Written by: Christian Salomone, Chief Investment Officer | Ballast Rock Private Wealth
Last year’s stunning collapse of FTX has inevitably led to questions about whether founder Sam Bankman-Fried intentionally misled and defrauded his investors.
But, it also begs a more fundamental question: How did the due diligence carried out by FTX’s large institutional investors miss the red flags?
This question is especially important to our team at Ballast Rock Private Wealth. Our focus is on private markets, where there is often less transparency for investors than in public stocks or bonds. Companies, like FTX, who raise capital from private investors aren’t always as forthcoming with information as public companies that are required to file financial statements for investors with the Securities and Exchange Commission. As investors in private companies, we do not believe a lack of disclosure requirements equates to a lack of responsibility to ask pointed questions.
Some of the market’s most sophisticated investors were forced to write down their holdings in FTX to virtually nothing. Almost all those investors have insisted they performed proper diligence. Venture capital firm Sequoia said in a letter to its investors that, when it invested in FTX, “we ran a rigorous diligence process.” Singapore’s Temasek, which has more than $400 billion in worldwide assets, described its own diligence process, which took eight months, as “extensive.”
Hindsight is 20/20, as the cliché goes, but it appears that red flags were uncovered during the FTX diligence process and, unfortunately, ignored. In a now-deleted profile of Bankman-Fried on its own website, Sequoia revealed that he was playing the video game League of Legends while on a Zoom meeting with Sequoia’s partners. That is a startling revelation! When we vet opportunities, management is one of our top priorities. We look not only at past track record, but also management structure, leadership style and company culture. As stewards of clients’ capital, the lack of professionalism demonstrated by FTX’s founder should have caused large investors to pause. Even if they didn’t know during the meeting that Bankman-Fried was playing video games, they certainly knew after. Instead of praising that behavior in an article, investors should have seen this as a sign that additional due diligence was needed.
Temasek’s due diligence also uncovered key issues that were not addressed prior to subsequent investment rounds. In a discussion of its investment in FTX, Temasek said it specifically “enquired about the relationship, preferential treatment, and separation between Alameda and FTX, and were given appropriate confirmations that were contractually binding.” Indeed, they asked the right question, but should have been more skeptical of the answer. Additionally, Temasek said, during further due diligence, “we had identified possible enhancements around FTX’s regulatory stance and gaps around leadership roles.” Again, diligence uncovered red flags, but they were not heeded. Like Sequoia, Temasek has written down its investment in FTX to zero.
It appears that some funds decided to pass on the investment because of these red flags. Venture capital firm Andreessen Horowitz reportedly declined several investment opportunities in FTX. The reason? Amongst others, FTX lacked a traditional board of directors, and its headquarters was located in the Bahamas, rather than the U.S, due to the island’s less stringent regulatory environment.
At the fund level, financial advisors are in an ideal position to ensure that diligence is tightened. Accredited investors are aware of the risk in allocating capital to private companies and in private-market funds. They are also aware that these investments can be an effective hedge against public-market volatility. When selecting a financial advisor who will allocate capital into private or illiquid markets, investors should inquire into their advisor’s diligence process. How do they vet direct-investment opportunities? How are they holding private equity and venture capital firms accountable for their own diligence processes? At a minimum, advisors should be asking questions of private market funds about how due diligence has changed in the wake of FTX.
Due diligence will never completely eliminate risk. However, at Ballast Rock Private Wealth our thorough due diligence process aims to mitigate unsystemic risk by asking the right questions, and then paying close attention to the answers and their implications.
Our clients deserve nothing less.