November 2022 - FTX & RCM’s Credit Process

Dear Investors and Friends,

Investors, business professionals and the media spend a lot of time talking about, analyzing and ultimately investing in ideas. Is this new company’s product a good idea? Will the CEO’s new strategy work? Is there a market for this new app or service? These are all great questions. They are, or at least should be, just the first steps when investigating a new opportunity. Too often, however, the people trying to answer these questions forget an equally and potentially even more important one. Is the idea well executed? A good idea poorly executed turns that good idea into something potentially dangerous for the investor. The recent and spectacular downfall of FTX is a textbook example.

As fixed-income investors, Mike and I spend a lot of time and energy thinking about bankruptcies and what causes companies to fail. In our experience and especially in cases where the bankruptcy is a surprise to the market, failure is overwhelmingly a function of poor execution not poor ideas or strategy. Less than five weeks ago, FTX raised money at an equity valuation of $25 billion. It had more than a million registered users and recorded billions of dollars in daily trading volume. Today, all of that is pretty much gone. So why did FTX fail? The purpose of this letter is to describe what we believe is the root cause of FTX’s failure by applying insights from Roosevelt Capital Management’s (RCM) default risk framework.

FTX: A Very Brief Overview

FTX was a cryptocurrency exchange. While cryptocurrency exchanges are recent innovations, they share a mix of products and services commonly associated with more traditional financial institutions including banks. In fact, understanding the banking aspect of FTX’s operations will help us understand its rapid demise.

Consider the following hypothetical transaction at FTX:

FTX’s Liquidity

A big part of what we do on a day-to-day basis is evaluate the liquidity of a company’s assets relative to its liabilities. The actual analysis can get rather complex, but the concept is simple. We compare when the obligations of a company come due vs. the resources available to pay those obligations in the form of things like cash on the balance sheet, free cash flow and available lines of credit. In the case of FTX, a significant portion of its obligations were something called “demand deposits”. A demand deposit simply means that customers have the legal right to ask for their money back at any time and the obligor has the legal requirement to pay them immediately. If this sounds like your bank account, that is because it is also a demand deposit. In the case of your account, however, banks have pressure-release valves like The Fed window and FDIC insurance for depositors. For FTX stakeholders, the Fed window is not available to crypto exchanges and FDIC insurance is not available to holders of cryptocurrencies. So, FTX had all the liquidity risk that comes with holding demand deposits and none of the safeguards that mitigate the risk of such a product in the US. Because of this, FTX management should have been holding liquid assets that adequately covered their demand deposits, which they did not.

FTX’s Solvency

Solvency is ultimately a function of investor confidence. At RCM, the corporate debt we buy is almost always issued by companies whose equity trades publicly. This allows us to have a daily and objective measure of solvency. While FTX did not trade publicly, its solvency was firmly established over approximately 10 funding rounds beginning in early 2018 in which it raised over $2 billion. This past summer the company raised capital at a $32 billion equity valuation and in its last funding round this past October, it raised $420 million at a valuation of $25 billion. While solvency can certainly be converted to liquidity, it is important to appreciate that it is simply a number on a piece of paper and can instantly evaporate.

FTX’s solvency vaporized for two reasons:

• Management lost all creditability with investors. As stated above, at the end of October FTX raised $420 million, $300 million of which Sam Bankman-Fried personally took out of the company. Two weeks later Sam Bankman-Fried is out in the market looking to raise a reported $8 billion. After “you” just gave him $420 million, would you believe anything he had to say? Would you put in ~20 times the money that you just did? Even if you wanted to, could you?
• Neither management nor investors understood what assets and liabilities FTX held, let alone the valuation of those assets and liabilities. It was believed that the assets were digital in nature, and it is well understood that cryptocurrencies are highly volatile. In the last year alone, Bitcoin which is arguably the most established of all digital currencies, has had a valuation ranging from nearly $60 thousand to about $16 thousand and that is the most stable of the cryptocurrencies.

FTX Other Factors

At RCM, we never invest because of “other factors” but we will often decline an investment because of them. Let’s consider these factors for FTX:

1. Registered in the Bahamas outside the purview of US regulators
2. Bright but highly inexperienced management team
3. Highly concentrated control among individuals with potential conflicts of interest
4. Focus on celebrity endorsers
5. Highly opaque business relationships

Other factors here are essentially all cautionary. Nothing about the ecosystem in which FTX operated should have given any potential investor much comfort.

Conclusions

It is, of course, easy to sit at our computer and do a post-mortem on something that has already failed. To be clear, our point is not to try to convince anyone that we would have had the prescience to predict FTX’s bankruptcy six weeks ago. We had no more idea than anyone else that FTX was going to fail. Instead, we suggest that had we faced the opportunity to evaluate this venture from a debt perspective, we would have applied the same framework we apply to all our corporate bond investments and likely passed. Our track record and holdings indicate that, in general, we stay away from financial institutions because it is difficult to evaluate the nature of their assets and liabilities. FTX would not have been an exception.

Additionally, it must be noted, that one cannot judge a decision based on its outcome. There are many venture investors in FTX like Sequoia that have wonderful long-term track records in the venture space. Many thoughtful investors clearly saw an opportunity with asymmetric risk. As we discussed in our May 2022 letter, The Kentucky Derby: Odds, Probability and Fixed Income Investing, there is nothing wrong with such an investment as long as one understands the risks and the expected value is meaningfully in their favor.

Finally, while FTX was incredibly innovative, when one makes such an investment, further due diligence should be conducted on management’s ability to execute well because it is execution that may make or break the company.

Please reach out to us with questions and comments. Thank you for trusting RCM with your capital. It is a privilege for us to serve you.

David and Mike