Analysis | FTX has benefited from the suspension of disbelief from venture capitalists.

Opinion

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 business empire, was that it was the result of an elaborate and sinister plan that only unfolded. A series of tragic events. After all, the smartest minds in the financial world have been tapped at Sequoia Capital, Tiger Global Management and the Ontario Teachers’ Pension Plan to name a few.

And that’s exactly what the venture capital and pension funds that seeded FTX would have you believe. No one could have guessed that they were unwitting victims in a fascinating and complex saga. Don’t fall for it. While we still don’t know all the facts, they shouldn’t go unchallenged. Without their continued financial support, stamp of approval and lack of questioning, FTX would never have grown as it has. Their carelessness meant that FTX customers could not recover billions of dollars in outlays.

Interviews given by Bankman-Fried in recent days suggest that FTX’s failure is linked to pure incompetence. This was an organization destined to fail. Exhibit A: In a business where risk management is the No. 1 priority, Bankman-Fried says there is no one in the company now responsible for risk management. “It’s a shame,” he told an audience at the New York Times’ Delbook conference on Wednesday. And that’s not all. FTX seems to be remotely lacking in board and subcommittees as usual. According to Bloomberg News, it is not known how many employees – or even employees – FTX was subject to. In the bankruptcy filing, the court appointed CEO John J. Ray III, FTX, said he was unable to provide a full list of who worked for it and in what capacity, saying the lines of responsibility were not clear.

So, how did VC firms and other so-called sophisticated investors not see this coming? What little they say leaves more questions than answers. In the year Since its founding in 1972, Sequoia Senior Partners, the most storied of all VC firms, has done due diligence on FTX and its $214 million investment in seed companies such as Apple Inc., Google, CCCCS Inc. and Airbnb Inc. Related parties. In a recent conference call, employees told investors that they had reviewed financial statements and that there was a connection between FTX and Alameda Research, which formed Banman-Fried, and that FTX’s customers were borrowing and losing money. They assured future investors, Sequoia could push startups to use the Big Four accounting firms.

keep it up! Sequoia invested in a company with a valuation of $30 billion and didn’t require the company’s financials to be audited by a reputable accounting firm? Let that enter. As for the allegation that FTX funds were being used to finance Alameda’s activities, Sequoia’s partners confirmed that this was not the case and that the two are separate entities. Again, even a Kusori audit by any licensed accounting firm, let alone one of the Big Four, would have been available.

As my Bloomberg News colleague Laian Odeh reports, it’s not like there aren’t any red flags. The conflict of interest between FTX and Bankmann-Fried Alameda and the absence of a proper board of directors was only too obvious. The Ontario Pension Fund, which underwrote its $95 million investment in FTX, called due diligence for teachers “robust,” adding that “no due diligence process can cover all risks, especially in the context of a technology business.” True, but the effort cannot be limited to asking questions and taking the founder at his word. Trust but verify. Even a basic scan would have exposed obvious weaknesses in how FTX works.

The obvious question is, if you miss the red flags on FTX, what else are you missing? It’s a fair question to ask. Like everyone else, the private equity industry has been a major beneficiary of the era of easy money. Funds were flooded with more cash than they could deploy, breeding complacency, which in turn led to increased betting on desirable startups in “normal” times.

The best accountability mechanism is the market. VC firms that lost client money on FTX should be asked to make a special case for new entrants – even the mighty Sequoia. This means demonstrating unique and robust processes for due diligence that go beyond a partner’s gut feeling after an entrepreneur or idea strikes. Requiring each VC investment to undergo some due diligence by an independent consulting firm that vouches for its work, such as verifying the reported financial results of a public company CEO or auditing firm, is a good start. And what about billing the due diligence provider separately to the lead investor to make it clear who the firm is intended to serve? (Bloomberg News reports that Bainman-Fried’s control of a vast web of FTX-related entities was among the risks identified during Bain & Co’s due diligence for Tiger Global, but the fund manager still believes it’s a good investment.)

Of course, every startup fails. For every Apple, there’s a Pets.com. But there is a difference between a startup failure due to changing market conditions or strong opportunities and a failure due to terrible management, as we saw with FTX. You can’t beat VC firms for the former, but you definitely have to for the latter. And it’s not just the wealthy who invest with VC firms who suffer, but retirees and regular workers who participate in pension plans funded by VC firms.

VC firms were not directly responsible for FTX’s failure, but they certainly share the blame.

More from Bloomberg Commentary:

• Miami Crypto House May Fall But It Was Still Valuable: Jonathan Levine.

• FTX is a characteristic of financial innovation, not a bug: Aaron Brown

• SBF would not have happened without the epidemic: Robert Burgess

This column does not necessarily reflect the views of the editorial board or Bloomberg LP and its owners.

Robert Burgess is the editor-in-chief of Bloomberg Opinion. He was previously the global executive editor responsible for financial markets for Bloomberg News.

Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, the Financial Times and The Independent newspaper.

More stories like this can be found at bloomberg.com/opinion

Leave a Comment