When Due Diligence Fails: Cautionary Current Events

With M&A activity likely to increase this year, excellence in due diligence will be critical for sellers and in particular for acquirers. Yet there are at least two recent examples of due diligence disasters – economic Titanics and PR embarrassments – for supposedly sophisticated and super-smart investors.

Most notoriously, the FTX crypto exchange has been exposed as an old-fashioned Ponzi scheme which some top fintech investors lined up for, eager to buy a piece of unlimited upside. Names like Sequoia Capital, SoftBank, Robert Kraft and the Paul Tudor Jones family trusts faced the zeroing out of their investments.

In a September 2022 profile that was taken off Sequoia’s website (after a $200 million write-off), the fan-like adoration of the head of FTX seemed cringe-worthy: “We were incredibly impressed,” said Michelle Bailhe, a Sequoia partner. “It was one of those your-hair-is-blown-back type of meetings.”

“Of the exchanges that we had met and looked at, some of them had regulatory issues, some of them were already public,” Bailhe went on. “And then there was Sam.” The exchange that Sam Bankman-Fried built was “Goldilocks-perfect.” There was no concerted effort to skirt the law, no “Zuckerbergian diktat” to break things, no “waiting to get permission to innovate.”

Charles Wendel of Financial Institutions Consulting

How did the best-in-breed partners respond to the founder who played a video game during the meeting?

“Suddenly, the chat window on Sequoia’s side of the Zoom lights up with partners freaking out.

‘I LOVE THIS FOUNDER,’ typed one partner.

‘I am a 10 out of 10,’ pinged another.

‘YES!!!’ exclaimed a third.”

Goldilocks-perfect, indeed.

Numbers Not There

Then Chase Bank shut down the website of Frank, which according to reports it acquired in 2021 for $175 million. Frank was described as the “fastest-growing college financial planning platform,” used by 5 million students to find various types of aid. Chase found that the actual users numbered 400,000, with the rest allegedly fabricated by a data scientist prior to the sale.

In 2020, Frank had been warned by the Federal Trade Commission that it may have been unlawfully misleading consumers about student COVID relief. In 2018, Frank settled with the Department of Education on an issue related to misrepresenting itself. Other warning signs occurred prior to the Chase offer, including four Congress members asking for an investigation.

Somehow Chase, about as smart a bunch of bankers as exist today, failed to check the numbers provided by Frank, despite that sketchy history.

Fundamental Errors

In both the FTX and Frank cases, the investors were sophisticated and well-experienced in evaluating investments. Yet they made basic mistakes, embarrassing themselves, losing millions, and setting themselves up for lawsuits.

How could this happen?

Probably the most impactful work we have done has been in the area of due diligence, helping clients wring the most out of transactions and, at least as important, warning clients away from deals that presented more pitfalls than likely profit. Here are six insights from that hard-won experience. There is some overlap between these items, and you may well have other issues to add.

1. Avoiding deal bias. A banker I knew from years ago (my boss for a time until he was fired) would cursorily look at a transaction and declare quickly, “I want to do this deal.” That’s a dangerous bias. Similarly, we have worked with chairmen who wanted or needed to do a deal. The want was from the desire to be bigger; the need may have been from using the new deal to cover past mistakes with a new entity.
2. Chasing the shiny penny. What was sexier than crypto? What segment is more attractive than the young, people whom a bank believes they can lock in for years? We’ve seen the “hotness” of an area fog the mind of supposedly tough-mined investors.
3. Relying on the other guy. We recently heard the head of a large and very well respected bank justify a bad partner by mentioning that this problem company had fooled many others. That’s true, but so what? The one stupid bank loan I made occurred in part because both my boss and I looked admiringly at the other banks who had already committed to that borrower. I made that mistake just once.
4. Bowing to the emperor. This point touches on Nos. 1 and 2 above. Years ago, we worked on a due diligence project for a long-time client. Our analysis (as well as that of other insiders) resulted in the recommendation not to buy the target, a company the chairman thought would help fuel growth. He wanted to do a deal. We were not invited to be part of the next due diligence process, this one resulting in a deal that did not go well for the acquirer. Frankly, I think we were excluded because we gave the “wrong” or undesired answer the prior time. Others working on that due diligence team may have OKed a deal because it was in their near-term self-interest to placate the big guy.
5. “COVIDing” laziness. Doing due diligence remotely? NO. As a consultant, I’ve learned so much by meeting people face-to-face, observing their office and work styles, and finding papers that might have been overlooked otherwise. But at least one of the PE firms investing in FTX was willing to rely upon Zoom. That team appeared so eager to do a deal that an in-person meeting might not have mattered, but maybe it would have.
6. Assigning the wrong team. One investor group I traveled with for a due diligence session spent much of their time on the phone ordering the right kind of limo to pick them up when they returned at the NYC airport to take them to the Hamptons. This group may have been smart, but they were not about to roll up their sleeves and get into messy details.

A January 21 New York Times article chronicling Frank pointed out that the site had only 67,000 unique visitors the month it was acquired by Chase. It asked, “Did the bank’s due diligence team include anyone who had been on financial aid, to see if the whole thing passed the sniff test? . . . The bank would not comment on this or other aspects of the due diligence.” I’m betting “no” is the answer to that question.

A retired banker recently described due diligence as a business segment at his top-tier bank, one that had a full-time leader who could cut across the institution to select the optimal team. Many companies lack the “bank-width” to do the same, but all can set clear goals for the team, supplement it with outsiders, and ensure that analyses and recommendations avoid emotions and special interests and are as fact-based as possible.

Charles Wendel is president of Financial Institutions Consulting, which works with senior management and boards on issues that are critical to a bank’s sustainability and growth. This article is adapted from recent postings on the FIC website. He can be contacted at cwendel@ficinc.com.