Investment Due Diligence vs Operational Due Diligence

Investment due diligence is a fund testing a business before buying it, and one of its four workstreams is operational. Operational due diligence, as an investor uses the phrase, is a different exercise: the investor testing the manager before committing, asking who can move cash, who strikes the value and who audits. Two words shared, two subjects, two instruments.

One phrase names two completely different exercises, and almost nobody says which one they mean. A reader who has met the phrase three times has quite possibly met three different things and stitched them into one confused idea. Wherever the words operational due diligence appear, the sentence is incomplete until it also says on whom. Naming the subject is the whole discipline.

Here is the second thing, and it is the reason the confusion is understandable rather than careless. Operational due diligenceTesting the firm that will hold, value and move the money, before committing to it. genuinely is one of the four workstreams that sit inside investment due diligenceTesting an asset before buying it, to establish what it is worth and on what terms.. Operational due diligence is also, separately, the whole name of a review an investor runs on a manager. The phrase is correct in both places. Neither use is a mistake, neither is slang, and no amount of insisting on one will make the other go away. The subject is what changes between them. In one the subject is a business somebody is buying. In the other it is the firm that will hold, value and move somebody else's money for the next ten years.

Everything else follows from that single difference in subject. Who runs it, what it asks, when it happens, what a finding produces, who reads the paper at the end, what a bad answer means and what the work turns into after the money moves are all downstream of one question: is the thing under the microscope a business, or a firm that looks after money. Answered correctly, the seven differences fall out on their own. Answered wrongly, a reader can work through a thorough, expensive, well written report that never once asked whether the subject was a business or a firm.

Why does one phrase end up naming two different exercises?

Consider the word inspection. A building inspection before the purchase of a flat and a fire inspection of the building somebody already lives in are both inspections, both serious, both done by qualified people with clipboards. The everyday words around them keep them apart, so nobody confuses them. One is about the flat, the other about the building's safety machinery. Due diligence has no such helpful words around it. The phrase arrived in India with the imported vocabulary of private capital and it arrived undifferentiated.

A comparison of two undefined things teaches nothing, so here are the two exercises, defined in full before anything is contrasted.

Exercise one is a fund testing a business it may buy, and it is the older and more familiar of the two. Nilgiri Alternatives Advisors Private Limited, invented, is the investment manager of Nilgiri Growth Partners Fund II, invented. Before that fund put money into the transaction that became its holding 4, Bhavani Speciality Chemicals Private Limited, invented, the manager ran four workstreams over the business. Commercial asked whether the demand was real and the position defensible. Financial asked whether the numbers said what the seller said. Legal asked what was owed, what was held and what was disputed. Operational asked whether the business could be run and whether the fund could sit on its share register. The four workstreams and what each one tests are covered separately. The shape of exercise one is one buyer, one target, four angles, and one decision to complete or not.

Exercise two is an investor testing the manager itself, and its subject is not a business at all. Investor 5 of Nilgiri Growth Partners Fund II, invented, is a fund of funds, and before it committed Rs 50,00,00,000 it ran a review over Nilgiri Alternatives Advisors Private Limited. Investor 5 asked whether the administratorThe firm that keeps the fund's records and strikes its net asset value. was genuinely independent of the manager. The review asked how a holding gets valued and by whom. Another question was who can move cash out of the fund's accounts and how many people it takes to do it. A further question, the one people call business continuityWhat happens to the operation if the office, the system or a key person stops., asked what happens to the operation if the office, the system or a key person stops. The last question asked whether the auditor had ever issued anything other than a clean opinion. The point of it was the manager's history and not audit practice, and audit practice is covered separately.

Notice what exercise two never mentions. Exercise two does not ask what Bhavani Speciality Chemicals Private Limited is worth, or whether its largest customer is too large, or whether its accounts hide a one-off. Questions about a target belong to a transaction that had not happened yet when investor 5 was deciding, and to eight other transactions nobody had thought of. Exercise two is upstream of every transaction the fund will ever do. The review covers the machinery, not anything the machinery will later produce.

On how many points do the two actually differ?

Seven, and it is worth saying plainly that seven out of seven is unusual for any pair of things people confuse. Usually two confusable ideas agree on most of their features and split on one or two. Investment due diligence and operational due diligence share their words and share nothing else. The grid below sets out the seven rows, and each row is worked through underneath with its reasoning and its invented instance attached.

The pair, worked on one invented platform

Here is the pair itself as a single object, so that the seven rows have something concrete to point at. Both columns describe things that actually happened inside the invented case, and the figures in them belong to Nilgiri Growth Partners Fund II, invented, up to the record date at the end of its Year 9 Quarter 2.

