Dec 1, 2022·edited Dec 1, 2022Liked by Arnold Kling
It would be interesting to know how many "VC"s were presented with this investment opportunity, but after due diligence and consideration, declined to do so.
When I worked in the legal & compliance dept. of a nationally-known mutual fund management company, I attended frequent meetings of its private equity investment committee. Audited (required) financial reports were scrutinized, management decisions were noted & discussed, results measured against expectations, ratios of PE investment to total portfolio assets were monitored. ...and more that I can't remember now, after many years. Yes, they wanted to be in on the "next new thing," but did not proceed with blind optimism.
There was actual accountability, from the initial investment proposal to the committee, to the positive (or negative) investment termination.
The VC/private equity investment community plays a vital role in the commercial development and success of many new business opportunities (and remember, even investment dead ends are teachable moments in the evolution of an innovative product.)
Einstein undoubtedly had intelligence and intellect the size of Planet Earth, but he would not be (if he were still alive) my first stop for neurosurgery or for that matter to fix an oil leak in my car. Because Job and Bezos are good at what they do, it doesn’t mean they are good at anything else. Unfortunately many ‘smart’ people do not understand/accept that and so entirely convinced of their omniscience and genius, do mesmerisingly dumb things.
Telling the difference between Amazon and FTX when you are in a bubble is difficult, but it is incredibly easy to tell the difference after the bubbles burst. Just wait, Amazon dropped by 95%, but survived, FTX dropped and it was immediately revealed that they were a fraud. You could have waited a month after the crash in 01', or two months, or a year or 3 years and still gotten a good deal on Amazon. All you have to do with frauds is wait for a market shake out to see what is a real business and what is a bad business/fraud.
This is why we NEED a business cycle, and the Fed trying to reduce recessions makes them worse.
Looking at Amazon vs Sears vs Wal-Mart is maybe more illuminating though Sears catalog business was already on the decline when Amazon was rising. Amazon was going to have to master logistics regardless. Wal-Mart would have needed not just a website but the entire infrastructure to support mail-order processing which Sears had been running for a century in addition to their stores. They almost literally would have just had to put their catalog on the Web to compete with Amazon and yet didn't do it. Sears wound up getting hit from both sides as Wal-Mart took away their brick-and-mortar business as Amazon went after mail-order. That's probably a flag that looking at the 'vetocracy' of path dependence and "we've always done it this way" is a good way to judge.
Yes, the business press and media generally carry some blame here, but my experience with the media is that they do not understand the topics they cover in any deep way. The #1 “villains” in this story are lenders. FTX/Alameda had a lot of leverage which allowed them to inflate the size of this catastrophe. Lenders as villains here fall into two categories:
1. Those who lent to FTX/Alameda without proper due diligence. The thing that brought down this house of cards was simply publishing their balance sheet. Can the diligence be anymore basic? These lenders neglected their fiduciary responsibilities- in the process losing their own firm’s/client’s funds AND enabling a much larger loss of public funds in the process.
2. Those who were asked, didn’t lend, and didn’t shout from the mountain tops “this looks like a total scam/tower of incompetence!!” There is a duty to the broader market to call bullshit. If enough well respected players had done this, the media likely would have had more signal to dig deep, celebrities would have been more reticent to endorse, politicians would have had a higher cost of taking their bribes, etc…. This lack of feedback gave oxygen to the fire. Evil flourishes when good men do nothing,…
I see no incentives for an auditor who has discovered something rotten in a due diligence process to broadcast that information. Moreover, libel laws, the high cost of being sued in many countries, and a dominant business culture that values cheerful demeanor over truth (for instance, say nothing unless you have something positive to say) create negative incentives. Such information is valuable to society but we don't have mechanisms at the moment to compensate persons who find such information for the negative effects accruing to them for making the information more widely known.
I think a big problem with people missing what was actually going on at Alameda and FTX, was that they thought they knew the scam and stopped looking deeper. FTX was convincing retail investors and unsophisticated institutional investors to start trading in crypto and then take a small fee for every transaction.
This was like a casino or a MLM business then. Kind of unethical, but not illegal.
So the fact that they were not actually earning all the money they were spending, but rather stealing it (or borrowing it against unserious assets), was not considered.
