Building Habits to Reduce Due Diligence Mistakes

Private Equity investing has been described as a combination of art and science, calling on a wide range of disciplines to make good judgements. In that spirit, I wanted to share a few thoughts I use to test my own judgment. They all surround a central question: What am I missing?

Here are a few common misses I find show up routinely in my world. They each tie to a logical fallacy that has a bit of a history:

  1. Correlation really is not causation. From Classics is Cicero’s post hoc ergo propter hocor roughly “after this, therefore because of this.” We are prone to assume strong causal links between events that follow each other. To the credit of the finance community, we do a lot to try to lessen the impact of this fallacy. For instance, we think probabilistically about the future – e.g., incorporating risk with return. However, in a world in which CIMs seek to dress up the performance of management teams as well as businesses, I find myself surrounded by assertions of cause and effect with no basis. And I find I have to regularly remember that events that follow each other are not necessarily linked.
  2. Don’t assume the status quo sticks. From mathematics, there is a related fallacy called the base rate fallacy, which is our collective tendency to make probability judgments based on conditional probabilities, without considering the effect of prior probabilities. Basically, these are models that forget their assumptions. For example, nearly all models are eventually conditional on the continuation of particular consumer (or business) habits, but I rarely find any models that actually incorporate assumptions tied to these base rates. Many models have an economic recession case, but that is a general and temporary contraction. I find it is important to at least consider for a minute the impact of an overall shift in the technology, a change to industry structure (e.g., new entrants or a consolidator) or changes in consumer preference that impact demand, and what a change in that base rate would do to this company’s prospects.
  3. Just because an argument is bad, doesn’t mean its conclusion can’t happen. Last but not least is the fallacy fallacy, which comes from formal logic. This is closely related to the strawman fallacy, and basically says that just because an argument is wrong does not mean the conclusion of the argument is false. Take an example from the oil and gas markets: several commentators argued that the market was driven by Saudi Arabia holding oil prices low to punish geopolitical and economic competitors through producing all-out. Critics analyzed this argument and identified flaws – e.g., that Saudi could not afford to continue the critical subsidies to its citizenry at low oil prices. But these commentators then assumed as a result that oil prices would not stay low. As it happens, U.S. unconventional production breakthroughs have held oil prices down in spite of Saudi’s change in strategy. These critics were right in attacking the argument that Saudi would not maintain the policy but ended up being wrong overall because they assumed that by disproving an argument, they had proved its conclusion would not happen.

My argument isn’t that we need to change our tools overall as an industry. Instead, I advocate for our team to build habits that help avoid those misses. I think of it as akin to stretching: good habits yield less risk of avoidable injury. If you think like I do, check out Jordan Ellenberg’s great book on a similar topic, How Not to be Wrong, which takes a penetrating look at how mathematics concepts are fundamentally misunderstood routinely in our media, business communications, and daily lives.

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