E204: Going All In: The Risks and Rewards of Concentrated Investing

0:00Rafael, welcome to the How I Invest podcast. Thank you for having me, David. Pleasure to be here. You started your career at some of the really top growth equity firms on the planet. You were at Summit Partners. You were at Vulcan, which was the investing arm of Paul Allen. And today you have your own fund. Tell me about what you're focusing on today. Cross-capital really started over a decade ago. It was a combination of who I am as an individual. I was born in Brazil, been in the U.S. for the last 25 plus years. I'm always investing in technology throughout my career. So I went down the traditional path.

0:35And as you alluded to, I had the great opportunity to kind of cut my teeth into the world of investing initially at Summit and subsequently at Vulcan. And now within Across, we bring with us a lot of the learnings from those times. And we're focused on backing software businesses across the Americas. It really started out a decade ago, the thesis for Cross, which was predicated on the fact that I was Brazilian in Silicon Valley. I saw a lot of entrepreneurs come through here, particularly from Latin America, trying to raise money in Silicon in Sand Hill. And I was helping them think through how to position their businesses for the Silicon Valley VCs.

1:14And at that time, I started personally investing in what went on to become the first crop of unicorns in Let M. That gave me conviction. Our timing in Latam made us a little bit of a unique animal in the U.S. where our portfolio company was seeking us out to help them with Land America, whether that was on the talent front, whether that was in the business development side. And that was a genesis for across. Tell me about the Brazil tech ecosystem. How has that evolved in the last decade? Great question. Look, I think Brazil has delivered one of the most successful returns in all emerging markets when it comes to tech.

1:45I'll say it's Latin's Silicon Valley, right? Whether you want to look at the Mercado Libre of the world, which is 100 billion plus market cap company, Nubank, which is a 60 billion plus market cap business, perhaps one of the most successful fintechs globally, or others such as Puck Segura or XP. We have had some M &A also happen down there, but it's a fertile ground for innovation. I think the backdrop is a big market measured both in terms of population and GDP, that is extremely tech savvy, both on the consumer side, but also on the enterprise side. And we're reaching a point where the talent density is there, right?

2:23We're kicking into this flight wheel where we have had exits. We have had folks building 10 million plus companies, and they're on to their second or third go around. So again, it's pretty fertile ground for innovation and tech in general. One of the undertold stories of Brazil is it's fintech and financial infrastructure. Why is Brazil have such high market share when it comes to these fintech startups? If you take a step back and you understand kind of how the banking system in Brazil was built, was really built out of chaos, right? If you look at the 80s and the 90s, the countries suffered from hyperinflation.

3:02That required the banking system to operate in effectively real time. with same-day settlement. And that kind of sets the tone for a lot of the innovation we have seen in the Brazilian fintech ecosystem, which is further propelled by a central bank that thinks like a startup, one of the most innovative central banks in the world, extremely progressive when it comes to innovation. What they've done in the last decade is nothing short of remarkable. We have had innovations such as PIX, which is the real-time payments rail provided by the central bank, which now has a penetration of 80 % plus of the adult population in Brazil, whether that's open finance and providing for data, portability, embedded finance, and a lot of innovation within the financial markets.

3:55And then you have other more structural nuances that makes it quite compelling to perhaps disrupt these incumbents, right? You have a very concentrated banking system, extremely high spreads when it comes to credit. There's still penetration to be had as relates to just financial products in general. And that ultimately translates into a very compelling market when it comes to innovating on the fintech side. You have a Brazilian company, QITech, that really powers a lot of the infrastructure and the fintech in Brazil. Very fortunate. to have had the opportunity to work with the team over at QI Tech.

4:33It was actually the first investment we did out of the Across Capital Fund. And we have been spending a great deal of time within financial infrastructure in Brazil specifically. And the notion being, you know, picks and shovels plays into this massive team which I just alluded to earlier, batting the race, not on the horse. And QI Tech, what it does is provides the infrastructure that enables any company, whether that's a retailer, a fintech, a shopping mall, a big pharma company to offer financial products. So think of it as a stripe of that part of the world, but with other elements as well.

