The diligence that matters happens after the LOI, not before it

Pattern #1: Quality of Earnings Validates History, Not Capacity

Quality of earnings tells you whether the historical numbers are real. It does not tell you whether the operation can absorb a transaction, sustain its performance through ownership transition, and execute the value creation plan that was modeled. That is a different question.

Pattern #2: Key Person Risk Is Underestimated

A $150 million business often has a single person who is the entire finance function, a single salesperson who owns 30 percent of revenue, a single supplier who provides 60 percent of input cost, or a single customer relationship that is held together by the founder who is selling. None of these dependencies show up in a quality of earnings report. All of them show up in the first year post-close.

Pattern #3: Tribal Knowledge Is Not Audited

Walk the operation and count the number of judgment calls that depend on knowledge that lives in someone's head rather than a system or process. In most middle market businesses, the number is high, and the knowledge transfers unevenly through ownership transition. The buyer inherits an operation that runs on assumptions the new team cannot see.

Pattern #4: Revenue Concentration Is Measured by Customer, Not Relationship

Top customer reports show concentration by name. They do not show concentration by the relationship that holds the customer. A customer that represents 8 percent of revenue but is held by a single sales relationship the seller is leaving is a different risk than a customer that represents 8 percent of revenue across multiple touchpoints. The reports do not distinguish.

The Diagnostic Question

If the founder and the top three managers left within 12 months of close, what would happen to the operation, the customer base, and the supplier relationships. If the answer is uncertain, the operational risk has not been priced into the deal.

The Implication

Operational diligence in the middle market is not the same as operational diligence in the large cap. The size and complexity are different, but more importantly, the resilience is different. A $2 billion business has redundancy in nearly every function. A middle market business often does not, and the dependencies are not visible in the standard diligence stack.

Most of this is knowable before close, with two or three weeks of operator time inside the business. Almost none of it is in the standard diligence stack. The buyers who consistently outperform on middle market transactions are not the ones with the best models. They are the ones who get an operator inside the business before signing, ask the questions that the diligence vendors do not ask, and price the operational risk into the deal terms or walk.

Buyers who skip this step are not making a decision to take more risk. They are making a decision to discover the risk later, when it is more expensive and harder to manage.