“Stopped looking at layer 1 of the scam” is a great way to think about this. If you see a rat in your house, there’s more than one…. We have a joke in my family where whenever we see a car driving erratically, we say “look for the dents”. 9 times out of 10, there is clear evidence that this isn’t the first time…
A venture fund basically runs a statistical business: 2 out of 10 investments will succeed and pay-out for the 8 that will go sour. However, the fact that 8 will go bust doesn't exempt an investor from running a proper due diligence and making sure that as a company transitions from a start up to a scale up the governance and the proper checks and balances are in place.
“It’s a [ponzi scheme] during a [ponzi scheme] boom and insane [investor ignorance].”
There is a fascinating article preserved on the web detailing Sequoia’s investment in FTX. At one point it describes Sam Bankman-Fried as giving what is clearly a B.S. answer to a question from a Sequoia partner while he was playing video games. The described internal chat reactions are pure gold.
And that was their due diligence for a $100+ million dollar investment?
This looked like gross negligence by venture funds and wasn’t merely a failure of the press.
Rohit is way off base to suggest venture capital funds would make this same call every time.
"It’s hard to see SBF in a clear light. The glitter of the self-made billions are blinding. His intellect is as awesome as it is intimidating." Oh, yeah, I can see why Sequoia deleted it.
I'm not so sure that it's reasonable to have expected anyone to have spotted the _particular_ fraud that 'FTX+' turned out to be.
'FTX' still seems to me to have been (and still be) a reasonable, if more modest, business. Them not having basically any bookkeeping/accounting seems hard to spot from the outside, and also unlikely to expect otherwise.
If SBF had allowed Alameda to go bankrupt, and even if that had caused 'FTX' to go bankrupt as a consequence, then – _without_ all of the other extraordinary malfeasance/negligence/incompetence – I'd guess I and many others would just think of that as a fairly 'normal' business failure.
Your statement: "I mostly blame other institutions for not acting as a check on SBF." implies someone could have provided a check. Other than shorting, which entails a huge down side risk, it is difficult to make a profit exposing frauds and over-hyped nonsense. My son, Dr. Nicholas Weaver, was claiming nonsense from the start, but as a computer nerd, his well-considered views had much less clout than, alas, they should have. https://www.youtube.com/watch?v=abcKL_x_aoA
The modern VC game is essentially a species of Ponzi scheme in which the investors are participants rather than dupes. Most VCs couldn't care less if a startup is ultimately profitable. What they care about is whether the startup can sustain a promising growth picture just long enough to reach the VC's predetermined offramp. Seeds are looking at getting to A at a minimum, A is looking at B, and so on. If the ride lasts longer, great. I've interviewed with scores of early-stage startups and a shared theme among all is "What's your path to the next round?" Very few give a shit about anything beyond 3-5 years.
The late/big round guys have a similar mindset, just on a grander scale. Their offramp is the IPO. Investors will keep piling on so long as they think the startup can convince downstream investors that there is still juice left to squeeze, even if that investor is John Q. Public. Therefore, the primary VC investment criterion is not "is this growth sustainable?" or "can this company ever become profitable?", but rather "can we maintain this facade until I reach my ramp?"
While you’re absolutely right that VCs are (perhaps rightly) more focused on the potential upside than the risks, I imagine they would still pay at least a minimum amount of attention to the risks and take at least some small steps to protect their investment. What’s suspicious about the FTX case is not that the VCs took a flyer on SBF, it’s that they seem to have avoided looking too deeply into how their investment was being used. For example, Sequoia Capital invested over $200 million in FTX, which I believe was one of the largest single investments they had. In such cases, Sequoia would typically require a seat on the company’s board, but not only does it appear that this didn’t happen here, it seems they were OK with a board composed of Bankman-Fried and two lieutenants. Furthermore, not long after Sequoia invested $200 million in FTX, Bankman-Fried personally invested at least $200 million in Sequoia funds. Surely that should have led them to raise questions, no?
I agree that vetocracy is ascendant. Thus the chief risk to most big businesses is the “disruption risk”. That is, some competitor will figure out how to steal the core business model while management studiously avoids risk.
It would be interesting to know how many "VC"s were presented with this investment opportunity, but after due diligence and consideration, declined to do so.
