Which SIPP Investment
Question 5: Do You Have A Due Diligence Plan?
Due diligence is the process by which you check all of the details of a deal. It is the area most likely to be skipped completely or done in a cursory fashion by individual investors. Many self-investors feel that just by attending a presentation and reading a perspective from cover to cover, that they know all they need to know. This is not the case.
In the early stage (Question 2), you had to understand the investment. I wrote there that it was acceptable to use facts and figures that you got from whoever was selling the investment to you. That was the understanding stage of the investment cycle. Due diligence is the stage where you check all those details that you were told.
Consider when buying a property and financing it with a mortgage. The bank does a lot of checks: that there is insurance, that people are who they claim to be, that inspections are in place, that the price is in line with the market, and so forth. This is because many house purchasers are unaware of all the checks necessary to purchase a house and the bank wants to cover its own interests. The bank has developed the necessary checks for purchase, and some checks for the on-going maintenance.
One of the checks that a bank does is to look at your own ability to pay. The bank has a second line of defence (other than the house collateral) to get its money back, namely you. If you invest in property, you will not have that second line of defence. This means that your due diligence into real estate must be more intensive than what a bank does.
With most investments, you do not have someone holding your hand. You must develop your own checks.
If someone claims they have a PhD in chemistry, and this is important for the investment (like in the kitty litter example), ask for the details of the institution and call to check. If someone says they have signing authority for a company, you must also check this. Is the company registered? Are there legal disputes pending? If someone claims experience with a process, or to have a good track record, ask for references and call them.
I also tend to not use telephone numbers that I have been given. If I need to check something, I research the telephone number. Almost all the time, the number I found through research is the number that I was given. Occasionally it is not, and some of those times are when I catch something that is not right.
If there is an assumed exit in the business, a final selling price that you are counting on for your profit, then you must look at other similar companies that have been sold and find their comparable selling price. You would need to understand the pricing of such companies. Typically it is a multiple of earnings, but not always. If you can find no similar investment that was sold, this should be factored into you thinking. You could pass on the deal entirely, or decide to use a lower ending valuation than you were given.
Realism must be brought to this assumption. Realism must be brought to any assumption. In fact, everything that you listed as a critical risk factor must be checked. This can be time consuming but it is critical. My general rule of thumb is to do due diligence until I would be able to sleep peacefully with my money in the investment. Research until you can relax with the idea.
Another way to think about it is that due diligence is your only guarantee of an investment. It is not a sure-fire guarantee, but it is stronger with more due diligence.
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About Dr Matt Modisett
Dr Matt Modisett, PhD, FIA, ASA, MMA is the Director of Financial Guard Limited. You can email Matt at firstname.lastname@example.org.
With more than 20 years’ experience, his career in investments and insurance has spanned the USA, Japan, The Netherlands, Spain, Belgium, Hungary, Australia, and the UK. He was formerly a Chief Investment Officer for an insurer, Asset-Liability Manager for 3 insurers, and has consulted for many years, all for top tier institutions. He has served as Professor of Actuarial Science and also as Professor of Finance.
He holds a PhD in Mathematics, is a Fellow of both the UK Institute and Faculty of Actuaries and the Hungarian Society of Actuaries, and is also an Associate of the USA Society of Actuaries. He has numerous publications to his credit.
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