Dialogue with Multicoin Co-founder: Crypto VC is Not Dead, Need to Rethink Fund Investment Strategies

Original Title: Death of Crypto Venture? Rethinking Crypto Fund Strategies | Tushar Jain \& Ray Hindi

Compiled by: Deep Tide TechFlow

Guests: Ray Hindi, CEO/CIO of L1 Digital; Tushar Jain, Co-founder and Managing Partner of Multicoin Capital;

Host: Jason Yanowitz, Founder of Blockworks

Podcast Source: Empire

Original Title: Death of Crypto Venture? Rethinking Crypto Fund Strategies | Tushar Jain \& Ray Hindi

Release Date: July 23, 2024

Background Information

• In this episode, Ray Hindi from L1D and Tushar Jain from MultiCoin Capital share their views on the evolving prospects of crypto fund management.

• They discuss the current state of the fundraising ecosystem, noting that investor interest is not as high as expected, leading many funds to face difficulties in raising capital. They believe that future opportunities may lie more in the realm of liquid assets as the shift from venture capital to liquidity investments occurs.

• The conversation also delves into the changing dynamics of token issuance, highlighting issues in the current token issuance process that prevent adequate marketing and price discovery akin to IPOs.

• Despite the unpredictability of market cycles, the right market timing can significantly impact investment returns, and macro funds often perform well because they have the freedom to choose the best investment opportunities.

• Political outcomes can also have potential impacts on the crypto industry, and the cryptocurrency community needs to actively engage in politics to demonstrate its influence through donations and voting.

Current State of the Fundraising Ecosystem: Overall Fundraising Difficulties, Smaller Funds Face Greater Challenges

• Yano points out that we are currently in a phase where funds should start raising and announcing financing. However, despite the sustained buzz around cryptocurrencies on social media, investor interest in actual capital allocation is not as high as expected, leading many funds to face challenges in fundraising.

Ray Hindi's Perspective

• Ray states that although pension funds in places like Switzerland have shown increased interest in cryptocurrencies, this has not translated into actual capital inflows. Globally, while venture capital funds are quietly raising funds, they struggle to meet their expected fundraising targets due to intense market competition.

• Ray believes that while large funds can still raise capital, smaller emerging funds face greater challenges.

Tushar Jain's Perspective

• Tushar notes that changing market conditions have led many fund managers to be reluctant to publicly announce smaller fundraising rounds, as this may be perceived as a sign of weakness. In 2021, many funds capitalized on opportunities in the capital markets to raise substantial amounts, but the current market environment is different.

• Tushar emphasizes that managers' responsibility is to match capital demand and supply, rather than simply pursuing growth in assets under management (AUM).

Capital Supply and Demand Balance

• In the venture capital space, Tushar believes there is currently an oversupply of capital and insufficient demand, making the venture capital market highly competitive. In contrast, in the public markets, the return disparity between high-quality and low-quality assets has significantly increased, providing more opportunities for active management strategies.

Evolution of Crypto Funds

• Ray reviews the development of crypto funds, noting that before 2018, the market was primarily focused on a few assets like BTC, with limited investment options. However, with the maturation of the market and the rise of decentralized finance (DeFi), investment choices have greatly expanded.

• Ray believes that while venture capital funds have dominated in recent years, future opportunities may lie more in the realm of liquid assets.

Evolution of Crypto Venture Capital: From BTC to Liquidity Funds

Early Stage: Bitcoin Funds

• Yano mentions that the initial phase of crypto venture capital was primarily focused on Bitcoin funds, such as Pantera's Bitcoin fund, which essentially invested solely in Bitcoin and charged a 2% management fee and a 20% performance fee.

Second Stage: Service Companies

• In the post-ICO era, investor interest in tokens diminished, and many companies were no longer seen as credible investment targets. Investment began to shift towards companies servicing the cryptocurrency ecosystem, such as Anchorage, Bitgo, Circle, and Coinbase. These companies attracted significant capital into the crypto venture capital space.

Third Stage: Protocol Investments

• As the market matured, some savvy crypto venture investors, like Multicoin, realized that true returns would come from investing in protocols rather than service companies. They began to allocate capital to these protocols and achieved significant gains.

