See below for a redacted for confidentiality version of the letter we sent our LPs this month commenting on the broader tech and crypto ecosystems, as well as our specific funds. We find in these volatile times, it can be helpful for our friends, founders, and the broader community to read our higher level thoughts.
Dear Compound I & II Investors,
Over the past few months, we’ve seen a fair amount of volatility in equity and crypto markets. While you all are paying close attention to these dynamics in your areas of the market, we thought it would be prudent to discuss how the mix of macroeconomic shifts, global conflicts, and reactions to other factors have impacted our funds and areas of focus.
Before getting into detail, at a high level, we have chosen over the past few years to not play the game of escalating valuations, lower ownership, and believing in a new paradigm where $10B+ outcomes are commonplace. We have always raised small funds with a fund model built around strong ownership, concentrated positions, a belief that every investment we make must be able to return the fund, and a desire to not rely on multiple multi-billion dollar outcomes in order to generate the returns we aim for.
This has been difficult the past few years as we’ve had to be very focused on getting to founders early, convincing them often to take a lower price than the market has offered, and being very disciplined on follow-on investments. In retrospect, we think we did a decent job at this, largely passing on $20M+ valuation seed rounds, and not following-on into pre-product market fit companies that raised multiple rounds at escalating valuations <12 months apart.
The other core tenet of our approach has always been one that optimizes time diversity. We invested Compound I (Fund 3) from 2016–2021 at a time where our peers raised 2–3 funds in that same time frame. We plan to deploy Compound II initial investments over ~3.5 years and (redacted) over a similar timeframe.
We want to build an institutional grade firm that capitalizes on a research-centric, thesis-driven approach to investing that can generate consistently great returns, while having the opportunity to have large outlier funds due to our size and ownership (we believe Compound I could be one of those funds). Put more plainly, our strategy can be summarized as diving deep in areas we care about, exploiting and growing that knowledge moat over multiple funds, being disciplined on fund math, and not chasing the noise around us.
For a more personal take on this past few years and how we’ve approached it, you can also read my tweetstorm here.
Now onto specifics.
Compound I
The concern of many LPs surrounding ~2016 vintage funds has been that multiples have been strong but liquidity has been very low. While we definitely saw material valuation increases, we weren’t as exposed to overpriced SaaS, Infrastructure, Fintech, or Consumer investments as many of our peers due to our more niche focus areas of AI/ML, Robotics, Bio, Healthcare, and Crypto. Companies building in our categories often spend years solving difficult technical problems, generating material IP, and then scaling commercialization. In an economic downturn, these companies still hold material real world value relative to their peers in other industries predicated on customer acquisition costs and unit economics that perhaps don’t make sense with expensive capital.
Taking into account the recent crypto sell-off, our portfolio is still valued at over xx MOIC and we’ve managed to return over xx% of the fund thus far. In addition, we are still holding positions that we believe have material upside (with $xM+ of additional capital to invest to get to our goal of 110% invested), while taking liquidity on some that we believe have capped out in value. We say this with a straight face as none of our core portfolio companies on the tech side have raised at valuations north of $xB and most are very well capitalized to weather any downturn.
Our potential fund returning (and largest positions) can be broken down as follows:
- *bulleted list of our four largest investments with amount invested, MOIC, valuation, and runway + commentary on the individual business metrics and progress*
In addition to the above investments, we also have a variety of earlier but still strong investments that could drive material returns in companies like *redacted list of companies*
Difficulties
The difficulty of investing at seed in the past few years has been that the abundance of capital has meant that decent companies don’t die as quickly as they used to. We believe this likely will change over the next 6–18 months and we’ll start to see the mortality in our portfolio that we thought we would see a few years ago. Companies that fall into this camp are likely *redacted list of companies*. These companies represent a cumulative ~$3.6M in investment.
To summarize, we feel Compound I’s core investments are very well positioned to grow into and past their current valuations, with *redacted’s* runway potentially leading to more dilution than anticipated being the only area of concern within the larger investments in our portfolio.
Crypto & Web3
Compound I Crypto Portfolio
We continue to believe strongly in the core trends of transparency, self-sovereignty, globalization of labor, trustless operation, wider distribution of ownership, and scaled efficiency that back Crypto/Web3.
In 2018 we saw our crypto portfolio draw down 90%+ along with the rest of the market after the rise and fall of ICOs and over-exuberance of the potential of blockchains wiped out the industry. We view that timeframe as similar to the dot-com bubble as there was little activity on blockchains, poorly thought through value accrual, short-termism, and a sub-standard operator cohort.
Since then we’ve seen blockchains scale materially in both dollars onboarded as well as use-cases. Despite this, there are still early mistakes that the industry must learn from and harsh realities that we must face about how to build for the long-term instead of shuffling dollars in a very adversarial environment (something that VCs often are not equipped to capture value in).
