Tag: Market Cycles

AI Musings #5 – Opportunists vs Believers

Sharing some observations and working hypothesis on Opportunist vs Believer founding teams in AI.

My biggest challenge as a venture investor in AI right now is figuring out which of the following 2 camps a particular founding team belongs to:

Opportunists – who are trying to leverage this moment in time when the market has massive curiosity about AI.

vs

Believers – who have high conviction, and are truly mission-driven about AI.

This is a critical evaluation point for these early AI deals. As previous super-cycles have shown us, a bubble-bursting trough in the space is inevitable in a few years (perhaps as soon as 3-5 years?). It will be brutal like previous resets – capital will get reallocated to the winners and dry up for the rest, exits will be on brutal terms, customers will tighten their belts, early-stage talent will flee and the general sentiment will turn from greed to fear.

In my experience, Opportunist founding teams are less likely to survive this trough. It will require grinding out on fumes and focusing on real customer problems vs vanity metrics and perpetual fundraising. It will need gut-wrenching decisions that sacrifice short-term gratification so that the long-term upside can be captured. It will require possibly resurrecting the company many times from the dead.

Being able to do all this requires extremely high conviction deep down in the gut. Founders who are Believers will have this conviction in their DNA, and when the cycle turns negative, this will become their competitive advantage.

Given this is turning out to be a key evaluation point for AI deals, have been thinking through what leading signals can be used to spot Believers with higher probability. Here are some working hypothesis thoughts on this:

[Disclaimer: am just thinking out loud here so please take this with a pinch of salt. This is nowhere near any gospel of truth, nor do I have significant experiential validation around these points given we are literally in the first wave of AI deals].

1/ Pre-ChatGPT AI builders – likely to have been working in AI much before ChatGPT was launched. They were most likely building with ML, NLP, and neural networks in a Big Tech team, a lab, a university, or some sort of R&D/ academic environment.

2/ Pre-AI domain experts – likely to have been working deeply in a specific domain/ industry/ sector/ function from pre-AI days and are now adopting LLMs to carry forward their domain work and solve customer problems that were previously unsolvable or unviable.

3/ Young tinkerers – likely to be fresh grads who started building AI-native products as a hobby during university, maybe as part of a side hustle, or even just out of intellectual curiosity. They would have likely built products and hacked a few early users even without “doing a startup”.

These are only some of the personas I have been thinking through. As I meet more teams, I will keep adding to this list.

If one looks at how the early days of Web 1.0 played out (eg. in eCommerce and Search), most first-movers ended up dying. The 2nd generation companies leveraged both the market that was created by the 1st gen, as well as learnings from their failures, to create new categories and emerge as viable businesses.

History doesn’t repeat exactly but often rhymes, thus requires being even more thoughtful about which companies to back in this 1st generation of AI. In my case, as a US-India corridor investor, there is an additional complexity to think through – how will AI companies being built out of India compete with those in Silicon Valley? Who is most likely to be stronger in which part of the AI stack?

With domestic data being of strategic importance to each country and the rise of country-specific models, is AI going to be an extension of the globally decentralized software product/ SaaS story of recent years? Or will there be opportunities in ring-fenced, domestic AI in each major geography?

These questions and unknowns are what make the present times in AI investing both interesting and challenging at the same time. To manage this context, I am trying to be open-minded, learn fast, and think from first principles as much as possible. But at the same time, balancing this default-optimism stance with being non-trigger-hungry, consciously thoughtful, and taking the time to build personal conviction on each opportunity.

PS: check out the previous post #4 in the AI Musings series – How To Differentiate As An AI Applications Startup?

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When will the next venture bull run begin?

While public markets appear to be decisively reviving this year, venture activity barring AI is still very slow at large.

With founders & investors worried about when the good times will return, I turned to an age-old framework by the OG Sir John Templeton to try and answer this question.

I recently listened to the latest quarterly update podcast, “What’s Exciting in the Market Right Now?” by Miller Value Funds. I am a big fan of Bill Miller & always make it a point to deeply reflect on what he says.

