The first mistake we often identify in an investment process is not that the FDD report is framed around accounting measures. That is part of its purpose. The mistake is allowing those measures to shape the investment decision without applying a corporate finance methodological framework and financial models that stress-test different scenarios.
The accounting measures may be correctly calculated, reconciled and supported by the available financial information, however not designed to determine an investment conclusion.
An adjustment to EBITDA does not establish what a business is worth to a particular investor. A net debt figure does not establish the amount of capital that will remain at risk after completion or a working capital analysis does not establish whether the business can finance its own operations under stress. While these measures provide important evidence, an investment decision becomes reliable when their combined effect on value, funding, risk and expected return is understood.
An investor can receive a technically detailed FDD report and still not know whether the investment should be made on the proposed terms.
The risk of the original decision being embedded in the proposed terms
The problem arises when the investor’s valuation, ownership percentage, instrument, leverage and expected return are treated as fixed assumptions rather than variables to be stress-tested against the true risk profile of the investor and investment.
This often creates circularity in the analysis insofar that the proposed valuation is inserted into the model, the forecast is built around the proposed transaction, and the resulting return is then used to justify the valuation that was assumed at the beginning. The calculations may be mathematically correct while the conclusion remains intellectually weak.
The same problem occurs when the investor’s target return is treated as evidence that the investment is adequately priced. A modelled return of 18%, 20% or 25% has little meaning on its own and does not automatically represent adequate compensation for risk. While an investor’s expectations remain relevant, those expectations should not drive the outcome of the analysis.
A proper assessment requires that a range of risk-adjusted outcomes be produced once the full investment structure and different scenarios are considered.
The original decision may ultimately be confirmed and confirm that the business remains investable but not at the proposed valuation, through the proposed instrument or with the proposed level of exposure. That distinction will not emerge from an analysis designed merely to validate terms that have already been accepted in principle.
The risk of template-driven analysis without comparative investment context
Another weakness we frequently identify is the use of standard templates to identify accounting adjustments, historical variances and control deficiencies rather than adapting the most relevant corporate finance theories and tailored financial models to determine how the proposed investment compares with investment alternatives.
Although mentioning theories might sound academic, they create a sharp distinction because different investment problems require different theoretical frameworks. Choosing the wrong framework, failing to challenge its assumptions or not adapting the most relevant theories to the commercial environment can change the conclusion. For example, disregarding agency theory when assessing control rights, management incentives and relative-party exposure results in a half-baked analysis. Similarly, failing to assess leverage, structural subordination, and refinancing risk alongside corporate finance, pecking order and trade-off theories produces weak findings.
A discounted cash flow model is not automatically a corporate finance analysis simply because cash flows have been discounted. Applying a formula without challenging whether its assumptions reflect the market, currency, liquidity, capital structure and investor position can create a false impression of technical sophistication.
The risk further amplifies when the same analytical template is applied across different sectors, jurisdictions, capital structures, currency exposures, investor profiles or exit routes. Two companies may report similar EBITA, margins and growth while presenting completely different investment risks. One may convert earnings into freely distributable cash, while the other depends on working-capital support, foreign currency availability, refinancing or shareholder cooperation. The accounting measures may look comparable even when the investments are not.
An investor does not only need to understand the risks of investing in X. An analysis should establish how the risks of X compare with those of investing in Y, whether the expected return adequately compensates for the difference and which investment provides the better risk-adjusted return.
Without that comparative context, a positive return can be mistaken for an attractive return. Capital may then be committed to an investment that is more complex, less liquid and more difficult to protect than another opportunity offering a similar outcome.
When accounting adjustments are mistaken for corporate finance conclusions
One of the most common points of confusion is the assumption that adjusting historical earnings produces an investment conclusion and when a valuation multiple is applied to adjusted EBITDA as though the resulting enterprise value were a neutral fact. The multiple may have been taken from listed companies or previous transactions that do not carry the same liquidity constraints, governance weaknesses, currency exposure, leverage or exit limitations. The calculation can be simple, but the assumptions imported it are not.
Accounting classifications can also hide the true economic position in as much as an item does not cease to represent a claim on value merely because it is not labelled as bank debt. Cash does not necessarily belong in equity value merely because it appears on the balance sheet. A liability does not affect the investor only when it becomes payable; it may already be restricting distributions, borrowing capacity or the ability of the business to fund operations.
The distinction is sharp. An accounting-led report is backward-looking and identifies what should be adjusted whereby a corporate finance analysis includes both backward-looking and forward-looking evaluations and establish the impact of accounting adjustments on investment decision and position.
