#28 - Michael Kim, Kelli Fontaine: Seed Investing, Small Funds

28:48And, you know, but the flip side of that, the other side of the coin is that you can never time technology innovation. It just happens. And so in a way, you want to have exposure to venture consistently and not try to cherry pick certain years. and you're ultimately betting on the fund manager to identify great companies and founders as I've described. But does that happen next quarter? Does it happen next year? Does it happen the year after? You don't really know. And again, it also ties down to this power law concept where one company can completely drive returns. So there are times where we have fund managers who look like they have an okay portfolio and we're like, they're okay, they're not great.

29:35And then suddenly one of their companies really breaks out and it becomes super valuable. And suddenly our fund manager looks like a hero and is now one of our best performing fund managers. So in a way, it is a long game. But there are sort of little mini tactical things that one should not do, such as invest your entire fund in one year. I guess said differently, you want diversification. And I think what we offer is as a fund of funds, we will have 20 to 30 core managers. We'll have 800 to 900 companies. We can talk a lot more about how we invest, but we're also diversified not only by counts, but by geography, by sector, but also most importantly by vintage year.

30:18And what that means is our fund managers are investing over two to three years and we are investing in these funds over two to three years. So we actually capture five to six vintage years of companies. And so I think that kind of diversification is very important, especially because, as you mentioned, venture is illiquid. It's a 10-year-plus game. And unlike buying stock in NVIDIA where you can just click the mouse and sell out of it, you can't really do that in venture. So you really need to have that diversification because, to be honest, you're kind of stuck with that portfolio for a long time.

30:53Yeah. And then I guess you really want exposure to that market and recognizing that there are a lot that fail. The more diversified you are, the greater your odds of catching something that is like the next Uber or Google. This is where I think we have done a good job. And it's been something that we've done from the beginning. We want to be the lead investor in our portfolio funds. So what that means today is that we write$10 to$20 million checks. we can be 20, 30, 40 % of a portfolio fund's capital. So it's high conviction investing. And we work very closely with our fund managers. Kelly can talk about how we engage with them.

31:33But it really is the fact that we are a very large investor in each of our portfolio funds. And as mentioned, each of those portfolio funds are getting relatively high ownership. So imagine where we're, let's say, a third of a portfolio fund's capital and they own, to make the math easy, 9 % of a company. So we are actually on a look-through basis. We have 3 % ownership in that company indirectly. And so contrast that to another investor who puts smaller checks into these funds. Let's say they're like 5 % of a fund's capital and that fund manager is just spraying and praying, meaning they're writing small checks into hundreds of companies.

32:17And let's say that fund manager owns, I don't know, 1 % of a company. So on a look-through basis, you're actually getting less than 0.5 % ownership of a company. Contrast that to what I just described. We're owning 3 % on a look-through basis. So that's why I think we have a high conviction investing. And that's why we look for fund managers that get relatively high ownership. because each company amongst the 800, 900 companies in our portfolio can make an impact, especially if they're an outlier. So let's say you have an investor who wants exposure to the seed market. Let's transition into how you can implement that.

32:58So you use a fund-to-funds approach. Many argue fund-to-funds are typically not attractive because of the multiple layers of fees. However, in seed, it may make sense. I've heard you talk about an investor may be too large and they can only write significant checks or they may be too small and they can't do proper due diligence. How do you think about a fund to fund structure from an investor standpoint? I think over the years. When I started Sindana and was fundraising for it, a lot of questions were like, what is seed investing? Is this a real thing? And then I'd say about five years ago, we started hearing groups saying, hey, we can do this ourselves.

33:41We don't need you. We don't need to pay your fees. And then today, we're actually hearing from a lot of investors, you're actually right. We don't have time on picking a few of these fund managers out of the 2 ,500 in the US. Or it turns out our venture portfolio is largely later stage. Because as I mentioned, a firm like Andreessen,$7.7 billion fund, most of that capital is later stage, not earliest stages. So I think in general, there's been a recognition that what we do is not easy. And we provide a solution to someone who wants very early stage exposure. Again, if you're a family office or an individual or even an institution, you can say, I'm going to build my own portfolio.

34:30And that's great, but is that the best use of your time? You know, venture probably is no more than 10%, 15 % of an investor's total portfolio. Do you want to be spending an extraordinary amount of time focused on finding the best seed funds or would you rather just outsource it? And we're very fortunate that a number of endowments and foundations and very large family offices have decided that we actually provide the better solution. And I would add that, you know, we had previously spoken about persistence of returns and venture. And so by the time endowments and foundations and family offices are looking and have that data to say, OK, this is a manager I would like to get into, it becomes an access game.

35:14Right. Do you have access to that manager? And there's underwriting capability. And so that's really where they focus their time and effort. looking for the early funds where you don't have those proof points, it takes on average seven years for a company to really inflect. So as Michael just described, there's managers that may look okay, but hey, in two years, they could have the top performing funds because they had a company that became an incredible outlier. So I think these are all very early funds when you're looking at the small seed stage that have not become brand names yet. And so how do you catch these managers and how do you look for them?

35:55It's a different skillset than looking at funds and their performance and the typical underwriting. We live in San Francisco, right? We have a partner in Boston. We have an associate in New York. We live in the geos of where there's the tech concentration and our lives are ingrained in these networks. And that's all we focus on is the early stage. And so the pattern recognition and our expertise is this area. And I think we are a partner. And Michael mentioned earlier how we work closely with our GPs. We work that same way with our LPs. So we work very closely with them if they are looking to build out a venture book.

