The dangers of "trust but verify"

Welcome back and happy Thursday!

In all forms of investment diligence, the phrase "trust but verify" is common, but the phrase is misleading at best and dangerous at worst for LPs looking for investments.

As I advise more and more LPs daily, I’ve realized that this topic isn’t so intuitive for many.

Today, I’d like to suggest a better framework for approaching trust within the context of investments and run you through a few edge case examples.

So, what’s wrong with trust but verify?

As I wrote in #1 of an investor's mindset and principles, a healthy dose of skepticism is extremely important when you’re assessing investments.

You have to be mindful because you simply don’t know the counterparty.

The baseline assumption should be that the GP is not honest, so I would suggest changing “trust but verify” to verify and only then begin to slowly trust.

Verify and only then begin to slowly trust

You might reasonably ask “why - most people aren’t fraudulent or lie so why would I assume that?”

Great question. For three reasons:

• Because you’re trying to protect your own capital - it’s fine to trust a neighbor who’s giving your kid some Halloween candy, but this isn’t the same thing

• While it’s true that fraud is uncommon, it’s quite common to come across investment opportunities that either aren’t great or misrepresent/exaggerate aspects of the deal

• When you’re asking a GP to invest in a deal (or vice versa), you have to remember that you’re in the middle of a sales process … so make sure to do more diligence on this than you would on your most recent car purchase!

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Where most LPs have a hard time with judgement are the edge cases, so here are some of the most common situations that I’ve experienced:

• “Of course I should be skeptical, but my friend invested with them and is recommending them”

• The friend might not know anything about investing

• His or her investment might actually be underperforming without them knowing (sometimes as a result of poor knowledge around investments or perhaps even due to the GP not sharing the reality for their own benefit)

• The investment your friend invested in could have a materially different risk profile than the one in front of you

• “My friend is literally investing alongside me!”

• That’s great, but doesn’t mean you skip diligence either…. and don’t forget to look out for conflicts of interest (sometimes your friend is being paid to get you to invest)

• Another version of this is feeder funds in some cases - you can see more on that here

• Referral deals are a double edge sword in a sense -

• On the one hand they have a higher probability of being better than the average deal you’ll find

• On the other hand they deceive many LPs into investing without diligence (or with less diligence) “because it came through a friend”

• “I found something that wasn’t great during diligence, but the rest of the deal was so good”

• Excuse the metaphor, but when you’re dating for marriage the counterparty tends to be on its best behavior, right? The same is true in investments - the counterparty is trying to put their best foot forward (remember - you’re in a sales process) and you still found something that was ~dishonest!

• There’s a big difference between misrepresentation and forgetting to update a number on a slide.. I think we can all agree on that.

• Minor mistakes happen, but if the GP showed you something that was (or seems to be) misleading .. that’s difficult to understand and you should definitely ask about it.

• How they respond to such a request is important - some won’t respond at all (no response can be a type of response), some will take offense to the question, some will respond but brush it off as if it wasn’t misleading, and some will update the slide and send you a new one thanking you for the catching the fact that it was misleading. You should obviously not make your investment decision based on their response, but you can see how these responses feel very different…

• “I’ve invested with this GP before and I’m getting paid, so I trust them”

• This will be the topic of a longer post in the future, but I’ll start here by saying that this is misguided for three main reasons:

• Just because you’re getting paid, doesn’t mean you’re getting paid from cash flow (i.e. there are other ways of paying you which aren’t a positive indicator)

• Just because you’re getting paid doesn’t mean your principal (the original capital you invested) is in a healthy place!

• Concentrating too much of your wealth in a single GP is generally not a good idea - more on this topic and LP allocations. The slowly in “verify and only then begin to slowly trust” is there for a reason - wait for an exit, and even then continue to be cautious.

• “They were so nice and they’re just getting started, how could I not invest”

• You can certainly invest to help someone, but then you should think about it as a donation rather than an investment :)

• If you’re genuinely thinking about it as an investment, realize that:

• Character is different in public and private many times

• Character can change in difficult times

• Character doesn’t mean too much in terms of making good investment decisions (i.e. if someone is honest with you about losing all of your investment you’ll appreciate the transparency, but would likely wish you invested the capital in more capable hands)

In summary, I suggest having a fairly low tolerance for any sort of dishonesty or misrepresentation, because:

• There are a lot of investment opportunities (I know you want to invest your money, but don’t rush!) - preservation of capital is paramount!

• The goal should be betting on the investment, not the character of the counterparty; you obviously can’t ever eliminate the character risk, but if you smell something early on I’d be happy you caught it and pass

• For every matter you figured out in your due diligence that didn’t smell right there are likely other things that you won’t know or be able to figure out with the information that you have in front of you. So give the GP a fair chance to respond, think through how the response might be incomplete or biased, and then decide if the answer is satisfactory.

Verify and only then BEGIN to trust!

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