Beware of deal-killers: Six common due-diligence pitfalls

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“So, what the heck do we do now? This is really bad!” I could visualize that vein running down the client’s neck, operating at 100% capacity. They had every right to be upset.

It was two years after the deal had been struck, and our client found out that one of the parties involved had been part of a fraud scheme and was actually still on a wanted list in their home country. To make things even more complicated, this person was not a low-level employee who could be replaced easily, but a co-investor, no less.

Fearing to become the laughingstock among his fellow investors, the client asked, “How could this happen?”

How could this happen, indeed? This was not the first time I’d received a call like this, and it wouldn’t be the last.

Unfortunately, this kind of thing is all too common, and the question is easy to answer. In fact, it shouldn’t be easy to answer – it should be hard to find out how something like this happened. It should be hard because everything that could have been done to prevent this had been done.

The irony is that these sticky situations often seem entirely preventable. Time and again, when the dust settles and a postmortem analysis is conducted, the root of the problem can be traced back to the beginning – the start of a relationship, a deal negotiation, or a hiring process. When things unravel, it is usually due to unaddressed orange or red flags that emerged during the due diligence: “The other investors checked this already.” “Their lawyers said it was fine.” “This is the third funding round, anything that might be an issue has been identified. Why spend more money on the DD? We want to make this deal.”

You’ve probably have heard these before. Did they really create a higher level of confidence in the deal?

To avoid these scenarios, family offices and family businesses must consider risk factors when making deals. Mostly, the financial part is at the heart of the due diligence, and once it has been satisfied, the deal team often moves on and pushes for a close. While the financial part is, of course, important, a plethora of other factors are often overlooked that later can lead to the aforementioned disaster.

Let’s look at six risk areas that deserve as much attention as financial due diligence, and explore detailed strategies for mitigating these risks.

1. Check out management teams

Management teams are the backbone of any venture, and inadequate due diligence on their background, track record, experience and reputation can lead to dire consequences.

Let’s look at the recent and ongoing Frank vs. JPMorgan Chase deal, in which Frank’s young founder sold the company to JPMorgan Chase for $175 million before the bank discovered that 4 million of the 4.25 million user accounts were apparently fabricated. Poor vetting and failure to interview key staff members properly were reasons why the verification of the management team was insufficient.

Mitigating the risks: Institutional investors can prevent this by conducting in-depth interviews, verifying professional certifications, assessing their industry connections and utilizing third-party assessment tools to evaluate their attitudes and aptitude. Also, often a single call with a former business associate or partner of the individual or team in question can reveal valuable insights.

2. Look at co-investors

Insufficient due diligence on co-investors can lead to reputational damage and even the downfall of a promising startup or an existing business.

For example, a family office we worked with unknowingly invested in a startup with co-investors who had a history of fraudulent practices. Through our investigation, this was revealed just in time, and had we not been commissioned to vet the co-investors, this could have come out at a bad time for our client.

A wealth management firm in North America faced significant financial losses when a regulatory change was introduced overseas that affected one of their holdings.

Mitigating the risks: Investors should perform comprehensive background checks on co-investors, analyze their investment history and risk appetite, and evaluate their legal compliance and ethical standards. Hiring a specialized due diligence firm for extensive investigations can also be helpful.

3. Mind regulatory changes

Ineffective “macro” risk management in deal-making can result in financial losses when external factors, such as regulatory changes, are not considered.

A wealth management firm in North America, for instance, faced significant financial losses when a regulatory change was introduced overseas that affected one of their holdings, and the firm was unprepared due to lack of strategic notice.

Mitigating the risks: Conduct scenario analysis and political risk scanning to identify potential vulnerabilities, seek expert advice on regulatory compliance, and engage in regular monitoring and reporting to ensure the firm stays ahead of any changes.

4. Don’t forget third-party vendors

In today’s increasingly digital environment, overlooking the role of third-party vendors, especially in critical areas such as cybersecurity and legal compliance, can lead to severe financial and reputational consequences.

Consider the case of a family office that relied on a third-party vendor for cybersecurity measures. The vendor’s security protocols were breached, causing substantial damage to the family office.

Mitigating the risks: Establish a comprehensive vendor management program. Regular audits and assessments of vendors – and clear contractual obligations ensuring service quality, security and compliance – can strengthen this program and help prevent mishaps. By securing their third-party engagements, investors can avoid vulnerabilities, maintain trust and protect their organization from threats that are unrelated to their behavior or performance.

5. Seek advice on deal structures

Neglecting proper deal structure can leave a firm bearing a disproportionate share of losses when a venture fails, as seen with a wealth management firm that invested without negotiating adequate protections for its interests. At this stage of the deal, investors should simply ask themselves how they want to be structurally protected if this deal goes through but they find defects with it a couple of years down the line. What safeguards can they put in place now that will lower their potential downside without hindering the investment target’s operation and management team?

Mitigating the risks: Seek expert legal and financial advice, ensure clear exit strategies and negotiate robust governance rights, such as board representation and voting rights. Additionally, implementing risk-sharing mechanisms, like earn-outs and performance-based compensation, can help align interests and minimize losses.

6. Consider culture, language

Ignoring cultural and communication differences in international ventures can lead to communication breakdowns, misunderstandings and failed deals. Institutional investors can avoid this by engaging cultural intelligence experts, participating in cross-cultural training programs and utilizing local legal and financial advisors that can help bridge the gaps.

Mitigating the risks: Address language barriers, either through hiring multilingual staff or using translation services, to facilitate smooth communication and collaboration. In our globalized world, where many have grown up, studied or worked across cultures and borders, this aspect can easily be overlooked.

Learning from experience

In conclusion, family offices and wealth management firms must prioritize risk management and due diligence in every aspect of deal-making.

Continual learning is also crucial. Every deal, successful or unsuccessful, offers insights that can help improve decision making and risk management strategies. For smaller family offices, maintaining an informal logbook and writing brief after-deal reports can be an excellent tool for spotting patterns of what works and what needs fixing.

By adopting a proactive approach and continuously learning from both their own experiences and those of others in the industry, family offices and wealth management firms can minimize risks and maximize the likelihood of successful investments. This, in turn, will enable them to fulfill their fiduciary responsibilities, protect the interests of their clients, and contribute to the overall growth and prosperity of the investment ecosystem.

For the past 15 years, Tobias Jaeger has been solving problems for companies and has dedicated his career to safeguarding the guardians of capital — human, financial, intellectual, social, and reputational. As the founder and CEO of Falcone International, a global risk management, corporate investigations, and business intelligence firm, Tobias leads with insight drawn from navigating complex challenges across a broad range. From dealing with fraud, theft, extortion, ransom, deception, kidnapping attempts to money laundering, sabotage, and corporate espionage, his professional journey spans the globe from the United States and the United Kingdom to South Africa and Brazil. He is based in London and Washington, D.C.

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