Discover more from European Straits
Diffracted VC: The Categories
Today: Digging deeper into the idea of Diffracted Venture Capital and mapping out the categories.
The Agenda 👇
Indexing at a large scale
SPAC, SPAC, SPAC
PE firms are coming
Diffracted VC refers to the fact that the contours of VC as an asset class are becoming blurry, with many VC firms diversifying beyond their core business, while non-VC firms are trying their hand at VC, bringing different expectations and approaches in the process.
As a reminder, here’s what diffraction is about (from Wikipedia):
The process by which a beam of light or other system of waves is spread out as a result of passing through a narrow aperture or across an edge, typically accompanied by interference between the wave forms produced.
As I’m currently building models to document this thesis, I thought I’d iterate by simply mapping out various categories that, to me, reveal the current diffraction at work in venture capital. (In truth this is more a compilation of notes than an essay, but there’ll be further iterations soon.)
1/ Indexing at a large scale
Like in other parts of the financial world (incl. the stock market 🎧), VC is currently divided between those who advocate the traditional approach of cherry picking and thus focusing on a few investments (active), and those who make the case for indexing at a large scale across the asset class (passive).
An important contribution was made last year by AngelList’s research team:
We found that investors could benefit from indexing as broadly as possible at the seed stage, by putting money into every credible deal, because any selective policy for seed-stage investing—absent perfect foresight—will eventually be outperformed by an indexing approach.
We did do some simulations on what indexing at seed actually looks like over human timescales. Over a ten-year investment window, indexing beats 90-95% of investors picking deals, even when those investors have some alpha on deal selection. So the idea that there are some terrific seed investors that soundly beat indices is not inconsistent with our results.
Tiger Global implementing its high-velocity deployment approach, as recently discussed by Everett Randle of Founders Fund, is one way of testing this assumption, although at later stages (Series A and beyond). It’s a seductive approach on paper, and I myself wrote about it in Velocity in Venture Capital. But you might also remember Bill Janeway’s skepticism in our conversation on founder control:
You know, investors like Tiger Global appear and disappear in every cycle, illustrating the oldest line in the book of financial markets: “Everyone’s a genius in a bull market”. I have no idea what Tiger Global’s returns are, but this much I know: making illiquid investments with minimal due diligence and zero concern for governance is not a formula for long-term investment success.
Indexing in venture capital is a topic I explored in greater detail (with lots of links) in my VCs: Would You Rather Be Yahoo or Google?, published last year.
2/ Secondary investing
Secondary deals are one of the hottest fields in tech these days—especially since the IPO market has been in overdrive, meaning everyone wants to buy shares in soon-to-be-public tech companies 🔥 Investors specialized in secondary deals have always existed in traditional private equity, so it shouldn’t be a surprise that many people are reflecting on how to translate the approach to VC.
There has always been such a thing as a secondary market, although it hasn’t been that big of a deal, as noted by Pascal Levy-Garboua in our conversation about angel investing and liquidity:
There are some very hot private companies for which demand significantly exceeds supply: these days it’s the case for Stripe, SpaceX, the military contractor Anduril (founded by Oculus’s founder Palmer Luckey), and Plaid. Then there’s another tier of companies for which there is some demand, usually at the last round’s price. And then there’s the rest, for which demand is essentially nonexistent (say, a few million dollars worth of demand).
So, yes, there is such a thing as a secondary market, but it’s not that deep, it’s not working that well, and there are a lot of constraints that make it essentially impossible to sell shares in many private companies. On the other hand, there are venture capital firms that find that the stock market has been going a bit too far in terms of pricing stocks and prefer to sell their stake early on the secondary market rather than waiting for the IPO. But it’s easier for a VC firm which can influence the company’s board and force a secondary transaction than it is for an individual investor who doesn’t have access to the big guys in the boardroom.
And so, as for Uber, it’s more or less a legend. Some people sold their shares shortly before the IPO, but most of those transactions happened internally—as in, the founders buying out some employees with capital brought about by pre-vetted investors such as SoftBank. Those were late secondary transactions, at a price that wasn’t far below that of the IPO. So from an investor’s perspective, the economic equation is similar to waiting for the IPO, and the returns are rather similar whether you sell one year before the IPO or during the IPO itself.
All in all, some investors have the opportunity to de-risk their investment by selling slightly ahead of the IPO (it happened with Uber, it happened with Facebook), but I wouldn’t talk of a liquid secondary market per se. For such a market to exist, you need many companies that are very hot on the market, and whose board makes it possible for early investors to sell their shares to third parties. It’s a very narrow category—for the time being.