36:31And we're very open and collaborative with them and look to be their trusted advisor and venture as well. Yeah. So there's more alpha potential in this space in terms of allocating across managers because it's a different market. Relationships matter. Understanding it deeply and having the experience matters. So it's much easier to cover whatever that added layer of fees is relative to, let's say, a fund of funds that invests in public markets. Right. I mean, just to address the economic question, we tell our LPs that we expect to generate three to five X for them, net of everything. And the proof obviously is in the putting.

37:11Our first fund is marked at 4x. Our second fund, which is younger, is marked at 3x. Our third fund, which is even younger, is marked at 2x. So we see that progression. And again, I think it really comes down to partly our picking, our pattern recognition, finding these amazing fund managers who are finding remarkable founders. But it also is a lot on our strategy, our investment approach. We want to be the largest investor in funds that get relatively high ownership. And I think that set of relationships translates, as I mentioned, into a look through ownership into companies that is very meaningful.

37:50There's also another advantage of a fund-to-fund structure for seed, and that is you can get really well diversified. And we talked about in this area, the risk of going to zero is relatively high. So diversification is absolutely critical. Yeah. I mean, just to address that, imagine a continuum of risk and reward. So at one end of the continuum, you have investing in one company. It may be the next Facebook, so high reward. But there's probably a 99.9 % chance that that company doesn't do well. Imagine in the middle of that continuum, you invest in one venture fund. So they might have 30, 35 companies.

38:27Again, power law. Maybe one or two of them will be amazing outcomes. The rest probably won't. But you still are limited to 30, 35 shots on gold. And then at the other end of the continuum where we play, as a fund of funds, as mentioned, we have 800 to 900 companies and diversified by time, by count, by geography, by sector. So we would argue that that diversification means that we have substantially lower risk. But even with that lower risk, we are gunning for 3 to 5x. And I would say that that's better than most venture firms. Why don't we get into the way you pick managers? You referenced that a little bit earlier.

39:12So when investing in a fund, many investors often wait until fund three, four, or later to see a track record. But you oftentimes invest in the first fund or the second fund. Would you talk through your philosophy around that? So again, back to the seed stage, it is about relationships, right? They're picking founders that do not know they're great themselves yet, as Michael liked to put it. It really is the pull. We want to find people that pull founders. They're not out there having to push. We do want managers that have grit and are like walking through walls. But there's something about a manager taking the risk and starting their own firm.

39:58that there's something unique about their career arc where that is the possible next step, right? Where they have the credibility in their networks to where they have enough opportunity to make a great, this their next career choice. So it typically is, you know, I would say it's the stage. It's a different profile than you would get at later stages. At later stages, there's more finance backgrounds, consultant backgrounds, but at early stage with the founder, the early stage founder, they tend to be ex-operators or founders themselves. And so it really is that recency of experience that they're bringing into their fund one and two, right?

40:37They just left an operating role at a company. They just left their startup they founded. And so there's the recency of experience in their networks that they're bringing to those funds one and two. The other thing is, is it typically tends to be their smallest fund, right? So as they have proof of success and grow, their funds get larger and larger. And again, we just think smaller funds outperform. So there's obviously that structural advantage. The other thing is if you look at their job, again, going back to it, sourcing, right? Well, by the time you're on fund three or four, you are spending a lot of your time on supporting all of the companies that you had previously invested in.

41:19So now instead of spending 70 % of your time sourcing, you're now spending maybe 30 % of your time sourcing. So we think it is a superpower of their time management in funds one, two, of how they have a lot more time to be sourcing. And then they have to switch and figure out how to scale their bandwidth around fund three. um again we go back to the recency of experience and the halo that comes around a founder right they're they're a splashy founder and they start a fund well by the six years later there's a bunch of founders that are splashier than them right so how have they recreated their brand you're having to recreate your networks and your credibility in your brand and so at the earliest stages we think there's something special about those funds one and two where you've taken the risk in your career to leave a firm or a company that could be lucrative to start this and plant your flag.

42:15And we think that, you know, there's the credibility within your network that you'll be able to pull those founders and that people will want to work with you. Yeah. Alex, let me describe this. One way that we think about what we have is a collection of networks. And so this again goes back to that fishing analog where we want groups to be fishing in certain ponds. And I'll give you two examples. So one, we invested with Jack Altman. Jack is the founder of a company called Lattice. It's an HR software company doing over 100 million of revenue. He was the founder and CEO. The company is valued at$3 billion most recently.

42:56He decided that he was going to devote full time on investing. So he brought Sarah Franklin in, who was the president of Salesforce. She became the new CEO. So that should give you a sense of what the high-quality company Lattice is. Jack is a very well-known operator. A lot of startup people want to work with him. And he doesn't generally lead with this. But by the way, he's Sam Altman's brother. So very tied into the open AI and AI worlds. And so that's a special advantage that Jack has. He has great domain expertise. He's a super nice guy. Founders want to work with him. So that sort of hopefully describes the pool that a GP could have with founders, as Kelly described.

43:47Another example is a guy named Dita Van Lomen, a Dutch guy living here in San Francisco. He was employee 27 at Stripe. He was the first head of Stripe International. And going back to my comment about how we view what we have as a collection of networks, we realized that we didn't really have anyone from the Stripe world. And similar to PayPal and how all these different individuals left PayPal and started their own companies or own firms, we thought Stripe is a very important part of the venture and technology ecosystem and landscape. And so we wanted to have someone who had amazing access to people who are leaving Stripe.

