The conviction of Sam Bankman-Fried by a New York jury earlier this month cannot be seen in isolation. WeWork, another fast-growing company with an innovative business model and backed by leading investors, is heading for bankruptcy.
These emerging trends need a holistic perspective to explore certain deeper issues. Globally and, closer to home, in India, we have been witnessing several situations involving financial sponsor backed companies facing allegations of financial irregularities and weak internal controls.
Financial sponsors often bring operational know-how, financial discipline and professional management to the companies they invest in. There is a general perception that companies backed by financial sponsors are better managed and have better governance standards.
But is it true? Would it be correct to generalise this?
FTX and Theranos
The situation that unfolded at FTX in the few months is nothing less than an eye-opener. Leaving aside the inherent risks associated with an emerging asset class like cryptocurrency, lack of corporate governance and disregard to due diligence prior to investing is unfathomable.
FTX had a nebulous corporate structure, only 2 directors, several related party dealings, no record-keeping of bank accounts or employees, and complex personal relationship between top management. Yet, pedigreed investors like Sequoia Capital, Third Point, Paradigm, Thoma Bravo, SoftBank and Tiger Global invested in it.
Theranos was no different. Set up by Elizabeth Holmes, a Standford drop-out, as a consumer healthcare technology startup to revolutionise the blood-testing industry, Theranos had Henry Kissinger, George Shultz and several other leading names on its board. Exaggerated revenue projections, fraudulent results of tests, false representations to doctors and patients, taking advantage of regulatory gaps and other red flags were not spotted in time. Theranos also had investors like Threshold (earlier DJF), Rupert Murdoch and Walgreens.
Root Cause Analysis
There is no doubt that, over the years, financial sponsors have improved governance in several companies. Cases like FTX and Theranos begets the question on why some of the customary standards of investing and management are occasionally overlooked even in most mature economies with strong rule of law. Reasons could include the following.
Personality Cult
A strong founder inspires confidence. A very strong founder or promoter could also emerge as a ‘personality cult’ and can unduly influence management and governance. There is something common between Jeffery Skilling (Enron), Sam Bankman-Fried (FTX), Adam Neumann (WeWork), Elizabeth Holmes (Theranos), Vijay Mallaya (UB Group), Ramalinga Raju (Satyam) -- all of them became larger than life individuals exercising immense control (if not absolute control).
Fear of Missing Out
Herd mentality to follow investment thesis of other sophisticated investors can lead to biased decision-making. Exuberance necessitates balancing. Credible names on the existing investors’ list should not be a reason for subsequent investors to get comfortable.
Lack of Diligence
Less importance being given to due diligence prior to investing, which is essential to gather and validate management claims, could be another factor for this. This is,particularly seen in sectors where technology is emerging, business is complex, or business is built to optimise opportunity offered by a regulatory gap.
Closer home
India has also witnessed several companies (like GoMechanic, BharatPe, Trell and Zilingo) backed by financial sponsors questioned on grounds of financial irregularities, lack of internal controls and weak governance. Some of these companies continue to be in dispute challenging some of such allegations.
Early Warnings and Red Flags
Some early warnings to spot a potential red flag include weak internal controls, lack of a CFO for a prolonged period of time, aggressive revenue recognition or other non-customary accounting practices, board members embroiled in personal relationships, non-filing of audited financial statements, and most importantly, a very strong founder or management team which is willing to overlook governance for growth.
A sound board of directors, solid internal controls and ‘truly independent’ auditors are guardrails that are intended to prevent mismanagement. These should not be overlooked.
If India is to emerge as a reliable and mature economy, governance needs to take centre-stage even at the cost of growth and profitability. Clinging to the allure of short-term gains often blinds us to the profound beauty of patient, enduring investments.
