Fund Update – Q2 2022

Previous quarterly update:
Fund Update Q1 2022

Q2 2022 Venture Investments

We continued investing throughout Q2 and did four net new deals. Our dry powder position remains strong, which has allowed us to shake off market conditions and continue focusing on high signal opportunities and founders. We also began seeing early stage valuations come down a bit, which we expect to see more of. We will cover more on market outlook further down.

CharmVerse (Seed, New)

We were excited to be a part of CharmVerse's recent seed round.

We've mostly stayed away from DAO tooling, but CharmVerse is a lot more than that. It's an all-in-one homebase for distributed teams to operate out of. Built-in access control is a key part of this – allowing teams to gate certain content for their team or community based on onchain credentials and NFTs. Over the last year+ we've seen countless deals that are building one niche corner of DAO tooling (similar to what we saw in many DeFi products), but didn't see those as investable.

The main bet here was also on the team and the Founders, who have successfully exited productivity startups and understand how to scale a consumer app and community of users. They are now taking what they've learned in their previous lives and moving into the crypto space, which is the kind of entreprenreurs the space needs – more pragmatic builders with firm, grounded experience. They are hard-headed builders and we believe they will figure out the DAO space and deliver what users want.

If you're a distributed team or someone seeking better productivity tools for crypto, get started with CharmVerse here.

Community Gaming (Series A,New)

The intersection of eSports and crypto is still in its infancy, along with figuring out sustainable play2earn (P2E) models. We think Player vs. Player (PVP) is a more sustainable use-case, as opposed to closed-loop tokeneconomics seen in P2E games. PVP and eSports have real value creation that occurs from things like prize pools and betting. Given Community Gaming's partnerships with many tournaments and venues across multiple games, there is a real source of capital for earning that doesn't simply emerge from token issuance or out-of-thin-air inflation models.

Community Gaming is a platform for PVP tournament/ladder match creation with automated, programmable payouts. They have big crypto plans we can't discuss here but already have a ton of users around the world spinning up tournaments and getting paid out in stablecoins / crypto.

Learn more here.

Lit Protocol (Seed+, New)

Lit Protocol has one of the best technical founding teams we've seen in crypto. Their vision and passion for threshold cryptography and private blockchain data is unparalleled. Their end goals for the project are much wider than we can discuss here, but it's very ambitious and we believe they have the team to deliver it.

Lit already has a ton of integrations with crypto-native apps looking to unlock access control, token gating, and various private data use-cases, along with "Web2" integrations for Shopify and Zoom.

The Founders also have experience in open-source / open-core software and how to monetize middleware and create network effects. As they grow out their initial use-cases, they want to move into things like enabling onchain identity, cloud wallets, and even broader compute for web3 apps.

Many cool things coming for this project – highly recommend following them for anyone interested in these areas.

You can join their community here.

Open (Series A, New)

We were stoked to invest in Open alongside Keith Rabois at Founders Fund and a number of other excellent funds and angels. Open spent a lot of time in R&D perfecting their 'mindfulness' app over the last couple of years, and figuring out how to balance it with in-person sessions and experiences. The App has 4.9+ stars with 600+ reviews.

In this increasingly digital economy, there must be a way to shut-off and look within again. We believe the in-person hybrid is an important contrarian bet, as people are looking for experiences and human connection right now, similar to what we saw with SandboxVR.

What we see with Open is unparalleled production value and design – a true brand we can see arise to create this category, especially in a time when mental health is in a very rough place.

Check it out here!

Venture and Macro Outlook

Similar to last quarter's update, we expect a continued valuation pullback as the market recalibrates multiples and comes up with a new subjective "fair value" expectation for venture and private equity. We've seen a substantial decrease in new deal volume, but plenty of quality coming to the surface. We have some deals teed up for Q3 we are excited about, and don't expect to slow down much over the next few quarters and beyond since our cash position is strong. At least two to three deals per quarter seems likely for the remainder of the year.