44:25And oh, by the way, he was also the co-founder of a company called Commure, which most recently was valued at$6 billion. And so he has the operating experience, not only at Stripe, but also starting his own startup. And so you can imagine someone like that, founders want to work with him, founders come to him. And so venture is hard. But if you have the right access, and you have the right pool, I think you have a higher probability of succeeding. Now, Kelly made a very good point about shelf life. You could have the best operating experience. You could have the best networks. But five years from now, those are going to be stale.

45:05The operating experience and networks have a shelf life. So we also look specifically for fund managers who have that hustle. They are trying to build their firms. It's their own startup. And they want to build market positions. They want to build brand recognition. They want founders to know that they're relevant. And I think that's sort of the extra special sauce that we look for in fund managers. Not only their operating experience, not only their networks, but actually how much hustle do they have? Are they just relying, sitting back, waiting for people to email them? Are they actively going out and looking for new opportunities?

45:44I suppose that's another reason to focus on one and two, fund one and two, because you come in, you have a great network. That's the low hanging fruit. Those are the first people you're going to call. And unless you can keep repeating that network and grow that network with time, your later funds, not only are they bigger, but it's harder to access some of the best opportunities. That's right. And that's actually why larger funds, they bring on new partners, because they're trying to bring in new networks to their own mix. And there's another sort of risk around that. Venture funds are over 10 years long.

46:22That's longer than the average US marriage. And so when you partner up with someone, you're in it for 10 plus years at minimum. And that's why we think partnership risk is actually one of the bigger risks with these smaller funds because they are fragile. They're startups. And adding a new person to the mix can create different dynamics that sometimes aren't helpful. When you're looking for newer funds, you're betting on the people more so than the performance track record. And one of the intangibles I've heard you talk about, you just mentioned some now, but one that I've heard you talk about that I think is really interesting is you look for people who are actually nice to work with.

47:01Would you elaborate on that? Yeah, this was something that Kelly called out because actually, and I'll let her describe it, but Kelly joined in January of 2018, started taking a lot of meetings with us and especially with our existing fund managers. And I think one thing that she remarked one day was, all of your fund managers are super nice. There is a strategic reason for that. So I'll let Kelly describe that. We talked about how venture is fun and sexy, but I do think it can be competitive and cutthroat at the later stages. Again, at the early stage, you're dealing with founders that are going from zero to one.

47:41There is no success or proof points that they're holding on to, right? They are fighting day to day to make this company work. And so I think it's really important that the manager has the empathy and the strength to understand how to navigate those interpersonal relationships and has the EQ of when to press a founder, how to work with them, where their drive is, and be that cheerleader mentor support and helping the business continue. They're looking for founders with grit as well. Hopefully, every founder has that grit that can carry it through, but there's going to be hiccups and nothing goes linear up in venture.

48:22And so we really look for managers that have that EQ and personality that can support. And I think Michael had been doing that. Again, I go back to the events and like why I joined Sundana, it was very notable that these people are all very collaborative and helpful to each other. And I think it's that pay it for thing. If you are helping each other in return, you're going to be remembered and, you know, we'll hopefully get returns through the same collaboration you provided other people. So, you know, it is, as Michael mentioned, a 10-year marriage that we're making with GPs when we sign up to work with them.

48:59And so we want to work with nice people, but more than anything, founders, it goes back to that reputation with founders. If you wrong a founder or do not live up to your expectations or harm with your words a founder, that's going to go a long way for reputation and having access to deals. Michael, you started a firm over a decade ago. How is your selection of managers and funds in which to invest evolved as you've grown and learned over time? I mean, two things have remained constant. It's that we want to be the lead investor in fund managers that are getting outsized ownership. Now, the world has changed and it's a much more competitive space.

49:40What we were looking at as seed funds over 10 years ago, today would be probably viewed as pre-seed. And what I mean by that is 10 years ago, the seed round was$1.5 million at a$10 million valuation. Today, that's actually what pre-seed funds are looking at,$1.5 million at a$10 million valuation. Basically, the seed rounds have gotten bigger. As I mentioned, the average seed round in our portfolio now is$4 million. Basically, a seed round is supposed to provide 18 to 24 months of runway. You got to wonder, why has that number doubled? Why has it gone from a little bit under$2 million to over$4 million today?

50:21I think it basically is because of costs. I think it costs more to hire people. If you think about a developer that you want to hire, they may be offered$500 ,000 by Salesforce or Google or whomever to work for them in a cushy, comfortable corporate life versus taking that leap and working for a startup, which might end up being a zero for substantially lower cash comp. But I think what's driven the history of venture and innovation is sort of the equity ownership. So employees get stock options. Those can become ultimately very, very valuable. I just read the story where Facebook, when they were private, they hired this muralist to draw a mural on their wall.

51:07Instead of paying them cash, they gave them stock. That stock, which the muralist apparently held on, is worth$200 million. So you hear stories like that, but ultimately, and those are obviously outliers, but I think it's important to recognize that ownership is important and it has that costs have increased in venture for a startup. And so that's why we're seeing larger and larger seed funds, which we have a negative reaction to. So I'd say that's been sort of the changes over the past 10 years since I started Sindana. Actually, at one point in 2021, we saw a lot of tourist fund managers. And what I mean by that is that, you know, someone comes to us and says, hey, my friend started a fund.

