FTX investors thought they were on a rocket ship to wealth, but the cryptocurrency platform’s spectacular flameout offers a salient reminder of how not to invest in an overhyped market. Impact investors should take note, as a more prudent approach to venture investing can lead to better overall returns.
In one of the biggest financial flameouts in recent memory, FTX is now in bankruptcy and with it, the entire cryptocurrency market is teetering on a knife’s edge. For investors who bought into the hype, FTX’s dramatic collapse is a rude reminder of the perils of venture investing.
Over the last few years, we’ve witnessed a spectacular run-up in venture funding and deal-making, with crypto in particular showing a massive escalation in interest. According to Pitchbook, fintech deals nearly doubled in 2021 from 2020, and as late as Q3 2022 money was still rushing into the space. Deal flow was continuing apace, and valuations remained high even though pricing for venture-backed deals was falling dramatically in other segments.
Cryptocurrency was the darling of fintech investors during this period, and FTX was the belle of the ball. Just a year ago in January 2022, FTX had just closed on a $400 million round of financing despite market headwinds bringing the firm’s valuation to an eye-popping $32 billion, up from $25 billion just a few months earlier in October 2021.
Beware of venture FOMO
I’ve been investing in venture for more than two decades through a number of peaks and valleys. One of the things I’ve seen consistently is that in frothy markets, entrepreneurs in hot sectors start to demand that investors commit really quickly – sometimes in a matter of days.
What happens on the investment side is there starts to be a blind follow. Too many investors, wanting in on all of the opportunity for upside, allow what can only be described as an emotionally driven fear of missing out drive their decision-making. Checks start to get written based on the promise of an investment without putting in the proper due diligence.
FTX is just the example du jour. Theranos is another example of a founder CEO who was able to cast a spell over some very sophisticated investors who let themselves be charmed into abandoning their commitment to prudent investing, which should always start by asking basic questions of a business. The humbled office rental business WeWork is another recent example of this phenomenon.
But even in less extreme cases, the trend in hot venture markets is that we see a ramp-up in valuations — often driven by larger firms who can afford to take a gamble — that are only sustainable until the music stops. The FTX bankruptcy and scandal will be remembered as the day the crypto music died, leaving many investors wondering what happened.
Virtue signaling is not a proxy for prudent investing
It’s not always easy for an investor to know for sure what’s happening behind the scenes of an enterprise. With FTX, CEO and Founder Sam Bankman-Fried was clearly quite excellent at the game of smoke and mirrors.
The pitch was incredibly seductive and had all the hallmarks of a new and better type of capitalism that might just save the world. Bankman-Fried became the poster child for the philosophy of “effective altruism,” donating much of his personal wealth to various causes. FTX created a new foundation, FTX Climate, to focus on getting FTX to the point of being carbon neutral while encouraging and advancing climate initiatives, including committing $1 million to carbon capture initiatives. FTX even went so far as to sign on celebrity supermodel Gisele Bundchen, who has been considered a climate activist and is a UN ambassador and philanthropist, to be the company’s ESG advisor. What’s more, Bankman-Fried advocated quite vocally for increased regulation of the crypto industry.
It was all pretty hard to resist.
Whether it was about donating to support the solar industry in the Amazon River basin or Bankman-Fried insisting that you have to do more than talk the talk with ESG investing, what FTX was selling had a real feel-good quality to it.
What’s clear with perfect hindsight is that while Bankman-Fried used all the right words, they were thoroughly insincere, as he has now acknowledged, and gave air cover to what appears to have been a house of cards.
Virtue-signaling of this kind is terribly unfortunate and complicates the picture for venture investors by borrowing liberally and even cynically from the language of sustainability-based values. Even more unfortunate is that the loose promises only serve to deepen the marketplace’s growing mistrust of firms that promise financial returns alongside important environmental or social outcomes.
Best practices from impact investing can help venture investors be more discerning
As someone who has devoted the last decade of my career to venture investing in the impact investing space, I find this kind of values-signaling particularly egregious and destructive to the important work that the impact investing sector has done and continues to drive forward.
But there’s a lesson for all venture investors in how shrewd impact investors go about discerning whether an investment can deliver measurable impact outcomes. And ultimately, some of these practices can go a long way to helping investors maintain discipline and avoid making FOMO-driven investments justified by an entrepreneur’s virtue signaling. That is because the kinds of questions that you should ask as an impact investor can reveal lots of valuable information about an investment and, in particular, a management team.
For example, whether you’re investing directly into a company or a fund, you should ask how the management team thinks about the impact they are seeking to create. How sophisticated are they when they discuss impact returns? What have they been able to measure? The answers are usually very telling about how they are thinking about social and environmental outcomes. You want to hear them talk about their vision and how they are going about catalyzing systems change.
We find that the ability to cite third-party evidence of impact outcomes is a must-have before proceeding with an investment. We always push a management team to go a layer deeper. It’s not just what they say but how they say it. You want to see them lean into these conversations. How deep can they go? Can they back it up?
There are some wrinkles here too, to be sure. For example, in our experience, some companies that produce strong impact outcomes gloss over the impact side of the equation, focusing much more on the financial returns to counter a widespread (and inaccurate!) belief amongst investors that impact investing equates to concessionary returns. In fact, at Impact Engine, we are committed to investing in funds and businesses that we believe can deliver superior market-rate returns as well as verifiable and very real impact outcomes.
To be clear, I am not suggesting that a company or a fund that produces strong impact returns is a great financial investment. But I do think that there’s a strong argument that taking an impact lens to investing during a frothy market can stress-test a management team and help give investors the intelligence they need to see through smoke and mirrors.
Virtue signaling and true impact are not one and the same; identifying those funds and firms that are walking the walk as well as talking the talk can be an effective due diligence tool. You do not have to sacrifice financial returns to deliver impact. Rather you can deliver superior, risk-adjusted returns alongside deep and quantifiable impact outcomes.
FTX will not be the last seemingly “too good to be true” investment that turns out to be a mirage. But it would behoove venture investors of all stripes to apply some of the due diligence best practices that are being developed in the impact sector to help them avoid getting caught up in the next hype machine.
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