What Is the Risk of Not Doing Due Diligence? FTX: A Cautionary Tale
Cryptocurrency & Blockchain
On November 10, 2022, the crypto exchange FTX filed for Chapter 11 bankruptcy. This column will not explain the cause of FTX’s failure. Instead, it explores why venture capital investors like Sequoia Capital, Paradigm, SoftBank, Blackrock, Singapore’s Temasek, and Ontario Teachers’ Pension Plan decided FTX “may very well end up creating the dominant all-in-one financial super-app of the future“?
Let’s put these investors’ decisions in the proper historical context. In 2021, general partners and investors were flush with cash and aggressively looking for opportunities in private market growth-stage crypto and DeFi companies.
FTX appeared to have the attributes associated with a big winner!
FTX had a real business with revenue and profits and, perhaps more importantly, a charismatic founder, Sam Bankman-Fried, who investors saw as the “archetypal Silicon Valley wunderkind – young, nerdy, socially awkward, clever and entrusted with the controls of mysterious but powerful financial instruments that can affect the real-world economy.” As one prominent investor in FTX told the Financial Times, “We were seduced…by its founder’s snowballing celebrity profile.”
(Not all seasoned investors were smitten by the cult of the star founder. During the $17 billion round, Chamath Palihapitiya met with Bankman-Fried. Palihapitiya’s team sent a note with recommended next steps in the diligence process and was subsequently told to “go fuck yourself.”)
But the competition for deals was fierce, especially for firms behind the crypto investing curve. So investment decisions had to be made quickly. Fear of missing out was a strong motivator; in the end, investors valued the speed of the decision and heuristics over the depth of analysis.
However, certainly, in the case of FTX, speed and heuristics were the enemies of the good.
FTX was not just a crypto exchange. It had about 130 other affiliated entities, including the crypto hedge fund, Alameda Research, which was a heavy user of the exchange. Additionally, according to several sources, FTX was run “by a gang of kids in the Bahamas,” all of whom are “are, or used to be, paired up in romantic relationships with each other.” Moreover, as Axios reports, “it’s unclear if FTX even has a board of directors, audit committee, CFO or chief compliance officer.”
While FOMO could be a reason for an individual to take a punt, many FTX investors manage assets for the benefit of others and have detailed policies and guidelines they must follow when making investment decisions. Some, like Ontario Teachers’ Pension Plan and Blackrock, have explicit fiduciary obligations requiring a duty of care, skill, and diligence.[1]
Alameda Research logo
Some investors and commentators have attempted to trivialize the losses FTX investors are likely to suffer (some of which have already written down their investment to zero) by arguing that such losses are just part of VC investing, where a handful of portfolio companies generates most of a fund’s return, with the rest resulting in a small profit or complete loss.
This calculus is true, but it disregards the fact that portfolio companies generally fail for ordinary business reasons (e.g., poor product-market fit, operational weaknesses, lack of a clear strategic plan). Not because of possible illegal activities such as fraud and mishandling of customer funds.
Others point out that the associated losses will have a de minis impact on the investors’ aggregate portfolios. This, too, is true; for example, Ontario Teachers’ Pension Plan said that “any financial loss on this investment will have limited impact on the Plan, given this investment represents less than 0.05% of our total net assets.” Yet it callously brushes aside the fact that funds lost were the savings of the thousands of plan participants and the reputational damage these investors will likely suffer. Moreover, this excuse fails to consider that investors’ support of FTX “helped lend Bankman-Fried’s business empire credibility before its sudden collapse this week,” and contributed to the ensuing contagion spreading across the crypto sector.
As veteran VC investor David Parkman told TechCrunch: FTX “was an entirely avoidable tragedy….But its leadership, with almost no oversight apparently, made a bunch of terrible decisions and did things really wrong.”
FTX’s Enron-like failure–and the recent collapse of other “blue chip” crypto businesses (e.g., Celsius Networks). Demonstrates that speed and heuristics are no substitute for rigorous due diligence (unless you’re Larry David).
Moreover, FTX’s collapse should reinforce the lesson that crypto and DeFi are not some alternative universes where the principles of investing are held in abeyance. The FTX investors that claim to have performed months of “extensive” due diligence. And engaged in “a rigorous diligence process before investing” should certainly rethink their processes, including the decision to outsource diligence to third parties. (It is noteworthy that one investor would not say if it even performed due diligence before investing in FTX.)
Specifically, when considering an investment in crypto and DeFi companies, this diligence should focus on the company’s governance, risk management, and financial controls.
(Given the universal reaction of lawmakers and regulators in the US and abroad to FTX failure. This diligence will most certainly become supported by a clear regulatory framework for the digital asset ecosystem.)
Additionally, as a condition of investing, investors should require the company to provide regular risk reports and audits of the company’s financials and code. And they should demand a board seat. And secure a contractual agreement that the board must approve all related party transactions. (Axios reports that “Venture funds invested around $2 billion into a company. Most recently at a $32 billion valuation, without a single board seat in return.)
Taking such steps will not guarantee a 10x return. But they will reduce the risk of bad actors destroying value for all stakeholders.
Angelo Calvello, PhD, is the co-founder of Rosetta Analytics.
An investment firm using advanced machine learning to build and manage investment strategies for institutional investors.
[1]https://digitalcommons.osgoode.yorku.ca/cgi/viewcontent.cgi?article=1683&context=scholarly_works#:~:text=Pension%20trustees%20are%20subject%20to,the%20purposes%20of%20the%20fund, P. 178 and https://www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter
What Is the Risk of Not Doing Due Diligence? FTX: A Cautionary Tale
