The most expensive year in the history of our industry. Round sizes are larger than we have ever seen, valuations are detached from any framework we know how to apply, and the SPAC market has become a parallel universe of its own. We have been deploying less capital than usual. This letter is about why.
On the Vintage We Are Skeptical Of
The 2021 vintage of late-stage rounds will, we predict, underperform every vintage of the past two decades on a risk-adjusted basis. The prices being paid require nearly perfect execution from companies that are, on average, less mature than the companies that received similar valuations in 2014 and 2015. The 2014-2015 vintages have themselves not been kind to their funders. We do not see a mechanism by which 2021 outperforms them.
We are aware that this is an unfashionable position. We are aware that we are foregoing apparent returns by holding it. We are aware, also, that the firms holding similar positions in 1999 produced the best fund vintages of the following decade. The pattern is reliable enough that we have institutionalized it. We have a written internal practice — drafted in early 2020 — that says, in plain language, that we will not adjust our underwriting standards on the basis of peer firm activity, regardless of how visibly the peer firms appear to be outperforming us in any single year. We have referenced this document in seven separate investment-committee meetings this year. We expect to reference it more in 2022.
The hardest aspect of this discipline, in 2021, has not been the discipline itself. It has been answering questions from friends and family about why we appear to be deploying less capital than firms with smaller AUMs and shorter track records. The answers we give are not satisfying to non-specialists. We have come to accept this.
On the SPAC Phenomenon, in Plain Language
The SPAC structure, as deployed in 2020 and 2021, was a mechanism for taking companies public on terms that were friendlier to the operators and the sponsors than to the eventual public-market shareholders. Many of these companies should not have been public; many of them will not remain public over a meaningful horizon; many of them will be associated with shareholder losses that are several multiples of any operational underperformance.
We declined every SPAC opportunity offered to us this year. We are confident this will be one of the cleanest decisions of our 2021 vintage. The SPAC structure obscures three of the most important pieces of information that public-market investors require — the underlying performance trend prior to the IPO transaction, the dilution structure of the eventual share base, and the alignment of the sponsor's economics with the long-term shareholder's economics. Each of these can be inferred, with effort, from the SPAC's disclosures; the inference is harder than for traditional IPOs and the disclosures are less complete. We do not believe shareholders, in aggregate, are doing the inference. The eventual underperformance of the SPAC cohort, when it is fully measured in 2024-2025, will be one of the largest aggregate losses ever produced by a single financing structure.
On the Companies We Sold Into This Market
We took partial liquidity on three positions this year, at prices that we believe will not recur over the next five years. We did so without flagging it to the founders as a vote of no-confidence; in two of the three cases the founders themselves had asked whether secondary was available. We do not see this as a contradiction with our long-hold philosophy. We see it as the corollary — when prices materially exceed what the underlying business will continue to support, partial monetization is consistent with discipline.
The three positions remain in the portfolio at substantial weights; we did not exit any of them. The partial sales were sized to recover meaningful portions of the original cost basis without altering the firm's strategic relationship with the companies. The founders, in two cases, used their own portion of the secondary to take partial liquidity themselves; the third did not. We do not think less of the third, but we noted, in our internal discussion, that founders who pass on liquidity opportunities at peak prices are demonstrating the kind of conviction that compounds. Both behaviors are defensible.
On the Discipline We Are Asking Founders to Maintain
Several of the founders we work with have, this year, raised at valuations that we believe will be difficult to grow into. We have not vetoed any of these rounds; we do not have that authority and would not exercise it if we did. We have, in board meetings, made a single point repeatedly — that the operational discipline required to grow into a 2021 valuation is qualitatively different from the discipline required to operate at 2019 prices, and that founders who do not internalize this distinction will discover it through the next round.
The point has, in our experience, landed unevenly. Some founders have absorbed it and have committed to operating plans that explicitly model the down-round scenario. Others have not, and have continued to assume that growth will validate any valuation. We are watching the differential carefully. The founders in the first group will, we predict, navigate the eventual correction with relative ease; the founders in the second group will be operating in the kind of crisis our 2008 letter described, and they will be doing so without the framework that the founders we backed in 2008 had developed.
A Closing Note Before the Reckoning
This is the last letter we will write before the inevitable correction. We do not know what month it will arrive. We know the framework that will hold through it.
The Partners
Winzheng Family Investment Fund · December 2021