The last row is a coincidence, and it is a useful one. The two exercises in this worked pair happen to carry the same rupee figure, Rs 50,00,00,000, and that figure means two entirely unrelated things. On the left it is the price of one company, paid once, at Year 2 Quarter 4 of Nilgiri Growth Partners Fund II. On the right it is a promise by investor 5 to hand over money in instalments across years, and against the fund's Rs 5,00,00,00,000 of total commitments that promise is exactly 10.0 per cent of the whole vehicle. Against the Rs 4,90,00,00,000 committed by the twelve investors alone, and excluding the manager's own Rs 10,00,00,000, the same promise is 10.2 per cent. Two denominators, two answers, and a sentence that gives the figure without naming the denominator has said nothing.

Who runs each one, and on whom?

Who runs each exercise, and on whom, is the first row, and it settles all the others, so it earns the most patience. In exercise one the runner is the buyer. The team at Nilgiri Alternatives Advisors Private Limited that will have to live with the consequence of the purchase is the team that commissions the work, reads it and decides what to do about it. Advisers are hired for parts of it, but the runner is the fund's own side of the table, and the subject is somebody else's business.

In exercise two the runner is not inside the fund at all. Investor 5 is not yet an investor when it runs its review, only a candidate deciding whether to become one. The subject is the manager. The manager is also the party that runs exercise one. The two exercises therefore put the same invented firm on opposite sides of the table, and that single fact explains almost all the confusion the phrase causes. When Nilgiri Alternatives Advisors is doing diligence, it is asking. When Nilgiri Alternatives Advisors is having diligence done on it, it is answering. Both sentences describe due diligence and they describe it from opposite ends.

The everyday version is a hiring panel. A company checking a candidate's references is doing one thing. The candidate ringing three former employees of that company to ask what it is actually like to work there is doing something else entirely, even though both are called checking. Neither is a smaller version of the other, and the candidate who assumes their reference check covers both has checked nothing about the employer.

What question is each one actually trying to answer?

Exercise one is trying to answer what a business is worth and on what terms it should be bought. Every workstream is a way of pressure testing a number and the conditions around it. A commercial finding that the largest customer is 31.0 per cent of revenue with fourteen months left on its contract is a statement about how durable the earnings are. Durability of earnings is a statement about the price. A financial finding that Rs 2,40,00,000 of the reported earnings before interest, tax, depreciation and amortisation was a one-off recovery is a statement that the run rateThe level a figure sits at when the unusual items are taken out, so the ordinary year is visible. is lower than the headline, and that too is a statement about the price. Everything converges on one number and one set of conditions.

Exercise two is trying to answer something that has no number in it at all. Exercise two asks whether the manager can be trusted with custodyWho actually holds the assets and who can instruct their movement., with valuation and with cash. There is no price at which the answer no becomes yes. If one person at the manager can move money out of the fund's accounts without a second person, that is not a defect somebody discounts by two per cent. The arrangement is either acceptable to the investor or the investor does not commit. Exercise one converges on a price and exercise two converges on a yes or a no, and that is why the same finding cannot be handled the same way in both.

Take the household version. A buyer of a second-hand scooter haggles over the dent, the tyres and the service history, and every fault found is worth a few hundred rupees off. Handing savings to somebody to look after while away is not a haggle. Nobody accepts a person who might lose the money in exchange for a lower fee. The first is a negotiation about a thing; the second is a decision about a person, and a decision about a person does not have a discount attached.

When does each one happen on the fund's own clock?

Time in this invented case is counted from each vehicle's own final close, so Year 1 Quarter 1 sits a quarter of a year after that date and Year 9 Quarter 2 sits 8.50 years after it. The convention makes the timing difference between the two exercises easy to see. The two do not merely happen at different times. One sits on the far side of the moment the clock starts and the other on the near side.

A commitment has to be signed before there is a fund to commit to, so investor 5 ran its review of Nilgiri Alternatives Advisors Private Limited before final close. There is exactly one of these reviews for the whole of Nilgiri Growth Partners Fund II, and once the commitment is signed it does not run again. Investment due diligence, by contrast, runs once for every transaction, and Nilgiri Growth Partners Fund II completed nine of them. On the fund's own clock the nine entries sit at 0.75, 1.00, 1.50, 2.00, 2.25, 2.75, 3.50, 4.00 and 4.75 years after final close, the last of them inside the five-year investment period. One review of the manager sits at the left edge of the whole picture, and nine reviews of businesses are spread across the four years that follow it.

There is a second timing fact worth holding. Exercise one is also a filter, and most of what it looks at never becomes anything. Across the life of Nilgiri Growth Partners Fund II, 412 situations were reviewed and 9 were completed, or 2.2 per cent of what was looked at. The pipeline itself is covered separately. Exercise two has no such funnel. Investor 5 was looking at one manager and the answer was going to be yes or no.

