There are as many reasons to do due diligence as there are people who need to do it. This post will cover some of the types of due diligence and the reasoning behind them. In categorizing due diligence inquiries, there is one major dividing line that separates all due diligence projects, questions, and strategies into one of two possible types, and that is the line that divides the positive from the negative.
Negative due diligence inquiries are looking for things gone wrong or potentially going to go wrong. Positive due diligence cases are looking for the potential for things to go right. One is evaluating for negative incidents in the past or for future risks and threats, while the other is evaluating for existing quality or the potential for quality. These two major categories are not superficially different, they are totally different. They require different plans, different methodologies, and totally different skillets among practitioners. Negative focused due diligence projects focus on “finding” information and intelligence, while positive ones largely focus on “evaluating” for quality and potential. When making an investment based on positive information, the information itself is not enough – analysis is required to determine if it truly represents a positive or not.
Having said that, even due diligence cases focusing on the negative, touch on the positive in one way – confirmation of facts and claims. Confirmation, however, is a far cry from evaluating whether something is, in fact, a positive or not. A typical Level 1 Due Diligence Investigation at Augustus Hall Limited engages in a search for unknown negatives, an investigation into known negatives, and confirmation of expected positives.
In addition, even negatives-focused due diligence investigations can be separated into ones focusing on known and unknown issues that have occurred in the past and negatives that represent risks or threats for the future. At Augustus Hall Limited, we separate these two cases into the following:
Level 1 Due Diligence – which focuses on both incidents that have become public knowledge or been recorded into official documents in some way, and market reputation concerning past incidents and operations.
Advanced Due Diligence – which focuses on uncovering and analyzing potential risks and threats which could impact the organization in the future.
As an illustration of a typical investment transaction, and the risks that it faces, consider the following potential ways the investment can go wrong. Each case is matched with the type of due diligence that should be done before the investment is made.
1 – You knew there was no quality yet, but you expected it to develop over time. It didn’t. Augustus Hall Limited doesn’t address this issue with our due diligence. This is a positives-focused due diligence.
2 – You thought quality existed but it didn’t. This is a Level 1 due diligence failure. Expected positives were not confirmed.
3 – Quality existed but negatives existed that you didn’t know about, causing derailment of the investment. This is a Level 1 Due Diligence failure. You received all the positives you thought you were buying, but also got negatives you didn’t know you were getting.
4 – Quality existed but known negatives were misjudged due to lack of insight, causing derailment of the investment. This is a Level 1 Due Diligence failure. This one works both ways. By not investigating the known negatives deeply enough and therefore underestimating them, an investment can produce “surprising” results instead of predictable ones. By not investigating a known negative enough, and overestimating its impact on the business, a known negative has cause a missed opportunity. In both cases, information existed, but insight did not.
5 – Quality existed but internal and external changes to the situation caused that quality to disappear. This is an Advanced Due Diligence failure. It is a failure to perform complete risk management on your investment. Sometimes the threats are predictable and visible to everyone but the investor, who is making the investment at arm’s length.
Each business person, upon looking at his investment target or transaction partner, must choose a due diligence type based on his specific situation as outlined above.