At Leonis Capital, we often share our musings of the venture market with our LPs. Recently, we have distributed this in our LP letter but I feel we can share part of the letter with our newsletter readers too1. For one, it’s amazing how fast the year has flown by; and two, it seems to me that a lot of market optimism has been baked into the asset price. And for that reason, we try to be more prudent than ever, which is certainly easier said than done. After all, who doesn’t want to dream with entrepreneurs and change the world.
In the latter part of this essay, you will be presented with a hyper-pro argument for venture funds as an asset class. And by its research data, maybe tech-focused venture funds are not as sensitive to high valuation as public stock/ commodity type investing (i.e. warren buffett’s Coca-cola type of investment). What do you think?
Feel free to respond back and comment.
Best,
Jay
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Current Market Environment
Many of you know what I’m paranoia when it comes to capital abundance, despite the fact that such a rich capital environment benefits the tech sector tremendously.
The reason is that the enthusiasm from the general public market and cross-over investors is only the lagging indicator. While we do enjoy the markup and will take some cash off the table when it’s appropriate, oftentimes we have to be extra mindful and remain level-headed when it comes to early-stage valuation2.
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We have seen seed-stage companies with little to no revenue that were demanding a $50M Cap and had no issues finishing the round by collecting checks from angels. Those are not our deals. However, it is fair to say that the general optimism towards tech and capital abundance were meaningfully magnified across the board in the early-stage investing. So we have to be pickier - to achieve a good balance between the entry price, risk profile, and the potential upside.
What we are thinking about
On that note, given the relatively high-valuation-high-risk environment, we will be tentatively exploring two strategies in parallel in H2 2021 to seek better alpha:
1) XXXXXXX;
2) XXXXXXX;
The two strategies might sound counter-intuitive at the first sight. But at its core, it’s consistent in that we are seeking to invest in “good companies at a fair price”. And right now, XXXXXXX. The key for us is to find the perfect combination of both.
Furthermore, both strategies will only work if we can underwrite the team and the business well at a fair price. Therefore, it’s imperative that XXXXXXXX.
In all cases, our goal is to be extra cautious with our capital deployment while proactively seeking strategies to outperform the venture and the broader market. We will keep you posted on this.
The Nature of VC funds
Speaking of venture capital and the broader market, I thought to share one of the posts by Fred Wilson. The money quote is this:
A working paper published by the National Bureau of Economic Research (NBER) in November 2020 contradicts that notion, showing that half of all VC fund managers outperform the public markets, and are therefore worthy of institutional investment.
This is an important finding. As we know in startup investing, there is a famous power-law (or the 80/20 rule) governing the return of a venture fund. However, the paper, by analyzing a large sample of VC fund level returns from 2009 to 2017, suggests that such a rule might not apply to VC funds as a category.
The data shows that half of all (technology-focused) venture capital funds generally outperform the public market - and, the performance of VCs as an asset class is so strong that even the (VC-focused) “fund of funds” beat the market.
This is surprising and not surprising:
Surprising in that there was a long-time notion that only the top 20% of VCs (the Sequoia, a16z, Benchmark of the world) can beat the market, and yet this is the first time we have the data to suggest otherwise;
Not surprising in that 1) as venture practitioners, we all know intuitively that notion is not true - because the name-brand funds cannot and would not serve all the founders at the early stage, especially as startup opportunities become ever more decentralized and as founders are becoming more unconventional (younger, non-ivy-league, immigrant, etc.); and 2) technology venture funds are highly co-related with the broader technology evolution - unlike other sectors, tech companies tend to create and compound value creation in a network-powered speed. And this type of value creation and capture will only accelerate with the emerge of AI automation economy companies.
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I have taken out some paragraphs for sensitivity reasons, but it should not affect the main points of the letter.
For those who are interested, here is the full report by Pitchbook on early-stage valuation analysis, which showed the increase: https://drive.google.com/file/d/1doU_VvcxBNgmh4Lq4pw_8Ep-Pd_C3iGz/view?usp=sharing