5:07It is a business that was extremely capital efficient when we had the opportunity to get involved, had explosive growth, growing 200 % plus year over year with EBITDA margins in excess of 50%, something that you do not see every day, and still with plenty of runway ahead as relates to the market itself. Tell me the difference between a LatAm fintech company and a US fintech company. How is it different to start a company there versus in the US? The way we see it is down in Latin America, you have the opportunity to build more end-time platforms. And this is just driven by just the overall market dynamics.

5:46If you look at QI Tech, you really started out offering much more of a lending as a service product whereby they were providing the infrastructure for traditional companies or fintechs to provide credit. Now we have a banking as a service product, which is checking accounts and payments. Now we have a fund administration business, which also helps custody the funds of clients. So it is building much more of an end-to-end platform, which is very different from the U.S., whereby oftentimes we're trying to solve a specific pain point or going after a big but perhaps narrow market. In Latin America, there's an opportunity to build things that are much more platform-driven and platform-oriented.

6:25And why is that? Is that the barriers to entry? Is there some technological advantage? Why are you able to kind of verticalize these solutions? Resources are just more scarce down there, whether that's capital, whether that's talent. And as a result of that, the winners tend to compound and drive better to entry for new entrants. Whereas capital is more abundant here in the U.S. Talent, definitely density is much deeper relative to LATAM. So those dynamics drives some of these forces I just mentioned. And you have very concentrated portfolio construction, 10 companies. Tell me about the strategy behind concentrating into less than a dozen companies.

7:04Concentration forces clarity in the end of the day. When you only get 10 shots, you tend to do deeper diligence. You lean into your edge, right? It gives you the ability to partner with companies in a meaningful and active way. So ultimately, it is something that's foundational across our investment philosophy. It's not a mindset of buying call options, right? The it's every single one of our partnerships are meaningful to us and drive that drives alignment with with the entrepreneur. We don't have a portfolio of 30, 40 names. It's 10 of those. So everything, it's incredibly meaningful to us. It drives a scarcity mindset, which, you know, for us means, you know, we need to have, you know, ruthless realization, I'll say, on how we spend our time.

7:55And that changes the way we source. It changes the way we engage with the companies and changes the way we pick them. So the punchline is, look, by only investing into 10 companies, that forces us to be incredibly focused. You know, everything is meaningful to us. And we like that alignment with our entrepreneurs. And we also like the fact that it gives us the ability to drive, in our view, very good risk adjusted returns for LOPs. And you said it forces ruthless prioritization. Why does having a concentrated portfolio change your sourcing capacity or your sourcing function? Top of the funnel, we're still talking to thousands of companies, right?

8:34But on the middle of the funnel and bottom of the funnel, that's where the ruthless prioritization comes in because we are spending a great deal of time with efficiency and speed to get to the bottom of things that really matters on the investment decision. So ultimately, we're spending an incredible amount of time, probably around 30 or so opportunities per quarter where we're diving in and really conducting deep diligence. On average, we get to know companies 17 months prior to making the investment. So that diligence is occurring over a year and a half period. That allows us to, one, ideally have built a relationship with that entrepreneur and have earned our seat at the table.

9:11to have the conviction to move with efficiency and speed at the time that they're looking to raise or transact, if you will. We have these top companies that we're pursuing. We're ultimately aiming to do two to four investments in any given year, and we need to focus on the companies that are going to be those two to four. And that is where the Ruthless Capitalization comes into play. It's Warren Buffett that popularized this idea. When you become an investor, you graduate college, you should have a punch card of 20 companies and you only get to invest in 20 companies kind of throughout your career.