On the other hand, the idea that you can facilitate employees and angel investors cashing out before the final exit is currently reaching new levels, with many people realizing that there’s a lot of value to be unlocked; lately we’ve seen experiments such as secondary powerhouse Forge and other new initiatives, about which I’ll write more!
3/ Emerging managers
Another very hot topic. Here are the reasons why we’re seeing more and more emerging managers/solo capitalists these days:
Everyone wants to be a VC, as I wrote in The fragmentation of venture capital (in Sifted).
Established firms are all chasing the same “safe” deals, which leaves a significant segment of the market uncovered—with a new breed of investors stepping in to seize the opportunity.
There’s now an infrastructure that makes it easier to become a venture capitalist—at least in the US. The most consequential innovation on that front has been rolling funds. See Minal Hasan’s Will Rolling Funds Roll Over the Venture Capital Industry? Long-Form.
Alas, we don’t have such a thing in Europe. For one, something like AngelList is more difficult to operate in Europe. One reason is simply our lag in churning out successful tech companies. But another is the European market’s fragmentation, as angel investors in one country only invest in startups in the same country, leading to thin markets that never reach escape velocity.
I’m still bullish on that one when it comes to Europe, however, because the pan-European ecosystem is slowly emerging before our eyes—and because, well, I know of a few interesting initiatives that I can’t put down on paper here yet 😉
4/ Revenue-based financing
I already did a deep dive into that one, so simply have a look at Notes on Revenue-Based Financing:
A whole discussion is still going on, notably on VC-oriented Twitter and blogs, about one particular wave in the current diffraction: the rise of revenue-based financing. Can you turn a tech company’s revenue into collateral to issue securities and raise debt from investors on the fixed-income market?
I should also mention that Pipe, a company co-founded by Harry Hurst, has seemingly been growing strong over the past few months, as have been “embedded finance” solutions provided by Shopify and others. Interestingly, at the heart of this key trend is one individual: Alex Danco—who, by the way, was formerly with Chamath Palihapitiya at Social Capital). Here’s why Alex stands out:
He is the author of the landmark article Debt Is Coming, which was a major hit when it was published at the end of January 2020. (I still remember where I was when I discovered it, read it, and then said to myself “Holy shit, this is it—we’re undergoing a radical shift”).
By coincidence, Pipe was launched more or less at the same moment. Obviously Alex and Harry Hurst ended up bonding, and the former interviewed the latter. Check it out here: It’s Not Debt, It’s Better: an Interview with Harry Hurst of Pipe.
Finally, Alex now works at Shopify, where he designs financial products for sellers on the platform. Read all about it here: What's Behind the Shopify Effect.
5/ Multi-asset strategies
The idea here is that VC activity can be complemented by other styles of investing for the sake of either maximizing returns or minimizing downside risk. The practical approach is that various investing activities are operated as part of the same firm because there are synergies either on the supply side (investors providing capital) or the demand side (companies in need of capital), or both.
This category would typically include a long-short strategy, such as I discussed in A Thesis For Sector-Focused Hedge Funds (with a focus on retail).
It should be mentioned that Social Capital, the firm headed by Chamath Palihapitiya (and, again, of which Alex Danco was long an employee), was all about exploring such diversification. We now know that it didn’t exactly work out, but the sequence is interesting:
When the firm was launched, they had this thesis that traditional VC should be complemented by other investing businesses, including operating a hedge fund. See Chamath Palihapitiya Is Launching a Hedge Fund (Fortune, 2016).
Then Social Capital went through a crisis, with Palihapitiya parting ways with other partners who had more of a traditional VC profile. Here’s his own account: The Reports Of Our Death Have Been Greatly Exaggerated… (2018).
Another journey to building a diversified powerhouse is that of Silicon Valley Bank (SVB)—a very interesting business, yet one about which not enough has been written:
As you may know, SVB started as a bank specialized in lending money to Silicon Valley startups. But then they realized that having this connection with founders created opportunities to diversify well beyond lending money to tech companies. Thus they launched new business lines focused on wealth management for founders and others that are essentially about being a VC investor. Once you have the relationship with key companies, a deep knowledge of the ecosystem, and a powerful brand, why not turn it into an opportunity to deploy capital like a VC?
Sadly not much is known about SVB beyond that, except (to my knowledge) for a few articles:
One which dates back to 2015, in the Wall Street Journal: Silicon Valley’s Hometown Bank Booms, But Risks Are on Horizon.
