Investing for Alpha or Beta?
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One of the things that continues to surprise me 10 years into the venture game is its collective groupthink. For an industry that preaches outliers and contrarian thinking, I find it (at the median) far more consensus-driven than any other form of asset management. During our recent annual meeting, we diagnosed some of these dynamics, identifying what we believe is a dislocation in the market. This isn’t the first time that we’ve called out a market dislocation (as we did in November of 2021 amidst the peak of the bubble) and feel strongly that awareness of market cycles and adherence to our long-term fundamental beliefs is what will drive the best product for our founders and the best returns for our investors.
Amidst the peak of 2021 when multiples were at the highest levels the Nasdaq had seen since the dotcom burst, VCs were there most active. Investors were seeing incredible liquidity in public markets and wanted to access some of those returns for themselves, disregarding traditional investment heuristics to capture the returns technology companies were having. It didn’t matter if a company was sound or not; it could raise money at attractive valuations. Investors were seeing companies with upside down unit economics (and in some cases little or no revenue) go public and were getting rewarded for it. You could not lose. This is characteristic beta-chasing behavior, with highly correlated returns for the entire category and little discrimination to actual quality. Chamath confidently protested that “Shooters Shoot” and the venture community listened, plowing more $ into the category than we had ever seen.
Unfortunately that didn’t work out too well for investors. Those who placed bets on the early end of the cycle benefited handsomely, but the late movers to the market were scorched. Many of the companies that went public are now down 80–95% making the primary determinant of returns not “how you invested” but rather “did you get liquid.”
The resulting fallout has resulted in a venture pullback unlike anything I’ve seen during my 10+ years in the business. As multiples have pulled back to reasonable levels, activity is entirely dormant. We find the behavior we’re seeing today nearly as absurd as what we saw in 2021. The most active late-stage firms from 2021 have essentially ceased deal activity in exactly the markets where valuations have pulled back the most. This is leading to a dynamic where late-stage capital is more demanded than ever before.
While the market is frozen at growth, seed stage continues to defy reality, with deal activity AND valuations actually up in 2022.
We’re seeing growth-stage investors rotate earlier to companies that will burn less money and have a longer horizon to liquidity. This also may be a function of investors attempting to stretch their dollars further, maintaining deal pacing the best they can amidst an environment where they’ll have to wait longer to go back to LPs. Tactically, this has made seed investing the LEAST attractive it’s ever been. While the valuation premium of a late-stage to seed-stage companies has historically been 20–25x (and peaked at 40x in 2021), it is now < 10x.
Where deals are happening is in razor-hot areas like Gen AI. Much like in prior hype cycles, we’ve seen firms flock to this market with exuberance and breaking all their rules to invest in the hottest companies. This trend mimics what we saw in crypto the last couple of years, but is perhaps amplified, with nine-figure valuations attached to pre-product companies and unicorn valuations attached to those without revenue or a business model. Amidst the hype cycle of crypto / blockchain / web3, investors exalted this as a revolutionary platform shift warranting such prices. Many of my peers bet their careers on this category, leaving behind traditional software/consumer/digital categories to focus exclusively on this brave new world. Two years later, we’re on to the next platform shift, with plenty of our peers now betting their careers that Gen AI will be the next big hit (some of whom are the same folks who were all-in on crypto just a few years ago).
This is a challenging dynamic for early-stage investors, given the long duration and extent of commitment early-stage investors make to their companies. Chasing a hot category generally means you are likely to overpay at the entry point, only to find that markets are less infatuated with that category by the time you want/need liquidity. Inevitably, there is ALWAYS something that is hot. I’m reminded of the tweet below from @shaigoldman — a long-time veteran of the venture / startup scene — where he shows that each year has had its “hot” sector. Companies grew quickly with cheap capital as investors plowed into these categories, and unit economics appeared stronger than they actually were, driven by the temporary market conditions. Valuations across these categories demonstrate typical beta behavior, with returns reflecting sentiment in the sector. Only problem is: most of these returns were on paper and founders/investors failed to get liquidity. If we look back at most of these vintages, had you invested in the “hot” category in a given year, you’ve likely struggled. Even with crypto, it’s the ones who invested prior to the consensus “hot” sector that reaped the rewards, not those that jumped on the dog pile. Bill Gurley highlights the challenge of this dynamic, highlighting the “Sawtooth Cycles” of venture capital. For those tying themselves to the beta of the market, your returns are far more likely to be determined by your entry point and ability to get liquidity during a “risk on” period (when valuations are inflated), than your actual skill. For those earliest in the game (where we play), you are most susceptible to the Sawtooth crashing upon you, turning glorious paper gains into wreckage.
At Equal, we focus our time on four core sectors — Insurance, Supply Chain, Retail and Climate. For us, these are multi-decade bets that will witness massive economic turnover from the digital transformation of each of these $1T+ industries. Amidst that turnover, we believe we’ll see multiple category-defining companies created. Over our four years at Equal, each of these sectors has oscillated between “hot” and “not”. To us, this is a distraction — minor, short-term deviations from the long-term development curve we believe in. I suspect that many in blockchain / crypto / web3 subscribe to similar beliefs and I applaud them for that — it’s one of the reasons why I believe that sector will have greater persistence and potential than the other sectors highlighted in Shai’s tweet.
At the end of the day, we’re not going to time markets or attempt to pick what’s “hot.” Instead, we’ll continue to focus on our core categories where have conviction in the multi-decade potential to produce amazing companies. We actually become more nervous when our categories are “hot” (like Climate is today) than when they are not (for example, we find right now a very interesting time to invest in Insurance). Our model isn’t based on chasing beta, but rather on identifying companies with persistent category-monopolizing businesses. We’re looking for the founders capable of championing the digital transformation of their industries and models with capabilities and moats that can generate persistent cash flow in the decades to come. These companies are the alpha generators and that’s our business model– to find above market returns decoupled from the beta of the overall technology market.
This requires immense patience, but time is something that we have on our side. Our objective is to deliver returns across and independent of market cycles. Those cycles will certainly amplify and depress returns, but we’re not going to lean in on predicting what will be “hot” or chasing the momentum of the market like our industry did in 2021. There is plenty of evidence showing investors’ inability to consistently time markets, and our mandate isn’t to gamble, it’s to invest.
We’re less likely to see our names in the papers attached to the hottest trends, but we are confident in the product we are delivering to founders and LPs. Our product hinges on dedication to our categories and to the founders building in them. This is tested most not when markets are “hot,” but when they are ice cold. Independent conviction is rarest and has the potential to be the most valued (both by the founders and in terms of the returns it can generate) when a sector is out of favor. Consensus investing in hot categories when markets are frothy may deliver high beta returns, but sticking to your conviction areas is the only pathway to delivering sustainable alpha over the long-run. As Warren Buffet once said, “What’s hot today isn’t likely to be hot tomorrow. The stock market reverts to fundamental returns over the long run. Don’t follow the herd.” From a guy who’s beaten the market his entire career, we think that’s advice worth listening to.
*Read this post on Medium here