Ep16. Nuclear Update, AI Fast & Furious, State of VC | BG2 w/ Bill Gurley & Brad Gerstner

29:32And I know you have some real thoughts about margin here, whether or not the quality of those revenues are the same. Right. So I thought I'd just throw that out there and ask you. Yeah. Well, look, I think your analysis is exactly correct in the only area of risk is what you just said. And I wrote a blog post years ago called All Revenues Not Create Equal, which we could put a link in for people to look at. But I think the one question I would have in this case, which is a data point I don't have, is gross margin. And there, everything we talked about, the high cost of maybe the GPU usage to get advanced voice, right?

30:14There's a chance that OpenAI or anyone else in this field's gross margins are more in the 10 or 20 % range versus the 57 and 81 that you have here in your charts. And that would be the one thing that might trip it up. And how low scale over time is tied exactly to all the things that we just talked about in the pricing model and the business model. So yeah, I think you could come to the conclusion you just made, but still have exposure in this one area. Yeah, and I think it's such an important point to make. Right? Like, when you're investing in a company, you got to get the top line. Like who's going to be the winner?

30:55And then you need to be able to forecast that top line. But that's not ultimately what drives valuation. What drives valuation, as we've often talked about here, is the future cash flows that those revenues can produce. And there's a real question on the table here that you've articulated well, which is, is there going to be a layer, a tax here, right? That in video and the cost of inference and the cost of training imposes in perpetuity on these companies such that it's going to always be a less profitable business than a meta or Google on the consumer side or an AWS and you know, and a Google Cloud or Microsoft Azure on the enterprise side.

31:40I certainly think you're right that at the start of the super cycle, like if you go back to the start of AWS, remember the debates then Bill, 2009, 2010, can it ever make money? Can it ever make money? Right? Because they had to get to massive scale and the cost of delivering that scale had to come down. So you're betting on two things, I think, with OpenAI, with respect to margins. The first thing you're betting on is that they can get to scale because this is clearly the second thing you're betting on is you have to believe that the cost of inference is going to come down meaningfully over time and that the cost of training will come down meaningfully over time.

32:23Now, we already know the cost of inference has come down by over 90 % over the course of the last 18 months and our friend Sonny over the weekend when we were in our group chat, you know, said he expects it to come down by another 90 % over the course of the next several years. So, but those are the types of things you're going to need to be true in order to have a margin structure that is consistent with those legendary businesses like Google and Meta. Yeah, and to be fair, your analysis had Google and Meta, but when you make AWS, the comparison that suggests that Amazon might be a better proxy, which trades at three times.

33:05Certainly for the enterprise side of OpenAI's business, I think the comp would much more be AWS, but on the consumer side of their business, I think the comp is fair to be somebody like Google or Meta, but in both instances, you have to assume that the cost of delivering, right? Let's be clear. AI and AI inference is a much, much more compute intensive activity than retrieval, which was the business of search. And so like we just have to see technology ultimately drive that cost down or there's gonna be a higher tax and it will be a lower margin business. It doesn't mean that it won't be a great business or even a good return.

33:45But to achieve those margins, you gotta see the cost of delivering the product go down. You know, there've been statements along this journey from both Jensen and Sam Altman and the input to this thing is compute. And you're gonna need tokens. And those sound like variable cost inputs. That's, you know, and I guess in the worst case scenario, it's like an airline where fuel costs are just, you know, a big part of what drives the incremental profitability. And so the thing I don't know, and so I'm not suggesting this is absolutely true, is an AI business inherently, a 20 % margin business. AWS is at 30 and Amazon commerce was at five until they added, you know, whatever added advertising like, or can it be like Google or Meta?

34:39Yeah. And I think until one of these things gets public and we can look at data a little more detail, we don't know. Well, it's going to be interesting to watch it unfold. but there's certainly a related topic, one that I know you're amped up about and is probably even more amped up given this rumored open AI deal is how the venture model is changing and whether these structural changes are good or bad, whether they're good or bad for LPs, whether they're good or bad for GPs and founders. So why don't you lead us in a discussion on that topic on the challenges to venture today. Yeah, and two things that I would encourage people to check out are friends at all in, talked about this a little bit on their pod last Friday, and then at their conference, Thomas LaFont of Coutou had a long presentation that I think is where everyone's worth looking at, that kind of sets this up.

