The successful completion of operational due diligence is an essential cornerstone of successful business relationships in the alternatives sector, bringing assurance that your third-party vendor’s will provide a service or function to you seamlessly and at low risk of disruption to that service. As soon as you enter into a service based business partnership with a provider, their financial viability, operational risk and security posture becomes an extension of your own, so you need to make sure you have been clear on your expectations and how the services provided will be measured for success.
The same principle follows for investment opportunities of all types, but perhaps even more for institutional funds being targeted by new enterprises such as crypto. What took place when FTX, founded by young tech entrepreneur, Sam Bankman-Fried, persuaded an array of major investors to part with their money, is testament to the vital importance of thorough ODD.
It has been reported that Bankman-Fried has conceded that “a massive failure of oversight of risk management” had occurred. The Justice Department and the Securities and Exchange Commission (SEC) are now investigating further to see whether FTX improperly used client funds to shore up a separate trading firm, Alameda Research, for which Bankman-Fried was also the founder. What’s clear now is how unlikely the company’s rapid success and failure would have been, if appropriate steps had been taken initially to ensure the company was well-grounded.
The Financial Times has suggested that what happened in this case is part of a gradual lowering of standards of due diligence which began many years ago and which may have started with a change in the approach of VCs looking for gains in Silicon Valley. It suggests that whilst investors acknowledged high risks in the early rounds of new business start-ups requiring a few $ million, they accepted this as a price worth paying for the next big thing to come along. This attitude seeped into later rounds with larger stakes even up into the $ billions. Brooke Masters from the FT explains, “As more apparently successful companies stayed private for longer, investors’ fear of missing out on the next Amazon or Google grew. That left them vulnerable to hucksters.”
Following FTX, BlockFi, another crypto trading platform, has filed for bankruptcy and Elizabeth Holmes, founder of so-called blood-testing company, Theranos, has just been found guilty of investment fraud.
In an article questioning what happened to ODD in these cases, the FT concludes that, “The boring process of checking that potential investments can live up to their promises has fallen completely by the wayside.” Meeting the people, witnessing the work, and seeing evidence of performance is the only real way to truly know a company is what it says it is. Any firm that does not carry out proper due diligence in the old-fashioned, effective sense, does so at their peril. Afterall, prevention is better than cure.
Investors who want to restore standards should start with the financials