What is due diligence, and what is pseudo diligence?

A theme that appears in nearly every review I post is the importance of due diligence when investing in unregulated or unlisted investments.

When a company asks a potential investor to lend them money, they are in a state of what economists call information asymmetry – in plain English, the borrower knows stuff the investor doesn’t.

There is an incentive for the borrower to conceal unflattering information from the lender in order to be able to borrow money from them at a lower interest rate.

However, the lender knows this and should not only demand that the borrower does not conceal information, but independently verify everything the borrower has told them is true. They can do so because while the borrower wants to borrow at the lowest possible rate, they also do not want the lender to walk away.

Ideally, at the end of the due diligence process the information asymmetry vanishes, and both the borrower and lender are in possession of all the facts, allowing a fair interest rate to be set.

Once due diligence is completed the investment does not become risk-free. The lender should never think that they can hand over their money thinking they have established that the investment is a guaranteed winner. If that was the case, the borrower would be paying almost cash-deposit rates of interest.

However, what the lender can do is reach the point at which there is no point doing further digging, and either has to accept that the interest rate on offer is worth the chance of losing all their money, or walk away.

The problem is that “due diligence” is a much abused concept. Time and again you see people losing money because they think they were doing due diligence when they weren’t.

What they were actually doing is pseudo-diligence, i.e. something that felt like due diligence but in reality wasn’t.

Due diligence mostly involves independently verifying that the information given by the borrower is actually true.

Pseudo-diligence mostly involves letting the borrower ladle on more information without verifying that any of it is actually true.

Pseudo-diligence is a classic example of the Dunning-Kruger effect, which can be simplified as “thinking you are cleverer than you are”.

Here are some examples of what people mistake for due diligence and what due diligence actually is.

Pseudo-diligence	Due diligence
Reading financial data provided by the borrower.	Independently auditing the data provided by the borrower. Are their accounts audited? Do annual accounts and monthly management accounts match up? Are they consistent with the company’s bank statements? Are assets worth what they say they are worth, according to independent valuers paid by you, not the borrower – especially if the investment is secured on these assets? If the loan is a secured loan, do any other borrowers have security over the assets?
Reading projections of future revenue and profits provided by the borrower.	Do their models of future cashflow work and add up correctly? If they rely on expanding market share or increased demand for the product, is this realistic and in line with independent market research? Is future revenue secured by existing contracts?
Speaking personally to the management.	What is the directors’ background? Do they have the expertise to back up their projections for how well their company will perform in the future? If their previous experience was in running their own companies, how did those companies perform? If their previous experience was in other people’s companies, why did they leave, and did they do a good job? Will their previous employer verify this – and that they held the position they say they did? Have they ever been banned as a director? Have they ever worked with other people who were banned as directors? (Note that Companies House does not list expired bans, but these are still very very relevant.) Does a search on Factiva or a similar media archive turn up any negative information? (Google News is not remotely good enough at this. A professional news archive is needed which typically charges hundreds of pounds a month.) It is all to easy for lay investors to be flattered by conversations with the management, thinking they are privileged to talk to someone with the title of CEO. In reality, you are the one with the money; that makes you the important one, not the borrower.
Being shown round the company’s premises or assets it owns, such as hotels.	The fact that (say) a hotel looks nice, or that a wind farm is operating, does not mean it is making a profit. The only purpose of a site visit is to check that operations are consistent with the financial data discussed above.

This is by no means an exhaustive list. Nor it should be interpreted as a guide to “how to do due diligence”. Any more than a list of punches and kicks would be a guide to how to practise karate. The above table is to illustrate the scale of the job. Banks and institutional investors pay a lot of money to experienced and qualified corporate finance professionals to carry it out.

Investors who are not confident in their ability to carry out the above should usually stick with mainstream regulated diversified funds.

When you don’t need to do due diligence

Due diligence becomes redundant when the company’s securities (shares or bonds) are being traded thousands of times a day on a regulated market.

This is because the Efficient Market Hypothesis applies. All the information investors need has already been disclosed to the market or discovered by other investors and baked into the market price.

At this point “doing your research” becomes another exercise in Dunning-Kruger futility. All it achieves is to give the investor a false sense that they know more than the market.

But with small unlisted firms this does not apply. No-one else is going to do due diligence on behalf of the investor (if anyone else has, they aren’t going to signal the results via the market price) so it remains the investor’s job.

Alternatively, if the investor doesn’t have the necessary expertise, they should stick with mainstream, regulated and diversified funds.

Nature abhors a vaccuum and economics abhors the money of someone who lends it out without paying any attention as to whether they’ll get it back. Sooner or later someone will take advantage of them.