Due diligence is a crucial aspect of quality decision-making. People consciously or unconsciously perform it during investment selection, deal-making, job interviews, or even grocery shopping. Of course, some argue against due diligence, dismissing it as trivial and claiming that outsized success doesn’t depend on it. But that's a discussion for another day. In this post, my focus is mainly on private investment. I want to discuss a common issue I see during the due diligence process: the tendency to be confirmatory.

What Does Good Due Diligence Looks Like?

The specifics of due diligence vary depending on the type of deal. Residential property investment differs from private company investment. Direct investment in a company looks different from indirect investment via a fund/manager. SaaS investment differs from biotech investment. I wrote about my views on deep tech in an earlier article.

At the end of the day, the due diligence process aims to answer one fundamental question: does the deal stack up? The depth of due diligence depends on choice and capability.

Due diligence is an expensive process and should not be performed on every single opportunity. My view is that if we undertake due diligence, the goal is to achieve outsized returns (alpha). Otherwise, investing in the public market index, which is well-regulated and offers good expected returns with little hassle or fees, is likely a better option.

Due diligence should follow an extensive screening process that retains only the top deals. For example, cash flow-focused property investors should filter out low-yield properties, deep tech investors should filter out ventures without viable IP claims, and growth investors should avoid ventures that lack product-market fit.

I tend to ask two particular questions early on:

1. Why does this opportunity exist?

2. Why me?

The answers to the first question can be:

• Scam, fraud, misrepresentation - NO

• Something about the asset itself - MAYBE

• The situations around the asset - YES

Outright scams and fraud are usually easy to identify, but in private deals, scams are often more sophisticated and harder to detect. For instance, a start-up might appear healthy and fast-growing with a low valuation, but the shareholder agreement strips out all minority investor protection clauses. This is why not performing due diligence in private settings is extremely risky. Misrepresentation is another issue. When projections are misrepresented as revenues or unreasonable assumptions are applied, the returns to investors might seem too good to be true. For example, founders might claim they are tackling a $10 billion market and expect to capture 10% of the market share next year, offering a dirt-cheap valuation of $10 million, despite having no product, team, or traction. Such deals are a NO for me.

Sometimes the answer relates to the asset itself. For example, cryptocurrencies are known for their right-tail returns based on historical performance. Biotechs developing biologics often have good probability-adjusted payoffs (see Pharmaceutical Investing). When the answer falls into this category, it's a MAYBE for me. The key consideration is whether the good returns are a feature of the product due to certain constraints or an unreasonably high discount rate imposed by the market, or if the good returns are borrowed from the future (see Investing When Everything is Expensive). If the returns are explainable, I ensure there is no middleman since this return results from beta, not alpha. If a middleman is necessary, it’s a NO.

The best answer is when the opportunity exists because of the situations around the asset, not because of the asset itself. This is the essence of special situation investing. Many have noticed that illiquidity premiums don’t really exist for private assets in the long term. I observe this missing illiquidity premium but also believe that high alpha resulting from special situation investing is inseparable from assets’ illiquidity. Many well-documented arbitrages/anomalies relate to this. For example, when large institutional transactions occur due to fund mandates rather than asset fundamentals, any price movement reflects transaction slippage and market impacts, magnified by speculators. In short, when sellers need to sell not because of the assets but because of themselves, good buying opportunities emerge.

The Necessary Pain

Due diligence is a painful process, not because of the outcome but because of its nature. The attractiveness of a deal peaks before due diligence and then declines, which is a dark and upsetting exercise. You will be fighting FOMO, sunk cost fallacy, and wishful thinking.

Human nature wants due diligence to pass, which makes a confirmatory mindset dangerous. I’ve encountered angel investors with good operational processes for due diligence but who never actually reject any deals or negotiate terms post due diligence findings. When I ask why, there are always philosophical answers incompatible with the initial rigorous due diligence process. I’ve picked up the term "theory mining" for this situation. The abundance of theories developed over thousands of years allows pretty much any viewpoint to be supported. It becomes convenient to have a view first and then look for support. Due diligence acceptance criteria need to be established beforehand, not afterward.

Once the theory mining trap is avoided, the sunk cost fallacy comes into play. The greater the due diligence and the more time spent, the harder it is to let go. Towards the later stages of due diligence, one often asks, "how do I make it work" rather than answering the original question, "does it work?" Due diligence should strictly play an observatory role. Many people take certain viewpoints for granted during due diligence and assume that the deal will play out according to what makes sense to them, but it rarely happens. For example, you might assume that private funds would have adjusted their hurdle rate given the recent increases in cash rates, only to find that many funds do not have hurdle rates at all, something only an immature capital market would tolerate at scale. For non-institutional investors, the unfortunate reality is that once money leaves your pocket, you lose all leverage. Best to clarify things beforehand rather than try to influence them afterward, or the deal will have a bitter taste from the start.

The hardest part for me personally is that killing a deal during later-stage due diligence feels like killing the goose that lays golden eggs. Imagine a deal with attractive valuations, a great fit for your portfolio, limited downsides, extremely attractive upsides, and a strong special situation story—it's already the top 1% of deals by far. You want it to work so badly because such deals are hard to come by. Then a hiccup occurs, leading to significant discoveries. For example, a property has fixable issues but is protected by special overlays that require years for approval, or a startup founder is clean on record but indirectly involved in unethical businesses, escaping punishment due to legal protections. The bottom line is that the goose never existed in the first place, and alpha is supposed to be hard to find. There’s no better way than being diligent and going through it all over again. The good news is that for an individual’s portfolio size, there will be more alphas than capacities, much like great books are low in percentage but high in volume.

Disclaimer: The data and information mentioned are from third-party sources, and accuracy is not guaranteed. This article shares information and personal views, not professional investment/legal advice or professional views of the company that the author works for. Consult professional advice before making investment decisions.