In this pod, Bill cited an insightful quote by the late Sir John Templeton, the legendary founder of Templeton Funds:

Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria.

Sir John Templeton

A. Templeton’s framework

Bill then goes on to apply this Templeton’s framework to explain market cycles over the last 15 years as follows:

  • During this period, the first point of maximum pessimism was in March 2009, which then birthed a new bull market. The next point of max pessimism was March 2020, which gave rise to another bull market.
  • Dec 2020 was the point of optimism, post which the market fell ~38% but then rallied again. Ultimately, the point of euphoria was reached in Nov 2021, which saw the peak of popularity for innovation bulls like Cathie Wood of Ark Invest. At this time, interest rates were at rock bottom while valuations of unprofitable growth companies were sky-high.
  • The most recent point of max pessimism was in the Fall of 2022. Since then, overlaying market performance on top of Templeton’s framework, it’s safe to say that the next bull market has already started. Markets are up ~20% since this last point of max pessimism and therefore, this new bull run appears to have reached the “grow on skepticism” phase in July 2023.

Bill then goes on to say something super insightful (man, the amount of wisdom in this 10 min monologue!). Paraphrasing a bit here:

Microstrategists try to use their view of the economy to determine where the market is going. And that’s exactly backwards.

The economy doesn’t predict the market. The market predicts the economy.

The market comprises of real people with real money at risk, and the totality of them is how the market acts.

Bill Miller

Just think about the 2nd para in the above quote. It’s an amazing thought! Intuitively, we all tend to think of the market as an analytical engine when in fact, it’s actually a prediction engine. It’s a complex system where hundreds of millions of people are looking at all the info they have, making a prediction of where the economy is likely to be headed & placing bets with real money based on this prediction.

But I digress! Coming back to Templeton’s framework, as I was digesting it in the context of public markets, I ran a thought experiment on whether it applies to the venture market as well. This is how the exercise went.

B. Applying Templeton’s framework to venture

It’s important to mention upfront that private markets differ from public markets in a few important ways, which manifest in specific behavioral characteristics:

1/ They are illiquid ➡ price discovery happens gradually & therefore, lags public markets at least by a few months if not years, due to system inertia.

2/ They have fewer (very small retail participation) but more sophisticated participants ➡ both upward & downward resets have relatively less internal momentum & are, therefore, more gradual.

3/ They have high information asymmetry ➡ takes time to gather, analyze & react to information. Given higher imperfections, probabilities & confidence intervals are assigned to conclusions more conservatively.

4/ There is negligible automated trading & auto-pilot inflows ➡ information is analyzed & acted on by real humans in a slower, more deliberate way.

Essentially, private markets are slower, more concentrated & more deliberate with longer feedback loops than public markets. Therefore, while public markets can be analyzed daily, weekly, or monthly, I believe a safe unit of time to analyze the cyclicality of private markets is a year.

To start applying Templeton’s framework to the US venture market, I looked at data for total venture capital $$ invested in the US every year since the dot-com bubble. Here’s how the data looks:

Source: NVCA Yearbooks (for years marked with *, data was sourced via ChatGPT as it was unavailable on the NVCA website)

Here are some insights I gathered from this data:

1/ During the dot-com bubble, 1997 and 1998 look like the years when the venture bull run entered the “grow-on-skepticism” phase. It then hit the “mature-on-optimism” phase in 1999, achieving the “point-of-euphoria” in 2000.

As per the Templeton framework, the point of euphoria is when the bull market typically starts its journey toward death. This is exactly what happened to the dot-com bull run between 2001 and 2003, hitting the point of maximum pessimism in 2003. Interestingly, going back to the earlier point of a lag between public and private markets, this 2003 point of max pessimism for US venture was a year behind the same for public markets (they bottomed in Oct 2002 when the S&P500 hit a 5 and a 1/2 year low).