35:39But despite our massive enthusiasm for AI, and I'd say the entire communities, enthusiasm. You know, we are at a seemingly problematic place in the venture capital industry with regard to how much cash is coming out of the system versus how much is going in. And everyone seems to be hyper aware that there is a historically low number of IPOs. It's like single digits where the average even in sub -par years has been closer to 70 or 80. M &A has had quite a high atus, partially driven by the restrictions on the Magnificent 7, although they're finding ways around that. And so what's going wrong? The cappermarket's seem to be doing just fine in terms of how well the S &P is performing and so why isn't this happening?

36:42And so I would offer a couple of thoughts. One, I think everyone now believes in Power Law's network effect scaling, all of that kind of thing. I think all the investors do. When I entered the venture industry, I think it was a competitive advantage to believe in them when people didn't and you could find a way to take advantage of that and make money. But today, I think everyone gets it. And so the other thing that's happened, I believe, is many of investors have decided late -stage investing is better than early stage. And I'm primarily responding, talking about the venture firms that have gone from being mostly early stage venture, a traditional venture to having 10 billion or more AUM and willing to write checks in hundreds of millions of dollars, which didn't happen a decade ago.

37:37And for those type people, the management fee is on a much bigger, you get the same percentage on whether you're deploying it at $5 million a piece or $200 million a piece. And you get way more dollars deployed, you don't take forward seats so the works less and the fees are massively bigger. And I think that for reasons that are just competitive, our whole world's kind of felt this gravity pulling them to that place. And despite the fact that we had this many correction, I call it many because that's what it feels like now that AI kind of just brought the sunlight out again, these firms have not have problems raising those dollars.

38:21And so despite the fact that a large number of the unicorns are still private from the previous investment cycle, this kind of behavior continues. And all these firms want to be in the hottest deals. You know this, you're on this field, you're a participant in this world. If there's an interesting company out there, it's very likely that they're going to be approached preemptively and told to take more money. And so I think you're going to, until this change, I think you're going to have very few companies that are considered to be doing well, then aren't asked to reply by the industry to raise $500 million or more.

39:03And that, in and of itself, is a very unusual, you know, compared to the traditional venture model from years ago. It's just super unusual because I'm almost done because this thing is so competitive and everyone is trying to get into hottest deals. The best way to achieve that is to be founder friendly and I think we talked about the profile that Thrive had I think on the cover of Fortune. I would encourage people to read that because that's it was almost I would called almost PR perfection for Josh and his team in terms of coming, you know, people vouching for them being founder friendly. And if you're going to be founder friendly and write big checks, guess what?

39:50You're going to be supportive of founder secondary. And you're going to be in for you're going to be supportive of broad based employee secondary. When you do those things, you are taking away probably the strongest motivating factor that pushed people to go public, that pushed founders and their teams to want to be public, which was liquidity. And so with that off the table, for me, there's no surprise that IPOs are happening or not happening or not happening because there's no incentive for them to go out. And it's a weird place for me when I look at the venture industry writ large, which is what's going to drive people to go public?

40:33How do large institutions get liquidity? I don't think large institutions can realistically get liquidity to the secondary market. Certainly not at a good price. But my biggest in addition to all those things, one thing I would raise provocatively is, You know, does overfeeding these companies with cash lead to not optimal execution? And you and I were deeply involved in the Uber situation, but you know, when you start losing a billion dollars a year, or even I would say $20 million a month, you're very far away from profitability. And we talk a lot about focus and constraints and how that leads to better decision making.

41:21That's hard to do when you're spending 20 million a month and the other thing that's hard to do is raise $500 million and not spend it and so I do I do propose the question that Maybe one of the things that's a problem with that previous generation of unicorns is they were they were overfed You know there's a there's a picture you can look up. It's kind of disgusting So people may not want to, but there's this thing called a garbage tube, which is what they used to make for draw, how they force feed the geese to get them just super fat. And that's the image I have in my mind, like, like, are we overfeeding these startups?

42:03And then they get so far away from profitability. They're spending on projects that if they were trying to get to profitability, wouldn't spend on that or lower return. And, And then maybe they get stuck. This is my last point. When I entered the venture business, one of the things I thought was in advantage I had coming from Wall Street is I knew what Wall Street wanted. They were the customer for the venture capital company that would eventually IPO and trade in their markets. And there's an interesting dichotomy right now. If you look at the public markets which have become much more sane, you would know this better than me.