What does a finding actually produce in each exercise?

What a finding produces is the sharpest of the seven rows, and the one most worth remembering. A finding is not an outcome. A finding is an input to something, and the something is different in each exercise.

In exercise one there is a transaction on the table, and a transaction is a document with terms in it. So a finding has somewhere to go. A finding can move the price. A finding can become a condition that has to be satisfied before completion. A finding can become a warranty or an indemnity. If the finding then turns out worse than described, somebody other than the buyer pays. Or, at the far end, it can end the transaction. Nilgiri Growth Partners Fund II, invented, took two of those routes on the transaction that became holding 4. The legal workstream found a chargeA security interest a lender registers against a company's assets, so the world can see the assets are pledged. over the company that had not been registered, and it was cleared before completion; charges and filings of an Indian company sit with the Ministry of Corporate Affairs at mca.gov.in. The operational workstream found no month-end close discipline and no second signatory on payments, and the fund turned both of those findings into conditions of the transaction. Becoming a condition is the most characteristic thing an investment-diligence finding can do.

In exercise two there is no transaction. Nothing is being bought from the manager. Investor 5 is deciding whether to hand over money under a set of documents that already exist and that twelve investors will sign in substantially the same form. So a finding has only two places to go. A finding can change the terms investor 5 asks for. In this invented fund those terms mean a side letter, and none of the six side letters of Nilgiri Growth Partners Fund II moves the fee. Or it can change whether investor 5 commits at all. No price sits on the table to adjust, so there is no third route. That is why the same word, finding, describes two completely different instruments.

One share the record cannot supply

Here is a place where being honest costs something. The financial workstream found that Rs 2,40,00,000 of the reported earnings before interest, tax, depreciation and amortisation was a one-off recovery. A one-off worth a twentieth of the earnings and a one-off worth half of them are very different findings, so the natural next question is what share of the headline that was. The headline earnings figure is nowhere in the invented record, so the share cannot be stated, and a denominator invented to complete the sentence would invent the answer with it.

Sit with how easy the alternative would have been. Any plausible headline number would have produced a percentage that reads perfectly well, that no reader would question, and that would then be quoted back as a fact. The finding is locked and real inside the invented case. The proportion is not. Saying so is the whole of what can honestly be said.

Who reads the output, and what can they do with it?

Every review ends as paper, and paper is only worth what the body reading it is able to decide. Follow the two reports to their readers and the difference stops being abstract.

The output of exercise one goes to the investment committeeThe body inside a manager that approves an investment or a realisation. of Nilgiri Alternatives Advisors Private Limited, invented. The committee has five members. Four of them are from the manager and one is external, so 4 of 5 seats, being 80.0 per cent, sit with the manager, and 1 of 5, being 20.0 per cent, does not. The same committee approves every investment and every realisation the fund makes. The committee holds the authority to say yes to the transaction that became holding 4, and it attached the two conditions.

The output of exercise two goes somewhere the fund cannot see. Investor 5's own committee reads it, inside the fund of funds, and its size is not fixed anywhere in the invented record. Nilgiri Growth Partners Fund II knows exactly how its own committee is composed and knows nothing at all about how an allocatorAn investor whose work is deciding which managers receive money. arranges its internal approvals. The one committee decides whether the fund buys a business, the other decides whether it becomes an investor at all, and neither has any power over the other's question.

What does a bad answer mean in each exercise?

A bad answer in exercise one is priceable. The commercial workstream on the transaction that became holding 4 found the largest customer at 31.0 per cent of revenue on a contract with fourteen months left to run. A customer that size is not a comfortable fact. Somebody can put a number on it, though: a buyer can ask what the business looks like if that customer leaves, can pay less for it, can ask the seller to carry the risk for a period, or can walk away. The point is that a range of answers exists between yes and no, and the whole craft of exercise one lives inside that range.

A bad answer in exercise two often has no range at all. Suppose the answer to who can move cash is one person, acting alone, with no second signatory anywhere in the chain. The investor is not buying a discounted thing, so no fee reduction makes that acceptable and no side letter fixes it. The investor is deciding whether to place money inside an arrangement. A finding about a price has a range of answers; a finding about custody, cash movement or who strikes the value tends to have exactly two.

The symmetry that has just appeared is the neatest thing in the whole comparison. The operational workstream in exercise one found the same class of defect at the target company: no month-end close discipline and no second signatory on payments. There was a transaction to attach a condition to, so the finding became one. The identical class of defect at the manager, in exercise two, has nothing to attach to. The same finding is a negotiating point in one exercise and a decision in the other, purely because of what it was found in.

What does each exercise turn into once the money has moved?

