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The Lion's Den Vol. 10 - A Concoction of Shrewdness, Maliciousness and FOMO
FTX's collapse is not that different than other historical debacles and yet everyone seems amazed. Pattern recognition is not just about finding winners, it's also about avoiding potholes
When I first set out to write The Lion’s Den my goal was 10 writeups and here we are at #10 - appreciate all the responses, emails and comments!
About a month ago I finished reading “Smartest Guys in the Room”, a really well-told chronicle of Enron’s rapid ascent to becoming one of the world’s most valuable companies and its even faster implosion. As I was reading it, I couldn’t help thinking “hey, some of this sh@# (ehm…stuff) still happens. I’ve seen it”. And then a week later, FTX happened…
Rather than regurgitating what exactly happened at FTX (plenty of sources for that out there. I personally liked Coinbase’s Brian Armstrong’s simple summary in the All-In podcast), I find it more interesting to draw parallels between FTX and Enron and think about pattern recognition for these types of events. Let’s Go!
The Common Denominators
There were several catalysts to the Enron catastrophe that, to some extent, are still prevalent today and definitely relevant in FTX. I broadly categorize them as:
Accounting “games” - At a high level, there were 3 main areas of accounting games at play for Enron:
Intentional conflation between non-recurring and recurring events. There’s a pretty cut-and-dry approach to one-time events. They should be reported as such and certain financials need to be showcased as adjusted for those non-recurring events. Enron reported many one-time events as recurring, grossly misleading investors. Not as relevant for FTX.
Mark-to-market accounting. As opposed to the conservative cost-accounting approach (i.e. an asset is worth what I paid for it until I sell it), mark-to-market allows companies to determine the fair value of an asset from time to time and recognize gains if it appreciates in value. Enron regularly abused this method to record fake profits and achieve EPS targets to meet wall st. expectations. This wasn’t exactly the case at FTX, but there are parallels. FTX controlled the quantity and price of its own token, FTT, and essentially determined the asset’s value by controlling the supply and demand and profited by trading the token through Alameda, its affiliated hedge fund.
SPVs backed by Enron’s stock. To avoid borrowing using debt on its balance sheet, Enron set up SPVs (that allegedly it did not fully fund and control - turns out it did), contributed its own stock as the main asset to those vehicles and went out to banks to get leverage with the Enron stock as security. As long as the stock value remained steady or increased, the company could issue stock when the loan came due to repay the debt. However, when the stock value plummeted, a death spiral began since Enron never had anywhere close to the cash necessary to cover its debt. This backward structure obviously created all the wrong incentives for Enron’s executives to do whatever it took to get the stock price to go up. Again, there are parallels to FTX. When the FTT token became worthless after Binance started dumping its holdings, a downward spiral began making FTX insolvent almost immediately. That’s also when SBF likely crossed the “fraud line” by using FTX customer accounts to lend money to Alameda in order to bolster FTT to no avail, which is seemingly how he lost billions for FTX customers.
The grey zone for these things is still pretty broad. One recent example of a funky “side entity” that comes to mind is WeWork and ARK. The company set out to raise billions of dollars from third parties (mostly real estate LPs) for ARK, a real estate fund that would be controlled and managed by WeWork and that would use investor funds to purchase real estate with the goal of leasing them to…WeWork. So while ARK was supposedly incentivized to get the highest-paying lessee, WeWork (which controls ARK) was supposedly incentivized to get the lowest-priced deals from the lessor. Needless to say WeWork and ARK had different sets of investors so the conflict of interest was glaringly clear.
Bear-hugging service providers - Enron was a huge fee-payer to management consultants, bankers and auditors. To work with Enron meant that you had to play along or be shamefully discarded. It meant that banks HAD to lend to Enron for its SPVs if it wanted to get any M&A fees. It meant accountants at Arthur Andersen HAD to find accounting loopholes or look the other way because Enron was by far its largest client. I know what some of you must think - it sounds ridiculous that smart professionals at these firms would go along with these shenanigans, but as a banker, I’ve seen it happen first hand. It’s unclear to me if FTX and its affiliates were properly audited and by who, but it wouldn’t come as a shock if it turns out the gatekeepers were looking the other way. These “star companies” create the ultimate bear hug. On one hand, their embrace creates the potential to earn tens of millions in fees, but on the other hand, imagine getting hugged by angry bear…
Loose governance & bad diligence - Enron was essentially a monarchy with nonexistent controls. Even though it was a public company, its two key executives, Ken Lay and Jeff Skilling, had a tight grip on information, controlled the board and created incentives to keep everyone aligned. Skilling and his minions were sharp, meticulous and conniving and made it uncomfortable to ask “stupid questions”, which caused a lot of smart employees, accountants, bankers, research analysts and investors to either not ask questions or get comfortable with murky answers. What happened at FTX from that perspective is just mind-boggling. SBF and his team were reluctant to share information or answer questions and still managed to raise hundreds of millions of dollars from so many tier 1 investment firms. This was the ultimate group think, bad diligence campaign. I divide “bad diligence” to 3 buckets:
Investors ask the right questions, but miss something important = Quite common and fixable. Investors are paid to take calculated risks and sometime they get it wrong or miss something. This usually leads to important learning and better performance later
Investors know what to ask, but they don’t (FOMO, group think, etc.) = Carelessness. This should raise warning signs about the decision making processes and thoughtfulness applied, especially if the investment amount is material
Investors know what to ask, get an unsatisfactory answer and still push through = Malpractice. This is evidence for poor sense of judgment and lack of fiduciary responsibility
Hard to disagree with anyone saying FTX seems to fall somewhere between #2 and #3…
Stabilizing The Pendulum
I’ve heard a lot of different opinions in the past few weeks about responsibility and blame with the “popular groups” being regulators, media and investors - I’ll focus on the latter for obvious reasons. At the end of the day, there is one party that is (apparently/allegedly) criminally guilty here and that’s FTX and its founder, SBF. BUT, and it’s important BUT, delusional-visionary-out-for-your-money delinquents were always and will always be around and the industry as a whole needs to have better guiderails. This type of event should lead investors to put in place better processes and oversight and inject some healthy fear and skepticism into the system. More broadly, the governance pendulum needs to swing back to normalcy a bit more. Over the past decade, founders have heard from hands-off investors that it’s “all about the founder” and that “the founder is always right”. They’ve gotten accustomed to super voting rights, silent boards and full control, but in reality for every success story there are at least as many companies that have made poor decisions and got obliterated. This is no knock on founders and it certainly doesn’t mean that good investors are the solution of all problems. The point is that balance of power is so important. No one person knows everything and every founder can benefit from helpful guidance and oversight of trusted partners. While events like FTX and Enron are horrible, I do think they help the industry self-correct, progress and gradually create better, stronger companies.
10 posts down, 10 more to go? :)
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