9:44And it's this kind of ruthless conviction, I would call it, that you have to be so convicted. I also think there's this bias towards diversification on a fund level that's unnecessary. And that's a very pro-GP strategy, not a pro-LP strategy. LPs actually want to have high concentration, want to have a basket of highly concentrated names. Those tend to be the best performing funds. You could argue it's not the case for the pre-seed and seed where there's power laws, where any one company, you want a lot of shots on gold. But once you get to a certain stage, you typically want your managers to be highly concentrated.

10:19Couldn't agree more. It's interesting because I can't speak for LPs, but if you think about it, at the LP portfolio level, they have ample diversification because you're investing across multiple funds. Each one of these funds are investing in underlying companies that provide further diversification. So they are diversified for all intents and purposes. In our view, as a manager of a fund, we like concentration because of the points I alluded to earlier. And to give you a practical example, QI Tech, which we talked about earlier, is a 20 % position in our fund. We truly live by this high conviction, high concentration mindset.

10:53Is that a fund returner? It's looking like it. We just actually announced yesterday a follow-on round, which marks the fourth time we're investing into the company. We co-led it with General Atlantic. Given where the pricing of that came out, which is close to$2 billion, we first invested in the business at$300 million. It's very close to being a fund return already. I just interviewed John Felix, who was at Wash U, St. Louis, and worked under the Faville CIO, Scott Wilson. And Scott Wilson not only invested into funds that are very concentrated, but he would meet and his team would meet with the managers and find out their top concentrated positions, whether there was an opportunity to deploy even more.

11:34So you had this kind of like ruthless concentration. Now, that being said, it probably was still hundreds of positions. But the idea that you have to have every fund be 30 to 50 companies and then you have 20 funds, the math does not justify that kind of diversification. Makes a lot of sense to me. We had this back and forth last time we chatted. You believe that growth equity is not about the power laws. It's about consistency and maybe even downside protection. What leads you to think that growth equity is kind of a different asset class than traditional early stage venture? Support for today's episode comes from Square, the all-in-one way for business owners to take payments, book appointments, man staff, and keep everything running in one place.

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13:12With Square, you get all the tools to run your business with none of the contracts or complexity. Run your business smarter with Square. Get started today. There's different types of strategies within the growth equity. I think growth equity has evolved quite a bit over the last decade. You could argue there's what some may view as traditional growth equity, which is minority investing into high growth businesses that tend to be capital efficient or profitable. This is how the likes of some at TA in the mid 80s were born. So you're effectively sitting in between venture and buyout, but still driving returns predominantly through growth and have been a minority investor.

13:48And obviously, I think to a large extent there is venture growth, which is just later stage growth rounds. And that resembles much more of the growth equity 2.0 than the growth equity 1.0. But to your question related to consistency versus parallel, particularly the way we think about it, given the concentration of our portfolio, we're much more focused on consistency of 3 to 5x returns versus chasing something that can be binary, which is chasing the parallel. something that could potentially return 10, 20, 30X or be a zero. We're less interested in those. We're much more interested in finding things that we have extremely high conviction on hitting our minimum return threshold of 3X with the downside protection, whether that's driven by the state reinvesting, the structure reinvesting, the IP the company has.

14:41But we have high confidence that capital impairment is going to be very low. In fact, if you look across our track record, we only lost money in one deal. So that speaks to our mindset around downside protection and being mindful of capital impairment while still preserving the capability of still achieving a 5x plus return. So that's ultimately what we're looking for is this notion of consistency. That does not mean that we won't have perhaps one or two companies in the portfolio, in our case, of 10 companies that will drive a lot of the returns in the fund. We just alluded to QI Tech being a 20 % position and being a fund returner.

15:20Obviously, the fund returning component drives by us sizing that position accordingly, which I think is something that we don't talk about enough, is how sizing matters. And that's a byproduct of concentration on the return of the overall fund and portfolio. But I, as a manager, I cannot be chasing things that could potentially have capital impairment because the portfolio construction does not allow for that. I want you to double click on the sizing component. You're at Summit. You're at Vulcan. You saw the kind of the best practices. Obviously, you invested 20 % in one company and you have a 10 portfolio position.