51:54I'm going to start one too. And I think that the tourists have been flushed out. But yet, you know, there's still a lot of seed funds out there, a lot of pre-seed funds out there. And so our job is to find the absolute best ones, the ones that have the most amazing access. And then, as Kelly mentioned, the credibility to write the check size that we think that they should be writing. And as later funds are launched with success of prior funds, are there any warning signs that you haven't talked about yet that you look out for when deciding not to re-up with the manager with the next fund? I mean, partnership risk is one, but I think the other main thing for us is that a number of our existing fund managers have gotten larger and larger.

52:36And, you know, we just think that it's going to be harder for them to generate a 10x fund return with a larger fund. You know, with a larger fund, you need larger exits. And, you know, over the next 10 years, you know, are we expecting a number of multi-billion dollar exits? Probably not. And that's why, as mentioned earlier, you know, we want to be investing in funds that can still generate meaningful returns with very modest exits. So I think fund size is the enemy of returns. I think fund size determines fund strategy. And our focus is on smaller funds, funds one, two, three. We have a number of great fund managers who are raising fund eight, nine.

53:18They're going to be raising 200 to 300 million. It's just no longer a fit for us. And so what we've been doing, and we haven't talked about this, is that, or actually Kelly touched on it. We're very collaborative with our LPs. We want our LPs to invest in our portfolio funds. And so we actively introduce our LPs to these fund managers and they can go in directly. So I think we continue on that relationship, but in a different way. Would you comment on the perspective that many feel to do well in seed or venture, you just need access to the top tier funds and everybody knows who they are and it's really hard to access them.

53:58Is that an accurate statement or is that more of a myth? Again, there is persistence of return of venture. So I will acknowledge that. If you look at the top performing funds ever, they're going to be smaller funds. And then those managers have. Again, their funds look very different. The platform funds size looks very different. And we can look in our own portfolio and we have managers, one manager has a 200X fund. That would never happen at a billion plus dollar platform fund of where you're trying to gain access to. So I think if we look at the returns that our managers have been able to generate and the DPI that they've been able to have, getting over 10X is very difficult on larger funds.

54:48So I don't think it's just an access game at the later stage. I think, again, the returns are where we focus at the early stage and smaller funds. I mean, just to emphasize that, we've had university endowments come to us and say, hey, we have a great portfolio of venture funds, all the top tier ones that you can imagine. But when we actually analyze where they're investing and where the dollars are going, it's much later stage. And so I think more and more institutional LPs are recognizing that they don't have very early stage venture exposure. And I think we're a very good way of providing that foundational investment and access to the very early stage.

55:28And then the question becomes, well, there are probably the top tier seed funds and we are going to go access them. And an investor might think that it is hard to get into them. We have a number of fund managers where they are way oversubscribed. As a lead investor, we actually sit with them, go through their list of other LPs, what the allocations they want. And together with the fund manager, we pick the allocation that others are getting. Now, we don't do that in every case. But I just wanted to give that example where we work closely with our fund managers. We're their trusted advisor. And we actually help with allocation.

56:14So, of course, if there's a Sandana LP who wants to get in that fund, we make sure that that happens. And so, you know, but in contrast, you know, if you're starting off building up a new portfolio of seed funds, you know, you can do that. There are 2 ,500 out there. You can pick like eight or 10. And the real question is, will those funds outperform, say what, we could build a portfolio for you. And our sense is that we've been doing this for over 12 years. We know what we like. We have our own sort of reputation, as Kelly described. Great fund managers have pool. Founders want to work with them.

56:58I would say that because this is all we do and this is our focus. We have the same pool with fund managers. So the top of our funnel in terms of new fund managers coming to pitch us is very full. And I would go far as far to say is that if we were to be an LP in a new fund, that's a strong signal to other LPs. And so we have many, many examples of where we were the first to commit to a portfolio, to a new portfolio fund. And that and we actively brought in LPs as well as help facilitate their fundraising. And so it's been hard, but over the last 12 years, we've built up a very strong market position in brand recognition.

57:44You have a relatively unique portfolio construction process. You've touched on some of the points so far, focus on smaller funds, and you've described why. You also emphasized writing large checks as a percentage of the total fund. Would you talk a little bit more about that and also how you think about diversification when you're writing large checks? I also want to address another thing. Historically, venture capital fund of funds would just simply re-up with their existing managers. And so I wanted to have something that was completely opposite of that. So we think that we have a fresh portfolio.

58:22And what I mean by that is we also, in addition to our large checks, we've been historically writing$1 million checks, which we call pilot. And those are the groups that we really like. but we still have some question about their geography or the sector they're going after. And then a few years ago, we started a program called Nano, where we were writing 20 % checks. So like$20 million fund, we'd write 4 million, really to go after these sub$20 million funds, these tiny, tiny funds. And in a way, both of those serve as on ramps to potentially becoming a core position. So in each one of our fund of funds, we have new names, we have a number of new names.

59:02And we moderate that by the check sizes we're writing. And we get to work with those fund managers over a fund cycle. And ultimately, if they decide to become a bigger fund, we can make that evaluation of whether we should write them a$15 million check. So the bulk of our capital is going toward our core managers. But we do have these smaller checks that we use, I guess, as Kelly would call them, discovery checks, and being able to uncover new fund managers that we still have questions about, but can serve as an on-ramp to be becoming ultimately a core position for us. And how do you think about diversification as you're writing the larger checks?

59:46I think that we are diversified by the number of underlying companies, right? So we have enough, you know, we have enough managers in the portfolio. But as Michael described earlier, we want to be a big enough percentage of the fund so that the underlying company is meaningful to our fund. So on a look through basis, we have, you know, 700 to 900 companies in that fund, but there's enough ownership in the company itself to where it matters. So, you know, it is high conviction investing. We don't want to be allocating to a bunch of managers that we aren't totally convicted on. It really, we want to keep it small enough to where our bar is high.