42:43relative to where they were three years ago. There's a high expectation for profitability. And so I think there's this incredible mismatch between what Wall Street wants to see and the state that a company is forced to be and as a result of this hyper competitive investment market. Yeah, no, I mean, listen, I think that it's a great analysis and framing really of the issue. And you bring up a lot of great questions, and I think the right concerns. So let's try to break them down because I think they fall into roughly like three buckets. Right? Let's start first with the question, just a more dollars, bigger funds, more competition and higher evaluations.

43:30Right? There's no doubt that VC has grown from 100 billion 10 years ago to 300 billion over the last 10 years. Right? If you set aside the COVID period where we all know because of Zerp, public markets lost their minds, venture markets, you know, went to high levels. Right? We're back to kind of this $300 billion level, which was pre -COVID. And so while we call all of this venture bill, one of the big differences I have here, and I've said many times, is that the venture market really hasn't grown that much. Right? Much of the investment that we're counting as venture, when you look at all these data sources that we pull, is into companies that are higher than $10 billion in valuation with huge revenues that would have been before captured by public market investors.

44:20And so I think it's important as an industry that we just, we start thinking about these things as different. Right? I call them internally into our LPs. I call those quasi public companies. Companies like Databricks, Stripe, OpenAI. I think it's silly to call them venture at this stage when they have 5 billion in revenues is growing 100 % a year. So yes, I would say this, the late stage quasi public market is much more competitive, just like the public market is more competitive, because it leads to better price discovery, but it also means that there's less arbitrage and returns are more dependent upon long -term compounding than some misinformation in the market, right?

45:04And as we saw in 2021, One, the public market's corrected. In fact, a lot of the IPOs that happened during that period are still down over 50%. So the public market's corrected, just did it quicker. In the quasi public markets, we've seen a lot of these companies shut down, sell, and still down over 50 % from the high. So I don't think there's a lot of difference there. And when I look at the early stage venture markets bill, So I would agree with you, there's a lot of excitement around AI, but outside of AI, you look at Series A follow on rounds or Series B follow on rounds. I mean, they're down dramatically.

45:45If you look at the number of first time funds that are getting funded as second time funds, those are down dramatically. So I see a lot of reversion to the mean happening rather than structural change. I think the big structural change that this data leads me to conclude is that because of the regulatory burdens of going public because of the change in Silicon Valley around sentiment, because of the ability to get liquid and secondary transactions, because of liquidity of this late -stage quasi -public market where institutions like Altimeter or the co -tos of the world or Fidelity's or Thrive's or whatever that we're here to provide that liquidity.

46:24I agree with you that there's a lot more money there because those companies are choosing to stay private, but we should think about these and compare them to their public company competitors, not to what's happening in the series A market. Two things I would highlight. Once, when you call it quasi -publics, I think you're talking about it primarily from a input point of view. In other words, it looks public relative to how, you know, Altymr would invest or other late -stage players would invest. But, but, and maybe this is where the word quasi comes in. But, you know, if you think about it from an output perspective, there's no liquidity for anybody.

47:08So you've taken a portion of the market that used to serve multiple purposes and now one of those purposes is going. If we're saying there's a permanent shift, you know, from one place to the other. two, there are these regulatory things that come up because many people believe that one of the SEC's goal is to make sure all investors can participate in that. Yes. That's the table. I mean, listen, listen, I've said publicly many, many times we should get these companies public faster. I want to see strike public. I want to see Databricks public. I think it's better for the companies. I think it's better for, you know, the investing public writ large.

47:48I'm just trying to explain the game on the field. then I see. The third point I was going to make is is the quasi public isn't the same as public in terms of how the public markets might shape the motivation and execution of the team. 100 % to the meta example where they went public, stock went down, Wall Street says you're not ready for mobile. You know, a zuck later said, shit, that actually kicked me into gear. Those things, You know, don't exist when this isn't here. And I agree with you, you know, this is playing the game on the field. And I'm not blaming anyone. I'm just highlighting this is where we've matriculated to.