15:56So it's roughly double your average position. Is that basically how you explain your sizing strategy, which is invest even more into your higher conviction bets? Is there more math behind that or double click on your strategy? On QI Tech, like I said, we invested four times in the business. So we built this position over time. So it was not from the get-go that we got to 20%. But from the get-go, we did size this position at 12.5%. That was our initial check. And then subsequent to that, we have increased it to 20 % as the company has beaten our plan every single time we have re-underwritten the business.

16:31And that's part of the strategy. Part of the strategy is to back your winners, if you will, and put more money in things that are working. And we think there's still, on a risk-adjusted basis, a compelling case to be had to allocate capital to anything. QI Tech is a prime example of our strategy. One of the things that you see a lot in the venture space, growth equity space, is this retrofitting of the thesis where you fit your thesis to what the current situation is with a company. And sometimes cynically, that's done to LPs to kind of paint a new narrative, but also it's done to fool investors themselves.

17:07So tell me about that. And it seems like you've institutionalized memo writing and assumptions and underwriting outcomes? And how important is that to stay on course with being a good investor? For us, discipline is core, right? We're not in the business of getting lucky. We're in the business of driving consistent returns and having a methodology to do so in a framework by which we do that. And that translates into system frameworks and processes that we hold internally. So to your point, yes, every time we re-underwrote the business. We looked at the underwriting we did, whether that top line, bottom line margins, returns, the drivers of each one of those things, how has it performed relative to plan?

17:47Why did it go better? Why did it go worse? Every memo we write, we have a slide that's what we call what really matters. Slide is really forcing ourselves to pick no more than five drivers of the investment case. Ultimately, an investment decision, in our view, comes down to three to five factors. And that's what really matters. And in a very objective way, assessing that. And then as we re-underwrite the business, assessing how those what really matter points have changed. And in an as objective manner as possible and as quantitative as possible, obviously there's qualitative assessment that goes into any investment, but that's how we think about it.

18:24The second time we invested into QI tech, I don't have the number top of my mind, but it was 20 to 30 % above our underwriting plan that gave us conviction to put more money behind the business. The margins actually expanded. We underwrote margins decreasing and suffering from competition was actually the opposite that happened. And as a result of that, we decided to put more money into the company. So it's all about having a process, which we're constantly fine tuning. I'll say that. That's also an element of, for us, it's extremely important. That's what makes investing for me really fun and intellectually challenging because you need to be adapting and improving yourself every step of the way.

19:03Tyler Sosin, who spent 17 years at Menlo and Excel, he told me that no company ever died because they saturated the market. In other words, if you go in, you saturate the market, you execute well, there's always these tangential markets that oftentimes you don't see until you've gone to that level. So I often think about this embedded asymmetry in companies that succeed. A famous case is Carta. They went in, they did the cap tables, and then they did fund admin. and for 9A valuations and all these different markets. Have you seen that over your career, this embedded asymmetry of if you do execute, sometimes a 3 to 4X could end up being a 1020X?

19:40Or is that an extremely rare case? The way I think about it is the compounders keep compounding, and the compounding is much more powerful than at times you go in thinking about it. And to your point is exactly that. I think it's this notion that these businesses that are foundationally solid with phenomenal teams behind them, they consistently find ways to keep compounding. And in this case, whether that's expanding time, that's expanding products organically, inorganically. And I have seen that. I think QI Tech is something that we're living through as we speak. The business has, you know, expanded time considerably since the first time we invested, both organically and inorganically.

