The Year Ahead for Alternative Assets

European Straits #245

Jan 18, 2024

Hi, it's Nicolas. Apologies for having interrupted the flow of new editions. I was ill with COVID some time ago and subsequently had a lot to catch up on, including the typical end-of-year tasks such as accounting, among other things.

Currently, I am in Switzerland, invited by my friends at Aperture to participate in two panels on 'The Year Ahead for Alternative Assets'. The first panel took place on Tuesday evening in Geneva, and the second is scheduled for today (Thursday, January 18) at 7pm at the Widder Hotel in Zurich. You can see the details and register to attend by following this LINK.

Nobody likes jargon, so let me first clarify what Alternative Assets, or 'Alts', entail. Essentially, they encompass any financial asset class outside of (i) shares in listed companies, (ii) bonds, and (iii) cash. Alts notably includes real estate, private credit, private equity in general (‘PE’), and specifically venture capital (‘VC’, effectively a subsegment of private equity), as well as commodities, cryptocurrencies, and various other even more exotic assets. Below, I present a few ideas on what to expect in this segment of the capital markets.

1/ Global Economic Fragmentation

As frequently discussed in this newsletter (see here), the trend towards global fragmentation is rapidly accelerating. The US is becoming more inward-focused, and other economic regions are similarly turning inwards—in no small part as a response to the diminishing presence of the US in international trade. This trend is exemplified by the challenges faced by shipping companies dealing with attacks from Houthi rebels in the Red Sea.

In this evolving landscape, asset allocators focusing on Alts must acknowledge the increasing difficulties in conducting cross-border business. This shift towards internal markets is likely to confine companies predominantly to their domestic arenas, restricting their expansion to the role of national champions. Such a development will have a significant impact on returns for private equity investors, including those in VC, and will constrain the opportunities for deploying private credit.

From a company perspective, this trend also means that accessing investors outside of one’s local ecosystem will become increasingly challenging. In certain countries, this won't pose a significant issue due to the abundance of local capital available for allocation to Alts. However, for others, it will present a challenge. This could be due to (i) a shortage of domestic capital in general, (ii) a tendency of domestic capital owners to seek opportunities abroad due to the absence of financial repression, or (iii) a preference among local allocators for traditional asset classes over Alts.

Another way to look at the fragmentation is that even for those companies able to cross borders, the number of markets available for expansion has diminished significantly. China, once a prime destination, is now effectively closed, especially for tech-enabled businesses. The increasingly competitive landscape in the US makes it a challenging market to penetrate, while emerging markets are likely to be dominated by either Chinese or US champions, making them inaccessible for European businesses.

In other words, in this increasingly fragmented global market, companies will only be able to expand into foreign markets (i) if they have already reached a critical mass domestically (as is typically the case for Chinese and US companies), or (ii) regardless of the size of their domestic market, if they are backed by a strong, supportive national government that prioritizes assisting domestic players in conquering foreign markets, as has historically been the case of many successful developing nations.

This dynamic has been a characteristic of capitalism for as long as we can remember. I discussed this in a 2019 issue dedicated to the work of French historian Fernand Braudel:

You can be both for capitalism and for more state intervention. Indeed, the most prosperous countries were always those where capitalists benefited, according to Braudel, from a certain “goodwill” on the part of the state. Or, as Dani Rodrik puts it, “capitalists need the state more than the state needs them”.

2/ Paradigm Shift: Complete

The transition from the age of the automobile and mass production to the current age of computing and networks, hastened by the 2008 financial crisis and 2020 pandemic, has now plateaued. With software having already transformed most industries, there's minimal scope for unexpected breakthroughs. I expect that new technologies such as AI are poised to contribute to widespread consolidation rather than disrupt already evolved industries, as was the case for the innovative manufacturing techniques introduced by Japanese carmakers in the 1970s. As a result, regardless of the AI hype, the emphasis in the near future will be on realizing profits through consolidation rather than disruption—a crucial adaptation for fund managers in the VC space.

The evolving dynamics will significantly impact how traditional private equity (PE, comprising growth equity and buyouts) and VC interact. Each sector may initially borrow strategies or practices from the other before eventually retreating back into its distinct niche.

From the perspective of traditional PE, generating returns now hinges on recognizing the need for investment targets to fully leverage any available, well-documented technology—including the imminent incorporation of AI. As a result, the market has witnessed a convergence and potential merger of PE and VC strategies—characterized by PE firms pursuing tech companies, and VC firms backing more traditional, tangible businesses.