48:29You know, this is where we stand today. I think it's right. So let's move to the second big point, which is this liquidity IPOs. And I think it is true. The number of IPOs has been anemic. And the exit amount is now in venture is now at about $100 billion a year. or while down a ton from the $700 billion peak in ZERP in 2021, you know, which was really a one time COVID high, we're basically back at the same exit level for venture that we were pre -COVID. Lots of people talk about the zombie corns, right? We have a thousand companies that are that were unicorns. A lot of those will never get back there.

49:07I've said 80 % of those companies will never get back there. where those companies need to get merged into other companies, need to get sold, need to get shut down, whatever the case may be, or do down -round IPOs like Instacart did, which is now off to the races under some great leadership. But I look at just our pipeline build, just to give you a counter example here. I think we may have four IPOs in the pipeline in the next four to six months. The rumors out there around companies like Cerebris and CoreWeave and Databricks, those are all in our portfolios. And on top of that, we recently sold tabular to data breaks, you know, that had a price rumored to be $2 billion.

49:46So exits are increasing. Interest rates are coming down, which I think will lead to more of that. The world is healing. And so again, I'm not so sure this is, I do think there are some things that are structural. The regulatory things are structural. The more dollars in quasi -public is structural. But there is still enough incentive these companies want and have boards that will get them public. I just think it may they may come public a lot longer when they're at 10 or 50 billion dollar valuations rather than they're at a two billion dollar valuation. But you know, as far as the companies I'm involved with, I'm pushing for them to come public sooner or at least when they're ready.

50:24And I think a lot of that pressure is off and I think the number of board members that are actually willing to push for that. And Jamaat talks about this a lot of I think is actually few. You might be one of few, but I think most of them don't, because they've been trained to applaud, and that's what they do. Well, I mean, it's partially just driven by competition. Once again, I'm not, I'm trying to give you my best view. Yeah, no, I think it's an important, it's a super important conversation. And by the way, if 80 % of the zombie corns are never gonna get out or are gonna get out reduce prices.

51:04I'm telling you flat out those are being held on the large endowments help, you know, SLPs at unrealistic high prices. I would say yes and no. So let me just give you a couple different examples, right? I mentioned we have a lot of good things in the portfolio, but we had a company that wasn't performing at the levels that, you know, it previously had been, it had been priced at many billions of dollars in, you know, at the peak of Zurb in 2021, a company called Lacework. And we ultimately, you know, we pushed to sell that company to Fortinet while we still had hundreds of millions of dollars of cash on the balance sheet.

51:40It's a great acquisition, you know, for that company, but it's out of the system. It's marked, we've distributed the cash to our shareholders. So we're distributing, okay. So I'm just saying that this is happening and we have other companies in those portfolios that were marked really high in 21, right? One is company you and I are both invested in, click house, which is growing through those valuations, right? Or a company like Sigma Computing that we're in, which is growing through those high valuations. So, you just have to break it down and look at these one by one. I think that they're definitely things in there that are held at too high evaluation, and LPs should scrutinize that.

52:18But there are other things that are healing. Let's just, I really want to talk about this question. I think it's the most important one, Bill. Great. which is does excess capital lead to companies being overfed, which leads to poorer outcomes for innovation. Because I think the potential for that, like at the end of the day, that would be the worst thing, right? And I think you and I have a lot of shared belief that too much capital does ruin corporate culture. It does lead to higher burn rates. It does lead to lower financial returns and it does lead to less innovation, right? I pounded the table on this topic, you know, the time to get fit.

52:58And I applaud Mark Zuckerberg. I mean, him stepping out in February of 2023 and writing a letter called the Year of Efficiency. And he said, we started doing this, just thinking that it was about getting back to the office. But what we discovered was that smaller is better, right? He said flatter is faster and leaner is better. And what he met is the cycle time on innovation, delaying the organization, getting rid of layers of L of VPs, right? Like really getting the organization tight and fit was better for the future growth and future profitability and future innovation of the business. So I tweeted over the weekend is great news that I saw that Zoom and Salesforce and Workdays, they're starting to get sober about stock based compensation.

53:50That is another component of too many, you know, too many, too much capital. Too many people leads to excessive SBC, which, which you and I've talked a lot about. So I think just because you raise a lot of money, doesn't necessarily mean you're unfit, right? Remember, open AI is not really a VC company at this stage, right? Google went public on two billion of trailing revenues. These guys are rumored to have five billion already. So three X that amount. And we've talked about building AI is just a lot more expensive than building the things that came before it. So I just think we need to have an apples for apples comparison.