Fourth Stage: Liquidity Funds

• Currently, there is an influx of capital into the crypto venture capital space, leading to intense competition. Yano believes that the next phase of opportunity may lie in the liquidity token market, with more liquidity fund managers expected to enter this space.

Ray Hindi's Perspective

• Ray agrees with Yano's classification and adds that when a large amount of capital flows into a specific strategy, performance tends to be mediocre, with only a few exceptions able to outperform the market. He believes that once traditional investors realize there are excess returns (alpha) in the liquid crypto market, they will pay more attention to this area.

Tushar Jain's Perspective

• Tushar points out that the structure of allocators determines their investment preferences. Many large allocators' venture capital teams are interested in cryptocurrencies, but their public market teams are not. This leads to capital flowing more into closed-end venture capital funds rather than liquidity funds. He believes this market distortion has resulted in an oversupply of capital in the venture capital space, while liquidity funds have more opportunities due to less competition.

Importance of the IPO Window

• Tushar emphasizes that crypto companies need the IPO window to open so that investors and company employees can gain liquidity through the public market. Without an IPO, venture capital funds struggle to demonstrate actual returns to their limited partners (LPs), affecting their subsequent fundraising capabilities.

• Ray adds that venture capital funds investing in decentralized networks have performed well in recent years, while funds investing in traditional crypto companies have faced challenges.

Advantages of the Liquidity Market

Skill Requirements

• Ray points out that in 2018, traditional finance (TradFi) investors typically believed that the liquidity market required active traders to suppress volatility. However, this thinking is flawed, as many investors attempted to launch market-neutral funds to suppress volatility, but these funds did not successfully attract significant assets under management (AUM).

Issues with Market-Neutral Funds

• Ray explains that a major issue with market-neutral crypto funds is that investors lack interest in such funds because they seek high returns in the crypto market rather than merely suppressing volatility. Additionally, these funds often face counterparty and smart contract risks, especially during periods of significant market volatility, such as in November 2022.

Evolution of Investment Strategies

• Ray mentions that the initial investment strategy was to suppress volatility through active trading, but this strategy proved ineffective during the market turmoil in March 2020. Humans often make poor decisions when faced with the high volatility of the crypto market, and using leverage to chase the market can ultimately lead to liquidation. Therefore, Ray and his team shifted towards a longer-term fundamental investment strategy, accepting market volatility and performing well over a 5 to 10-year investment horizon.

Advantages of Fundamental Investing

• Tushar adds that his investment philosophy is based on strengths rather than avoiding weaknesses. He believes that trying to find a manager who excels in all areas is a flawed strategy. Instead, investors should focus on a manager's strengths, such as fundamental analysis and forecasting future market developments, rather than attempting to control market volatility through trading.

Challenges of Market Psychology

• Tushar points out that attempting to control market exposure through trading is a misguided strategy because the market is chaotic and unpredictable. Trying to predict market movements through technical analysis or market psychology often leads investors to sell at peaks and buy at higher points, resulting in greater losses. Therefore, investors should focus on fundamental analysis rather than trying to find patterns in the market.

Differences Between Liquidity and Venture Capital

Boundaries Between Liquidity and Venture Capital

• Yano mentions that there is usually a clear boundary between traditional venture capital and liquidity markets, often defined by the IPO window. Investors invest during the private phase of a company, and regardless of their optimism about the company, they typically sell their shares once the company goes public. However, in the crypto market, this boundary is not clearly defined.

• Example Analysis: In the crypto market, investors can directly purchase tokens from the public market or buy tokens at a discount from the project's treasury, which may have a lock-up period of several months. In this case, it is difficult to distinguish whether this is venture capital or liquidity investment.

Different Mindsets of Venture Capital and Liquidity Investment

• Tushar points out that making investment decisions based on market price discounts is entirely unreasonable. Investors should assess the actual value of tokens from the ground up and then decide on the best investment approach, rather than simply looking at discounts. Historically, companies like Three Arrows Capital (3AC) have failed due to such arbitrage strategies.

• Ray adds that liquidity funds should set the valuation of tokens rather than allowing market makers or founders to price them. Different types of investors will have varying risk tolerances and skills at different market stages, so liquidity funds should play a larger role during token issuance.

