The rapid and spectacular collapse of FTX, which was the world’s third-largest crypto exchange, last week is a painful lesson in the importance of due diligence and the blinkering power of herdthink. Some of the biggest names in venture capital including Sequoia Capital and Andreessen Horowitz (a16z) lost their investors’ capital in the deal. In relative terms, it won’t tank these funds. FTX represented less than 3% of Sequoia’s Global Growth Fund III.
However, it raises important questions for LPs about how they should review their GPs’ diligence approaches and investment processes, and whether these are sufficiently rigorous or prone to FOMO. Sifting through Twitter in the aftermath of this failure, which at this stage is an alleged fraud that involves the misappropriation of user funds for leveraged bets, makes for eye-opening reading.
Marcelo Claure, who was CEO of SoftBank at the time of its investment in FTX, had this to say on the matter.
I have been reflecting personally on the whole FTX fiasco and it taught me one more time that we should NEVER invest because of FOMO and we should always 100% understand what we are investing in. I totally failed here on both.— Marcelo Claure (@marceloclaure) November 12, 2022
And here’s an insight from Frank Chaparro, editor at large of The Block, a crypto and digital assets online publication:
Just spoke with an LP in several crypto funds: he said when he asked funds why they did “lazy” DD on FTX, they responded basically “he was on the cover of Fortune Magazine. He was a big name.”— Frank Chaparro (@fintechfrank) November 13, 2022
There’s going to be a lot of lawsuits. And a lot of funds will shutter.
The abiding question in all of this is, was there any way of FTX’s investors knowing that something wasn’t right? Were there any red flags along the way that should have alerted them to the fact that all was not well?
Hindsight is 20/20, but it seems as if clues were there all along. Some of these were privately known, others were on public display, if due attention was paid. Chamath Palihapitiya, CEO of Social Capital, recently shared his experience of being offered an investment into one of FTX’s early rounds.
Companies rejecting basic governance and oversight measures should sound loud alarm bells. Even with boards in place, though, companies have repeatedly shown their ability defraud customers and investors. A key piece to the FTX puzzle is Sam Bankman-Fried’s seemingly cavalier, if not deluded, view of risk management.
A conversation SBF had with a Twitter account as far back as 2020 lays this bare. It is well worth reading, but to summarize, the FTX CEO argued against the Kelly criterion, essentially a scientific gambling method devised by Bell Labs in the 1950s that determines the optimal bet size assuming an infinite number of bets.
Two years ago SBF wrote a thread on bet size and Kelly betting.— Matt Hollerbach (@breakingthemark) November 11, 2022
I questioned him on it. He engaged with me.
Let’s take a look at this thread and SBF’s views on bet sizing in light of the events with FTX and Alameda this week. https://t.co/tGiUxpJyz6
Kelly-style analysis was adopted as part of mainstream investment theory in the 2000s and used by household names like Warren Buffett to right-size investments. Simply put, if you invest too much capital into any single play and it fails, there won’t be enough to make that outlay back. Don’t put all your eggs in one basket. The Kelly criterion does not care how big the potential reward might be. SBF argued that on a coin toss, if the reward was vast, say 10,000x, he would be prepared to risk 50% of his entire portfolio for the opportunity. This was a big red flag for anyone paying attention and happened long before the company he founded would go on to raise successively larger funding rounds, ultimately at a $32bn valuation.
In the end, SBF is accused of losing billions of dollars in user funds and wiping out equity investors with his actions, potentially setting back industry by years or more in the process.
For venture capital and private capital fund investment, there are lessons to be learned. LPs need to understand how exactly their GPs approach due diligence on any one deal, including, importantly, how they assess the health of a deal target’s governance structures and practices.
As investors across multiple funds, LPs also need to understand their ultimate crossover investment exposure to individual assets. Being an investor in a single VC fund that backed FTX won’t cause material issues, but being exposed across multiple funds could lead to significant write-downs. As well, institutional investors need to be careful following GPs with direct co-investments that double down their exposure and should conduct their own thorough and independent due diligence at all times.
LPs are also increasingly requiring more comprehensive reporting from their private capital managers, something that we see with our own clients. Investors will no doubt want more of this in the wake of FTX’s demise. High-level financial information, company updates, and quarterly valuations won’t be enough. Insights on governance reviews should begin to take precedence.
One of the biggest takeaways from all of this is that when liquidity is in abundance, as it was through 2020 and 2021, standards slip. Investors piled into risky assets at eye-watering valuations during the mass money print and those investments have come back to bite them as conditions have tightened. Allocating capital should always be based on fundamentals, not hype.
Simply investing because a CEO is flaunted on the cover of Fortune may, in the end, cost a fortune.