EUVC #243: Fred Destin on navigating the current market and reflections on life, the future and the role of religion

0:28Hi, everybody, and welcome to the European VC podcast. life tech wolf and hoffy and some notable investments counting zoopla pill pack superhuman linkly deliveroo secret escapes daily motion and integral outside if you're listening in and love our show you know what to do drop us a review follow the pod and subscribe at uwc

0:48tear down this wall it's more than just an alliance this is a union of values

1:03The nature of a problem requires a European response. Europe is a story of new beginnings. Let's start acting. This show is not investment advice and the hosts of this episode may be invested in the funds and companies featured. Fred, we were meant to do this fireside chat in Dubai for the Expand North Star Conference. Unfortunately, the stars didn't align or we couldn't make that happen, which was a shame. I was personally sad about that. But we decided, well, we can't let this opportunity pass by. And so you thought we would do this on the pod instead. Fred, welcome to the show. How are you today?

1:44Thank you so much. I'm great and I'm glad to be back. So for those that don't know, Expand North Star, and it was my first time in the region and in Dubai specifically, is a very interesting conference and they had investors from all around the globe. We had Europe represented, we had US, we had Asia, we had, you know, it was really interesting to see all these different viewpoints. And so the whole concept of this fireside chat with Fred was kind of give a view, start starting off with giving a view on the market from where we stand and from specifically Fred and Stride stand. So Fred, would you give us a quick rundown of where you see the market today?

2:19and let's not shy away from giving kind of a macro view as well to people that might not be living and breeding venture like we are every single day. For sure. So look, I think the theme of the day is that we're processing the overhang. So I've been in venture since 99 and I think the crisis we're in right now is probably comparable to 2002 because of its depth and its length. And, you know, if you've lived through the 2008 crisis, that was a liquidity crisis. But, you know, we had the benefit in tech that we recovered within six months. You know, the iPhone came out and the whole mobile platform plays, started delivering value.

3:13And so we really didn't feel it that much. It was tough in the moment, but it was short. whereas this one is complex and all-encompassing. And so right now, I think if you were a 2016 vintage fund and you had five years to bring companies to any form of liquidity window, you're probably doing okay in the sense that you had a chance to exit some capital to show some decent DPI numbers. But, you know, we come out of a stage where we had this incredibly high graduation rates, 80 % plus compared to market standard might be 50. We had fast markups between rounds. We had blitzscaling strategies based on infinite capital access.

3:58And, you know, by the time you get towards the end of that cycle, as I said, either you'd hit the liquidity window and good for you. You basically pass the bag on to someone else, which we can discuss whether that's right or wrong. or you get risky mega rounds done for your companies. And so if you look at maybe the 17, 18, 19 vintages, they're more in that category, which is they get a lot of companies that get funded and extremely high valuations, raising 50 to 200 and at sky high values and with huge liquidation preferences. So now we're looking back at that and looking at, I think, three primary things that are happening for existing funds.

4:46So one is, call them re-ratings or markdowns that are in line with public companies. So say, if you look at the Bessemer Cloud Index, it came down 50 % to 60%. And so you're going to naturally find that some of your more growthy companies are getting re-rated. And it's painful from a return standpoint, but it's okay because these companies are healthy. They should drive value over time. So it's going to reduce your return profile, but your asset is still performing. You then have a second category, which is either recaps or cram downs. That's when the liquidation preferences come down. The growth funds will use that either in recovery scenarios, but also will use them offensively to drive their ownerships up.

5:30And that is the kind of scenario where it's almost impossible for seed funds to recover from that. We just don't have the far power to follow in these recaps. And then the third category are segments where you have full market dislocation. So certain segments are just completely shut down for new funding. You can think about online groceries, for example, as one of those where just nobody wants to touch the segment. You know, insurance, maybe if you look at lemonade and what happened with Luko would be in a similar category. where there's just no capital and people are kind of people so burnt that they don't want to come in.

6:06So we're looking at this stock of companies inside seed funds, for example. And I think one of the issues we're faced with right now, or there are two of them on the LP side. Number one is the LPs have no confidence that the GPs are showing the true value of their portfolio. I've heard this now 20 or 30 times that managers, instead of marking their portfolios down, or at least being transparent about the state of the assets, are sort of trying to play a game of let me delay the markdowns for as long as I can. And DLPs are really pissed off because they don't know what to believe in terms of what they're being shown.