1:00:30And so we have a high conviction strategy of where we're writing a meaningful, large check to the underlying manager. And obviously that feeds into this ecosystem that you're building. And you've talked about the importance of building partnerships, between you and the managers and the managers with the founders. Would you expand on that ecosystem, that Sendana ecosystem that you're continually developing and evolving? I would say that in a number of cases, we have fund managers who have invested together into a specific company. And when we did the analysis, those companies tend to be outperformers in our portfolio.

1:01:11So we actually encourage multiple fund managers of ours to go into companies. We help facilitate that. So if there's a fund manager that's looking at, say, a supply chain and logistics company, we can introduce them to our supply chain and logistics fund manager. And so we're actively being the human router where we're trying to connect relevant people together so that they can look at things. one thing that we did in our current set of funds was to bring on some strategic LPs. And so these include venture firms, later stage firms, secondary firms. And in each of those cases, we are doing monthly calls with them.

1:01:54And where relevant, we are showing them companies that are coming up for funding. And in a number of cases, they've actually invested in the companies that we've made introductions to. And that's helpful to our fund managers. and obviously helpful to the underlying portfolio companies. And it's helpful to our strategic partners because they're getting access to a differentiated set of deal flow. Yeah, I think an important thing was, since Michael was first to this space, he's always been the largest LP, but really a trusted advisor, right? More than an LPAC seat. And we take that very seriously of wanting to add value and help the managers because again, these are companies they're starting, they just happen to be investing.

1:02:41So we view ourselves as the lead investor and how we can help them. And so through that, we have a Slack channel for all of our GPs so they can ask each other questions directly. We facilitate experts coming on a monthly basis to speak to the entire group. We call it a monthly noon Zoom. But I think a really important part of how we work with our managers is we do a 30 minute standing monthly call with each of them individually. So it's a no agenda call. It's meant for them to come to us with questions or things that they're working on. And hopefully we get intel on how the portfolio is progressing as well, which we do.

1:03:19But I think it's important. It's, you know, if they're thinking about hiring, what are comps in the industry? Which other firms have hired for this role? How do they go about it? What has worked? What hasn't worked with adding this type of person to the team? or if they are having an exit, how much should they keep and recycle and reinvest in the fund and how much should they distribute to LPs? So we wanna be that thought partner with them on their investing, on their firm building. And so we wanna be a text if they have a question away. So we wanna be that first call and we really think we foster that relationship.

1:03:55So through that, we always look for ways that we can add value to the group, to individual managers. And as Michael mentioned, And the most recent form of that has been strategic LPs, live events. I mean, as much as we do so much on Zoom now, there's really no substitute for the in-person connections and serendipity that can happen in live events. So we try to host a number of live events around specific themes or the geos for our managers. And that ecosystem has a virtual cycle because the more you do it, the more you learn best practices from the best performing managers, the more you can share that with other managers.

1:04:33And this is in a world where most LPs, limited partners who invest in a fund, are passive investors. They're not really adding a lot of value other than just providing capital. So you make yourself a very valuable partner, which helps with access in the future and credibility, even with those that you're not working with today. Is that right? Exactly. We're just very proactive with our LPs and our GPs. We want really to accelerate serendipity. And I think that's hard to do if you're an investor that's not located in a venture ecosystem. I think it's hard if you're also very passive and just showing up to the annual meeting once a year.

1:05:16We're the opposite of that. We're constantly working on facilitating relationships. And in fact, last year, we hired a director of platform and operations, Hillary Tyree. And Hillary came from SVB where she was actually doing just that. And she was very plug and play in that she knows all of our fund managers are ready. And she's on point to help fostering closer ties between our fund managers. And she's on all of our monthly calls with our fund managers and actively arranging meetings between them or with our strategic LPs and helping organize events, etc. So I think a lot of that is heavy lifting, but it's very worthwhile.

1:06:01And again, we have the data. In a portfolio company that has multiple fund managers of ours, they tend to outperform, at least by 1x. Yep, 1x higher. Yep, 1x higher. So obviously to keep your success going, you have a relatively high turnover of managers as they grow with success and they move on from the C-level and their funds get larger. Do you need a large team to track, oversee, and truly maintain expertise in C-level managers? It's a very good question. You know, when you think about like someone like Yale University's endowment, they're in New Haven, right? They don't have offices around the world.

1:06:41They don't have teams around the world. I think we punch above our weight. We're a team of nine. And I think that's buttressed and fortified by the fact that this is all we do. We focus on seed and pre-seed. And so, as I mentioned, I think we do have strong brand awareness and market position. So, the top of our funnel really isn't an issue. And we have a specific set of characteristics that we look for in fund managers and their portfolio constructions. I mentioned 2 ,500 seed funds. I would say 90 % of them are spray and pray. They're writing 250K checks. They're getting maybe 1%. That's not what we're looking for.

1:07:22So then we filter down to a subset of that 2 ,500 that we really focus on. Now, there are always newer names coming out, so that makes our job exciting. but there is a certain set of characteristics that we look for. And I think that serves us very well, partly to help mitigate our time management in that we're not meeting every single fund manager. We're meeting every single fund manager that could be a fit for us. So I think that's an important distinction. And could we always use a little bit extra help? The answer is yes, but I think we have the flywheel spinning. you know we have a number of fund managers who are sending us opportunities uh you know they might be working with them on a company as a co-investor they'll be like hey kelly this is this is a this is a person that we really like you should take a look they're raising a new fund we have our lps you know they come across a lot of interesting opportunities and they send them our way so i think you know through our lps our fund managers we have a great advisory board of venture capitalists and people in the industry, we're getting a lot of interesting referrals.

