Private investment risks – lessons from FTX
Today I came across an article saying, “smart investors are allocating to private markets for lower risk.” We’d argue that smart investors are cashing out their private investments to invest in discounted listed investments, but the real problem we have with that statement is the idea that private market investments are lower risk because they are marked to model rather than marked to market. This is one of the most profound misconceptions about private markets, but we’ve heard it many times.
It is simply misleading to compare changes in listed market volatility with variations in accounting valuations. We’ve made this point before by comparing accounting book value with market value for the same investments. But another way of looking at it is to look at the fundamental characteristics of the two investment styles and assess the risks qualitatively.
|Characteristic||Public markets||Private markets|
|Business type||Predominantly very large, well established businesses that are leaders in their fields.||Small, young companies that are cashflow negative or loss making (venture capital or growth private equity), highly indebted (buyout private equity), or too risky for banks to lend to (private debt).|
|External scrutiny||Audited accounts (equity) and analyst reports.|
Ratings from independent ratings agency (debt).
Board of directors accountable to shareholders.
|Investors are entirely dependent on the fund manager for information.|
|Information flow||Continuous disclosure requirements; insider trading laws; auditors are accountable to the regulator.||Investors are entirely dependent on the fund manager for information.|
|Alignment||The law generally requires investors to be treated equally. Valuations are set by the prices other investors are willing to pay.||Fund manager collects higher fees if valuations are increased, and so has a disincentive to reduce valuations. Performance fees are assessed on individual investments, not the whole portfolio, and on the internal rate of return, not the cash return to investors. Some vehicles have guaranteed total minimum fees for the fund manager (such as 10 years’ management fees) even if the manager is replaced by the investors.|
Looking at table above, you’d conclude that public businesses are lower risk fundamentally, and have more external checks and balances to give investors protection.
Private markets funds of course talk about their strong risk controls, the lengths that they go to ensure that businesses are sound and investor money is safe. But in public markets we have a wide range of external checkpoints to verify that. In private markets we basically only have the manager’s word for it, and they have obvious incentives to paint a positive picture.
The recent collapse of FTX brings this into sharp focus. Up until quite recently the company was valued at over $30B USD, with over $1.8B invested by a host of big names including Sequoia Capital, Ontario Teachers’ Pension Plan, NEA, Lightspeed Venture Partners, Insight Partners, Temasek, SoftBank Vision Fund, Thoma Bravo, Coinbase Ventures, Ribbit Capital, Multicoin Capital, Paradigm, Altimeter, Steadview Capital, Tiger Global and Insight Partners.
According to the New York Times, investors thought they’d done their due diligence:
Four FTX investors, who declined to be identified, said they were shocked by the company’s sudden collapse. They said they had properly researched the company’s financials, which showed a healthy, growing business that provided an easy-to-use platform for people to buy, sell and store crypto. And they were completely in the dark about FTX’s possible self-dealing with Alameda, they said.Investors Who Put $2 Billion Into FTX Face Scrutiny, Too – The New York Times (nytimes.com)
And yet it now turns out that FTX did not have even the most basic governance or controls. The company did not only not keep adequate records of key decisions, both financial and otherwise, but it deliberately chose to use messaging systems that would delete that information. It did not record its bank accounts. Employees appear to have bought houses for themselves with company money. Company money was mixed with client accounts. Sam Bankman-Fried publicly said that the investors’ financial models were all made up.
The new CEO, who has been brought in to wind up the business, is John J. Ray, who previously dealt with the Enron collapse. His assessment is damning:
“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here,” he wrote.
He said that FTX appeared to be run by a “very small group of inexperienced, unsophisticated and potentially compromised individuals.”
“This situation is unprecedented,” he wrote.FTX says it owes more than $3 billion to creditors – The Washington Post
So clearly the “proper research” that these high profile fund managers did before they committed hundreds of millions of dollars fell very short of the most basic auditing that is required for public companies.
There are probably a host of other private markets fund managers who would be keen to point out that they aren’t like those managers listed above; that they do their research properly and keep investor funds safe. But we, as investors, will never know if that’s true or if it’s marketing. On the other hand, public investments have a wide range of external confirmation points that reduce the risk of governance failures or outright fraud to very low levels. These protections are so strong that many investors use index funds that do not assess the merits of each investment at all, they buy a small piece of what everyone else is buying at the same price that everyone else is paying. Despite the price volatility, we think that’s a much safer bet.
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