6:47We had a case for one of our companies where we took it down 50 % early because we could kind of see the writing on the wall. and then a number of my LPs called me and said, hey, I'm seeing these other funds that have marked this position, you know, either at cost or maybe they took a 25 % markdown and we're trying to make sense of what's going on, which, you know, puts us in a difficult position because we're not trying to hamstring our co-investors. But, you know, it's an example of, I think, very differing views inside the GPs as to where these assets should be. the second thing that's a little bit complicated is that a number of lps either forgot or have had no experience that this is a cyclical market so the experienced lps you know the harbor vests of this world who are used to investing through fund cycles know that from time to time you're going to have a tough vintage and you kind of have to go look through that for alpha whereas somewhat less experience LPs are at the moment screaming and going, hey, you promised me money back.

7:52And now your portfolio took a bunch of punches in the face. And where's the cash? And so you're seeing people asking for DPI on quite recent vintages, even 2018, 2020, they're going, where's the DPI? And the answer is, well, you can't generate DPI that fast. and now you have this secondary craze which is coming up which is the time to do secondaries was 2021 and now it's all the rage to talk about gps need to learn how to generate liquidity and the worst time in the world to sell your portfolio assets is you know late 2023 and so you know now we're again looking back in the rearview mirror trying to optimize performance by doing exactly the wrong thing now don't get me wrong in some cases you have to generate liquidity so this is a a must not a not a nice to have but i think we're we're seeing counter cyclical strategies being deployed which i think is just not not the way to go you just have to be patient put your head down focus on the portfolio drive value one company at a time i think there you're hinting towards your view and and which i would share right it's it feels like a stark period but as you said it's it's part of the cycles right and experienced people know that and recognize that.

9:09I'd love to do a side note here and ask you, because you painted a very, in my view, at least clear scenario what this means for fund performance, mostly for seed funds, seed VCs or seed GPs. What does this mean for founders these days? What do you think the real impact will be? Do you think we will see actually some negative outcomes of the cycle right now towards founders and entrepreneurship? I don't know how to answer that question generically. What I would say is there is a lot more education and acceptance of the fact that founders need to be motivated going forward and or at least the management teams that are running the companies that may or may not be the founders hopefully it is the founders and that investors fully understand the need for carve outs on lower value exits re-incentive of the management team with cleaned up cap tables And so my current experience is that people are a lot more mature about understanding that, you know, if you don't put a few million dollars worth of exit value on the table for a founder, which is valuable years of their life they're spending trying to build value, that there's a lot more acceptance for that.

10:25The flip side of that is it's the oldest game in the book for an incoming investor to go ally themselves with the founders with their cram down and we re-incentivize. Actually, I think that's healthy because there's no way around the reality of what it takes to incentivize people and build a company. But I think we're seeing quite a healthy response, at least in the viewpoint I have on the market, a healthy response to that. What you described there are somewhat, let's put it, they're not simple deal dynamics. Let me put it like that, if I will. And with a period where we had a lot of new, whether that's new funds, whether that's new practitioners in the VC industry.

11:09And here I'm really focusing in Europe right now. Do you think, and it's a bit of a philosophical and provocative question, but do you think our stock of VCs, seed stage, early stage VCs, are ready to deal with these complex dynamics happening in their portfolios in the market the way it is today? Let me answer the question indirectly. Whether or not you are ready to deal with these dynamics, the reality is these situations are unlikely to be situations when you drive a lot of value. so I think that it's important to fight for every dollar but as we know the two, three, four if you're lucky best companies are going to drive 90 % of your returns and so I don't know that as a seed investor your ability to deal with complex deal dynamics is necessarily going to save your ass I think your fundamental ability to pick category defining companies etc is what's going to save your ass and so you're rightly so i think the lps are very focused on what's driving value in the portfolio and for ourselves you know this is where it gets tough because you think okay i want to keep as many shots on goal as possible i want to keep as much austerity in the portfolio as possible but the reality is you know in in markets that are this brutal a lot of these companies are shot like they may be shot because your return profile on them is shot so in other words the capital structure is such that you're unlikely to recover much of anything or that the businesses themselves are impaired and so i think it's important for the gps to just take a somewhat dispassionate look at this stuff and this is where you move into your portfolio you put your portfolio management hat on and you know in my experience you can have very honest conversations with founders, they take it quite well, which is to say, hey, look, I think the strategy is complicated.