1:08:31And so our job is to process through that. And again, it really helps us that we have sort of a defined set of characteristics that we're looking for. I think there's a certain taste. And so you can't expand the team too broadly without knowing the taste that we have in managers. But I would also add that, you know, we've spent a lot of effort on the data side. And so as that data side expands, it's just easy for us to benchmark a new manager's prior track record. So we invest in first-time fund managers, but not first-time investors. There's always some type of angel track record, prior track record from a different firm to look at.

1:09:07And so we can easily benchmark that against our own portfolio and filter their fintech, right? If they're focusing only on fintech, we can filter our entire portfolio for how it's looked every single vintage in fintech. And so I think utilizing the data and focusing on data also really supports our investment process and our investment team. And so I think that's been a big focus for us as well. Would you talk about the ultimate exit? Has the landscape materially changed recently as we've gone from a period, almost three or four decades of either falling interest rates or zero interest rates to an environment or regime that's potentially higher for longer?

1:09:49I mean, I think it's pretty clear that the IPO window is closed for the most part. So it's going to be difficult for companies who have the throwaway to be able to go public. But also, quite frankly, a lot of later stage venture-backed companies don't want to go public anytime soon. They've been staying private longer. And so if people talk about this one example where Amazon went public in 1997 or 8, or sorry, 1999, and their market cap was$430 million. And so much of the value appreciation was attributed to actually public equity holders of their stock. Now today, using Uber as an example, Uber stayed private until they were worth over$60 billion.

1:10:37And then now they've gone public. There's been some appreciation for the public equity holders, but much of the value appreciation was accrued to the private investors. So you have companies staying private longer, like Databricks or like Stripe or companies like that. Now, when you look at acquisitions, and this goes back to my old Morgan Stanley days, Cisco acquired over 120 companies in the late 90s. And that was basically outsourcing their R &D. They were acquiring interesting technology to help build their growth story. And we still see that, although the regulatory environment right now with antitrust is very difficult.

1:11:17You see very large transactions kind of on hold or actually rejected by the FTC or the European Union. The example there is, for example, Adobe trying to acquire Figma for$20 billion, and that ultimately got called off. So I'd say that the regulatory environment right now is a bit difficult for these large acquisitions. But where I think we really benefit is that our fund managers can do secondaries. So what that means is that our fund manager can offer their shares or some of their shares to a new buyer. And that new buyer, they negotiate the price. They can buy 10%, 20 % of our fund manager's position.

1:12:02That may actually return a material part of our fund manager's entire fund. And in April, one of our fund managers had a company that most recently was valued at$11 billion. He sold 15 % of his position in that company and returned half his fund. So I think there's greater degrees of freedom that early stage investors have with regard to secondaries. And I think we've been seeing that over the past five to eight years. I think you're going to see a lot more of it as the sort of public options have become a bit more difficult. And also large acquisitions have become more difficult. I'd love to hear some of your thoughts about the market outlook.

1:12:50You've zoomed in a little bit on some of the underlying companies in which the fund managers may invest. Are there any key themes that stand out in terms of what looks very promising looking forward? I think when you look at what the key themes were and what the hype were, it never lines up with what the actual company that started that year. So typically, once it's become a key theme, a company was founded three to five years ago, focusing on that. And that becomes the winner. You know, we can talk about the sharing economy becoming big, you know, Airbnb and Uber were started years before that actually became a thing.

1:13:25so we were looking for managers who can see around corners is how we put it so we don't know what the big themes are quite yet but that being said I think things that are interesting currently you know real world problems so deep tech hard tech are interesting there's a lot more money going to those themes I think health tech can be interesting and vertical SaaS because again And talking about where AI can be applied, it really is these vertical SaaS applications and industries where the expert matters. The domain expertise matters as much as the technology being applied. And so I think those are interesting at this stage in the market.

1:14:08What would you say is your overall outlook for seed and venture over the next few years? Well, I think it's a return to normalcy. And what I mean by that is 2021 and the first half of 22 were kind of bubbles. Valuations were out of control. The pace of investing was out of control. And I think we're beyond that now. You know, NASDAQ fell 33 % in 2022. It was up 33 % in 2023. And, you know, we're basically at all-time highs now. But that's really been driven by a handful of names, NVIDIA, etc. In venture, what a return on normalcy means is that there's been greater discipline around valuations.

1:14:56Ultimately, at the early stage, valuation is driven by how much are you raising and how much is the founder willing to give up. We would look at our data and the historic amount of dilution, how much the founder wants to give up, is range from 20 to 25 % for that round. And today, the average seed round in our portfolio is 4 million on a$16 million valuation, so 20 million post. So 4 million is basically 20 % dilution, right? The founder is giving up 20 % of his company or her company for that 4 million. But back in the bubble days in 21 and 22, that dilution fell down to 15%. And so that meant that founders had all the power because so many people were chasing after them.

1:15:47And now I think the pendulum has shifted. The pricing power has gone back to the VCs and away from the founders. And I think in my mind, that's normal. I think we feel that valuations are, are if you extrapolate where 2018, 19, 20 were and ignore 21 and 22, it's sort of exactly where it should be. The bigger question, of course, is, yeah, of course, you can get your seed stage companies funded. How about the next round? And so that's the series A. Those are$10 to$15 million rounds and say$50,$60 million valuations. These are done by multi-stage firms. What's that market look like? I would say in the last six months, our fund managers have been reporting that more and more of their companies that are coming up for Series A are actually raising very strong Series A's.

