The diligence almost everyone skips: background and references

The financial diligence tells you whether the deal is good. It does not tell you whether the sponsor is honest, and that is the more important question, because a good deal run by a dishonest sponsor is worse than a mediocre deal run by an honest one. As the risk section explains, the operating agreement has usually already narrowed an investor’s remedies to gross misconduct and fraud, which means the investor’s real protection is not the contract. It is having picked a sponsor who will not need to be sued. The diligence that tests for that is not financial, and it is the step almost every investor skips.

The financial model tells you if the deal is good. The reference call tells you if the sponsor is honest, and only one of those is recoverable if you get it wrong.

Three checks, in rising order of value

A background check is the floor. It overlaps with the sponsor’s own obligation under the bad-actor rule covered in the securities section, where certain disqualifying events can cost the whole offering its exemption, so a bad-actor problem is both a character signal and a legal defect. Confirm identity, credentials, and the absence of the kinds of regulatory and criminal events that the securities rules themselves treat as disqualifying.

A litigation search is more revealing. One lawsuit proves little; people in real estate get sued. A pattern is the signal, especially a pattern of investors suing the sponsor, or the same allegations recurring across deals. Prior investor litigation tells you how this sponsor’s deals tend to end when they end badly, and whether the sponsor’s response to trouble is to make investors whole or to fight them.

The reference call is the most valuable and the least used, and the trick is which references to call. The sponsor will offer references from deals that went well, and those calls are nearly worthless, because a sponsor is easy to like when everyone is making money. The reference worth finding is an investor from a deal that lost money or disappointed. That investor knows the only thing that ultimately matters: how the sponsor behaves when there is nothing left to distribute and no upside to protect. A sponsor who communicated honestly, took responsibility, and treated investors fairly through a bad deal is a sponsor worth backing. A sponsor who went quiet, shifted blame, or maneuvered against their own investors when the money ran out will do it again.

The structuring consequence

Run the background and litigation search and make the reference calls, specifically to investors from the deals that did not work, before wiring, because these checks are cheap, almost everyone skips them, and they catch the two things the financial model cannot: the legal defect that the bad-actor rule punishes, and the character defect that the operating agreement will not protect you from. The numbers can be re-run. The choice of a dishonest sponsor cannot be undone once the money is in.