2/ Moving forward, the US venture market again followed Templeton’s argument of “bull markets are born in pessimism”. The seeds of its next bull run were sowed in 2003, subsequently entering grow-on-skepticism during 2004 and 2005. This bull run entered mature-on-optimism in 2006 and 2007, growing 25%+ y-o-y.

But before it could hit a real point of euphoria, the housing crisis happened in 2008. The US venture market hit the point of max pessimism in 2009, and similar to the dot-com run, lagged the public markets by a year (their point of max pessimism was in Sep 2008).

3/ With the tailwinds of the Fed’s zero interest rate policy post the ’08 crash, the US venture market saw a secular bull run between 2010 and 2021. Barring a few corrections and a brief Covid hiatus, this was an almost uninterrupted, decade-long, dream bull run.

Fueled by massive liquidity injection by the Fed to counter potential Covid-driven economic distress, on top of astonishingly low levels of interest rates, the US venture market hit the point of euphoria in 2021. As I wrote in my post “Making Hay During Market Peaks“, this was the year of “Crypto shitcoins, ape NFTs, meme stocks, IPOs of unbaked tech companies, and real estate boom in as far as Denver & Raleigh”.

C. Where are we now in the current venture cycle?

Consistent with Templeton’s framework, the recent decade-long venture bull run started its downward spiral from the point of euphoria in 2021 and subsequently hit a point of max pessimism in 2022 (~30% y-o-y decline in VC $$ invested).

But this framework also tells us that the seeds of the next venture bull run were also sown simultaneously at this point of max pessimism in 2022.

As we stand today, I get the feeling that the US venture market is close to entering the Day 0 of the grow-on-skepticism phase of its next bull run (I wrote about how the excesses of 2021 are now winding down in my post “Cheetah in the Rainforest: 2021 Vintage of Venture“).

Per Bill Miller, public markets have already entered the grow-on-skepticism phase decisively, showing ~10% gains in H1 2023, and are likely to continue on this trend in H2. Assuming a ~1-year lag between public & private markets like in previous cycles, my expectation is that the next venture market bull run will decisively enter the grow-on-skepticism phase in 2024.

C. Closing thoughts

As a disciple of Charlie Munger, while I don’t believe in macro forecasts (especially by economists & equity research analysts), I am also a disciple of Howard Marks and therefore, a strong believer in the importance of studying market cycles across asset classes. Where we are in a cycle should be one of the important inputs for deliberation on an optimal investment stance, including what mix of offense & defense to aim for.

Hence, my fascination with Templeton’s framework, and how well it works as a tool for studying cyclicality in both public & private markets.

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Making Hay During Market Peaks

The recent rise & fall of Hopin shows that during market peaks, buy-side is the patsy while sell-side is the baller.

Here’s how you can position yourself to “reap” during market peaks.

One of the more interesting startup stories of the last few weeks has been the rise & fall of Hopin, a virtual events platform. After having raised more than $1Bn from the likes of a16z, General Catalyst, Tiger & Coatue, who valued the company at close to $7.7Bn as recently as 2021, Hopin’s core assets were recently acquired by RingCentral for a paltry $15Mn upfront consideration (+ another $35Mn contingent consideration, based on performance targets to be met in future).

RingCentral’s filing on the acquisition of Hopin

Now here’s the most interesting part of the story – while the company has seen a drastic reversal in fortunes, the Hopin founder has already netted ~$195Mn personally by selling his shares in secondary transactions. With the company’s recent subpar exit, the issue of founders making life-changing money before investors & other shareholders have made any returns is now attracting serious attention.

These developments got me reflecting on some interesting learnings from this story for founders, investors, and employees. Here are some real-time thoughts running through my head:

1/ Market peaks can get wildly irrational – the last few cycles indicate that peaks in asset prices tend to typically happen every 7-8 years, perhaps even 10 years. Clearly, they aren’t frequent and one would expect to catch only 2-3 at best during the core years of any career.