Finally, I was tempted to write that the multi-asset strategy clearly resembles what Andreessen Strategy is doing (see, for instance, my Reinventing Financial Services, published in 2019). But then I changed my mind, deciding that they were going more for the ‘digestive pill’ strategy (see below 👇).
6/ SPAC, SPAC, SPAC
By now you’ve heard about those, right? They might be slowing down, both because of regulations and because investors are moving on. On the other hand, it could settle into a long-term trend, as I was writing in Some Quick Notes on SPACs:
SPACs might be the new IPOs, but regulators will likely force SPACs to change so much that they will eventually resemble traditional IPOs and become the default, with a few welcome tweaks.
Make sure to have a look at my colleague Mathias Pastor’s A Primer on SPACs.
7/ PE firms are coming
By private equity, I mostly mean buyout firms—that is, firms with funds under management that deploy capital as both equity and debt, in variable proportions, preferably in companies that are already profitable and can thus generate a dividend to pay down the debt. I know that venture capital technically belongs to the larger category of private equity, but here I’m referring to the likes of Silver Lake, Vista Equity Partners, and Thoma Bravo rather than Sequoia, Andreessen Horowitz and Index Ventures. At this point, I have no other purpose than to share general ideas as to why private equity might be the future of funding tech companies in Europe.
The short version is that traditional private equity firms entering VC means several things:
These firms learn to cope with the specifics of software economics: they don’t necessarily count on hefty dividends right away, even if they tend to impose a shorter path to profitability.
And sure, capital is cheap these days and they’re all desperate to deploy it, but PE firms also tend to focus on sectors and companies that are familiar, not disruptive.
An example that comes to mind is Zoopla, an important company in the recent history of the London tech scene (founded by Alex Chesterman, now the CEO of Cazoo (which just merged with a SPAC), and backed by prominent investors such as Stride VC’s Fred Destin): it was listed on the London Stock Exchange in 2014 before being bought out by Silver Lake (a firm I plan to write about soon) in 2018.
You can see why Zoopla is attractive for a private equity firm such as Silver Lake: it’s a tech company and it was backed by VC firms at the early stage; but still, what’s so new about listing properties for sale in the UK? Moving the industry online makes it more efficient and improves the user experience, but it’s still familiar enough for a traditional investor to get interested.
8/ Indie financing
This is the early-stage version of traditional private equity firms venturing into VC. Quite simply, once people realize some ‘tech’ companies such as Zoopla can reach profitability early on, they will start looking for the equivalents, but at a much earlier stage.
It will give rise to investment firms focused on spotting early-stage companies with a potential for profitability, then deploying capital in these businesses and putting them on track to reach profitability in the best circumstances possible. This approach will be the large-scale version of a very interesting experiment known as Indie.vc.
By coincidence, a few weeks ago I wrote about Bryce Roberts of O’Reilly AlphaTech Ventures announcing that they were discontinuing their pioneering Indie.vc program. Have a look at my Funding Profitable Businesses, and here’s all the details about how it works (from Bryce’s What Ended Indie):
A key tenet we felt was important to Indie was putting founders in control. Not just of their companies, but of their cap tables too. One important way we manifested that value was through our unique set of terms that allowed founders to control their dilution by repurchasing up to 90% of our equity at any point for 3x our initial investment.
The reason I think it’s still a promising segment of Diffracted VC, despite the discontinuation of Indie.vc itself,n is because, in my view, companies with lesser returns to scale but earlier profitability will multiply as software starts eating more tangible industries on more fragmented markets.
Here’s how I put it in my Europe should lead the way on alternatives to traditional VC (in Sifted):
Here are the perennial problems with European startups whereby the traditional model doesn’t always fit: a fragmented market that makes scaling up more difficult than in the US or China; the lack of capital at later stages that forces founders to reach profitability sooner than their US counterparts, thus potentially cutting down on increasing returns; and the lack of liquidity at the exit stage that makes it especially tricky for fund managers to generate the returns that their LPs are expecting. In short, because Europe is so fragmented, the approach to financing as it’s practised in Silicon Valley doesn’t quite deliver the results.
9/ Digestive pills
This is a slightly different idea. Let’s put it this way: now that software is eating more tangible/regulated/difficult/hybrid industries, investors will have to diversify the way they deploy capital.
An example: online lenders. When someone founds a tech business in this field, they raise actual VC money for the company handling operations, counting on increasing returns to scale from a business perspective; but they also need to raise capital that will actually be lent to customers. The debt fund is obviously a different bucket, ruled by different regulations and usually raised from different investors with different expectations when it comes to risk-adjusted returns.
