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It was a bad month for professional investors.
The FTX debacle revealed that everyone from risqu hedge funds to stable pensions to sovereign wealth funds had put their money into crypto exchanges with weaker financial controls than Enron.
Elizabeth Holmes was sentenced to 11 years in prison for Theranos, a fraudulent blood-testing scheme that defrauded Oracle founder Larry Ellison and media mogul Rupert Murdoch.
Shares of publicly traded tech companies have plummeted during the 2020-2021 Spac frenzy, leaving many cryptocurrency companies teetering. BlockFi declared bankruptcy on Monday despite claiming it was “backed by the best companies” including SoFi, Tiger Global and Peter Thiel.
Doesn’t anyone do due diligence? The tedious process of checking if a potential investment can deliver on its promise is completely lost. Due diligence used to mean sending bankers to see if a mining company was actually running a gold mine, hiring an accountant to scrutinize the books, or having a lawyer sign a nasty deal in bankruptcy. It meant to ask you to identify.
These days, it’s hard to know what due diligence really means. The Ontario Teachers’ Pension Plan, which put $95 million into his FTX, claims its experts “perform rigorous due diligence on all private investments.” At $38 million, Tiger Global pays outside consultants, including Bain & Co, to do the work. But both missed what FTX’s new chief executive described as a “complete failure of corporate governance.” FTX founder Sam Bankman-Fried, who gave $214 million to Sequoia Capital, was playing video games during the pitch, but it was a fine line. While rarely apologizing and promising stricter standards in the future, they insisted they had due diligence.
A veteran Silicon Valley dealmaker says standards are slowly eroding as venture capitalists stop trying to select and nurture the smartest entrepreneurs and start splurges with cash. Venture capital models have always assumed that most fledgling companies would fail, but investors made up for those losses by capturing some big successes early.
But decades of making easy money and failing to get a decent yield from a safer alternative means that this approach has gone from early investment rounds involving millions to billions of dollars. It means that it has spread to huge transactions including
As the apparently successful companies took longer to go private, investors grew worried that they would miss out on the next Amazon or Google. That made them vulnerable to hacksters. Investors began choosing companies based on who else was in the funding round rather than whether the entrepreneur’s business plan made sense.
The longer low interest rates lasted, the worse the problem got, as institutional investors increased their allocations to private investment funds. Big companies like SoftBank, Tiger Global, and Sequoia were flooded with large amounts of dry powder and boasted the speed at which they could deploy capital. This put pressure on competitors to fire lawyers and accountants. Many people agreed to invest their money with little or no protection. Bankman-Fried refused to put investor representatives on FTX’s board and used his two little-known audit firms.
Even if investors insisted on diligence, the practical work was usually left to the youngest lawyers, consultants and bankers. Today’s 20-somethings lack the experience of a meaningful economic downturn, so they lack the experience of judging the adequacy of regulations and provisions that only matter when funds start to dry up.
And then run out of it. Venture capital funding in the third quarter fell 53% year-over-year, according to Crunchbase. Rising interest rates and bond yields have removed the need for investors to place wild bets for decent returns. Volatile markets are a reminder that valuations don’t always go up, even for winners. Shares of Google and Amazon have fallen by more than a third since his January.
Investors who want to restore standards should start with finance. The FTX debacle provides a reason to argue for a proper audit that delves into how companies are spending money and fully discloses related-party transactions. give strong justification to raise governance concerns.
Some sensitive founders are against it, and some visionaries struggle to meet the higher standards. But the best new companies survive. They may rise even higher if they no longer face competition from mediocre people kept alive by prodigal investors.
brooke.masters@ft.com