With the crash of LUNA (an ecosystem we had no exposure to) and a broader risk-off mindset, we saw correlation between equities and crypto tighten, and forced selling due to liquidations drive down prices materially. Our crypto portfolio in Compound I fell from a value of ~$xM in March to ~$xM as of May 26th, 2022. Today, on $xM invested we have seen proceeds of $xM, having taken liquidity along the way.
There are two ways to look at crypto markets and being a holder of liquid assets that have seen a fast rise in prices, but very short-term value capture.
Option A: The rise in prices were driven by growing adoption and proliferation of crypto’s readiness, and speculation pushed cumulative network values to heights that were unsustainable in the mid-term. Because of this, we should aggressively take liquidity along the way, locking in very good returns for our LPs, ignoring any potential reputational risks to the firm by being an early seller.
Option B: The cumulative crypto market cap range of $1-$2T in this past cycle is materially lower than where we believe the world is going. Ultimately our goal is to invest in asymmetric, power law driven categories, companies, and protocols, and wait for long-term, large scale outcomes. Because of this we should be comfortable with short-term token emissions that push down price over time (as seen in tokens like x), and believe that we have invested in long-term, effectively duopolistic market leaders in their given category, generating fantastic returns for our LPs on minimal cost basis.
Through the life of Compound we have largely operated under assumption B, taking small amounts of liquidity when possible to lock in smaller multiples on investment, while holding liquid tokens we believe will become fundamental protocols within a much larger crypto ecosystem by 2026 (redacted commentary on specific protocols).
While with hindsight there are certain tokens we wish we would have sold more of, we feel that the existing tokens we hold today have a strong chance to bounce back as the broader crypto market does, and that as dispersion happens (as it should as the market matures) we will have outperformers that show power law dynamics. As the bear market continues to progress, the core thing we will watch is if the protocols that already have made material wealth continue to build, just as they did in 2018. If we see slowing development, we will likely evaluate network values and sell those that we have lost faith in, just as we did with (redacted) last year.
Broader Crypto Market
In December of 2021, when ETH was trading at $4000 we tweeted our predictions for 2022, and specifically said that we would see ETH fall to $2500. Ethereum and crypto broadly is at a point where net new inflows largely is what creates fast ratcheting of token prices across the still fairly correlated ecosystem. Because of the fact that as a firm we felt crypto had run out of new narratives after a very strong 2020 and 2021, it was clear we needed a reset within the industry in order to drive more adoption, usage, and capital.
At the same time, the macro environment for all risk assets has eroded, with many high flying tech stocks actually performing worse than BTC and ETH over the past year. This environment paired with the (in our eyes inevitable) collapse of LUNA, means we have entered into a bear market in which correlation between equities and crypto has tightened, and there is little positivity around the ecosystem.
While we don’t have a strong view about whether this is 1973, 1989, 2001, 2008, or 2018 on a macro basis, we do think we have reached a net negative churn of talent and adoption of decentralized blockchains for the future. We believe there likely will be euphoria in the market if/when the Ethereum merge happens in Q4’22, and a recovery would be sustained assuming better macroeconomic clarity as well as better mechanisms and narratives to build valuable protocols on blockchains.
With all of this said, we are seeing prices come in materially, tourist funds leave as quickly as they came, and despite it being cliche, expect some of our best investments to be done in the space over the next few years, just as when we funded The Graph in 2018.
Compound II
Thus far we have invested just under $4.5M from Compound II. As mentioned above, we’ve always been very intentional in deployment, only investing in companies and projects where we have deep conviction and the fund math works for our return goals. Because of this, as the early-stage and broader tech markets were experiencing incredibly high prices in 2021, we passed on or weren’t able to win companies that we thought were great, but that were being done at prices that we believed were irrational.
We feel very excited by the slowing down of pace of deals for the broader market as well as falling prices that will allow us to do our job and get strong initial ownership we likely haven’t seen since 2020.
A core dynamic we will be watching is how follow-on investors approach deep tech companies that are at times more capital intensive than other categories. At a time where capital was cheap, many investors expanded their scope into our areas of focus, but as capital becomes more expensive and volatility increases, it feels likely that those bullish on deeper tech areas will narrow, especially due to the horrible public performance of many companies over the past year that were haphazardly SPAC’d by our peers with little traction.
Summary
To summarize our feelings at this moment in time, we are excited about the future, cautious about the present, and proud of the past. We’ve been disciplined and focused at a time when it became very easy to not be, and while we have certainly made mistakes along the way, we welcome the return of dispersion of companies and returns.
Investing isn’t supposed to be easy, and for better or for worse, we have conviction that our approach to investing thrives in times where capital becomes more selective and founders become more disciplined.
Thank you for your continued belief and support in us, and please do not hesitate to reach out if you have any further questions or would like to hop on a call to discuss anything related to this letter, the broader markets, or more.
Best,
Michael & David
