The FTX meltdown is a wake-up call for co-investment due diligence

It’s crucial for investors not to skimp on due diligence – no matter the lack of resources and time – to fully understand any risks to which they are about to expose themselves.

Much has been written about the unravelling of cryptocurrency exchange FTX, including the need for thorough – or any, for that matter – due diligence. More is likely to come to light in the days and weeks ahead. Investors including Temasek and Ontario Teachers’ Pension Plan have said they will mark down their full investment in FTX – ranging in the tens to hundreds of millions of dollars – to zero, while managers including Sequoia Capital, Tiger Global Management and Thoma Bravo are licking their wounds.

It’s unclear how many LPs have exposure to FTX via direct co-investments versus via discretionary co-investment funds – Missouri State Employees Retirement System being an example of the latter, as our colleagues at Buyouts have reported.

Still, for institutional investors, the scandal highlights the importance of due diligence in an era when many LPs are doubling down on their co-investment programmes to cut costs. Nearly two-thirds of LP respondents in PEI’s latest Perspectives survey – published next week – plan to participate in co-investment opportunities over the next year.

Their biggest hindrance to doing more co-investments? The speed required to execute transactions, with some 44 percent of respondents indicating so. Insufficient staffing within organisations came in third.

The pressure and tight deadlines within which to decide on co-investments can make executing on a co-investment opportunity almost impossible, Per Olofsson, Swedish pension AP7’s deputy CIO and head of alternatives, told us in a 2018 interview. “The GP may have been working on the deal for six to 12 months, and you have three weeks to decide if you want to participate or not. It’s very hard to make up your mind unless you have a very strict process and internal resources,” Olofsson said.

A participant in PEI’s latest co-investment roundtable noted this as well – that LPs are sometimes pressured to make quick decisions in co-investment processes in as little as 24 to 72 hours. “With these due diligence processes, deal partners care about certainty and execution,” the participant said. “They just want to get the equity signed up for the deal and the deal done within the timeframe, whatever it takes.”

Those closely watching may see the situation as investor FOMO – something sources tell us is much more common in late-stage venture capital and growth tech deals than in buyouts. Investors have seen this before with emergent, fast-growing businesses, says Martin Devenish, a board director of London-headquartered intelligence and cybersecurity consultancy S-RM. He adds that in such cases the “focus is on top-line growth, branding and marketing… that internal controls, governance and broader management capabilities tend to be at best threadbare or may have been non-existent”.

Is there a lesson for private equity co-investors from the FTX disaster? It could be as simple as knowing when to throw in the towel.

“Don’t blindly follow your GP in terrifically hot areas,” says Kelly DePonte, advisory board member at the Investment Management Due Diligence Association. “Second, just say no. If you’re not given the information that’s necessary for you to do your job, maybe you should just walk away.”

PS. Private Equity International is turning 21 next week. We’ll be releasing our 21st Anniversary issue on 1 December, including a list of 21 changemakers who’ve influenced the industry’s evolution over the past 21 years. Stay tuned.