Both reviews end. The paper that starts arriving afterwards is completely different in each case, so what replaces the review is the clearest single tell of which one was run.

After exercise one, the fund is a shareholder in one company and the work becomes monitoring that company. In this invented arrangement, and stated as its own contracted term rather than as anything usual or required, Nilgiri Growth Partners Fund II receives a monthly pack from a portfolio company within fifteen business days of month end, sits at a board meeting each quarter, receives audited annual accounts, approves an annual budget, and is told immediately about anything falling inside the matters the contract reserves. Every one of those is about one business. Nine such streams ran at various times inside this fund, and each of them began the day a transaction completed.

After exercise two, investor 5 is an investor and the work becomes reading what the fund sends. In this invented arrangement, an investor of Nilgiri Growth Partners Fund II receives a statement of its own capital account each quarter, an unaudited quarterly report within a number of days of quarter end that the fund's own documents fix, an audited annual report, a letter from the manager alongside the quarterly numbers, a notice for every capital call and every distribution, and an annual report from the independent valuation agent, Palani Valuation Advisors LLP, an invented limited liability partnership (LLP). The stream ran from the day investor 5 signed and was still running at the record date, 8.50 years later. By then investor 5 had paid in 96.0 per cent of its Rs 50,00,00,000 commitment, being Rs 48,00,00,000, and every investor in this fund is drawn strictly pro rata.

Now put those two lists next to each other and read the last one again. Every single item investor 5 receives is produced by the same machinery it reviewed once, before it committed, and never had the chance to review again. The administrator keeps the records. Kolar Fund Services Private Limited, invented, is that administrator, and Ashwin Baliga, invented, is the fund controller there who strikes the net asset value. The valuation agent produces the annual value. Farida Contractor, invented, the chief operating officer of the manager, signs the capital call and distribution notices. Exercise two was the one and only test of the people and the process that generate every number investor 5 will read for the rest of the fund's term. None of that argues that exercise two matters more. The observation is about when exercise two can be done, and the answer is once, at the start.

What is the one sentence that keeps the two apart?

All of the above collapses into a habit that costs two words. Never write or say the phrase operational due diligence without naming, in the same sentence, the thing it was run on. Operational due diligence on the target. Operational due diligence on the manager. Either is unambiguous, both are short, and the bare phrase is ambiguous every single time it is used, including in a sentence whose writer knows perfectly well which one is meant.

Three sentences show the difference immediately. Take the operational due diligence flagged a second-signatory problem. The sentence could report a finding about Bhavani Speciality Chemicals Private Limited that became a condition of a transaction, or a finding about Nilgiri Alternatives Advisors Private Limited that ended a conversation with an investor. Take operational due diligence is being run next week. The sentence tells a colleague nothing about whose office anybody is visiting. Take the operational due diligence was light. The comment is either about a transaction review or about a manager review, and the two would worry completely different people. Add two words to each and every one of them becomes a sentence somebody can act on.

There is a version of this discipline for the reader as well as the writer. The bare phrase in somebody else's document is not a thing to guess at; the subject is the thing to look for. If the paragraph around it is talking about revenue, customers, margins, a seller or a completion, it is exercise one. If it is talking about cash controls, an administrator, valuation, an auditor or continuity, it is exercise two. If the surrounding paragraph genuinely does not tell, that is itself worth noticing. A document that cannot say whose operations it examined has not said what it did.

How does somebody use this distinction in a working week?

Take an analyst at an allocator. Their working week has two folders in it that must never be merged. One folder holds the questions asked of a manager: who can move cash, how many signatures it takes, who the administrator is and whether it is genuinely independent, who strikes the value of an unsold holding and how often, what the continuity arrangement is, and what the auditor has issued in the past. The manager folder is opened once per manager, before any commitment, and its output goes to the analyst's own committee.

The analyst is not buying companies, so the other folder holds nothing the analyst will ever run. The folder holds what they read: the diligence summaries a manager sends when it reports on a transaction it has completed. An allocator reads exercise one and runs exercise two, and mixing the two folders is how a review of a manager quietly turns into a review of the manager's deals. The tell is simple and it is the first row of the grid: who is on the other side of the table. If it is a business, the exercise is one to read. If it is a firm that will hold money, the exercise is one to run.

The same split shows up far away from private funds. A bank lending to a small manufacturer runs something very like exercise one on the borrower's order book and its receivables. The same bank's own treasury, deciding which custodian to place securities with, runs something very like exercise two, and nobody in that second conversation is haggling. A household choosing a school for a child compares fees, results and distance, and that comparison is the first shape. The same household checking whether the school's bus driver has a licence and whether anybody else has a key to the gate is doing the second, and no fee discount would settle it.

Where does this go wrong in practice?