Private Equity Diligence Overlooks Survival Risks, Argues Lee McCabe

In a recent LinkedIn post, Lee McCabe critically examines the typical approach to private equity due diligence, arguing that it disproportionately focuses on upside potential while neglecting crucial survival risks. McCabe contends that the standard diligence process is often geared towards validating a deal’s attractiveness rather than rigorously stress-testing a company’s resilience.

McCabe highlights the common emphasis on historical performance metrics, stating:

“Private equity due diligence is obsessed with what a company has done. Historical growth. Historical margins. Historical retention. Historical cash conversion. Historical customer concentration, dressed up just enough to stop anyone panicking.”

While acknowledging the importance of these historical figures, McCabe pivots to what he believes is an under-addressed area: a company’s ability to withstand adverse conditions.

The Neglected Downside Risk

According to McCabe, the critical question that often goes unasked or insufficiently explored is about a company’s breaking point. He suggests that diligence teams rarely simulate scenarios where multiple normal business challenges converge, which is precisely how businesses typically falter.

McCabe elaborates on these potential simultaneous threats:

“What happens if the founder leaves and takes half the judgment with him. What happens if the sales leader walks. What happens if the top Google rankings disappear. What happens if labour gets tighter, lead costs rise, one major customer churns, and the ERP implementation goes exactly as badly as ERP implementations usually do. Not one at a time. Together.”

In McCabe’s view, this oversight leads to a disconnect between the diligence findings and the reality of a company’s fragility.

Fragility vs. Diligence Presentation

The author argues that fragile businesses often do not appear fragile during the diligence phase. Instead, they can present a facade of resilience until several assumptions fail concurrently. He criticizes the current diligence methods as often being too superficial when assessing downside risks.

Critique of Current Diligence Practices

McCabe points out that downside analysis can be too theoretical or compartmentalized, with management answers accepted without rigorous follow-up. He suggests this is partly because stakeholders may prefer to keep the deal process moving smoothly.

“The downside work is often too polite. Too theoretical. Too compartmentalised. A sensitivity table here. A consultant slide there. A management answer nobody pushes on because everyone would quite like to keep the process moving.”

This approach, McCabe warns, can lead to surprise when a business that seemed robust during diligence later proves to be fragile.

Prioritizing Survival Over Improvement

A core tenet of McCabe’s argument is that understanding a company’s capacity to survive should precede the underwriting of its potential for improvement. He questions how much operational sloppiness, customer concentration risk, dependence on key individuals, or margin pressure a business can truly tolerate before its financial narrative collapses.

McCabe concludes by emphasizing the fundamental flaw in prioritizing potential upside over the understanding of downside risk:

“A lot of firms underwrite improvement before they have properly underwritten survival. Which is backwards. The first question should not be how much better this business can get. It should be how quickly it breaks.”

He asserts that without a thorough understanding of a company’s breaking points, the diligence process has effectively only assessed the prevailing positive sentiment rather than the business’s true underlying stability.