54:29But if you want to champion to stand with you on this issue of companies raising too much spending too much, you know, they got to be really careful. And so I gave some advice to one of our fellow founders the other day. He's got he's got money coming in over the bow at a multi billion dollar valuation. And he's like, we don't need it. We already have hundreds of millions on the balance sheet. Should we raise it? And I said, here are all the downsides of raising it. You can't go raise another 500 million and not have pressure from all your employees for employee secondary for spending more money on more projects, and the NPV on those other activities will be lower.

55:08And the incentive your employees have to stay with you. Once they sell 10 or 20 million dollars worth of stock, it's going to be less. And so finding that balance, I think, is a critical function of leadership of these companies. Yeah, and I would just say to that, Brad, I do think this is a huge dichotomy. Like, for the, I do believe that the hyper -competition in the late -states market leads to incredibly large number of preemptive rounds where hundreds of million dollars are being forced fed to a company. And if you're spending 20 million a month, you're burning 240 million a year. If these companies in AI are 50 % gross margin or whatever, you got to get revenue to twice that.

55:56You're right at that 500 million run rate before you could think about being profitable. And you know, once you've gone to that place, which is ironically the same number I think where Philippe Lafante said you got to be to go public these days. And the thing I would say to you, if that becomes true, if that kind of path dependency is is cast upon every venture capital company that comes along, you're going to end up with an excessive amount of zombie corns because previous to this evolution in the late -stage markets, plenty of companies either were bought at 300 million or went public at 250 or 500 million and created positive returns for their early venture capital investors.

56:50And if it's really 500 million in revenue or bust, I think there's gonna be a lot more bust than we've traditionally. Yeah, no, NetNet. I agree with you, VCs harder, it's more competitive, but I think the structural changes that we're seeing are more reversion to the mean than VCs forever bad. I think, listen, this has always been a hard investment category. And I think if you're not backing a VC who has a right and a process that gets them into the top death style, right? Then returns are not going to be great. It's a power law business, always been a power law business. I think these are super important issues, but why don't we just in the spirit of time?

57:33Wait, wait, wait, wait. Oh, there you go. There you go. Yeah, one response. I would encourage the, our listener base to look up, there's a piece of research that's called the observer effect. And it started in physics, but it's used more broadly. And the observer effect is the idea that observing a phenomena or situation changes it. And that's really the point I'm making here is that I think prior to now, the investor and how they behave didn't actually impact the situation on the field in terms of, in terms of like changing the game and how it's played. And to me, the way the competition that's evolved in the venture industry is actually perturbing and affecting the situation.

58:25So anyway, I'll leave it. No, I think it's another way of saying that is negative reflexivity, right? That, you know, when dollars come in, it actually leads to poor behavior. We'll take a deeper dive on that sometime because I also want to get your thoughts on how that might change. But why don't we finish just in the spirit of time with a quick tech check like we always do. Awesome. So the big big event and this macro world is more you than me, but the big event obviously was the Fed decision to lower by 50 basis points. What's the impact from your point of view? Yeah. I mean, you and I talked a bunch about this along with our friends at all in.

59:08I really we were in historically restrictive territory. And what that means is basically we just have a little bit of the emergency break on the economy. And so once they were convinced that inflation was going to have a two handle which it now has and that, you know, they were starting to see some slowdown in the jobs market. You know, what we did is like we want to take a jump start to reducing the restrictiveness of the economy. I thought that was a smart thing to do. I think it's just getting back on side. I don't think they were seeing anything other than what we're seeing in the economy.

59:43But it's incredibly significant to the markets that we're now on our way down. Remember, we had two years, two plus years of historically steep rise in interest rates coming out of COVID. And so this gives predictability as companies enter their budget cycles this year, right? Every company right now is thinking, what can I invest into AI infrastructure next year? And so knowing that interest rates are not going up is a super, super important input into those pieces of analysis. But the debate remains. I mean, I think it's interesting, you know, you had Jamie Diamond and gunlack come out and say, hey, this battle with inflation is not over, de -globalization, all these other things.