20:22At times we see geographically as well. So you're operating in one given market, which we underwrote the base case on them just playing that market. All of a sudden they are playing regionally or globally. So I completely buy that. And I think we, at a different sort of level, we see that with the MAG-7, right? These are businesses that just have, they just keep compounding, right? It is a flywheel that just keeps getting stronger, whether that's because they have phenomenally sound businesses, which I think is the case, but also talent, capital, products is a flywheel that just has gotten stronger and stronger.

21:05And I firmly believe that and why I think investing, you know, one thing I learned in my career, investing the number one player in a given market is incredibly important because the value disproportionately accrues to that. number one player. Going full circle to these businesses that compound in Brazil once they have an advantage, but even the US, even Uber, who would have thought that Uber eats and now probably at some point they'll have driverless Ubers. It's almost literally unknowable what the opportunities will come either from within the company or something happens in the industry. When Uber started out, it was just black cars and then Lyft started with their pink mustaches and the peer-to-peer and then unlock this whole industry.

21:50So there is something extremely valuable to staying alive and compounding that I think is underpriced. Absolutely, absolutely. I couldn't agree more. And I think just to thread the needle a little bit, I think as an investor, it is almost like the blue sky case scenario that we talked about earlier, the whole notion of parallel within growth and how we think about it. Ultimately, we're investing in businesses that have that tail potential outcome of keeping compounding and being the parallel. So we want to have that. We do not want to depend on that. So that's, I think, a very different way. And in fact, when we underwrite, we underwrite cases and we assign probability to them.

22:26And those we get to like a weighted probability set of outcomes. And oftentimes in the upside case scenario, if I will, it relies on this, you know, expansion of product time and future compounding. Anything on the best ones, you know, we always undershoot it. Always. But you cannot rely on that. Perhaps an obvious question, but what compounds in the market leaders? Is there anything non-obvious that compounds in a market leader? Look, I think the obvious one is what's often talked about, whether that's network effects, data network effects. But ultimately, if you think, you know, in a very first principles thinking, you're ideally investing in businesses that as they scale, the value that they provide for their customers increases over time.

23:15And perhaps the cost to serve that additional customer decreases over time. And that drives the compounding effects, whether that's grounded on the data network effects, whether that's grounded on just the social network effects, whether that's grounded on the infrastructure that they built. What we're seeing now with LLMs and the likes of OpenAI, we're talking about the compounding effects. I think that's a business that's going to keep the company for a long time. Why is that? Users drive data. Data drives monetization. Monetization drives capital. As capital comes in, they can drive more users and drives that five wheel effect and drives the stickiness and they're able to drive more value with the unit cost of serving that additional user decreasing over time.

24:00So that is ultimately what drives this compounding effect. You mentioned AI. How is AI affecting the growth equity space? There's this thesis that in the future, there's only going to be the pre-seed investors and the Andreessons and the Sequoias writing billion dollar checks. You know, there's this concept of seat strapping where you just raise a seed round and then you don't have to raise more money. How's that affecting you today, day to day? It's an interesting question. Look, I think bootstrap companies have existed for a long time, so that's nothing new. I think that's the reality of it.

24:34We talked about the growth equity 1.0. 100 % of growth equity 1.0 was predicated on backing bootstrap companies that had gone into growth and scale without a single penny. And, you know, why is that? I think it is the best proxy that you have a sound business model in a great team, right? If you're able to get to scale with growth and being profitable, you probably have a good business model. You're very good at executing behind it. So it's just empirically a very clean way to look at things. So I don't think the whole seed bootstrapping is anything new. The way we think about it is there's a tremendous amount of disruption happening.

25:12And as an investor, that creates excitement, but that also creates a very dynamic environment that you're investing into, which I tell my team with a lot of landmines, right? Because the level of innovation is only speeding up. So what may be unique and innovative today may not be the case tomorrow, may be disrupted extremely quickly. So, you know, most become increasingly important. What we are very excited about on the F &L of AI as it relates to growth equity is regulated industries. It's industries, you know, a lot of financial services, which we just discussed, which are going to benefit from AI in a massive way.