But when the peaks do happen, they are wild! The dot-com bubble saw sub-scale companies with no business models go IPO within a few years of starting up. During the housing bubble of ’07-’08, both individual investors & Wall Street assumed that house prices would keep going up forever, with banks engaging in rampant sub-prime lending & their investment banking arms trading complex derivatives that they themselves struggled to fully understand (remember the jenga scene from the movie ‘The Big Short’?)

Ryan Gosling in ‘The Big Short’

Similarly, 2021 was the peak of a post-Covid, liquidity-fueled mania. Crypto shitcoins, ape NFTs, meme stocks, IPOs of unbaked tech companies, and real estate boom in as far as Denver & Raleigh, there was literally no asset class that was untouched by super-inflated valuations & crazy investor behavior.

One of my favorite lines is – “crowds have short financial memories”. As a full generational cohort turns over every 7-10 years & new blood comes in, it tends to underestimate how high the market peaks can really go. To truly appreciate this, one has to live through at least one such peak, & be both old enough to participate in it as well as mature enough to assimilate learnings from it.

2/ Sow for many years, and then sell “high” – to make the most upside over a career, one has to be well-positioned on the sell side when the market peaks. These peaks are getting higher & wilder with each new cycle, therefore turning out to be generational selling opportunities.

Framing this idea in a more interesting way:

During market peaks, buy-side is the patsy while sell-side is the baller.

How does one ensure you are the baller when the next peak comes around? That’s where executing with persistence during tough times becomes critical. When times are hard and one has to be a price-taker (like the current funding environment), that’s precisely when founders should be heads-down in the “sow” mode, laying a solid foundation for the business & being as capital efficient as possible. So when the peak is around the corner, the business is well-positioned to be in a “reap” mode.

Btw, this advice applies to all asset classes & includes careers too. Peaks are the best times to get that coveted CXO role, get quicker promotions, and sell RSUs at a massive premium. But, being firmly positioned to reap these benefits requires many years of upfront sowing.

3/ Leverage diversity to avoid being the patsy – inspired by that famous line from Mike Tyson – “everyone has a plan until they get punched in the mouth”, I have my own version of it for investor behavior during peaks:

Everyone is rational until they experience a bull run.

Greed & fear are two core driving emotions of human behavior. The job of a professional investor is to manage these emotions & hold on to the fundamentals of doing business during both good & bad times. Unfortunately, as the Hopin example shows, this is easier said than done. Case in point: even the best VCs neglected to do basic due diligence while investing in FTX.

I was thinking hard about what investors can do to avoid becoming the patsy. One word that kept coming up in my mind is “diversity”. Building a diverse team that brings together both the optimism of youth as well as the battle scars of experience across multiple cycles, could be a good way to provide behavioral checks and balances. Of course, merely assembling diversity isn’t enough. Empowering everyone equally so each person has a voice at the table is critical to leverage this diversity.

While the best option is “direct” diversity in the team, investors can also utilize “indirect” diversity – surrounding the team with investment committees & advisory boards that can step up at the right time to provide battle-hardened inputs. Again, it’s vital to ensure that these roles don’t end up as rubber stamps. Instead, they need to be staffed with people who have the stature & credibility to ask the tough questions & play devil’s advocate when required.

Overall, it’s important to set up mechanisms that can create behavioral balance within the firm – naturally introduce a bit of fear when greed is rampant in the market, & bring back some greed when everyone else is fearful.

Be greedy when others are fearful.

Warren Buffet

Closing out with my 2 cents on founders doing secondary sales – founders take extraordinary risks, sacrifice immensely & literally go through the fire for years, sometimes decades, before seeing any payout. If there are willing buyers for some of their stake, I see no reason why they should be admonished for selling, unless there is something unethical or illegal about it.

Investors hedge their bets across a diversified portfolio while founders put all their life’s eggs in one basket. A majority of them draw below-market salaries for several years and don’t see a significant financial outcome for ages. A large proportion of them never see a commensurate payout at all, courtesy of the VC preference stake. When no one really sheds a tear for these struggles, often framing them as “a typical price every founder pays”, people shouldn’t be complaining when some of them get the opportunity to make some early money during market peaks.

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