Commodity Capital Quarterly LP Letter Q1 '23

The New Industrial Base - 3 Themes

Theme 1: Talent Inflows into Our Space

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Over the past 3 years, Commodity Capital has been very fortunate to interact with the smartest, most driven, and innovative Founders that are focused on the New Industrial Base. In fact, these impressive New Industrial Base founders are eclipsing many, if not all, of the founders that I’ve seen during the past 12+ years of exposure to founders in the general enterprise software space.

These New Industrial Base founders are interested in solving problems that are much larger, with greater impact upon the world relative to the likes of gaining ad clicks, building better online shopping experiences, or low margin delivery service businesses focused on delivering products right to your doorstep. While these other endeavors have a place in the world, they pale in comparison to building companies and products that aim to secure the future of the industrial base for the United States and allied democracies around the world - not to mention much larger markets.

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On a related note, there has been a significant amount of talent looking to make the jump into the New Industrial Base. This is staggering when compared to historical patterns. Consider Basil Siddiqui for example. Basil is the new Head of Engineering at Hadrian and has historically worked on building consumer products, yet he has made the transition to the New Industrial Base. He highlights this trend with a call to action seen below:

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(Source: Twitter, Link Here)

Theme 2: Growth Investors Enter the Market

Over the last six months there has been a noticeable increase in larger growth funds making public efforts to back the New Industrial Base. For example, General Catalyst ($33B AUM) recently published, “Building Globally Resilient Systems for a New World Order: Investing in Modern Defense & Intelligence.” Their viewpoint is summarized with,

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“We see tremendous opportunity in building modern, resilient systems for the most essential parts of our economy and society in order to compete and win in this new world order.”

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The New Industrial Base is about competing and winning against a backdrop of great international change and opportunity. Having larger, growth capital funds increasingly available for the New Industrial Base represents a significant reversal from the early days of investing in the New Industrial Base some three years ago. This is also of course a massive win for startups in our space as well as for earlier stage capital allocators such as Commodity Capital. This increasing presence of sophisticated growth investors, those willing to “take the baton” by allocating capital into the New Industrial Base as companies move into maturity, serves as a win-win-win for Founders, Commodity Capital, and LPs.

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(Source: Wall Street Journal, “Pentagon Woos Silicon Valley to Join Ranks of Arms Makers”)

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Theme 3: AI and the New Industrial Base

As a product person I am excited and see all the potential possibilities with ChatGPT-4, HuggingFace, Midjourney, etc. The technology is amazing for increased research and engineering output, yet as an investor I am in “wait and see” mode for domains large incumbents will not have an advantage on. Put another way, I am cautiously optimistic. It appears to me that a majority of such companies newly launching are just wrappers around the OpenAI API and lack long term viability as they are competing with existing products built on top of large amounts of data with a history of significant customer usage and distribution. Merely existing as an AI company built on top of another company’s data and technology won’t necessarily carry a company to the “promised land”. It’s more complicated, and outcomes at this point are certainly uncertain.

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There are many use cases built by large incumbents applying these powerful AI models on top of their existing data sets to enhance existing product. A strong example can be seen with Bloomberg (see here):

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(Source: Bloomberg, Announcements - Mar 30, 2023)

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With that being said, there is immense power in having “total recall” resulting in faster research and weaving together answers from multiple sources (both internal data and web-based data) coupled with the ability to ask and receive answers / actions using natural language which can be applied to everything from copywriting to engineering.

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When applied to the Commodity Capital portfolio, some potential examples can be seen below:

Hadrian - a customer could ask a Hadrian chatbot questions about the particular strength of certain types of aluminum to help make a decision on what would work best for a particular application

Volition - a user could quickly get an answer right in their CAD + Volition integration to the question “What type of screw works best in saltwater?”

Mercator - users could quickly get an answer to “How many vehicles do we have in our east coast fleet?” using Mercator’s search functionality

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General Market Update

Credit Markets Impact on the Portfolio

New Industrial Base companies tend to be shielded from consumer spending. Therefore in recessionary times, minimal impact on Commodity Capital portfolio companies can be expected. On the other hand, New Industrial Base companies, in particular those with larger than average CAPEX requirements, have a medium level of exposure to interest rates as these tend to use interest bearing debt to fund CAPEX. As it stands today, only 3 companies in the portfolio would be impacted by this and these do not appear to be experiencing any issues right now.

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The most likely outcome is that the Federal Reserve continues to keep interest rates higher for longer (and most likely continuing to increase them) to tame inflation and companies should therefore operate as such. The advice given to portfolio companies has been that it is better to be safe than sorry when dealing with leverage. The specific advice is to ensure interest coverage ratios are 2.5+. The ability to navigate the credit markets is a key issue that will be monitored for current and future investments in the event that interest rates pose a risk to operations or if access to credit fully dries.

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The Federal Reserve recently noted:

“Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation.”

-Mar 22, 2023, ‘Federal Reserve issues FOMC statement’²

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Finally, while the events of SVB and Signature Bank are behind us all, there are other financial markets that may rapidly show weakness (e.g., commercial real estate market). This situation will also be closely monitored as it could have knock on effects across the venture capital market.

Early Stage Financings

At the pre-seed / seed stage there has not been a massive reduction in valuations as was seen in April of 2022. I am seeing that the majority of investment opportunities have become more competitive as capital allocators look to invest in a smaller subset of companies at earlier stages and with a more reasonable approach to establishing appropriate underlying business fundamentals / metrics.

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Note, there is a perception of safety in the early stage market compared to later stage and public markets. For example, VC backed IPO companies are down 59% TTM¹ and as of December 1, 2022, the US Unicorn Index returned 1.0%¹ which is also forecasted to be negative for 2023. This dislocation is caused by the lack of volatility on a day-to-day basis in private companies, the ability to unilaterally negotiate on price, and compared to late stage companies less focus on public comps.

What does this all mean for Commodity Capital?

Advise companies to assume higher for longer rates so forecast accordingly
Should prices come down in the earlier stages, expect to see an increase in the pace of capital deployment
There’s a strong conviction in New Industrial Base startups, so investing through every stage of the cycle is to be expected - this does not mean fast and loose on valuations

Sources:

1. VentureBeat,”U.S. VC Exits and Investments Plummeted in 2022 - NVCA”

2. Board of Governors for the Federal Reserve System, “Federal Reserve issues FOMC statement”