1:16:43They're raising top of the range. And that's a little bit different than what they were reporting last year. So that's very promising. Ultimately, it's a question of how much dry powder, meaning how much unused capital is on the sidelines and how willing those multi-stage firms are to writing checks into these new rounds. And we're starting to see that. I would say that the next round after Series A, which is Series B, is actually still a hard market. Because by the time a company is at Series B, they can't be waving their hands around describing their vision and their dreams and their future.

1:17:22They actually have to be a real company. And so the economic environment has been more muted for software companies because if a company lays off 10 ,000 people, that's 10 ,000 Salesforce licenses that went out the door. And so I think companies, the larger enterprises are less likely to try new product solutions from startups. And so that's made it a bit more difficult for startups to get that revenue traction they're looking for. But venture is hard. And ultimately, we're looking for fund managers who find those remarkable founders who will walk through walls, who have created products that people will buy.

1:18:05I would say for this era of seed, the lean startup was the book and big trend back in 2011, you know, when Michael founded Sundana. And that kind of as all the platforms raised more and more money as SoftBank, etc. came in with these mega funds that went out the window. Right. Those philosophies on how to build capital efficient businesses, how to get to product market fit with the correct experimentation and building the right talented teams that went out the window of just raise as much money and throw money at the problem and buy bad revenue. And I think with constrained capital, it'll make more efficient, better businesses.

1:18:49And, you know, we focus at Seed where we don't want to be diluted down a ton. We don't need, you know, our managers aren't investing that huge amount of capital or needing to put out a huge amount of capital into these companies. So I think it's a better environment for Seed. And, you know, we've touched on AI, but I think it's to be seen how it can really accelerate the zero to one. so you know 40 plus percent of the code written on github is written by microsoft copilot so it's written by ai not the coders themselves developers themselves and so if you think that efficiency is happening on open source like what can happen internally with these companies and i think um the tools we really haven't seen the efficiencies yet but i think that's something that you should be able to see and this um and these next vintages of starting a company is efficiencies being able to be seen in-house and building products because the AI can help them.

1:19:44Yeah, that's an open question that we have right now is if AI is going to add productivity to developers, you push a button, it does all your code for you in one second. Do you need less developers? Do startups need less capital because they get so much more out of using AI solutions with the handful of developers they have? We haven't seen that yet. But it'll be interesting to see over the next few years whether, well, certainly developers will become more effective and productive. But the question is, will startups show some discipline around hiring people like that? And are they still going to throw bodies at the problem?

1:20:24There's been a noticeable trend of funds getting bigger and bigger. Is this, in your view, sustainable while delivering high multiples for investors? Or is this another cycle that will ultimately revert? I mentioned that size is the enemy of returns and that fund size determines fund strategy. And as funds get bigger, you know, I'll give you an example. So, you know, let's say a$60 million seed fund owns 15 % of a company. It sells for$100 million. They get$15 million back. That's 25 % of their fund. Imagine a$400 million fund that owned 20 % of that company sells for$100 million. They get$20 million back.

1:21:08$20 million back to a$400 million fund is 5 % of their total fund. And so these larger funds need much larger exits. And again, it's power loss. So maybe some of these funds will be able to find amazing exits. and let's say they find a$10 billion exit and they own 20 % of that company, they're going to get$2 billion back and let's say their fund is$2 billion. So with a$10 billion exit, they just return one times their fund. Now, I think there's rational economic reasons that these firms are getting bigger. It allows them, for example, to invest in LLM companies, like the open AIs and anthropics of the world where they are raising billions of dollars.

1:21:58But ultimately, I think it's going to be a very difficult world where these funds are going to be generating 3 to 5x. But economically, to use just a specific example, let's say you have a billion dollar fund and you get a 2x on that. So you made a billion dollar profit and your carry is 20%. That's the percentage that the fund manager gets to keep. So they're getting$200 million, right? 20 % of the billion dollar gain. That's pretty good, even on a 2X. But let's say you're a$100 million fund and you got a 10X. So you made$900 million of gain and you get 20%. That's$180 million of carry. So the larger fund that gets a below average 2x return, they're actually getting more in carry than that fund manager that generated a 10x return.

1:22:54So that's actually why. And then that doesn't even address management fees, right? A billion dollar fund is getting 20 million of management fees alone. Times 10 years, that's$200 million of management fees. So there are economic reasons that fund managers have gotten bigger. I think the legitimate reasons is so that they can go after these larger opportunities. But from an investor perspective, I think it's going to be more difficult to expect anything better than a 2x from these multi-billion dollar funds. So that's why we don't focus on those. We focus on these tiny little funds, sub 100 million.

1:23:34We're 20 to 50 % of their capital. We want them to get 10Xs. And we and our investors do very well. Yeah, we didn't spend a lot of time on fees. But to me, I always go back to what business are you in? You know, when I'm talking to a manager, because we're underwriting managers as well, I always ask myself, what business are they in? And I think of it as a continuum. On one end, business of generating returns for the clients. And on the other end, business of gathering assets and charging the highest fees and maybe the largest carry dollar-wise. And everybody will tell you they're in the business of generating returns, but their actions may not support that narrative.

