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The Diff is a newsletter exploring the technologies, companies, and trends that are making the future high-variance. Posts range from in-depth company profiles, applied financial theory, strategy breakdowns and macroeconomics.
Where Fraud Lives and Why
This paper has been getting some attention lately for its eye-catching estimates: 11% of publicly traded companies are committing securities fraud every year, with an annual cost of over $700 billion. The paper is a classic use of two powerful tools for coming up with useful generalizations:
There's a natural experiment: when Arthur Andersen collapsed, its former clients all had to find new auditors. The new auditors were more likely to hunt for fraud, both because they didn't have the institutional disincentive that spotting a fraud they'd previously allowed looked bad, and because Arthur Andersen's own accounting was tainted.
If we treat this as a meaningfully random sample, we can extrapolate to get some kind of base rate for fraud. There are many reasons to doubt this: what if Enron was a representative case of Arthur Andersen's auditing? What if they focused on industries with lots of fraud? The paper actually does a great job of addressing most of these concerns (Andersen-audited firms had fewer accounting restatements than similar companies audited by other major firms, for example, and adjusting for industry exposure didn't have a big impact).
The paper notes that fraud is cyclical, and that the natural experiment occurred towards the middle of the cycle, so it's not too tough to get a full-cycle estimate of fraud from that snapshot. But what if fraud is cyclical, but not purely so, and Arthur Anderson’s collapse just part of a cycle within a secular trend towards less fraud? There are good reasons to think that accounting fraud at US public companies is not as common as it used to be. The equilibrium for fraud is set by two forces: how rewarding it is for companies to engage in it, and how rewarding it is to catch it:
Sarbanes-Oxley created a bunch of annoying disclosure requirements for companies, but it also made it much easier to go to prison for committing fraud. And while some of the big accounting frauds were of the making-up-numbers variety, many of the problems caught in the early 2000s were more about smoothing out numbers than manufacturing new profits out of nothing.
The growth of long/short funds as a sub-asset class meant that there was a larger dollar value of short positions, and thus more demand for reasons that would make a stock plummet. (Aggregate short interest has been rising for decades.)
Cheaper and better data meant that some symptoms of books-cooking—companies booking more accounts receivable relative to actual cash revenue, for example—get incorporated into systematic models. And then the long/short process kicks in: if a stock looks cheap in part because systematic models are betting against its low-quality earnings, a fundamentals-oriented analyst might look into it as a long and determine that it's a short instead. (A below-market P/E is only as good as the E!)
Investors increasingly expect mature companies to return all of their earnings in the form of buybacks, and will evaluate these companies on the basis of free cash flow rather than reported earnings. If a company is persistently unable to convert stated earnings into actual cash, or unwilling to release cash from the balance sheet to buy back stock, investors will wonder why.
The market has also gotten more liquid, and the market in ideas is more liquid, too; early-2000s fraud was partly ubiquitous because the people best positioned to spot it either had fees to worry about (if they were sell-side analysts) or couldn't spread their ideas widely (buy-side analysts). Today, short theses and rebuttals (or lack thereof!) spread fast through FinTwit.
So generally speaking public markets in the US have gotten more hard-headed about frauds. Today, if you hear about a massive accounting misstatement plunging a company into bankruptcy overnight, it's more likely to be in an emerging market or in Europe. Look at Wikipedia's table of big accounting frauds you’ll find the same thing—it was utterly dominated by American companies in the early 2000s, but post-crisis the only frauds involving American companies are 1) Autonomy, a British company whose accounting issues were discovered after it was acquired by the American HP, and 2) Wells Fargo, where the fraud was perpetuated by lower-level employees against management (albeit because management set up terribly perverse incentives to do so).
But since fraud is a human problem, and not purely a matter of better accounting standards, it's not likely to have just gone away. But if the rate of accounting problems among big publicly-traded companies is lower than the 11% number cited in the paper, the question isn't "why did it disappear?" but rather "where did it go?" And we can take our list of trends against fraud and invert them:
Sarbanes-Oxley does apply to private companies, but only on the penalty side, not the disclosure side. But accounting frauds in private companies are often less visible; many investments go to zero, anyway, and it's less embarrassing for everyone involved not to say why.
There are no short-sellers in private markets. There have been efforts here, but they don't work out because the market doesn't clear ("everyone wanted to short Theranos, Dropbox and WeWork"). The closest you can get to shorting is to pass on a round and then brag about it later. Big deal: I didn't invest in FTX, either.
There's less data available on private companies, though the rise of alternative data tools means it's easier to get decent proxies.
Startups are not expected to return capital. It's a bad sign if they do. They're often valued either based on strategic considerations or starting with a multiple of sales—a dollar of sales is much easier to fake than a dollar of earnings or cash flow, so the incentive to do so is strong.
The idea market in startups is liquid when it comes to successes, but it would be pretty tacky for a VC to write a long blog post explaining why they passed on a live deal. (That memo may exist internally, but to the extent that it's shared it's in the form of a quick summary over Twitter DM or Signal.)
JPMorgan Chase's writedown of their fintech acquisition Frank is a great case study in all of these forces. The NYT has a good story digging into the details: Frank's founder is a serial exaggerator whose self-promotion veered into fraud (once again, if the rate of continuous improvement in public perception to be maintained exceeds what the fundamentals can deliver, compound interest works its ruthless magic). The company was valued at a high multiple of what turned out to be a flexible metric, total email addresses captured. And there were alternative datasets that could have pointed to problems: given the likely number of student aid applicants in the US, Frank's numbers implied that it had reached near-dominant market share in the category with little marketing. Meanwhile, its monthly site traffic was not enough to have acquired that sizable a customer list over Frank's entire existence. So it could have been caught, if the buyer had been looking for fraud. But one paradox of frauds and cheats in general is that lying is less than half the work—most of the effort is in appearing not to need to lie. The more impressive a company looks, the more embarrassing the basic due diligence questions are.
A down market and a series of high-profile failures might give private markets the same kind of natural experiment that Arthur Andersen's failure did for public markets. Due diligence checklists will get longer and more thorough, and new funding rounds will feel more like a cross-examination and less like a party. One reason for a high base rate of fraud is that at least some of it stems from inattention rather than malice—the Arthur Andersen study finds that most of the frauds were fairly minor, and could be more the result of poor internal metrics than of intent to mislead. But either way, standards will get higher, and private companies will need to step up their efforts accordingly.