1:00:23So they're suggesting that you could actually see inflation kick back up. That would be a negative surprise. And others are saying that the feds are ready behind the curve and needs to go faster with respect to the slowing economy. So that's the debate that's in the market. Well, I'll just tell you where we are today, we talked about taking a bunch of units of risk off, which we did in June and July. And as we were heading into these rate cuts, we're back at average levels of exposure today. So and that's because we saw a lot of really positive statements coming out of the earnings this summer.

1:00:58You know, and the economic data continued to be constructed. We expected a 50 basis point rate cut, which I had been sharing with you and folks on this pod for for some time And so we think that's a good setup heading into the fall now We have an election we got to work our way through and we got a lot of other question marks But you got to take those data points as you get them Your team is listening to so many different earnings calls and whatnot What's your what's your take on the consumer and and that side of the demand equation like like irrespective of inflation, is there a mini recession, or have we literally landed the soft landing, or do we not have yet?

1:01:40Listen, I think behind the scenes, we've been going through many recessions in a bunch of different industries. Like for example, housing went through a mini recession. I think things like home renovation went through a mini recession. The entire supply chain about that happened. The S &P we talked about, The S &P has continued to outperform, but if you take out the 10 best performers from the S &P up until a couple weeks ago, it was actually down on the year. So this has been a period of halves and have nots. I think the economy writ large is pretty stable, but let's just look at multiples here for a second because I think for tech investors, it's really what it comes down to.

1:02:19So this first chart just shows you that multiples for these big tech companies have come up quite a bit, certainly off of the January 23 lows, we were trading about 21 times, right? This is forward PE for these companies for the max seven. You're showing forward P for the max four P for the max seven. So, you know, if you look at the 10 year average of this, it's about 25 times in January 23. When we're all talking about Mike Wilson's hard landing, the economy's going to crash like all this stuff. You know, people have post traumatic stress from 2022. We got as low as 21 times. So now we've run up to 31 times on the Ford PE.

1:02:59So on that dimension, you would say that looks pretty darn expensive. But if you go to the next chart bill, which I think is an important one, which is this is the PE ratio divided by growth, right? So this is the expected growth rate of these companies. You can see one of the reasons people are excited is because they expect a lot of growth. So on that dimension is below the 10 -year average. And so what's my conclusion based on that? You know, it looks cheap if you expect, if you believe in those growth rates, but if those growth rates don't show up for Microsoft, for Amazon, for Google, et cetera, next year, then you can expect that these companies are gonna, their stocks are gonna go sideways to down, right?

1:03:42Because the valuations are much more full. And so I think that that's really the debate, you know, now. And I think it's a stock pickers market from here. We have average levels of exposure. I think for example, we think the entire Nvidia and AI infrastructure supply chain is gonna continue to be under supplied. So Nvidia's come off from 140 to 115. There's a lot of debate in the world. A lot of people think that they're not gonna hit the numbers. You know, we're kind of at, you know, six million GPUs for next year. The bearish people are at like four and a half million. And like the numbers will ultimately tell.

1:04:21If they do six million next year, the stock's going higher. If they do four and a half million, the stock's going lower. That's the way this business works, right? And so we're just out there trying to collect all our data. In fact, Clark's over in Taipei right now, talking, you know, meeting with the supply chain, understanding what's really going on. And I think, you know, in January 23, you had a huge margin of safety. All you had to believe is that the world wasn't ending and that we're in the start of a new super cycle and you push chips onto the table, right? If you understood that you had pocket kings or pocket aces as we sit here today The world is as much more bold up Right, so you know even if you have a differentiated point of view It's more like sitting on pocket nines You know not like pocket kings.

1:05:05I think you got to take a more measured view of the market and and think about this Distribution of probabilities. There's certainly we could see the economy slow certainly we could see Blackwell doesn't get his production levels up. That would be a challenge for the entire ecosystem. So it's an exciting time. I don't think there are any no -brainers in the market, but I can also see how, you know, when I look at the tailwinds behind tech right now, both in the private and the public markets, I couldn't be more excited about the next five years. It'll be volatile as they always are, but there's no doubt they're gonna be some big winners produced, you know, in this cycle.

1:05:42Let's wrap it there. It's good to see you. Let's do it. Let's see. I'm gonna be down in Austin, so let's get a podium. Yeah. Okay. Thank you.

1:06:01As a reminder to everybody, just our opinions, not investment advice.