Differences Between GP and LP

• The discussion also touches on the differences between GP (General Partner) and LP (Limited Partner) shares. Large allocators may demand GP shares, which can create significant conflicts of interest. Ray states that they typically do not do this to avoid conflicts of interest, especially when servicing pension funds.

Current State of Token Issuance

• Tushar points out that the current token issuance process has issues, primarily due to regulatory reasons, preventing adequate marketing and price discovery like an IPO. Current token issuances often have low liquidity and high fully diluted valuation (FDV), which is detrimental to market price discovery.

Impact of Airdrops

• The current token issuance model often involves users earning points through certain protocol actions, followed by airdropping tokens to these users. However, this model is easily exploited by airdrop farmers, who sell tokens immediately after receiving them, damaging the price discovery process. Tushar believes the market has begun to recognize this negative impact, and some projects like Layer 0 have started taking measures against airdrop farmers.

Token Launch: The Meta Transition in the Crypto Market

Outlook for the Next Six to Twelve Months

• Tushar predicts that in the next six to twelve months, the market will no longer accept simple, easily manipulable airdrop mechanisms. Once the market recognizes the falsehood of these mechanisms, their effectiveness will diminish.

Improvements in Price Discovery Mechanisms

• Tushar hopes to see better price discovery mechanisms before tokens begin trading. For example, using bonding curves or other methods to achieve price discovery before tokens are transferable and tradable. He believes this experimentation will primarily come from offshore founders, but if the regulatory environment changes, more innovation may be seen in the U.S. and globally.

Evolution of New Capital Raising

• Tushar mentions that each bull market cycle is triggered by new token distribution methods that attract new users and activity. For instance, 2013 was marked by proof-of-work hard forks, 2017 by ICOs, 2020 by DeFi liquidity mining, and 2021 by NFTs. He believes the evolution of the current cycle may be meme coins, as they attract new user groups.

Impact of Meme Coins

• Tushar believes that meme coins attract new user groups who wish to engage on-chain. Although meme coins lack actual cash flow, their fun nature and lack of required expertise appeal to ordinary investors. However, he also notes that while meme coins are entertaining, they lack practical utility.

Anticipated Next Evolution: DePIN

• Tushar believes that the next significant token distribution mechanism will be decentralized physical infrastructure networks (DePIN). He thinks DePIN will incentivize people to perform genuinely useful work and provide a new method of capital formation to achieve previously impossible tasks. While DePIN has not yet fully entered mainstream crypto market awareness, he is optimistic about its future development.

Specialization of Funds

Specialization of Ecosystem Funds

• Ray mentions that the specialization of ecosystem funds could be very interesting, especially in cases where specific areas are highly attractive. However, he emphasizes that it should not be assumed that there is a need to invest in specialized managers. Although funds like EV3 Escape Velocity have performed well in the DePIN space, this is just an exception. Their investment strategy is determined by the attractiveness of specific areas and potential asymmetries.

Risks of Specialization

• Tushar adds that whether in liquidity management, venture capital, or any form of investment, investors should not be forced to trade. Specialization may lead to being compelled to purchase certain assets because the fund focuses on a specific area, and missing out on trades can create pressure. This pressure may force fund managers to make decisions that do not align with their investment standards.

Challenges in the Fundraising Process

• In the fundraising process, fund managers often need to demonstrate their uniqueness to LPs, which may lead them to focus on specific areas. However, the market changes rapidly, and focusing on one area may lead to being forced into undesirable trades. Tushar believes that excellent fund managers should not make investment decisions based on LP demands but should decide based on market conditions and investment opportunities.

Unrestricted Investment Strategies

• Ray further points out that even outside of cryptocurrencies, the most sustainable investment returns typically come from unrestricted investment strategies. Macro funds often perform well because they have the freedom to choose the best investment opportunities. This freedom is key to achieving long-term sustainable returns.

Risks of Focusing on Specific Areas

• In discussing a fund focused on Monad, Tushar reiterates the risks of forced trading. Focusing on a specific area may lead to the necessity of participating in every trade, resulting in investments in lower-quality projects. This strategy may perform well due to the success of a particular project, but overall, it is not an ideal investment strategy.

