The Art of Looking Where Others Prefer Not To
“Risk comes from not knowing what you’re doing,” Warren Buffett has said, repeatedly, over the decades of his investing career. Due diligence is the process that turns the unknown into the known. It does not eliminate risk—but it ensures that you make your decision with full awareness of what you are agreeing to.
The Price of Ignorance
Howard Marks, the co-founder of Oaktree Capital, divides investors into two categories: those who don’t know, and those who don’t know that they don’t know. The second category loses more.
In business transactions, ignorance has a concrete price. Hidden tax liabilities that transfer with the company. Contracts with clauses that activate upon change of control. Legal disputes that are potential today and costly a year from now. Accounting practices that look acceptable—until an auditor or a tax authority takes a closer look.
Benjamin Graham, Buffett’s mentor and the father of fundamental analysis, wrote: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Due diligence is the difference between investment and speculation.
Three Dimensions of Inquiry
The legal dimension: what the company can do and what it cannot. The ownership structure and its history. Contracts that bind and constrain. Disputes past, pending, and gathering on the horizon. The legal status of assets—whether the property you are buying actually belongs to the party selling it.
The tax dimension: where the company stands with the fiscal authorities. The correctness of filings that seems obvious today may be challenged at the next audit. Related-party transactions requiring special documentation. Reliefs and preferences the company has claimed—and whether it has claimed them properly.
The financial dimension: what the numbers say and what they don’t. Financial statements show the past, but due diligence searches for what lies between the lines: the quality of revenues, the durability of margins, the reality of assets, the liabilities that don’t appear on the balance sheet.
Seth Klarman, one of the most respected hedge-fund managers alive, puts it this way: “You achieve a margin of safety by buying at a discount to value. But first you have to know the value.” Due diligence is the process of establishing that value.
Paranoia as Method
Andy Grove secured his place in business history not only as the builder of Intel but as the author of the maxim “Only the paranoid survive.” In the context of due diligence, paranoia means systematically assuming that something is wrong—and looking for evidence.
This is not suspicion of the counterparty. It is intellectual discipline: the assumption that documents may not tell the whole truth. That people remember selectively. That the seller’s optimism colors the presentation of facts. That what has not been said may matter more than what has.
Philip Tetlock, the psychologist who studies the quality of forecasts, found that the best forecasters are those who actively seek information that contradicts their hypotheses. He calls this “thinking like a fox,” as opposed to “thinking like a hedgehog,” who knows one big thing and interprets everything through its lens. Due diligence requires thinking like a fox.
When to Walk Away
One of the hardest moments in any transaction is the decision to withdraw. You have invested time, money, emotion. The board is waiting for the closing. And then due diligence reveals something that changes the picture.
John Templeton, the legendary investor, advised: “The best time to invest is when you have money.” But his lesser-known counsel was different: the worst time to invest is when you feel you have to. The pressure to close leads to the ignoring of warning signs.
Charlie Munger puts it more bluntly: “All my life I’ve tried to avoid things that look easy but are dumb.” A transaction in which due diligence reveals serious risks, and the parties decide to ignore them because “we’ve already put so much in”—that is precisely the thing that looks easy but is dumb.
The Value of the Report That Says No
Business culture worships positive thinking. Advisers who tell clients what they want to hear have an easier life. Their clients, not necessarily.
A due-diligence report that identifies risks precluding the transaction is not a failure of the process. It is its success. The cost of an investigation that uncovers a problem before signing is incomparably lower than the cost of a problem uncovered after.
