Optimistic Skepticism: Putting Due Diligence Discoveries into Context
Investors need to be optimistic skeptics. We need to be optimistic enough to be able to find a potentially great deal out of the flow of transaction opportunities that don’t fit our focus, while at the same time remain skeptical enough to understand that even in great situations the facts are usually not as positive as they initially appear to be, that the details that you hear are usually only part of the story. Overly optimistic investors lose their principal, overly skeptical investors never close a deal.
Due diligence provides investors with the opportunity to validate their initial assumptions. The mechanical steps are easy; the trick is to put the information generated by the due diligence process into the proper context. Sometimes a single fact turns a good deal into an impossibly risky one. Usually, however, due diligence uncovers a whole range of issues that are slightly different than originally expected. The reality is that transactions tend to reach a tipping point slowly—often no single issue is fatal, but combined they change the risk of the transaction significantly.
The key is to be disciplined enough to periodically step back and reassess the deal, rather than just focusing on the individual facts that the due diligence uncovers. It’s important to understand what those facts mean to the deal as a whole and how those facts relate to each other. If a team is involved in managing the due diligence process make sure that all the members of the team share what they have learned with one another. Investors need to compare the business reality with the perceptions that existed when the valuation was developed. Since most investors suffer from the challenge of not closing as many deals as we would like, our tendency during the exclusivity period is to focus with a single-mind on getting the transaction closed. While this is an attribute that helps overcome the multitude of small obstacles that plague any deal, it can also lead to blinders that can result in a loss of capital.
What is the answer? Be candid with yourself and your partners about what due diligence is uncovering. Second guess the original investment thesis as due diligence clarifies the reality that exists. Be realistic about what issues can be overcome and what issues just have to be accepted as they are. Finally, be cognizant about the level of risk that you are willing to accept and the level of risk that you are undertaking. Deals rarely are as advertised; some are worse, some are better. The closer you are to a closing, the harder it is to recognize and accept that a deal has changed. In many cases, having the ability to walk away is key to making a great investment decision.
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