Timing of Liquidity Investments

Investment Timing and Cycles

• In the crypto market, timing is a crucial factor. Traditional capital markets do not have fixed cycles, while the crypto market is often considered to follow a four-year cycle. This cyclicality may change in the future, but it remains a significant characteristic of the market.

Relationship Between Cycles and Returns

• Tushar and Ray discuss that in the crypto market, the biggest drivers of returns are not the selection of specific tokens but the correct grasp of market cycles.

• Ray points out that while choosing the wrong token (like privacy coins) may not yield profits, selecting the right L1 token (like Solana in 2021) at the right time can lead to substantial returns. Correct market timing can significantly influence investment returns.

Challenges for Fund Managers

• Fund managers may face pressure from LPs when navigating market cycles. For instance, when a fund manager decides to convert investments to cash, LPs may question why they are paying a 2% management fee just to hold cash. Ray notes that this pressure may force fund managers to re-enter the market at inappropriate times, affecting the fund's performance.

Historical Performance and Strategy

• Ray mentions that since 2018, they have invested in 25 funds in terms of liquidity, with only two funds performing exceptionally well. The performance disparity among these funds is primarily due to their project selection and risk management strategies. Those that perform well typically do not convert to cash but maintain investments and achieve high returns through careful project selection.

Importance of Liquidity

• Ray emphasizes the importance of liquidity. He illustrates how an expanding fund made two investments in 2019 and 2020 and conducted risk control at the end of 2021. This liquidity allowed the fund to reduce risk at market peaks and reallocate at market lows. Thus, funds with liquidity can respond more flexibly to market changes.

Psychological and Behavioral Advantages

• Tushar points out that psychological and behavioral advantages in investing are crucial. Market volatility can affect fund managers' emotions, leading them to make poor decisions at the wrong times. For example, selling at market peaks may result in missing subsequent gains, while buying at market lows requires significant psychological resilience. Even legendary investors like Stanley Druckenmiller have made similar mistakes during the tech bubble.

Structural Advantages

• Tushar also mentions that structural advantages are an important factor in investing. Funds with flexibility can adjust their strategies at different stages of the market, leading to better returns. For example, funds not restricted to specific areas can freely adjust their portfolios in response to market changes, avoiding forced undesirable trades.

Rise of Applications

Infrastructure Fatigue and Resurgence of Applications

• The discussion touches on a new trend of infrastructure fatigue and the resurgence of applications. Although infrastructure (like L1 and L2) was once a hot investment topic, investors are now fatigued by its complexity. Compared to the simple elegance of integrated stacks, the complexity of modular stacks makes it difficult for investors to understand and keep up.

Investor Interest in Applications

• Tushar states that Multicoin and some other large investors are very interested in investing in consumer-facing products or applications. The issue is not that investors are unwilling to invest, but rather a lack of fundamental theories about which consumer products have potential in this industry.

Future of DeFi and Payments

• Tushar believes that DeFi represents a "second phase" of applications, where ordinary people will not directly start using DeFi. They first need to acquire wallets and assets through some means, ideally obtaining tokens without purchasing them through a consumer application. Payments are similar; while blockchain is clearly the future of payments, it will not be a direct start.

Ways to Obtain Tokens

• Tushar believes possible avenues include DePIN (decentralized physical infrastructure networks) and gaming, which can allow consumers to obtain tokens without entering credit card information, thus entering the on-chain economy. This approach can make it easier for users to engage with blockchain applications and gradually utilize other features.

Non-consensus Nature of Gaming

• Ray adds that gaming is currently a non-consensus area, despite having received significant attention a year or two ago. Due to intense competition in the infrastructure space, gaming as a non-consensus area may be very attractive when building a portfolio.

Where Are We in This Cycle?

Unpredictability of Market Cycles

• In discussing market cycles, Ray and Tushar both emphasize the unpredictability of market cycles. Despite numerous variables and market expectations, accurately predicting market direction is nearly impossible.

Current Market State

• Ray points out that the current market state is very attractive, especially in terms of liquidity. He mentions that since the FTX incident, their investments in liquidity funds have significantly increased, reflecting their optimism about the liquidity market. They believe there is a structural imbalance in the current market that may take years to resolve, which is why they are actively managing liquidity.

