In Defense of Due Diligence

December 23, 2008

Yes, this post is self-serving to a certain extent. I get involved in due diligence from time to time, and certainly the firm I work for does a lot of these investigations.

Regardless, since I have been thinking and talking about risk a lot recently, the latest big story from Wall Street, whereby a hedge fund guy named Madoff was running a fraudulent shop and pissed away USD 50 billion, reminded me just how important due diligence is in the real world.

Before those comments, read this bit from Frank Rich in the NYT on the Madoff scandal. The passage really encapsulates my thoughts:

There is a moral to be drawn here, and it’s not simply that human nature is unchanging and that there always will be crooks, including those in high places. Nor is it merely that Wall Street regulation has been a joke. Of what we’ve learned about Madoff so far, the most useful lesson can be gleaned from how his smart, well-heeled clients routinely characterized the strategy that generated their remarkably steady profits. As The Wall Street Journal noted, they “often referred to it as a ‘black box.’ ”

In the investment world “black box” is tossed around to refer to a supposedly ingenious financial model that is confidential or incomprehensible or both. Most of us know the “black box” instead as that strongbox full of data that is retrieved (sometimes) after a plane crash to tell the authorities what went wrong. The only problem is that its findings arrive too late to save the crash’s victims. The hope is that the information will instead help prevent the next disaster.

The question in the aftermath of the Madoff calamity is this: Why do we keep ignoring what we learn from the black boxes being retrieved from crash after crash in our economic meltdown? The lesson could not be more elemental. If there’s a mysterious financial model producing miraculous returns, odds are it’s a sham — whether it’s an outright fraud, as it apparently is in Madoff’s case, or nominally legal, as is the case with the Wall Street giants that have fallen this year. 

So what’s the point? There are a lot of crooks out there, and some of them are even pillars of the community. Why, oh why, would anyone ever do a deal without checking out the other party? Why do anything based on trust? I know the usual excuses, I’ve heard them for the past 10 years with respect to Sino-foreign deals:

1. Due diligence costs are too high.
2. We don’t have enough time to conduct proper due diligence.
3. People I trust vouch for this company.
4. The CEO is a close friend of . . .
5. The company has ties to the Ministry of . . .

You get the idea. None of this is new, and most people have read countless articles over the years on this topic. I am wondering whether the recent goings-on will make some people stop and think before doing something stupid. Perhaps, but I also know that the list of five excuses is compelling, even to the most professional deal-maker out there.

By the way, I shouldn’t keep this post limited to due diligence. All of this goes for other kinds of investigations and audits of licensees, distributors, suppliers, etc. Multinationals that don’t do their homework are asking for trouble, and with all the examples out there of bad practices, there really is no excuse anymore — if something goes wrong, you will be punished.