The Dangers of Piggyback Riding

When we’re young, it’s common for friends to jump on each other’s backs or shoulders and get a piggyback ride. These are heaps of fun until the first time we crack our head on the monkey bars or a tree branch. After that, we give the environment in which we try piggyback riding much more thought.

As many strong voices in finance, investment, and due diligence try to dissect the implosion of the cryptocurrency exchange FTX, we keep nodding our heads at a common question: How did reputable FTX backers miss the warning signs? This query leads to a simple and distinct conclusion for due diligence professionals and their stakeholders: beware ‘piggybacking’ due diligence, or one may end up hitting proverbial monkey bars like the fraught crypto exchange.

What is Piggybacking?

In the alternative investment field, prospective investor firms may look over a myriad of standard items: financial statement trends, auditor quality and opinion, capacity of employees to cover necessary duties, asset modeling, underwriting, and many others. Among these items is quality peer reviews.

Firms often look to see whether an asset or investment program has passed the investment committees of asset class leaders they believe to have significant weight and expertise. If so, a firm may have an increased comfort level if or when the same program reaches their investment committee. Executives may press certain issues with less fervor, essentially piggybacking off the due diligence of the asset class leaders, however intentionally or unintentionally. As the FTX case proved, this can incur significant risk. 

The FTX Case

Sequoia Capital has been a standout name among venture capital firms for nearly 50 years, having managed 34 funds, over 359 portfolio company exits[1], and an adviser entity overseeing over $80 billion as of early 2022[2]. The firm has had some of the highest profile successes in Silicon Valley: Apple, Cisco, Google, LinkedIn, WhatsApp, and Zoom, among several other sizable names[3]. By most measures, this can be viewed as one of most successful track records in venture capital and could reasonably denote a substantial expertise of underwriting and monitoring to investors.

In July 2021, one of Sequoia’s funds invested $150 million into FTX entities during a Series B funding round, and another Sequoia fund separately invested $63.5 million[4]. And they were not the only ones. About 80 firms participated in funding FTX with nearly $2 billion in a two-year period, including Softbank, Temasek, and Paradigm[5]. During the process, Sequoia decided to forgo some of its standard due diligence controls for investments of this size, including external board oversight[6].  The firms would go on to miss a myriad of flags.

Flags

FTX had a definitive conflict of interest with its leadership owning and running a hedge fund engaged in crypto trading (Alamaeda Research). In fact, FTX founder Sam Bankman-Fried indicated he had started FTX to help fix difficulties that Alamaeda was experiencing[7]. Additionally, FTX embraced significant leverage and loaned money to Alameda[8].
FTX featured a small staff and young executives[9], despite running something as complicated as an exchange in a growing, but fledgling asset type. FTX maintained an employee count of several hundred, while its competitor Coinbase hired thousands[10]. At the same time, FTX had no real human resources department[11] and exhibited a disparate and complex organizational structure[12].

After the failure of FTX, the replacement CEO brought in as part of the bankruptcy process stated that he hadn’t observed “such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” His immediate remedy actions began with the establishment of controls for “accounting, audit, cash management, cybersecurity, human resources, risk management, data protection, and other systems that did not exist, or did not exist to an appropriate degree prior to my appointment.” The new CEO, John Ray III, oversaw the Enron bankruptcy and has about 4 decades’ experience in the field.[13]

Meanwhile, Sequoia had refrained from contacting the exchange’s founder for updates, and he had been known to play video games on investor update calls. A partner quote from a self-published Sequoia article read: “Embarrassingly, we had never tried to reach out to Sam, because we figured he didn’t need us. I thought they were just minting money and had absolutely no need for investors.”[14] 

Signals

As a trained due diligence professional makes their way through the (inexhaustive) catalog of flags above, the professional can easily surmise that a number of the flags above would have come to the fore during basic steps of their own process. Yet, one of the top VC firms in the world missed nearly all, if not all of them.

While the FTX position ultimately represented a small percentage of the funds in which it was held, Sequoia eventually wrote its entire $214 million exposure down to zero[15]--a complete loss on the position. Such a large process failure sends a signal. And there are few stronger signals that investors and investment firms should beware piggybacking. Rather, they might consider hiring strong due diligence professionals and keenly examining their independent analyses, even when preeminent asset class leaders back a popular investment. Monkey bars hurt.

About Buttonwood

Now in our 20th year, Buttonwood Due Diligence is a leading provider of research, education and due diligence support to the Broker Dealer, Registered Investment Advisor, and Family Office communities. Our knowledge and insight into the alternative investment industry is backed by decades of experience and credentialed analysts including MBAs, CPAs, CAIAs, and JDs.

Buttonwood provides a wide range of fully customizable services including:

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Source List/Endnotes