Three counterintuitive lessons from crypto investing

Good morning, readers! This post will cover three counter-intuitive lessons I’ve learned as a crypto investor over the past few years. Of course, I’ll also explore more interesting topics in future posts.

1. Portfolio construction is more important than picking the right companies.

This is the most counterintuitive experience, but the math behind it is actually pretty simple. Suppose you invest 0.5% of your fund in a company that returns 100x. Even if that company gets that return, your fund still doesn't get a return. Since the distribution of venture capital returns follows a power law, 100x winners are actually pretty rare. So whenever you come across an opportunity like this, you have to make sure your investment is even more valuable. To be successful, you need to focus on investing, not just hoping for good luck.

If the portfolio is not constructed correctly, and just having a bunch of nice company logos on the fund website does not necessarily mean that the VC will get good returns. This also explains why some venture capital funds with more than $400 million in assets are still in the seed investment business.

Some people think that investing small early is about taking advantage of the “goal” opportunity and then planning larger investments from there. But in reality, larger funds enter the market more aggressively and capture the lion’s share of the gains (i.e., the later you invest, the closer your round is to zero-sum). On top of that, if you are not the lead investor in the seed round, you may not receive a pro rata share, so your ownership stake may be significantly diluted (I have seen dilution as high as 90% in one case).

If we take this experience to its extreme (i.e. completely ignore the importance of picking the right companies), then the optimal portfolio construction is 100% dollar cost averaging, also known as "beta". To be honest, the unspoken rule of crypto investment institutions is that most funds launched in the last cycle did not outperform the above portfolio construction. Assuming the average ETH dollar cost from 2018 to 2020 was $200, your fund TVPI could reach 15 times today's price.

Many people use the famous study by AngelList as a counterexample, which shows that generally more investments by funds lead to better returns. However, I don't think this statement applies in the crypto space. Since the public market equivalent benchmark returns (such as investing in ETH through DCA) are already very high, you need to focus on asymmetric returns to have a chance to outperform the market. Otherwise, over time, the average return of crypto investment institutions will be lower than the return of using a strategy of only buying ETH. In the long run, it is not easy to outperform ETH.

So with every new investment you should be thinking “will this be able to outperform my ETH gains and return my capital?” At the same time, you should also be confident enough to make the bet.

2. Before product-market fit, there is very little correlation between how “hot” a funding round is and what the final outcome is

If you look back at history, you’ll find that the biggest winners in the previous cycle were almost never the hot seed-round projects.

DeFi: While Uniswap was once a hot exchange, Aave was priced at just a few cents when it was called ETHLend and available to any retail investor on the open market. In fact, all investments in the Ethereum DeFi space were not very attractive (that’s when new BitMEX competitors were the hottest), until the DeFi summer arrived.

NFT: While DeFi was hot last year due to the “risk-yield farm”, SuperRare’s digital art market was completely ignored. The price of XCOPY and Pak’s works still remains at the price of a single ETH.

L1: Ironically, Solana was not one of the hottest “VC chains” at the time (unlike Dfinity, Oasis, Algorand, ThunderToken, NEAR, etc.), but ended up becoming the best performing alt L1 investment.

This is why it makes sense to be very tight on valuations at the seed stage. I’m seeing more and more VCs chasing $6k-$100m valuations in seed deals as well. The only exception I can think of is L1, where the market size/upside is so high. Also, you can buy publicly traded tokens with market recognition for less than the FDV of some seed deals.

However, after product-market fit, the exact opposite happens: the most successful investments are often those with the clearest prospects for success. This is because humans are naturally hard-wired to perceive exponential growth (e.g. look at how many people shrugged off COVID-19 in early 2020); we tend to underestimate the potential of winners and the likelihood of becoming monopolists. OpenSea was valued at $100 million in its Series A, which may have seemed high at the time, but quickly became more than worth it as their trading volume grew rapidly.

This is a great example of the “dialectic” (relative truth in its extremes). In terms of investment risk-return, the best bet is either a company that is cheap before product-market fit or a company that is expensive after product-market fit, with nothing in between.

3. It’s hard to pick good projects amid hot narratives and fierce competition

Over the past year, I’ve noticed a trend where Web2 founders are building towards Web3’s hottest narratives and most competitive areas. Many venture capitalists see the influx of talent into crypto as a positive sign, but I think newcomers may have good credentials but are not necessarily suited to the specific needs and requirements of the crypto market. Unlike other industries, heroes in crypto come from all over. Historically, almost all of the most successful crypto projects were founded by people without an Ivy League or Silicon Valley background.

I have some concerns about some of the “obvious” ideas in investing.

These ideas attract profit-driven founders. These founders are good at copying what already exists (such as copying ETH DeFi to other L1 chains, and copying existing web2 SaaS products to web3 DAOs), and then actively marketing their products. But as the cryptocurrency hotspot shifts, the industry these founders are in is bound to suffer a certain degree of decline. For example, we are seeing this situation now, with the ETH DeFi token falling 70-80% from its historical highs, while DeFi on other chains has become the new hot spot. In the ETH DeFi projects launched by the DeFi boom in 2020, profit-driven founders have turned to angel round investments, while evangelistic founders have been sticking to the product vision and continue to build and innovate.

A good way to distinguish between “profit-seeking” and “evangelistic” founders is to work through ideas with them. Can the founder detail what others have tried before and what they are doing now that is better? If the VC knows a lot more about a particular space than the founder, that’s usually a red flag.

These ideas are extremely competitive. When there are a dozen projects trying to build the same thing (like the Solana lending protocol), it’s much harder to choose the good ones. In every industry or category, there are only a few dominant companies that dominate the market share. If you take a concentrated investment approach (as per #1 above), then it’s not appropriate for you to invest in their competitors due to conflicts of interest.

These ideas have high valuations before the product launches. We can see DeFi clones to chain X with valuations of at least $40-60 million, and even as high as $100-200 million. While this may be profitable for traders who are looking to make a quick profit by buying tokens during the pre-sale period and then selling them after the token launch, it may not be attractive to venture capitalists who are looking to invest in a product that has the potential to generate significant returns and generate excess returns to return funds.

I have no conclusion, so I will end this post on a controversial note: funds that raise large funds by showing LPs paper investment returns will underperform Ethereum once those paper returns become actual returns.