Liability-Side Due Diligence
Identify how an investment can break before evaluating its potential return
- Difficulty
- Moderate
- Time to result
- ~weeks to results
- Steps
- 5
- Confidence
- 99%
Liability-Side Due Diligence reverses the common order of investment analysis. Instead of beginning with the story and asking how much money might be made, the evaluator first inventories how the manager, strategy, financing structure, liquidity profile, and operating model could fail. Each failure mode is tested for likelihood, severity, interaction with other risks, and available controls. Only after understanding the residual downside does the evaluator turn to expected returns and ask whether the compensation is sufficient. The balance-sheet analogy is behavioral as well as analytical: starting with liabilities interrupts the natural attraction to persuasive narratives and upside projections. The result is a structured risk-reward decision rather than reflexive optimism or indiscriminate skepticism.
Origin
Paul Zummo credited mentor Joel Katzman with reinforcing skepticism and described this balance-sheet analogy on Masters in Business.
Core principles
- 01Downside analysis should precede upside enthusiasm
- 02Every strategy and manager has identifiable failure modes
- 03Behavioral bias draws investors toward stories and potential gains
- 04Expected return matters only relative to the risks required
- 05Skepticism is a tool for inquiry, not automatic rejection
How to run it
- 1
Start with Breakage
Ask what could break in the manager, strategy, portfolio, financing, and operations. Generate concrete failure modes rather than generic statements that markets are risky.
Pro tip Use historical failures in comparable strategies to expand the list.
Watch out Beginning with expected returns can anchor the rest of the analysis toward approval.
- 2
Trace Failure Mechanisms
For each risk, identify the trigger, transmission path, and potential loss. Include interactions such as leverage combined with illiquidity or redemption pressure.
Pro tip Ask what happens second and third after the initial problem.
Watch out Risks assessed in isolation may look safer than they are together.
- 3
Inspect Controls and Contracts
Evaluate whether diversification, limits, hedges, financing terms, and governance actually constrain the failure modes. Pay particular attention to contractual triggers and liquidity mismatches.
Pro tip Read primary agreements instead of relying only on summaries.
Watch out A named control is not necessarily an effective control.
- 4
Estimate Residual Risk
Assess what remains after controls, including low-probability but severe outcomes. Decide whether the loss profile fits the wider portfolio.
Pro tip Use scenarios rather than a single expected-loss estimate.
Watch out False precision can conceal uncertainty in tail events.
- 5
Turn to Compensation
Only now evaluate the prospective return, diversification benefit, and strategic value. Invest only if the expected compensation justifies the residual risks.
Pro tip State explicitly which risks the return is paying you to bear.
Watch out High projected returns do not compensate for risks that cannot be understood or survived.
In the wild
An investment committee postpones the performance presentation and first maps the manager's leverage, collateral requirements, redemption terms, and financing triggers. It models a spread shock that causes both asset losses and tighter financing. After testing available liquidity and contractual protections, the committee compares the remaining tail risk with expected returns.
→ The allocation decision reflects the full financing and liquidity mechanism rather than the manager's headline yield.
Common mistakes
Starting with the Story
An attractive narrative anchors investors on upside before they understand what can go wrong.
Stopping at Risk Identification
Listing risks without tracing triggers, consequences, and controls produces superficial diligence.
Mistaking Skepticism for Rejection
The method asks whether risk is compensated; it does not require avoiding every risky investment.
Is it for you?
Best for
It is best for investment committees and allocators conducting manager, strategy, financing, or operational due diligence.
Not ideal for
It is not ideal when used as blanket pessimism that rejects every uncertain opportunity without comparing risk with compensation.
From the transcript
“Be a skeptic approach due diligence from the perspective where does this break?”
“You need to approach it from the liability side, like what can go wrong with this manager?”
“what can go wrong with the strategy?”
From the episode
How to Think About Alternatives with JPMorgan's Alternative Asset Management CIO Paul Zummo
Paul Zummo