I call the debt fund a ‘digestive pill’. It’s a separate asset that will help the company get a foothold in the market and eventually secure a large share of it. Like in this case, many tech companies these days need investors that are ready to fund their particular digestive pill—an asset that will help a specific company enter (and eventually eat) a specific market. Here are examples:
Tech companies in the real estate space need specialized investors to fund real estate assets.
Tech companies in the bio space need specialized investors to fund new drugs.
Tech companies in the manufacturing space need specialized investors to fund factories.
Tech companies in the airline space need specialized investors to fund airplanes.
Tech companies in the music space need specialized investors to fund catalogs.
I wrote about it at length in An Investment Thesis: Help Software Digest the World. And I think that this idea of digestive pills to help software eat the world is what explains Andreessen Horowitz’s apparent diversification far beyond the traditional realm of venture capital:
Once you realize that software needs digestive pills so as to eat industries that are more tangible and/or more regulated, the infinite diversification of Andreessen Horowitz starts to make sense. They are far from being present in all corners of the world (yet), but they have set up dedicated vehicles specifically targeted at funding digestive pills in interesting fields…
I wouldn’t be surprised to see Andreessen Horowitz launching more specialized funds in the future, with a focus on industries that software still has a hard time eating, such as energy, agriculture, construction, space. In any case, theirs is an example that more investors across the world could follow.
10/ Moonshot investing
We’ve all heard the concept of a moonshot in the context of funding innovation. It’s about allocating lots of capital toward achieving a goal that seems completely out of reach, hoping that there’ll be interesting intermediate outcomes from the whole effort.
It’s usually used in the context of industrial policy (the initial inspiration is John F. Kennedy’s legendary speech about going to the moon) or corporate innovation. But it’s now made its way onto the stock market: ARK Invest’s Cathie Wood, for instance, sells shares in ETFs through which investors can be exposed to what she deems key technology trends, such as robotics or artificial intelligence.
It’s a category I decided to add as of yesterday after reading an article in the FT, Meet the academic who has fired up moonshot investing (about the economist Hendrik Bessembinder):
Some investors cite [economist Hendrik] Bessembinder’s work as evidence that aggressively investing in a narrow clutch of potential corporate superstars — almost whatever the price — is actually the way for active asset management to regain its mojo. After all, his data implies that finding just one of these nascent stock market titans can more than compensate for losses elsewhere.
Bessembinder’s influence can be most obviously seen in Baillie Gifford, the money management group that has seized on his work as backing for its big bets on fast-growing, disruptive companies. Baillie Gifford has hired Bessembinder as a consultant, and bankrolled his 2019 global study.
But his subtle reach can also arguably be detected in the approach of Cathie Woods’ Ark Invest and Chase Coleman’s Tiger Global. The former has caused a stir in the traditional investment world by making outsized, wildly successful bets on hot technology stocks, while the latter’s gung-ho investment spree in an array of promising start-ups is now ruffling feathers in Silicon Valley.
11/ Global Currents
Finally, another dimension of Diffracted VC is that founding teams now need venture capital all across the world—that is, in contexts that are very different, from both cultural and regulatory perspectives, from that which traditional venture capitalists are used to.
Therefore we should expect the rise of a new breed of investors: individuals and firms that learn to deploy capital in tech startups far from the most mature ecosystems. I call this particular category (which I discussed at length in my podcast discussion with Chris Schroeder) ‘Global Currents’ (in the same maritime spirit as European Straits).
"I started to observe a changing dynamic whereby emerging markets entrepreneurs chose to forgo personal gain and refused the sale of their companies to foreign tech titans as it was not in the best interests of their countries. The Trump administration’s decision to walk away from the Trans-Pacific Partnership Agreement (TPP) in January 2017 was a turning point in the course of tech geopolitics as emerging markets entrepreneurs could now partner with their governments to implement regulation that protected domestic digital assets and opportunities. China and Russia showed the way by fostering the emergence of local Emerging Markets Titans who offered local solutions, who benefitted from regulatory protection, and who leapfrogged foreign competitors."
Halpert and his team have since turned the idea of Digital Decolonisation into a "lens" – an analytical framework – through which they view investment opportunities.
(BTW Halpert trademarked the acronym ‘DigDec’, which is why I had to forge my own concept of ‘Global Currents’—to be continued!)
If you enjoyed this edition of European Straits, you should subscribe so as not to miss the next ones.
From Munich, Germany 🇩🇪