13:12I think the company's future is impaired. We don't know what to do. And we're going to go focus our energy elsewhere. And, you know, if you ever need a heart-to-heart conversation about your strategy or what to do with the business, I'm here. But, you know, we're going to go focus our energy on the things that actually You drive value. And I think founders get that. I think there's nothing worse than this kind of benign neglect that happens where founders just get ignored or left aside. You might as well just have the honest, direct, truthful interaction with them. And they get it. I mean, they understand our business.

13:47They're not stupid. And at least they're getting a true answer, you know, a true representation of where you're at. That clarity, yeah, of course. So I think if we were doing this in the room that we had planned to do initially, there were some less, let's call them less experienced LPs in venture so that they're new to venture. They're looking at the asset class now. I think it's fair to say that they might be thinking, listening to this, well, maybe I'm just going to focus on like more growth stage funds and like not really, you know, risk the pre-seed stage. I know that's not your view. So I'd love to ask you, how do you balance things off now?

14:28Because it feels a bit stark the way we've spoken about it so far. So as an LP, you both have risk intolerance, and especially family offices just don't like to lose their money. And then you have, depending on your strategy, you really theoretically invest in venture for alpha. So there is a middle of the road way of thinking about this, which is to say, I'm just going to give my money to a large scale fund because that feels safe because they're big. The problem with that strategy is the large scale funds that are really exceptional. You probably cannot get access to Index, Excel, General Catalyst.

15:09I mean, good luck. They're oversubscribed. They've always been oversubscribed. But these are not managers that it's really easy to get into, even if you spend years building a relationship. I know because I used to be at Excel and getting a new LP in effectively requires an existing LP to drop out for whatever reason. Or there's some small rebalancing, but it's really tough to get access. So then you're potentially left with managers that are middle of the road where you're really not getting paid for the illiquidity premium that you're getting. and let's remember that the only thing that matters is getting into some form of quartile performance so your job as NLP is really to go assess on what dimensions a manager is going to generate top quartile and whether that story is credible and we know that individual GP performance persists over time but fund performance with a few exceptions does not persist either so you can't really rely on history.

16:08And at the moment, you know, when people are nervous or anxious, they over-index on existing numbers, history, et cetera, as a sign of safety. But, you know, the numbers historically tells you that may not work, or at least it's not very predictive. So I think the flight to safety in venture is a dangerous way to think. You actually, if you look at early stage portfolios, for example, they're not that easy to lose money on. It's interesting because there's kind of a misconception that at the individual company level, these bets are highly risky. So you will have LPs to say, oh, 30 % of your portfolio went bust, you're doing a bad job.

16:51Whereas in reality, if you're taking enough risk at an individual company level, you're expecting your loss ratio to be relatively high. But at a portfolio level, if the portfolios are built with discipline, you're unlikely to lose money. You could have lackluster returns, but to really lose money in venture if you're disciplined, unless, again, you get a terrible down cycle, but in a normal quote-unquote market environment, it's not that easy to be losing money for your investors. It takes a special kind of skill, I think. I think I can't remember, and I apologize for that, but I can't remember neither the guest nor the data source, but we had a guest recently sharing like a counterintuitive learning they had when they started in venture was, and they quoted some kind of data source that I can't remember.

17:39It was like the portfolios with biggest write-offs or highest levels of write-off also tend to have higher returns or potential for returns, which is very much what you're saying, right? It's not that you have 30%, 40, 50 % of the companies going bust within the first three, four to five years that that you're not making money. Yeah, exactly. Mapping or stack ranking funds based on the loss ratio is completely irrelevant. And if you're taking big enough bets, your loss ratio should be higher than if you're investing in relatively safe, say, you know, SaaS analytics companies where, you know, you're not going to drop that many balls, but the likelihood that you generate north of 2x net is pretty low, right?

18:23Because you've just compressed your risk profile. So we're kind of touching on this lightly, like portfolio, you know, different strategies. I'd love to ask you, and here I'm asking you, Fred, investor, not you, Fred from Stride. How do you think about the different venture strategies that one can employ and should employ? And maybe I'll ask a pre-question to that question is, can you believe that it's possible to time the market? general opinion tells us no. But as you think of your strategy as an investor, that's definitely something that comes into play. Sure. So let's talk about venture strategies first.