But now that the paradigm shift is complete (or, as I termed it back in September 2023, the door is closing for startups), I believe we’re about to witness VC's re-specialization. Contrary to what many expected (myself included), VC hasn’t eaten the investment world. Instead, VC has effectively struggled to grow beyond its role of funding high-tech companies, visibly straying way too far from its core while backing companies with a subpar potential for generating increasing returns to scale.

As a result, a correction is now at work and I anticipate VC will now divide into three distinct segments:

Some VC firms are now re-specializing in cutting-edge technology, returning to the original focus of VC reminiscent of General Doriot’s ARD. Today, this specialization is notably aligned with climate tech. Observing the sectors that have received substantial government funding in recent years reveals significant financial opportunities in backing these cutting-edge tech companies. For some mapping, see my An Investment Thesis: Helping Software Digest the World.
Other VC firms will specialize in backing Software-as-a-Service (SaaS) companies. In this segment, large markets are already dominated by established giants, leaving minimal room for new entrants. Additionally, the significant role of quantitative analysis in SaaS simplifies the prediction of success and the monitoring of performance. This trend makes SaaS businesses resemble restaurant franchises more than traditional tech startups. With SaaS increasingly dominated by spreadsheet-driven investment firms (as evidenced by the interest from PE firms like Thoma Bravo and Vista Partners) and specialized conglomerates (such as Constellation Software), it raises the question of whether such investments still warrant the VC label.
And then there’s a third category: 'VCs' that aren't truly VCs funding 'startups' that don’t actually qualify as such. Indeed, many businesses, though labeled as 'tech startups' and funded by self-proclaimed ‘VCs’, don’t genuinely fit into the category of ventures typically backed by VCs. They are often too tangible, too regulated, too labor-intensive, and face significant challenges in scaling up. Some of these businesses are likely to be passed on to more traditional PE firms, which are better suited to handle lower returns due to their capacity to leverage debt. Meanwhile, others will be recognized for what they truly are: unsustainable ventures that have managed to exist solely because of low interest rates and the abundance of cheap capital.

3/ All in All, Not a Great Year Ahead for VC

As the disparity between AI hype and return expectations continues to widen, it seems increasingly doubtful that VC will experience significant growth in 2024.

Historically, funding for technology has not been characterized by numerous short-succession waves. Technological revolutions do not happen merely because investors ride from one wave to the next. Rather, they occur when specific breakthrough technologies (certainly not all of them, as exemplified by the Concorde) coincide with just the right macroeconomic conditions. These conditions create a bubble that can inflate, thereby facilitating the mainstream adoption of that particular technology.

This phenomenon was evident with the Internet in the 1990s, and then again with mobile and social platforms following the 2008 financial crisis. We observed a similar trend beyond computing and networks, in other high-tech industries such as fracking in the US. The fracking industry experienced a surge beginning in 2008, driven by remarkable advancements in engineering and the simultaneous situation on Wall Street, where there was an excess of cheap capital with limited avenues for investment.

But the current macroeconomic conditions are in fact significantly adverse to VC. Many capital allocators are feeling pressured to demand guarantees of minimal returns in light of the sustained increase in interest rates. This means a shift in expectations towards more modest gains and an emphasis on minimizing risks. And when evaluating VC as an asset class, allocators observe several concerning factors: the illiquidity of investments, widespread markdowns across VC portfolios, and spectacular failures both at the company level (like WeWork) and in investment ventures (such as Softbank and Tiger Global).

In short, capital allocators see the writing on the wall: there’s not much room left for a paradigm shift in the context of high interest rates. As a result, they will most likely rule out allocating more to VC in 2024. Instead, rising interest rates are likely to favor debt investments over equity and will prioritize capital-efficient, even profitable companies when selecting targets. If asset managers do not initiate the change themselves, capital allocators will compel them to do so.

4/ US Dominance in Financial Depth and Sophistication

From an Alt perspective, the US stands as an outlier and is likely to remain so. Its significant lead in financial depth and sophistication is vital for nurturing frontier businesses. This advantage is not limited to Silicon Valley-style tech companies but extends to every sector, such as fracking, biotech, and many, many others, where financial acumen needs to be finely tuned to accommodate industry-specific high levels of ambition and risk.