When I worked in the legal & compliance dept. of a nationally-known mutual fund management company, I attended frequent meetings of its private equity investment committee. Audited (required) financial reports were scrutinized, management decisions were noted & discussed, results measured against expectations, ratios of PE investment to total portfolio assets were monitored. ...and more that I can't remember now, after many years. Yes, they wanted to be in on the "next new thing," but did not proceed with blind optimism.
There was actual accountability, from the initial investment proposal to the committee, to the positive (or negative) investment termination.
The VC/private equity investment community plays a vital role in the commercial development and success of many new business opportunities (and remember, even investment dead ends are teachable moments in the evolution of an innovative product.)
Einstein undoubtedly had intelligence and intellect the size of Planet Earth, but he would not be (if he were still alive) my first stop for neurosurgery or for that matter to fix an oil leak in my car. Because Job and Bezos are good at what they do, it doesn’t mean they are good at anything else. Unfortunately many ‘smart’ people do not understand/accept that and so entirely convinced of their omniscience and genius, do mesmerisingly dumb things.
Telling the difference between Amazon and FTX when you are in a bubble is difficult, but it is incredibly easy to tell the difference after the bubbles burst. Just wait, Amazon dropped by 95%, but survived, FTX dropped and it was immediately revealed that they were a fraud. You could have waited a month after the crash in 01', or two months, or a year or 3 years and still gotten a good deal on Amazon. All you have to do with frauds is wait for a market shake out to see what is a real business and what is a bad business/fraud.
This is why we NEED a business cycle, and the Fed trying to reduce recessions makes them worse.
Looking at Amazon vs Sears vs Wal-Mart is maybe more illuminating though Sears catalog business was already on the decline when Amazon was rising. Amazon was going to have to master logistics regardless. Wal-Mart would have needed not just a website but the entire infrastructure to support mail-order processing which Sears had been running for a century in addition to their stores. They almost literally would have just had to put their catalog on the Web to compete with Amazon and yet didn't do it. Sears wound up getting hit from both sides as Wal-Mart took away their brick-and-mortar business as Amazon went after mail-order. That's probably a flag that looking at the 'vetocracy' of path dependence and "we've always done it this way" is a good way to judge.
Yes, the business press and media generally carry some blame here, but my experience with the media is that they do not understand the topics they cover in any deep way. The #1 “villains” in this story are lenders. FTX/Alameda had a lot of leverage which allowed them to inflate the size of this catastrophe. Lenders as villains here fall into two categories:
1. Those who lent to FTX/Alameda without proper due diligence. The thing that brought down this house of cards was simply publishing their balance sheet. Can the diligence be anymore basic? These lenders neglected their fiduciary responsibilities- in the process losing their own firm’s/client’s funds AND enabling a much larger loss of public funds in the process.
2. Those who were asked, didn’t lend, and didn’t shout from the mountain tops “this looks like a total scam/tower of incompetence!!” There is a duty to the broader market to call bullshit. If enough well respected players had done this, the media likely would have had more signal to dig deep, celebrities would have been more reticent to endorse, politicians would have had a higher cost of taking their bribes, etc…. This lack of feedback gave oxygen to the fire. Evil flourishes when good men do nothing,…
I see no incentives for an auditor who has discovered something rotten in a due diligence process to broadcast that information. Moreover, libel laws, the high cost of being sued in many countries, and a dominant business culture that values cheerful demeanor over truth (for instance, say nothing unless you have something positive to say) create negative incentives. Such information is valuable to society but we don't have mechanisms at the moment to compensate persons who find such information for the negative effects accruing to them for making the information more widely known.
I think a big problem with people missing what was actually going on at Alameda and FTX, was that they thought they knew the scam and stopped looking deeper. FTX was convincing retail investors and unsophisticated institutional investors to start trading in crypto and then take a small fee for every transaction.
This was like a casino or a MLM business then. Kind of unethical, but not illegal.
So the fact that they were not actually earning all the money they were spending, but rather stealing it (or borrowing it against unserious assets), was not considered.