When the amount of capital at risk is greater than the proposed investment
One of the highest risks for an investor occurs when the analysis is geared towards the initial investment amount. The assessment should extend to the capital required by the underlying business to maintain operations, meet debt obligations or avoid dilution since working capital deficits, deferred capex, refinancing gaps, currency shortages, contingent liabilities and shareholder support can convert a one-off investment into repeated capital calls that the investor did not initially anticipate.
The initial amount invested can therefore give a false impression of a defined exposure and once capital is committed, the decision to provide further funding is no longer made in the same circumstances as the original decision. Refusing to participate in additional capital call may result in dilution, loss of influence, default, suspension of operations or a transfer of value to the party willing to provide rescue capital. Hence the investor can become exposed to a much larger amount without having intended to make a larger investment.
Investors should be provided with an analysis that quantifies the total capital required under base, downside and recovery scenarios before committing capital and additional funding should be assessed to determine whether a capital call supports temporary liquidity needs or finances an underlying operational incapacity to generate sufficient returns. This distinction is essential as funding a timing difference is not the same as repeatedly funding a business model that cannot finance itself. Growth capital is not the same as capital required to prevent further deterioration.
When the cross-border structure changes the economics
Taking for granted that an offshore jurisdiction is the best conduit for investing in an African country because of a tax treaty advantage provides a weak basis for advising an investor.
A favourable tax position can become irrelevant where the structure provides weak protection against expropriation, limits access to investment treaty remedies, creates enforcement difficulties, increases exposure to political interference or fails to meet the investor’s governance and ESG requirements.
A tax treaty quoted at the beginning of an investment does not establish that the structure will qualify for that rate, retain the benefit throughout the investment period or allow cash to reach the investor without delay. Substance requirements, beneficial ownership, changes in tax treatment and challenges to the commercial purpose of structure can alter the expected outcomes.
The analysis should compare jurisdictions according to the investor’s profile and the underlying investment, including treaty protection, enforceability of contractual rights and arbitral awards, asset security, capital mobility, currency convertibility, sanctions exposure, substance requirements, ESG obligations and exit routes.
These factors do not carry the same importance for every investment. A jurisdiction that works during the base case can become an obstacle in the downside and tax efficiency would not compensate for cash that cannot be moved, rights that cannot be enforced or an exit that cannot be completed.
When the return exists in the model but not in a realisable exit
Another weak analysis occurs when the investor’s return depends heavily on an exit value without sufficient consideration of how that exit will actually take place.
An exit multiple inserted into a model does not create a buyer, neither does a forecast sale date establishes a sale at that time. The assumed value may depend on market liquidity, regulatory approval, currency availability, shareholder cooperation and a buyer willing to accept the same risks that the existing investor is trying to exit.
This is particularly important in private markets where the number of credible buyers may be limited. A business can increase in accounting value while remaining difficult to sell. An investor can also be prevented from realising that value by transfer restrictions, unresolved shareholder issues, weak financial information or a capital structure that becomes unattractive to a future buyer.
The return can therefore appear attractive because the model assumes that value will be realised, not because the analysis has established that it can be realised. The difference is even greater where the investment produces limited distributions during the holding period and most of the expected return is concentrated in a single exit event.
An investment is not successful merely because a valuation model shows a higher terminal value. The analysis must evaluate the risks associated to an investor ultimately receiving the proceeds on exit.
When the downside changes the decision even though the base case remains attractive
An investment decision based merely on a defendable base case scenario is probably the most immature decision that can be adopted by an investor. The relevant question is not whether the base case can be justified, but how quickly the investment economics deteriorate when one or several assumptions fail and whether the investor retains the financial capacity and contractual control to respond.
In private markets, downside is rarely limited to a proportional reduction in earnings. A minor drop in growth and profitability can jeopardise working capital, trigger debt covenant defaults, suspend distributions, create refinancing dependence, require emergency capital and transfer value from equity to lenders or controlling shareholders. The investor may therefore suffer permanent impairment before the underlying business reaches insolvency.
The weakness becomes more apparent when each downside assumption is analysed separately. Revenue can decline at the same time as the local currency depreciates, interest costs increase, customers delay payment and lenders reduce their appetite to refinance.
A base case may still generate an attractive return, but the investment decision changes when a scenario reveals disproportionate loss, limited recovery or a period of capital lock-in that an investor is not willing to absorb.
This is the distinction between an analysis that supports the numbers and an analysis that supports the investment decision. Investors do not only need to know whether businesses can perform, they need to know whether a proposed investment remains worth making when the valuation, structure, capital requirements, control, cross-border risks, exit and downside are considered together.