Byrne Hobart, the publisher of the newsletter The Diff and a one-time guest on the European Straits podcast, penned a seminal essay in 2021 about American Exceptionalism. In this essay, he highlights the financial system as a crucial factor in why America distinguishes itself as an economic superpower:

The US is, by far, the best place to raise early-stage funding. It's also a great place to raise late-stage funding, to hold an IPO, to do a secondary offering, to borrow enough money to take an unloved company private, to hedge any conceivable risk and tweak any imaginable corporate structure. The US has a critical mass of financial skill and available capital at almost any level. This has a complicated relationship with the dollar's status as a reserve currency; if your career revolves around doing interesting things with money, you'll have more things to do if the money you choose is the dollar.

For Europe to become competitive in terms of deploying capital in Alts, it needs to bridge this gap in financial expertise and innovation, especially in private markets. But, as always with strategic positioning, it’s a very hard thing to do if Europe doesn’t start by acknowledging what makes it different from the US—namely, the fragmentation and the specific constraints it imposes on capital markets:

From a business perspective, accessing capital is a very different game than for companies not located in the US. There's obviously a downside, as limited access to capital can constrain growth and put a cap on scaling up. However, there's also an upside: the fragmentation of capital markets (Alts included), and the resulting scarcity, create a powerful incentive to seek capital efficiency from the outset. This approach can lead to exceptional business performance in the later stages and offer outsized returns for capital allocators who partake in the journey.
From an investment standpoint, Europe’s relative weakness in the financial sector should foster a keen focus on efficiency. This necessitates the development of infrastructures tailored to accommodate Alt investors operating on a smaller scale and within a more regulated environment, as compared to the US. In my 2021 essay on debt capital in Europe, I highlighted this paradox: while financial innovation predominantly occurs in the US, it is actually in Europe where such innovation is most needed. Europe’s disadvantage in enhancing access to capital underscores the urgent need for financial innovation on the continent.

5/ Reasons to Be Optimistic About Europe

And this is one reason why it is so rewarding to spend time with the team at Aperture, as they are precisely dedicated to supporting and investing in innovative companies that are working to enhance the efficiency of European capital markets, especially within the Alt space. Among my fellow panelists in both Geneva and Zurich was Julien De Mayer, a seasoned professional from the European VC powerhouse Rocket Internet and now serves as the founder and CEO of fundcraft. fundcraft is an Aperture portfolio company that specializes in providing digital infrastructure for asset managers active in the alternative assets sector, including PE, VC, debt, and funds of funds.

In a recent interview, Julien alluded to the fact that fundcraft's product specifically addresses challenges unique to Europe. These challenges include market fragmentation, which can be mitigated by adopting digital strategies, and the limited scale encountered both in business operations and investment activities. This limited scale is often offset by increasing the number of lines in portfolios and/or expanding the number of investors in a fund—which is only possible with the right infrastructure:

Generally, all asset managers in the PE, VC, fund of fund or debt space are a great fit [for us], but we are particularly attractive for two groups: First, asset managers with large portfolios or a large investor base, as we have the tools to manage these in an easy and efficient manner. Second, asset managers with a digital approach. We are the only ones to provide a fully digital “front-to-back” integration for them.

It’s often easy to adopt a pessimistic view of Europe from a high-level perspective, but optimism quickly takes over when you're on the ground, engaging directly with active founders and investors. I am grateful to my friends at Aperture for their invitation to partake in such stimulating panel discussions (a special thanks to Ben Robinson 🤗). I'm also very pleased to have had the chance to meet founders and investors as impressive as my fellow panelists Julien of fundcraft, Michael Sidgmore of Broadhaven Ventures, Zsolt Kohalmi of Pictet Alternative Advisors, Teena Jilka of Mercer—with more to come tonight in Zurich. Register and join us!

6/ Further readings:

Why Debt Capital Is a Good Fit for Europe (and Why Europe Is Lagging Behind Anyway) (me, European Straits, October 2021)
We’re going through a “paradigm shift” in real estate: Pictet (interview w/ Zsolt Kohalmi, Delano News, September 2023)
fundcraft, why we invested (Ben Robinson, Aperture, November 2023)
We asked experts in private markets for their 2024 predictions. Here's what they said (Michael Sidgmore, Alt Goes Mainstream, December 2023)
Fundcraft Q&A: how fundcraft is revolutionising fund administration (interview w/ Julien De Mayer, Funds Europe, 2023)

From Geneva, Switzerland 🇨🇭

Nicolas

European Straits