Market Expectations and Pricing

• Tushar mentions that market expectations are already reflected in current prices. For example, expectations regarding interest rate changes and election outcomes have been factored into prices. Although these expectations may not be entirely accurate, the market has considered these factors to some extent. This complicates the prediction of market cycles, as market pricing already incorporates these expectations.

Market Efficiency and Investment Opportunities

• Tushar further points out that while the market is not completely efficient, it is relatively efficient when it comes to market beta. However, when selecting specific projects, the market is relatively inefficient. This means that when making specific project selections, investors have more opportunities to achieve excess returns through informational advantages, analytical advantages, or behavioral advantages.

Ideal Investment Strategy

• Tushar emphasizes that as investors, one should focus on areas where they have an advantage rather than trying to compete in the most challenging areas. He believes that predicting market beta is very difficult, so more attention should be paid to specific project selection, as this aligns better with investors' areas of strength.

Importance of Market Liquidity

• Ray adds that market liquidity is the biggest driver of market beta. However, predicting short-term changes in market liquidity is very challenging, not only in the crypto market but also in traditional financial markets.

Impact of Trump or Biden Winning

Importance of Political Participation

• Tushar mentions that Multicoin recently announced a special donation campaign to support conservative super PACs, demonstrating their emphasis on political participation. He quotes an old saying: "You may not be interested in politics, but politics is definitely interested in you." Therefore, he believes it is essential to actively engage in politics rather than hoping for good things to happen automatically.

Strategies for Political Participation

• Tushar emphasizes that the key to political participation is to demonstrate to political parties and the political class that the cryptocurrency community is a significant voter bloc that can play a role in key elections. He believes that politicians care about power rather than moral correctness. Thus, the cryptocurrency community needs to showcase its influence through donations and voting, making it clear that this support comes from the crypto community.

Worst Political Scenario

• Tushar believes that the worst political scenario for cryptocurrencies in the U.S. is if the progressive faction, particularly Elizabeth Warren's faction within the Democratic Party, gains significant power. These progressives oppose cryptocurrencies and do not believe in the property rights supported by cryptocurrencies, leaning more towards state control.

Best Political Scenario

• Conversely, Tushar believes that conservative control in the U.S. is the most favorable scenario for cryptocurrencies, as they currently appear more supportive of them. However, the key is to make conservatives aware that the cryptocurrency community played a significant role in their victory; otherwise, cryptocurrencies will not become a priority for future governments.

Key Role of the Senate

• Tushar points out that the Senate plays a crucial role in confirming all regulatory appointments, so their political activities are primarily focused on the Senate. They believe that donating to key swing state Senate elections is the most effective way for the cryptocurrency community to engage politically.

Investor Perspective

• Ray mentions that when he communicates with limited partners (LPs) or allocators, U.S. regulatory issues are very important to them, even for institutional investors in Switzerland. These institutions are concerned about U.S. decisions and progress, as this drives the market. However, they do not change investment decisions based on short-term election outcomes; they are more focused on long-term progress.

Advice for Fund Managers

Transparency and Investor Relations

• Ray emphasizes the importance of transparency. He notes that despite facing many challenging situations, those managers who have maintained long-term relationships and high transparency tend to perform better. Transparency not only helps build investor trust but also maintains good relationships during difficult times. Therefore, he advises emerging fund managers to always be transparent with their investors.

Identify and Stick to Your Strengths

• Tushar suggests that emerging fund managers need to seriously assess their strengths and focus on them. He believes that the market is very adept at taking funds from investors who do not have advantages. Therefore, fund managers need to clarify their areas of strength and avoid operating in areas where they lack advantages. He lists four sources of advantages:

• Analytical Advantage: Gained through in-depth analysis and research.

• Information/Access Advantage: Gained through unique information or market access channels.

• Behavioral or Psychological Advantage: Gained through understanding the behavior and psychology of market participants.

• Structural Advantage: Gained through unique arrangements in market or investment structures.

• Tushar emphasizes that fund managers need to evaluate these advantages and focus on areas where they truly excel, avoiding strategy drift.

Launching a Liquidity Fund

• Ray suggests that if emerging fund managers have the capability and advantages, they might consider launching a liquidity fund. He believes this presents a great business opportunity from a supply and demand perspective. Of course, this requires identifying their strengths and assembling the right team.