Seed stage valuations are always the last to readjust, and we are just beginning to see that. We expect to see many more seed deals under the $15M-post level for the rest of the year, with pre-seeds being back well below $10M. There will still be some quality opportunities and bridge rounds at higher levels (or startups still pushing the limits of seed valuation in a now buyer's market), but this is likely the baseline.

Macro will continue posing the real threat to the duration and depth of this bear market. What we are witnessing is a combination of delayed onset pandemic policy effects, foreign policy, failed energy policies, and a host of second order effects from all this combined to create the current setup. But above all else, an energy crisis. Until oil/gas prices are much lower, inflation is unlikely to improve by any healthy measure, and that means more rate hikes, which will continue to destroy demand and risk appetite. The reality is that energy prices underpin everything else and we massively take that for granted in modern society. The double-edged sword is that when energy prices do fall, that likely means recession has begun. And while it's possible inflation has already started to peak and may have lower prints from here, it will still remain unacceptably high for a while, and the reason for its decrease will be due to demand destruction and recession. The catch-22 is palpable. Better inflation prints may lead to pumps, but they're more likely to be fleeting, as other economic effects materialize.

As predicted in our last update, recession is also now being used in daily speak as a real risk now – whereas before it was being danced around and padded with "soft landing" verbiage. The bigger test will be Q3/Q4 GDP numbers and guidance there. While we do believe this bear market may drag out for a while, we don't think it will be as long or deep as Nasdaq/tech took to recover after the dotcom bubble as some are suggesting. Tech is fundamentally a different market, and while it needs a very harsh reality check and reset, there are foundations built that simply weren't there last time – and far more dry powder and activity. It's likely there will be a slow and long sideways grind for quite some time, but once there's a strong signal for risk-on to return, we expect the engines to start back up.

Q2 2022 Crypto Update and Outlook

Outside of a few venture/crypto overlap deals and some incremental new positions into Bitcoin, Q2 crypto fund activity was light overall, as we've been in wait-and-see mode most of this year. Many crypto deals are specifically still overvalued and it's often hard to see how reasonable returns will occur for most of these opportunities. Although we began slowly deploying into liquid markets, sometimes the hardest thing to do in investing is nothing.

In Q4 2021 and earlier this year, we made a quite contrarian bet at the time to move a lot of the non-core (i.e. non-BTC/ETH) fund holdings back into cash and stablecoins and take profits while many were still steeped in euphoria, calling for a supercycle and decoupling from stocks. When things get irrational, most people don't have the self-awareness to know they are sitting inside of widespread groupthink and while we are far from perfect, we learned this the hard way years ago and it paid off this cycle. The psychology of markets is what's ultimately fractal – not necessarily price charts or technical analysis or historical data (although all that can all be eerily fractal as well).

We didn't foresee the current bear market playing out exactly this way in terms of the recent liquidations and endless stream of wipeouts and bad news, but it makes sense, as this is also a byproduct of lower asset prices, macro, and correlation to equities to begin with. All of these counterparties weren't necessarily a root cause of the initial selloffs, rather a festering risk vector that eventually had to be wiped out to clean the slate once $30,000 levels broke. Too many were banking on $30,000 holding and adding obscene amounts of leverage – we never believed it would hold.

Last cycle, there was virtually no concept of these lenders. While it's disheartening to see crypto fall into the same traps as traditional finance debt and leverage, this is another growing pain for crypto that we are confident will pass. These centralized lenders that custody your assets ultimately isn't what crypto is about – and we almost don't put it in the same category. They are the worst of both worlds – taking away self-custody and ownership while not even being insured in any way.

DeFi has actually shown its strengths with proof of reserves and onchain data. It leads to more transparent markets, which makes transactions and activity more meaningful and auditable. Communities can also hold DeFi protocols far more accountable given their open-source nature and track the flow of funds in real-time. Aave, Compound, etc have fared very well throughout this debacle and are working as intended. At this point, all the undercollateralized, unaccountable centralized lenders who gambled with user funds need to blow up so the space can rebuild towards transparency and move away from untenable, opaque yield. Even if they are bailed out (which will be to the utmost benefit of the acquirer party), they have lost the trust of many customers. Once withdrawals open again for the lenders that closed them, we'll see what % of deposits and trust remains (especially with yields going lower). Most people just want their assets back and more trusted platforms like Unchained Capital with hybrid custody models saw record inflows over the last few weeks.

