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Is due diligence still due diligence?

One of the shared features of the FTX, Theranos, and Madoff disasters — through which a combined $50 billion or so of investors’ money disappeared — is the presence of ultra-sophisticated investors whose due diligence apparently failed to reveal ridiculously visible red flags.

Let’s start with FTX.

Six days after outsider John Ray became CEO of the crumbling FTX empire, he filed a bankruptcy petition that started this way:

Never in my [40-year legal and restructuring] career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.

Ray then cataloged some of the red flags he’d discovered (with his team of forensic experts).

Governance and leadership consisted of a “very small group of inexperienced, unsophisticated and potentially compromised individuals.” FTX lacked controls over cash and disbursements. There was no list of bank accounts. Ray couldn’t identify all job holders or functions because FTX “combined employees of various entities and outside contractors, with unclear records and lines of responsibility.”

Those aren’t small problems. They’re massive corporate defects. And yet, a slew of big-name investors apparently missed them all.

As Jason Zweig said Friday in the Wall Street Journal, “Despite their vaunted investing expertise, these firms all missed the many red flags fluttering high above FTX. And seldom in financial history have red flags been redder than this.”

Singapore’s Temasek Holdings Limited — a sovereign wealth fund with at least $500 billion in assets under management — invested $260 million in FTX from October 2021 to January 2022.

Last week, when Temasek wrote off its entire FTX investment, it released a statement that described its due diligence this way:

Similar to all investments, we conducted an extensive due diligence process on FTX, which took approximately 8 months from February to October 2021.

Temasek’s due diligence marathon included gathering “qualitative feedback on the company and management team based on interviews with people familiar with the company, including employees, industry participants, and other investors,” the statement said.

Sequoia Capital, the renowned Menlo Park-based VC with about $85 billion in assets under management, invested $210 million in FTX.

When it wrote off its investment two weeks ago, it said:

We do not take this responsibility [for investing] lightly and do extensive research and thorough diligence on every investment we make. At the time of our investment in FTX, we ran a rigorous diligence process. 

Extensive. Thorough. Rigorous. Really?

Softbank was another FTX investor, along with the Ontario Teachers’ Pension Plan and hedge funds Third Point and Tiger Global. As fiduciaries, wouldn’t all of them have done proper due diligence?

Moving on to Theranos.

Safeway’s CEO said his company performed “at least 100 hours” of due diligence before spending about $400 million on a joint venture with the blood-testing unicorn.

Walgreens invested another $140 million.

Both chains reportedly “consulted experts from Johns Hopkins University and the University of California, San Francisco, who deemed the idea [of Theranos’ blood testing machine] sound, but did not get their hands on the device to test it themselves.”

And yet, a lone reporter from the Wall Street Journal, John Carreyrou, sniffed out fraud at Theranos by reading a glossy magazine and talking on the phone.

Carreyrou, an experienced medical reporter, hadn’t heard of Theranos or founder and CEO Elizabeth Holmes until he read a profile of her in the New Yorker in mid-December 2014. He didn’t understand the secrecy surrounding Theranos’ daily operations or the vague description of its technology.

He later said, “I also was immediately suspicious because this whole conceit at the heart of the story was that she was a college dropout who was revolutionizing this very technical corner of medicine, namely blood diagnostics. That didn’t seem right to me.”

A few weeks later, Carreyrou heard from a pathologist and expert in blood testing who’d read the New Yorker profile and didn’t believe it. After two and a half more weeks, Carreyrou connected by phone with his first source inside Theranos, lab director Adam Rosendorff, who told Carreyrou the truth.

Carreyrou’s first story about Theranos and its problems appeared in the WSJ in October 2015.

Elizabeth Holmes was sentenced Friday to 11 years and three months in prison for fraud.

Over to Bernie Madoff.

Harry Markopolos, an independent financial fraud investigator for institutional investors and others, said it took him five minutes to know something was very wrong at Bernard L. Madoff Investment Securities LLC.

How did Markopolos uncover the biggest Ponzi scheme in U.S. history? He looked at a readily available performance chart.

“It was a 45-degree angle without any variation,” Markopolos told NPR. “It went in only one direction: up. It never had variation like the market does, like this. And that was the key tip-off.”

The 162-page list of Madoff’s investors includes Spain’s Banco Santander ($3.5 billion invested), Bank Medici of Austria ($2.8 billion invested), Fortis Bank Nederland ($1.35 billion invested), HSBC ($1 billion invested), BNP Paribas ($475 million invested), and Nomura ($358.9 million invested).

It took Markopolos nine years to convince the SEC to act.

Bernie Madoff pleaded guilty to fraud in 2009 and died in prison.

After FTX, Theranos, and Madoff, what should we think when sophisticated investors talk about due diligence?

Do they mean due diligence in the traditional sense: A review or audit undertaken before a financial transaction to determine valuation and assess legal, regulatory, and contractual risks?

Or do they mean something else?

Clearly, every investor I’ve named here can perform effective due diligence. So, what went wrong?

Did the investors do too little due diligence to learn the truth? Or did they do enough to see the red flags but choose to ignore them, risking everything for financial returns that were too good to be true?

Either way, their due diligence wasn’t really due diligence after all.

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