Sheldon MacDonald: A very deep dive into due diligence

I was scuba diving on holiday recently when a valve on my back-up breathing regulator failed. As a result, the air from my tank was rapidly depleting. You’ve probably seen something similar in films. It’s not the most pleasant experience in the world.

Fortunately, this sort of scenario is practised on every scuba qualifying course. I was able to use the second regulator on my guide’s equipment and, thanks to this “buddy breathing” technique, could safely ascend and surface. There was no massive panic in the end – but it wasn’t an episode I would care to repeat anytime soon.

“All right,” you might say, “you’ve duped me into reading this far. What has any of this actually got to do with due diligence?” The answer is that I later realised I was probably at least partly to blame.

First, the basis on which I picked the company that organised the dive was pretty flimsy. I just strolled along the beach and chose a business whose dive schedule suited my own and whose prices suited my pocket.

Every guide claimed to be a member of the Professional Association of Diving Instructors (PADI). The PADI flag was flying left, right and centre, and that was good enough for me.

It’s also essential to check your equipment is working before a dive. I must admit my check was somewhat cursory. Apparatus at a dive shop is generally quite well-used – but it should always be fit for purpose, right? To some extent, I feel I merely trusted everything would be okay.

All in all, this amounted to a slapdash effort. My due diligence was at best inadequate and at worst non-existent. I should have done more, because scuba diving involves risks.

The same can be said of investment, of course. When an adviser selects a third-party provider – or when a business like ours selects a fund – minimising the likelihood of unpleasant surprises is a fundamental goal.

As we all know, this is why due diligence must be robust. But what truly qualifies as “robust” in this context? How far should we go? What constitutes a realistic approach?

By way of illustration, let’s briefly head back to the beach. What might have happened if I had insisted on rigorously examining every single component of every single diving kit at every single outlet?

Well, for a start, I suspect my wife would have been less than impressed. That’s no way to spend a holiday, after all. Also, the task would have been so overwhelming that there’s a reasonable chance I wouldn’t have spotted the fault in any event.

But maybe it needn’t have come to that. Perhaps I should have begun with the simplest of checks – looking on the PADI app to see if the dive shop was genuinely accredited.

Next, having found a legitimate guide, I could have taken a couple of minutes to inspect more thoroughly the particular kit I was supplied with. I could have posed a few pertinent questions while doing so, too.

Granted, none of this would have absolutely guaranteed my safety. There was no real way of knowing if the valve would get stuck. Every diver has to accept a certain amount of risk.

So, too, with investments – there’s always a leap of faith involved. But this gives us a rough idea of the process required, which is to begin with a “bigger picture” outlook and then gradually zero in on salient details.

Theoretical physicist Richard Feynman memorably framed this notion in one of his books, The Meaning of It All. Drawing on his genius for visualising problems and solutions, he likened scientific progress to a cascade of sieves with ever-smaller holes.

A scientist might set out with numerous theories. Many will pass through the higher sieves, but fewer and fewer will survive as they flow down and encounter increasingly tiny holes – indicative of greater scrutiny, further research and so on.

Eventually, when the holes have become miniscule, just one or two ideas are likely to squeeze through. These are the ideas that are worth pursuing. The rest will have been rightly discarded.

This neatly sums up how we should make informed choices in any setting. It’s how we should arrive at knowledgeable decisions about financial products and services, scuba-diving shops and anything else we might care to mention.

Following this approach, the early stages of an adviser’s search for a third-party provider might see multiple candidates ruled out on the basis of “bigger picture” factors. These could include breadth of fund range, reputation, pricing and so on.

But as the search intensifies – that is, as the sieve’s holes get smaller – the remaining options will demand much closer examination. The outcome will ultimately reflect the finer points of considerations such as a provider’s operations, resources and ability to put stakeholders first.

This is the stuff of due diligence which we all know and love, yet its importance can all too easily be forgotten. As I found out beneath the waves that day, we should never take it for granted – because it really can determine whether we sink or swim.

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A version of this article was first published on Professional Adviser on 24/10/24

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