What we've learned over the years is the market always needs a reason to continue a bullish uptrend or a bearish downtrend once the psychology of either is initiated. We simply haven't gotten confirmation in any area (sentiment/macro/price action/etc) that this is over yet. Valuations are still in recalibration mode and markets are being ruled by macro and monetary policy announcements which may have short term stints of optimism, but primarily feel like delaying the inevitable. Markets are as reflexive downward as they are upward, it's just harder to notice the mirrored psychology on the way down, as most market participants have a long-bias. This is fine of course, as we have this bias as well, but it's also important to understand both sides.

In terms of liquid activity, we did purchase some Bitcoin under $20,000 for the first time in over 18 months. Similar to how we started to buy at $6,000 in 2018 (followed by ~$4,000 when BTC had its final shakeout), we believe buying in this general range is still a long term bargain and trying to time the bottom is never prudent. For bigger allocations, we are still targeting lower prices or more indication that a bottom was potentially met. Generally, anything under the $20,000 will start to become a buy range for our liquid fund. Any altcoin purchases will be considered down the road when more clarity comes. In our view, there will be plenty of time to make moves in other altcoins when risk turns back on and it's foolish to rush back into high beta plays prematurely.

Since 2016, Ether has remained a substantial position in the fund, along with a bunch of newer bets being built around the ecosystem. As discussed previously, we don't believe the upcoming merge event date will be a catalyst for major new demand. Outside of ETH's naturally higher beta coming off oversold zones (i.e. ETH generally corrects harder in selloffs, but bounces more aggressively after), we don't see the merge itself being the primary catalyst for price (and certainly not enough to decouple from macro conditions as some have been claiming). In any possible relief rallies, which would require equities to rally in parallel, it will be a mirage that ETH is only going up because of the merge narrative – when in fact a higher beta reversal is more likely the primary cause (and would've bounced harder than BTC regardless of the upcoming event). Although we think the merge will roll out successfully, it's more likely to be anticlimactic than anything from a price perspective (and more likely to be a sell the news event). There will likely be sizeable options/futures volumes heading into the merge to bet on the event, but when all the hedging is factored in, it will have nothing to do with real organic new demand for holding the asset itself. CME ETH futures also release in September and this could be more of a negative reflexive factor depending on how markets are holding up. This is an unpopular opinion with all the mania and bullish consensus heading into the merge countdown and although we are still excited about Ethereum long term and believe it's a huge technical feat, we've taken a different angle.

From a risk and volatility perspective, it's not worth it for the fund to start buying new positions other than Bitcoin for now and even that will continue to be done incrementally. One of the worst mistakes people can make with strong gains coming out of a bull market is plunging upside back into the market in a hurry. There is no rush and there will be other opportunities to add positions – let markets repair and recalibrate. This risk approach also includes things like increasing regulation uncertainty and censorship-resistance, where Bitcoin has some advantages under the current regime.

We covered more of our crypto review and outlook in our May blog post "It's Not Different This Time", which received great feedback. We've always been believers in fractal markets and expected and prepared for a deeper correction phase, when many were calling the bottom at $30,000 levels. We believe the industry will come out stronger eventually but it will be a rocky road. From a timing expectation, we are ready for at least another year of choppy price and battered sentiment before the fog lifts, which is necessary to counter all the previous euphoria and madness of crowds that occurred. In other words, the bears have to take a few victory laps and spout a lot of "told you so" rhetoric for a while for nature to heal.

The good news is, a lot of exceptional builders are more active than ever right now and the true giants and winners will be defined in this bear market. We're already seeing a lot of potentials.

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