Bitcoin's late-2017 high near twenty thousand dollars had given way, by year-end, to prices below four thousand. Trade tensions reshaped the supply chains we had assumed were permanent. The fourth quarter delivered the broadest equity correction since 2011. This is what we mean when we talk about cycles.

On the Crypto Winter We Predicted Without Predicting Its Timing

We wrote last year that the regulatory response to the 2017 token wave would be more aggressive than participants expected. The response has been mixed; the reckoning has come anyway, through price rather than through enforcement. The token market closed the year at roughly twenty percent of its January high. Many of the projects funded last year will not survive 2019.

The technical work continues to interest us. The capital structures continue not to. We have, this year, deployed our first capital into the cryptographic-consensus space — not via tokens, but via traditional equity rounds in companies whose products use the underlying technology against problems where the technology offers genuine advantages over centralized alternatives. The companies we have backed are, in some sense, the inverse of the companies we declined to fund last year: they do not raise from non-institutional buyers; they do not promise returns to participants in their products; they do not depend on the durability of their tokens for the durability of their businesses. They are companies. We are investing in them as such.

The lesson we draw from the year, more broadly, is that we were correct about the regulatory framework's eventual response and incorrect about the timing. The market repriced before regulators acted decisively, which means the holders who had been counting on a long enforcement runway had less time than they expected. This is, in our experience, a typical pattern in cycles where the underlying assets are mispriced — the correction usually arrives via price before it arrives via institutional enforcement. We will recalibrate our timing assumptions.

On Trade and the Asian Supply Chain

The tariff escalations of 2018 have already begun to reshape the supply chains we had assumed were stable. Companies in our Asian portfolio that depended on cross-Pacific component flows are, in three cases, actively redesigning their supply chains. The redesign is expensive in the short term and possibly competitive in the long term — a bifurcated supply chain may be a structural feature of the next decade rather than a temporary inconvenience.

The companies most affected are those whose hardware components originated in mainland China and whose end markets were primarily in the United States. The reshoring that has begun in our portfolio is partial — none of these companies are abandoning Chinese suppliers entirely — but the pattern is a structural shift toward redundancy. The companies are accepting higher costs in exchange for lower geopolitical exposure. We endorse the trade-off, with the caveat that the cost of redundancy is permanent, and the protection it offers is contingent on the political conditions remaining adverse for an extended period. If the political conditions reverse, the companies that invested in redundancy will have over-paid; if they do not, the companies that did not invest will be exposed.

We are pricing in a wider distribution of trade outcomes than we have at any point in the firm's history. Several of our 2018 commitments would have priced higher under our 2015 framework; the discount we are now demanding reflects, almost entirely, the increased variance in cross-border outcomes.

On the Quality of the Companies Now Coming Public

The 2018 IPO cohort in technology was, in our reading, of materially higher quality than the 2014 or 2015 cohorts. The companies waited longer, scaled further, and entered public markets with operating discipline that several years of late-stage abundance had previously suppressed. The fourth-quarter correction obscured this; the underlying improvement is real.

The companies we have watched go public this year share three properties that distinguish them from earlier cohorts: their financial disclosures are more candid; their guidance practices are more conservative; and their post-IPO communications with shareholders are more frequent and more substantive. Each of these reflects, we believe, a structural shift in how late-stage venture-backed companies are being prepared for public markets. The shift was driven partly by the 2012-2015 IPO disappointments, which provided cautionary examples for the founders going public now, and partly by the increased presence of long-term institutional shareholders in late-stage private rounds, who effectively trained the management teams in public-market discipline before the actual IPO.

On What This Correction Has Already Bought Us

Late-stage round valuations in the fourth quarter were, on average, fifteen to twenty percent below where they had been in the second. Several conversations that had stalled in mid-year because the founders' price expectations exceeded ours have re-opened. We have written four checks in the last sixty days that we would not have written at June prices. Each of the four was, in second-quarter conversations, a deal we passed on. None of the founders are surprised that we have re-engaged at lower prices; the process of accepting lower valuations has been, in each case, candid and reasonable.

This is the rhythm we were founded to operate in. The fourth quarter of 2018 produced the kind of pricing environment that, in our experience, distinguishes the long-cycle vintages from the average ones. We expect to deploy more capital in the first half of 2019 than in the second half of 2018. The conditions are working in our favor.

A Closing Note

Cycles are not anomalies. They are the substrate against which the long hold is defined. A firm that does not love them is a firm that does not understand them.

The Partners
Winzheng Family Investment Fund · December 2018