19:03I think the purest form of venture ends up and remains a founder entering into partnership with a partner somewhere and they collectively deciding they're going to go build a great business. That at the end of the day, whatever we say about venture being shit or great or whatever, There is something quite pure about that, which is I believe in you as a founder and together we're going to go build something wonderful. In that model, I think that model is very hard to scale because it's highly dependent on the quality of the GPs and you need this kind of multifaceted skill set. This is where you'll find benchmark, USB, et cetera, which are very much the role models for how I try to work, which is this boutique one-on-one engaged approach.

19:52and where you make no apologies and you say, you know what, I am your partner in building this company. And that is the purest model. And then the problem with that is there's too many venture capitalists, and I'm not trying to generalize, but there are too many venture capitalists who don't have a view about the world that is particularly original, who don't know how to engage with founders, et cetera, et cetera, which is why venture gets a bad rap because you get a nondescript person on your board who's sort of a money manager and has no particular view about your company, the world, you as a founder, et cetera.

20:27And it's sort of a pretty mediocre experience. But done well, it's beautiful. Then you look at venture strategies that I think are differentiated and work well. And I'm just going to throw a few examples. I mean, the canonical example of ghost in the machine would be YC, right? Let me build a network of experienced founders and operators. Then I build a selection method and then I let the network do its work. almost don't need to be there in terms of selection and i've created such a brand and such a community around myself that you know it kind of becomes a self-fulfilling uh center of excellence you could argue in europe that c camp is similar you probably have five six hundred companies in portfolio the network itself feeds you know input insights and community with the founders and you know that's quite nice they live at pre-seed they can write tons of checks highly diversified you kind of get or the value prop is very clearly.

21:21I really like, like my former partner, Harry, I think has built something similar where he can't necessarily be the lead investor because of the way he operates, but what he's selling is very clear. You get media exposure on the front end, you know, massive full leadership machine, and then you get his network or the network of his network with the vertical funds he's doing, but that's a pure network asset. In other words, don't ask me to do any work with you. I'm not going to sit down for half a day and go through a strategy, but you want access to Collison or you want access to anybody, I can provide that to you in under 48 hours.

21:58I mean, it's a very clean value prop. So I think these strategies, so that's more of a follower strategy. You're going to work, you know, you're going to follow the tier ones into the deals that they do. But I mean, it's pretty beautiful and I think it's pretty clean. I like, I think the strong thematic approaches are powerful, provided you get some kind of virtual circle. So Visionaries in Berlin, I think is doing a great job because their LPs are industrial families. They're focused on B2B SaaS. They're talking about digitization of existing industries. The investment strategy is not that novel, but the ecosystem they built is powerful, right?

22:36So that's very consistent and coherent. And I think that's great. I also like people like 50 years on the West Coast. And because they're like, hey, we're going to precede people solving humanity's big problems, and let's build an ecosystem of visionaries around that, again, with a very clear value prop, high-velocity investing. So these are thematic examples that I like. And then you go into the operational support VCs. Now, I think most platform services are pretty average. You know why? Because they're hard to do well. You have to put real resources and intent behind it. But if you look at Insight, for example, I have the example of two companies I worked with Insight.

23:25So one is Recorded Future and the other one is Sedna here in Europe. Insight has two portfolios. There is the tactical investment portfolio. So they'll put$30 million into a company, minority ownership, and then they have the more strategic portfolio. So they double down on company. And then they start deploying these operational support teams. I think there's 300 people strong. And I think that the people in that organization are world-class at sales, organization design and leadership, like whatever segment you want to choose. And so they're going to roll out these incredibly experienced operators into your company and really help you design playbooks and operationalize better the way you work.

24:06I mean, I have to say, having seen this in action, it is really powerful, done well, and it's quite transformational to companies that need to move from my stage to proper scaling, right? This kind of 30 to 500 million in revenues, which, you know, to be honest, I know about, but I get so bored by it that, you know, for me as a VC, if I'm on the board and we're now talking about scaling the Salesforce from 20 to 100 and sales incentive programs, et cetera, like, I mean, I'm just, I'm starting to phase out completely. So great partners and I think very powerful models. And if you have to compete with Insight head-to-head and they start telling you what the playbook is going to be, what benchmarking they can do pre-investment and how they're going to help you.

24:50I mean, these are quite, they're really a compelling investor and definitely one of my go-tos. So, you know, there's as many venture strategies almost as there are funds. But I think there's some canonical examples like that. And the question for the GPs and for LPs is like, are you playing in your natural underwriting territory? Are you playing the game you're best at? I love deep work on product, strategy, people, branding, narrative. So does Gabby. And so we are quite naturally suited at the boutique model. And in fact, most of our work happens outside the board meeting. Like we will do three-hour workshops or full-day workshops where we go deep dive on a topic.

