to two other investors already, the seemingly benign clause that creates massive frustration down the road. That's most of it.

The rest is the part you accept knowingly, at a price that should pay you commensurately for accepting it.

Skip the work and you'll still get the same question.  You will just dislike the answer more.