1:24:15And I could see the example that you just gave, you could see why there's financial incentives to get bigger and bigger and bigger. But the clients should be thinking about the returns. That's what they earn, not the fees that the managers are charging. So you do have that inherent conflict in the industry. And I I guess that all goes back to why you focus on smaller funds. Yes, absolutely. We've had a pretty massive regime change from low rates to higher rates, and that may permanently have an impact on this market segment. Or do you feel like the results are far more dependent on how well the founders execute on their business plan?

1:24:56Or is it a combination of both? You know, and also presumably rates will come down, but no one knows when or by how much ultimately. I don't think we're going to be in a ZERP era ever again. I think that's, I can say that with high confidence. But the real question from an investor's perspective is, what kind of return am I getting risk-free, US treasuries, versus what kind of return will I get from a very illiquid investment in venture? And I think venture long-term, if you look at the Cambridge Associates benchmarks over 20 years, has generated somewhere around 20 plus percent net IRRs. So that's annually.

1:25:36That still is higher than public equities, certainly higher than fixed income. And I think the real question is, if you're deciding whether to do venture, you need to have a longer term horizon. And because ultimately, if you're in with the right managers, you can generate those 20 % net IRRs. That's what our funds are that are Our first few funds, our oldest funds are in the 20s. So, you know, I think, but I can see from an investor's perspective, risk-free being relatively high versus the unknown of being an illiquid strategy like venture. You know, there's a trade-off. And, you know, that really came home to us.

1:26:21Kelly and I were in Brazil two years ago. And there are not many very active Brazilian LPs in venture. and partly because their local risk-free rate was in the, you know, like 15%. So why bother investing in venture when you're getting risk-free 15 %? And oh, by the way, you don't have to deal with the US dollar, you know, currency fluctuations. So, you know, it is a real thing. There's no doubt about that. And, you know, I think as the markets were coming down in 22, you know, investors had a denominator effect, meaning their allocation in public equities was shrinking. And then suddenly their private allocations were over the range, over the top of the range.

1:27:03I think that's corrected now because we are at market high, equity highs. So you can argue almost that some of these institutional investors are actually underweight the private market portfolio exposure that they're looking for. And that doesn't even get into a number of new sources of capital, like the Middle East, sovereign wealth funds. They all want to be active in U.S. venture. You know, Kelly and I were in Singapore a few weeks ago. There's been, over the last five years, almost$2 trillion of capital coming from Hong Kong family offices to Singapore. And they are all looking for U.S. venture.

1:27:45So fundamentally, there are newer sources of capital that will drive U.S. venture. The real question, of course, is will U.S. fund managers accept that source of capital? for a variety of reasons. They may not. But it really is a trade-off between the risk-free rate and what venture can offer as a very illiquid asset class. This has been great. You've been very generous with your time. I'm going to end with a question on AI because that's the hot topic today. So when we look at this market segment, should the focus be on companies that are learning to use AI to operate more efficiently and compete or is it more about the companies involved in building the AI infrastructure that other businesses will need to add to their platform to grow?

1:28:33Yeah. I mean, AI, obviously, I think, you know, let's just start off by contrasting that with cryptocurrency. You know, if you took the average person off the street and say, name 10 use cases for AI, they can probably give you 20. If you took the average person off the street and say, what do you use Web3 or crypto for? They probably couldn't give you more than one. So, you know, it definitely permeates. the popular imagination people and get you know play around with it right and that's why chat gpt3 when it came out in november of 22 was an amazing thing it opened the eyes to so many people i mean even my mother was just asking me what ai is and she called it a1 she's like what is a1 what is a1 and we're like that's a steak sauce but you know if my mother is talking about ai then you know i think it's it's it's permeated the popular culture from an investment perspective you know we we have three buckets uh in ai we have like the llms those are like the open ais that's where the big boys play that's where corporates like microsoft are putting 13 billion dollars etc you have the software infrastructure space which is what i think you were talking about and we do have fund managers who are specifically focused on software infrastructure that could be developer ops you know dev ops could be developer tools could be crypto it could be data inspection etc.

1:29:52And so we have a lot of fund managers focused on that. And then the last layer is the application layer, you know, what people touch. So you have consumer apps, you also have enterprise apps. And our fund managers typically focus on enterprise. So they are seeing a lot of these vertical software plays, like HR software, etc, where AI is being used to enhance efficiency and productivity. So I would say that software infrastructure, but more on application and definitely not LLMs. Yeah. So in other words, AI is everywhere. It's everywhere. This was great, Michael, Kelly. I appreciate you taking the time and sharing your insights with us.

1:30:36Absolutely. It's great. That's a lot of really good, thoughtful questions. Thanks for listening. We hope you enjoyed this episode. please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast if you have questions feel free to email us at info at insightfulinvestor.org and if you enjoyed the discussion please subscribe to this podcast to ensure you don't miss future episodes and don't forget to forward today's conversation to others you think would enjoy listening this podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice.

1:31:17All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of Evoque advisors, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that securities trading, commodity trading, and alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors.

1:31:51Listeners should be aware that guests featured on The Insightful Investor may have current or past associations with Evoke advisors or the host, including as an investment manager of a private fund opportunity by Evoke, or access through an affiliated Evoke fund, or as a client. Participation as a guest on the podcast should not be perceived as an endorsement or testimonial with respect to Evoke Advisors, the podcast host, or their services. Similarly, the inclusion of a guest on the podcast does not imply that Evoke Advisors or the host endorses the guest or any company with which they may be affiliated or employed.

1:32:30Evoke has neither paid nor received compensation from guests for their participation. Thank you.