25:31and I have no problem saying that we do move the needle, not with all our companies, but with some of our companies. I think the work we do helps our founders move the needle. And, you know, so there's this notion of VC value add, which is the most overused term on the planet. But if you look at where people are within their zone of excellence or their zone of genius or their zone of competence, I think they do actually help. And I think founders will say, hey, you know, if you speak to the pill pack founders, they'll say, hey, there are a few moments, not all the time, but there are a few moments in the company's life where we shifted our strategy or we moved the needle, our ambition or something that helped us execute better.

26:13So I think I live for these moments, which is when is the insertion point where you have something meaningful to say or to contribute. And the rest of the time, you're just like founders run their shit. I like that a lot. um from an lp perspective here and and it's always tough to to speak from that perspective because the last thing we want to do is to be giving out advice or whatever right but but from your world view or viewpoint do you see trade-offs between because you know there's different models and there's different portfolio models as well right and they they coexist right so it's like a diagram of search right in the sense that you can have very different models that lead to concentrated portfolios are going to have very different models leading to very diversified and wide, wide portfolio.

27:00And so from an LP perspective, specifically on this topic of portfolio, I'd love to ask you, what are your views on the trade-offs? And the reason I ask is because I myself, I've done a couple of angel investments in funds and I have these very early stage incubator-like huge portfolios, right? But also the very kind of, you know, synthetic bio-focused fund, like super, super nerdy, super geeky, like very much doing less bets, much more deep work in picking and supporting and selecting, etc. I think there's this kind of opinion in the market that everything that has a diversified portfolio is spray and pray, which I don't really agree with.

27:47I'd love to hear your thoughts on the trade-offs between these two archetypes. Venture math math without a doubt supports what you might call as a spring prey so actually if you're evidence based there is no question that more diversification tends to play well in venture lab so theoretically the it depends a little bit on the variance you want about potential outcomes and the security the certainty of where your multiple is going to be and that's where the geeks start geeking out on doing their Monte Carlo simulations. So based on historical data, you actually continue to benefit from diversification almost infinitely, which is unusual and is different from other financial instruments.

28:33So you could go to 1 ,000 companies, you keep driving your expected return up, which is unusual, but of course you reduce the variance of the outcome. If you want to do 2.3x net, you invest in 1 ,000 companies. and you know maybe the optimal number is somewhere around 150 so if you look purely adventure math people who knock spray and pray don't understand the nature of fat tail returns you know in the kind of world we live in however that's not the whole story because you also have a you know you need a value prop to founders that makes sense because otherwise you're going to end up in a very adverse selection phenomenon, or you're going to end up, a lot of the large-scale incubators, where I'm concerned, is they engineer companies out of nothing with people who aren't naturally founders, who haven't spent the hard yards finding the idea that's actually worth backing.

29:29So even though you're not going to find the comfort in numbers if you're kind of engineering companies out of nowhere and just giving people free money to try to be entrepreneurs, that's not going to work either. But in any event, And when you look at the benefits of diversification, you get about 85 % of them by the time you get to 25 companies, which is why most people land on that number, because it's diversified enough, but you still have time to be a lead investor, be present, be at the board, do good governance and all that other shit. So then you get into, do you believe in picking? And, you know, do you believe in picking is a vexing question.

30:08and I think people think about it slightly the wrong way because you're actually not trying to determine a winner. That's the wrong way to think about picking because we cannot determine who's going to win. What we can do though is we can look at whether we're putting the right kind of risk return trade-offs in the portfolio. This is where discipline comes in, which is are we putting the type of return profile that we need to be putting in so that on whatever level of diversification we've chosen, we've put enough shots on goal for things that are multiple fund returns. That's what you're trying to do.

30:47You're not trying to determine from the outset whether every one of your companies are going to win, right? It would all be Warren Buffett if that was possible. There's a misconception there. Yeah, but what you're saying is, in other words, is what we're doing is can we as a team or as an investor see an outcome that is big enough for it to justify the level of risk that we know that is inherently here. So we can see this making enough money for it to grant whatever risk in our model exists with this investment. Correct. And then the risk type you take is also important because there are some risks you cannot mitigate.