FTX & Stewardship
I wasn’t planning on writing a blog post about FTX or SBF, because I don’t do anything with crypto at Verbatim, and frankly, I didn’t think any of my clients would really know or care what those initials even stood for before last week. The story keeps growing, with each revelation seeming crazier than the last. This Financial Times piece hits the highlights.
The thing that pushed me to share some thoughts is really the surprise that so many people seem to have at seeing such big name investors, and therefore, their clients, having been swindled by Bankman-Fried & FTX. How could this happen? I have thoughts.
If you are a professional investor who handles other people’s money and you think your job is only to maximize returns, you are in the wrong business.
Money managers all disclose the possibility of loss. Those that invest in high risk assets might even highlight the fact that you could lose it all. But let’s be serious for a minute. Whether they admit it or not, most clients don’t just pay fund managers to get a better return, they pay to reduce their chances of losing money. They pay for stewardship. Professional investors who don’t take that responsibility seriously should be in a different business.
Know what you’re investing in. Seems obvious, no? Judging by the performance of many professional fund managers over the decades, sadly, the answer is, “no.” Part of this is due to the pressures of the job. At many shops, the pressure isn’t only to identify the right investments, it’s to make sure clients think they’re not missing out on the next shiny thing, and crypto has been that shiny thing for a while now.
Everyone is under the pressure. That’s the secret. It takes a special manager & special management to allow portfolio managers & analysts to do their jobs. Does that seem strange? The world is a strange place. More money, more strange. Pressure from the top. Pressure from clients. Pressure from sales relationships. As a PM, your best defense is your process, and your process had better include real due diligence.
Due diligence is where institutional investors really do have an advantage over individuals, no matter how smart, and if your investment manager is not making use of their greatest strength, that’s a problem.
Due diligence. Even the best individual investor, who’s spent hours or years reading as many books & blogs as humanly possible, will simply not have the resources that institutional investors have to do proper due diligence. All the copies of Graham & Dodd that you can buy won’t give you the ability to call up the investor relations department and schedule a meeting with the C-suite. Getting the meeting is only step one. Due diligence. You have to do it every time. Spoiler alert: it can get boring. You start to think you’re an expert in your sector. “Geeze, why do I have to ask the same questions of the CEO & CFO? Do we have to fly to the middle of nowhere to speak to the folks on the floor?” But you have to just put your nose to the grindstone & dig in. Every time.
Back in the 2000s there was a company called National Century Financial Enterprises (“NCFE”). They were based in Dublin, Ohio, and they securitized healthcare receivables. They were a darling of the asset-backed securitized bond (“ABS”) market, & I managed an ABS portfolio.
As always, we were looking for ways to squeeze extra return out of our AAA holdings, and NCFE triple-A bonds offered a yield premium. But why? Triple-A bonds receive the highest possible credit rating. Liquidity? Didn’t seem like it. So, credit? But it’s AAA, right? All triple-A’s aren’t created equal, and we were a credit shop, so we decided to dig in. That was when the trouble started.
We requested our sales coverage for the lead investment bank to set up a due diligence call. The call with the C-suite was… interesting. Interesting enough to warrant a trip to Ohio. “Why do you need to go to Ohio? These are AAA bonds!” the bond salesman asked. We were insulting them. But I guess they wanted our money badly enough to have a meeting.
You know where this is going. The balance sheet was… odd. There were entries that didn’t make sense or tie out, and the assertions didn’t help. We chose not to make an investment. There were consequences. My boss got a call from our senior sales coverage. His boss got a call from a senior banker at the lead. We wasted their time. These were triple-A bonds. Who did we think we were!?!
I’m not saying we were brilliant, and the old saying I learned at KPMG, “you can’t audit for fraud,” is true. We just couldn’t, “get there,” and instead of making us feel better, the C-suit made us feel worse.
Stewardship.
We each felt genuinely responsible for our client’s money. They paid us to do exactly this: to dig as deep as we could to identify both good and bad investment opportunities. Sometimes finding the bad ones is more important than finding the good.
I’ll eave some links here. It’s an interesting story. Maybe echoing a bit today? Are the assets even real?
https://asreport.americanbanker.com/news/ncfe-investigated-amid-charges-of-fraud-anonymous-letters-and-lawsuits-allege-non-existent-receivables
Why was my team among the few to identify the problem? https://www.forbes.com/2002/11/21/cz_sl_1121ncfe.html?sh=503feec15caf
What happened to the company leadership?
https://www.justice.gov/opa/pr/former-national-century-financial-enterprises-ceo-sentenced-30-years-prison-co-owner
In fairness, it takes a while to internalize this concept of stewardship. Surprised again? You shouldn’t be. We’re trained from children to try to win, to, “outperform.” Don’t believe the, “everyone gets a trophy,” hype. From Little League to spelling bees to getting in to college, it’s all a competition. So why should any of us be surprised when we carry that desire to win into the business world. Maybe that’s ok or even good in many businesses, but when it comes to investing, that desire to win needs to be tempered with the need to protect.
When the coach of our favorite team looks like he’s playing to tie, and not to win, we yell at the screen. I’d suggest that we should root for our financial advisors and investment managers to play for the tie more often.
