Over a long holding period, whatever is fragile in a business will be tested, often when credit is scarce. Our diligence therefore concentrates on what could break.
The five tests
Cash conversion: does the business fund its own growth, or does growth depend on lenders? Pricing: can it raise prices without losing its most important customers? Management: are the operators allocating capital, or only reporting on it?
The balance sheet under stress: how does it hold up if revenue falls by a fifth and stays there for two years? Our own exit assumption: we write it down at the start, so we can later tell whether the investment worked because of the business or because of the valuation multiple.
Writing the exit assumption down also shows how much of the expected return depends on the price at which the holding is eventually sold. When most of it does, we go back to the business case.
Most opportunities fail at least one test, and we expect them to. The portfolio is what remains after many opportunities have been declined, which is why it holds few positions.