“Stopped looking at layer 1 of the scam” is a great way to think about this. If you see a rat in your house, there’s more than one…. We have a joke in my family where whenever we see a car driving erratically, we say “look for the dents”. 9 times out of 10, there is clear evidence that this isn’t the first time…
A venture fund basically runs a statistical business: 2 out of 10 investments will succeed and pay-out for the 8 that will go sour. However, the fact that 8 will go bust doesn't exempt an investor from running a proper due diligence and making sure that as a company transitions from a start up to a scale up the governance and the proper checks and balances are in place.
“It’s a [ponzi scheme] during a [ponzi scheme] boom and insane [investor ignorance].”
There is a fascinating article preserved on the web detailing Sequoia’s investment in FTX. At one point it describes Sam Bankman-Fried as giving what is clearly a B.S. answer to a question from a Sequoia partner while he was playing video games. The described internal chat reactions are pure gold.
And that was their due diligence for a $100+ million dollar investment?
This looked like gross negligence by venture funds and wasn’t merely a failure of the press.
Rohit is way off base to suggest venture capital funds would make this same call every time.
I believe the article you're referring to can be found here:
https://web.archive.org/web/20221109230422/https://www.sequoiacap.com/article/sam-bankman-fried-spotlight/
And I loved it, thanks for the pointer.
"It’s hard to see SBF in a clear light. The glitter of the self-made billions are blinding. His intellect is as awesome as it is intimidating." Oh, yeah, I can see why Sequoia deleted it.
I'm not so sure that it's reasonable to have expected anyone to have spotted the _particular_ fraud that 'FTX+' turned out to be.
'FTX' still seems to me to have been (and still be) a reasonable, if more modest, business. Them not having basically any bookkeeping/accounting seems hard to spot from the outside, and also unlikely to expect otherwise.
If SBF had allowed Alameda to go bankrupt, and even if that had caused 'FTX' to go bankrupt as a consequence, then – _without_ all of the other extraordinary malfeasance/negligence/incompetence – I'd guess I and many others would just think of that as a fairly 'normal' business failure.
Your statement: "I mostly blame other institutions for not acting as a check on SBF." implies someone could have provided a check. Other than shorting, which entails a huge down side risk, it is difficult to make a profit exposing frauds and over-hyped nonsense. My son, Dr. Nicholas Weaver, was claiming nonsense from the start, but as a computer nerd, his well-considered views had much less clout than, alas, they should have. https://www.youtube.com/watch?v=abcKL_x_aoA
The modern VC game is essentially a species of Ponzi scheme in which the investors are participants rather than dupes. Most VCs couldn't care less if a startup is ultimately profitable. What they care about is whether the startup can sustain a promising growth picture just long enough to reach the VC's predetermined offramp. Seeds are looking at getting to A at a minimum, A is looking at B, and so on. If the ride lasts longer, great. I've interviewed with scores of early-stage startups and a shared theme among all is "What's your path to the next round?" Very few give a shit about anything beyond 3-5 years.
The late/big round guys have a similar mindset, just on a grander scale. Their offramp is the IPO. Investors will keep piling on so long as they think the startup can convince downstream investors that there is still juice left to squeeze, even if that investor is John Q. Public. Therefore, the primary VC investment criterion is not "is this growth sustainable?" or "can this company ever become profitable?", but rather "can we maintain this facade until I reach my ramp?"
While you’re absolutely right that VCs are (perhaps rightly) more focused on the potential upside than the risks, I imagine they would still pay at least a minimum amount of attention to the risks and take at least some small steps to protect their investment. What’s suspicious about the FTX case is not that the VCs took a flyer on SBF, it’s that they seem to have avoided looking too deeply into how their investment was being used. For example, Sequoia Capital invested over $200 million in FTX, which I believe was one of the largest single investments they had. In such cases, Sequoia would typically require a seat on the company’s board, but not only does it appear that this didn’t happen here, it seems they were OK with a board composed of Bankman-Fried and two lieutenants. Furthermore, not long after Sequoia invested $200 million in FTX, Bankman-Fried personally invested at least $200 million in Sequoia funds. Surely that should have led them to raise questions, no?
I agree that vetocracy is ascendant. Thus the chief risk to most big businesses is the “disruption risk”. That is, some competitor will figure out how to steal the core business model while management studiously avoids risk.