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Bankrupt FTX Benefited From Venture Capitalists’ Shocking Suspension of Disbelief

In a bankruptcy filing, court appointed CEO John J. Ray III said FTX had been unable to provide a complete list of who worked for it and in what capacity.
By: BLOOMBERG
Updated on: Dec 06 2022, 14:29 IST
Interviews given by Bankman-Fried in recent days suggest that FTX’s failure is tied to pure incompetence. (Bloomberg)
Interviews given by Bankman-Fried in recent days suggest that FTX’s failure is tied to pure incompetence. (Bloomberg)

The narrative that emerged in the days after the collapse of FTX, the $32.5 billion exchange at the center of Sam Bankman-Fried’s crypto trading empire, was that it had to be the result of some highly sophisticated and nefarious scheme that only came to light following a series of unfortunate events. After all, some of the smartest minds in the financial world were sucked in: Sequoia Capital, Tiger Global Management and the Ontario Teachers’ Pension Plan, to name a few.

And that’s what the venture capital and pension funds that seeded FTX surely want you to believe. That they were unwitting victims in an unfortunate and complex saga nobody could have foreseen. Don’t fall for it. While we still don’t yet know all the facts, they shouldn’t go blameless. Without their continual funding, stamp of approval and lack of questions, FTX never would have grown as big as it did. Their carelessness means FTX customers are out billions of dollars they are unlikely to ever recover.

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Interviews given by Bankman-Fried in recent days suggest that FTX’s failure is tied to pure incompetence. This was an enterprise destined to fail. Exhibit A: In a business where risk management is priority No. 1, Bankman-Fried now says there was no one at the company responsible for risk management. “That feels pretty embarrassing,” he told the audience at the New York Times DealBook Summit on Wednesday. And that’s not all. FTX appears to have lacked anything remotely resembling a conventional board and subcommittees. Bloomberg News reports that it’s unknown how many compliance staff — or even employees — FTX actually had. In a bankruptcy filing, court appointed CEO John J. Ray III said FTX had been unable to provide a complete list of who worked for it and in what capacity, adding that the lines of responsibility were unclear.

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So, how did the VC firms and other so-called sophisticated investors not see this coming? What little they have said leaves more questions than answers. Top partners at Sequoia, the most storied of all VC firms for seeding companies such as Apple Inc., Google, Cisco Systems Inc. and Airbnb Inc. since its founding in 1972, have defended the due diligence on their $214 million investment in FTX and related entities. They told investors on a recent conference call that staff reviewed financial statements and asked multiple times about the relationship between FTX and Alameda Research, a trading firm that Bankman-Fried also founded and which reportedly borrowed and lost FTX customers’ money. In the future, they assured investors, Sequoia might push startups to use Big Four accounting firms.

Wait! Sequoia invested in a company at a $30 billion plus valuation and it didn’t require the company’s financials to be vetted by a reputable accounting firm? Let that sink in. As for the allegation FTX funds were being used to finance Alameda’s activities, the Sequoia partners said they were assured that wasn’t happening and the two were separate entities. Again, even a cursory audit by any licensed accounting firm, let alone one of the Big Four, would have found otherwise.

It’s not as if there weren’t any red flags, as my Bloomberg News colleague Layan Odeh reported. The potential for conflicts of interest between FTX and Bankman-Fried’s Alameda, and the lack of a proper board of directors were only the most obvious. The Ontario pension fund for teachers, which wrote down its $95 million investment in FTX, called its due diligence “robust” and said that “no due diligence process can uncover all risks especially in the context of an emerging technology business.” True, but the effort can’t just entail asking a question and then taking the founder at his or her word. Trust but verify. Even a basic amount of scrutiny would have exposed blatant shortcomings in how FTX operated.

The obvious question is if they missed the red flags at FTX, what else are they missing? It’s a fair question to ask. As much as anyone, the private capital industry has been a prime beneficiary of an easy money era. Funds have been inundated with more cash than they can deploy, breeding complacency, which then fueled bets on dicey start-ups that would have gone wanting in a “normal” era.

The best form of accountability is the market. VC firms that lost client money on FTX should be required to make an exceptional case for fresh inflows — even mighty Sequoia. That means demonstrating specific and robust processes for due diligence that go beyond a partner’s gut feeling after becoming starstruck by an entrepreneur or idea. Insisting that every VC investment be subject to some tire-kicking by an independent consultancy that has to vouch for its work, much like a public company CEO or an auditing firm has to vouch for reported financial results, would be a good start.

And how about charging the due diligence provider’s fee separately to the end investor, to make it clear who the firm is meant to be serving? (Bloomberg News reported that Bankman-Fried’s oversight of a vast web of FTX-linked entities was one of the risks highlighted during the due diligence Bain & Co. conducted for Tiger Global, but the money manager still believed it was a sound investment at the time.)

Of course, not every start-up will succeed. For every Apple there’s a Pets.com. But there’s a difference between a start-up failing because of changing market conditions or old-fashioned tough luck, and failing due to appalling governance, like we have seen with FTX. You can’t beat up VC firms for the former, but you certainly should for the latter. And the ones that suffer are not just the wealthy who invest with VC firms, but retirees and regular workers who participate in the pension plans that provide funding to VC firms.

VC firms weren’t directly responsible for FTX’s collapse, but they certainly share the blame.

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First Published Date: 06 Dec, 01:55 IST
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