Rohit Krishnan is a former hedge fund manager. Both he and Noah Smith are now mainly-economics commentators, and have been good guides to the FTX crash on Twitter.
I found this short piece very helpful in getting a sense of how big the screw-up was by the investors in FTX.
It opens like this:
We live in the golden age of technology fraud. When Theranos exploded, there was much hemming and hawing amongst the investing circles, mostly to note that the smart money on Sand Hill Road were not amongst those who lost their shirts. When WeWork put out its absolute sham of an IPO prospectus before getting cut by 80%, most folks said hey, it’s only the vision fund that was lacking vision.
But now there’s a third head on that mountain, and it’s the biggest. Theranos only burned $700 million of investors' money. Neumann at WeWork supposedly burned around $4 Billion, but that was mostly from Softbank. FTX puts these to shame, incinerating at least $2 Billion of investors' money and another $6-8 Billion of customers’ money in mere hours. Soon to be legendary, worse than Enron and faster than Lehman, there is the singular fraud of FTX and its CEO Sam Bankman-Fried.
But unlike those other crashes, this seems like it might take down multiple other firms, and create a 2008 moment for crypto, which used to be a $2 Trillion asset class. More importantly, to figure out how we can stop something like this from happening. Not fraud, since that’s part of the human OS, but at least having the smartest money around the table getting bamboozled by tousled hair and cargo shorts.
The part that I found the most illuminating was this section on 'Dumb Enron' and some of the specific mistakes made by big investors like Temasek and Sequoia.
I. The problem: this is Dumb Enron
Temasek, not known to be a gunslinger in the venture world, released a statement after they lost $275 million with FTX. It’s carefully written and well worded, and is rather circumspect about what actually went wrong.
They mention how their exposure was tiny (0.09% of AUM) and that they did extensive due diligence which took approximately 8 months, audited financial statements, and undertook regulatory risk assessments.
But the most interesting part is here:
As we only had a ~1% stake in FTX, we did not have a board seat. However, we take corporate governance seriously, engage the boards and management of our investee companies regularly and hold them accountable for the activities of their companies.
Sequoia, when it lost $214 million across a couple of funds, also mentioned in their letter to LPs they did “extensive research and thorough due diligence”. A week later they apologized to the LPs on a call and said they'll do better, by maybe using the Big 4 to audit all startups. I suspect this is hyperbole because otherwise this is medicine sillier than the disease.
These are not isolated errors in judgement though. The list of investors in FTX is a who’s who of the investing world - Sequoia, Paradigm, Thoma Bravo, Multicoin, Softbank, Temasek, Lux, Insight, Tiger Global.
Doug Leone made the reasonable point that I made above, that VCs don’t really do forensic accounting. They got some audited financials, and it looked good, but it's a snapshot at the end of a quarter, so why would they know shenanigans had taken place!
But honestly, if VCs had been snookered by Theranos, that would make more sense. Like what do VCs know about how much blood is needed to test something? Sure it doesn’t quite sound right (100s of tests from a single drop of blood!) and there were people saying this is impossible, but they say that kind of thing about everything! And Holmes’ professor from Stanford was on the Board! That would’ve been a good reason to lose money, and Sequoia’s letter would be 100% on point.
But an exchange? That’s not an unknown business model. Frankfurt exchange has been running for over 4 centuries. We know how this works. We know how brokerage works. When Matt Levine writes about how this is insane, he doesn’t need to, like, study up on esoteric secrets of cryptography. Whether you’re trading baseball cards or stocks or currencies or crypto, a margin loan is a margin loan and a fee is a fee.
What they should have known however are the basic red flags - does this $25 Billion company, going on a trillion by all accounts, have an actual accountant? Is there an actual management team in place? Do they have, like, a back office? Do they know how many employees they have? Do they engage professional services like lawyers to figure out how to construct the corporate structure maze? Do they routinely lend hundreds of millions of dollars to the CEO?
Sure Temasek didn’t get a Board seat, but did they know there was no Board at all? Or how exactly Alameda and FTX were intertwined, if not all the other 130 entities? It seems sensible to ask these things, even if you’re only risking 0.09% of your capital.
These are hardly deep detailed insane questions you skip in order to close the deal faster. Speaking as someone who’s lost deals because of that kind of silliness, this is a whole another level. I’ve had investments where we ask the company to get an audit done as part of the round requirements, and that’s at 1/10th the size! The answer to most of these combined will take like half an hour max.
This isn’t Enron, where you had extremely smart folk hide beautifully constructed fictions in their publicly released financial statements. This is Dumb Enron, where someone “trust me bro”-ed their way to a $32 Billion valuation.