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There is a lot of hot debate amongst VCs about the state of the market and lord knows I have some strong opinions on it as well.
One camp of managers preaches the rise of American Dynamism, Manufacturing, Defense, Energy Infrastructure, Space, etc. These are large, but massively capital-intensive sectors that have traditionally relied more on infrastructure finance (which historically would be happy with levered yields at 5-8% above LIBOR) that now have become the dominant receivers of venture capital. The growth of these categories over the last few years has been historic and the gains on those companies equally so, showing some impressive returns for those who committed early to these companies and this school of thought.
There is another camp of VCs that has preached capital efficiency, building companies that grow 200-400% per year with stellar metrics and defensible market positions. Amidst this camp, however, many are lamenting that the lack of interest from the larger venture firms (those in the first camp) in those companies. Does that make these companies bad? We don’t think so. We have pursued those companies deliberately over the last 2-3 years and laid out our logic in the “Power of Patience”. I received a lot of phone calls and emails after that post, so I thought I’d elaborate further on what I was seeing and what I think the ramifications are.
I personally believe this comes down to competitive strategy. I spend a lot of time reading books on competitive strategy and one of my favorite people in venture land is Brian Singerman of Founders Fund / GPx. Brian is a strategy buff and will often cite that the best in any profession not only find the best way to exploit their own unique strengths, but also to tilt the game in their favor to amplify those strengths.
As we think about that in today’s venture landscape, the market has exploded with new firms over the last decade with many of them targeting seed given the limited barriers to entry of launching a fund. LP capital is the fixed cost of entry and the number of firms that can write a $500m check is just a small percentage of those that can write a $500k check.
With that, the big firms are gravitating toward the opportunities where they can put $500m (or more) to work in a single company. Callous folks will say this is just a fee grab. Perhaps some are, but for the most part, I don’t think that’s the case. I think it’s much more of a combination of their earnest belief in those categories and the unique role that they can play in catalyzing those opportunities. If you can play a game that 5 firms can play rather than 5k, you should play it. I’ve written about some of the unintended consequences of that dynamic, but I think the incentives align for this playbook and the returns justify it. For firms that have the biggest war chest, capital intensive companies that have limited competition can be extremely attractive. In fact, the very capital intensity of these plays ends up being a strategic advantage, much in the way that vaunted “barriers to entry” have always been a fundamental staving force for long-term margins. To put $25m to work and own 20% of a company with a $5b outcome (which is obviously an incredible return) doesn’t provide the same total return profile of being able to put $500m to work to own the same 20% of a $50b outcome. Despite the lower return multiple, the latter is much more attractive to a firm looking to return multiples on a $10b fund, so they’re fixated on companies with this profile. Companies I call “Weapons of Mass (Capital) Deployment”.
This is not good or bad, it just is. Those big firms are not only playing to their strengths (the most capital intensive strategies where they are most advantaged compared to other firms), but have also tilted the overall direction and perception of the market on these categories. That’s extremely powerful and downright brilliant on their behalf. They’ve opened up entirely new industries that are dramatically larger than traditional software and shifted the broader investor mindset from cherishing SaaS companies and asset-light business models for their capital efficiency to touting the trillion-dollar potential of fully vertically integrated players. For what it’s worth, we have long loved this playbook as well, having backed technology-enabled disruptors like that for over a decade.
That said, a lot of investors have followed this path of investing with a fundamental flaw – they aren’t playing their own game, they are playing those of firms that dwarf them in size and capability. Yes, there are opportunities at the edge and the occasional (but waning) ability to front-run, but largely speaking, playing someone else’s game is a recipe for mediocrity. The best non-mega fund firms I know for the themes I discussed above aren’t the ones that hopped on this trend recently, but those that did it for a long time before. They played their game and then others came to find their game interesting. They often looked a little crazy doing it at first, but their courage is rewarding them now, just as those who were early believers in crypto, AI or whatever THE opportunity of the moment does. When I started investing in technology-enabled services with a venture checkbook, people thought I was crazy and now I’m blown away by the interest in these same approaches.
This has all created a definitive gap in opportunity for everything that is NOT in the purview of these big firms. I call this the “Veeva Gap”. For those who don’t know, Veeva is one of the best returning venture investments of all time driven by a capital efficient opportunity where <$10m of capital eventually yielded a $50b company. Maybe I’m wrong, but I don’t think an opportunity like that gets funded by the current landscape of investors today. I can’t identify the type of investor that would take on that opportunity and I think that represents a structural flaw with today’s market.
We see incredible companies with triple-digit growth, amazing efficiency metrics and durable moats that have clear pathways to building public companies that have seemingly ZERO value to mega funds. This lack of interest from the mega funds has cascaded upstream prompting other investors to fear investing in these companies given the risk of down-stream funding and lack of markups (which for better or for worse, is oxygen to most VC funds looking to raise subsequent capital). This leaves a universe of great companies unfunded and undervalued. Don’t believe me? Look at the numbers. Today a company that is profitable and growing at 50% trades for >22x revenue in the public markets. That same company in the private markets might net 3-5x revenue. That means we are seeing a 90% distortion in the value of these companies for current market pricing…that’s unlike anything I have ever seen in my 14+ years as an investor in private technology companies.
Amidst this, AI is creating more opportunity for investment than ever before. Not just in investing in AI companies, but in the ability for existing companies to cut their costs meaningfully and achieve unprecedented capital efficiency. For companies that have strong defensible positions that can compound over time, this is the Golden Era. These companies will have virtually zero competition (new upstarts will not be funded) and the gains from AI are going to enable them to operate with unprecedented profitability. We’re seeing this in our portfolio and while I love our AI “heaters”, there is a clear gap for buying ownership into these companies and practicing the “power of patience”.
AI is going to create some VERY large outcomes, but I fundamentally believe that our job as investors is to produce the highest return profile we can, not the largest total return that we can. Others believe very different things, but that leaves a huge portion of the investing landscape ignored. This can be chaos for some (those with portfolios that resemble that profile and are running out of cash), but could prove to be an incredible opportunity for others. Markets have a tendency to correct themselves and I suspect that the 80% discounts between private and public markets for comparable metrics will eventually dissipate. In the meantime, if you aren’t a “Weapon of Mass Deployment”, stay solvent, find the right partners aligning toward your long-term plan and build the next Veeva. If it’s in one of our core sectors (energy, insurance, retail and supply chain), you know where to find us 😊