Commodity Capital Quarterly LP Letter Q3 '23

Follow Up on Vertical Integration and Venture Scale

"We live in a culture where it’s hard to get people bought into something that's very complex to build - this is done unsurprisingly little today - this is a business form that is very valuable.”Peter Thiel on Vertically Integrated Complex Monopolies

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What we’re seeing is a significant drop in the cost of building software that allows for software to not just continue eating the world but rather to become part of the DNA of every company. While the chart below shows software engineering costs going to zero, the future looks more like software engineers leveraging tools to become 10x more efficient - not disappearing.

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Software Development Costs

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Source: SK Ventures

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Multi Level Thinking

I’m a massive Howard Marks (Founder of Oaktree) student - he associates most of his success to his ability to understand second level thinking which is,

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“First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.” • First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!” • First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.” The Most Important Thing by Howard Marks

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First level thinking: SaaS get’s harder and harder to generate alpha

After building and scaling two enterprise software companies I saw a very scary trend happening and that was the flow of invested dollars going to sales and marketing not research and development. Specifically, software is getting so easy to build that the only moat is distribution which just means a race to the bottom and a lack of differentiation in the market between products.

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Second level thinking: Vertical integration get’s easier

The good news is that because software is getting so easy to build the second level impact is that vertical integration get’s a lot easier in complex industries with very large TAMs, ie. manufacturing and all of its sub-sectors.

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Venture Scale

Vertical integration and the proliferation of software into everything provides not just great margins but also the ability to scale rapidly. Anecdotally, Chris Power from Hadrian has this to say,

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Source: @2112Power on Aug. 5, 2023

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Beyond Hadrian, I’m also seeing this across the software enabled companies in the portfolio as well as prospective investments.

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VC Macro - Things are Getting Better

Continued Slow Dealmaking

I’ve seen a slowed pace for dealmaking since the beginning of 2023 - nothing we don’t already know - but the chart below puts into perspective how slow it’s been compared to years prior.

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US Pre-seed Deal Activity

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Source: PitchBook as of June 30, 2023

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What will most likely reignite the deal volume is a better market for Series A’s as well as a better handle on the reality of the current market. From prospective founders, folks who are still at their current employer, there is an overall feeling of fear in starting a company now given the macro and micro picture. To reverse this sentiment we’ll need to be more confident in backing founders at the idea phase and a clearer path to Series A’s.

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This all trickles down from the growth stage environment which is in the process of dethawing - this is from conversations with founders in the portfolio and late stage investors.

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Pricing Resiliency in the Seed Stage Market

Investor appetite to take on pricing has not stopped even since the frothy days of 2021 and 2022 (see charts below). There’s a few factors at play:

The earlier the company the more removed from the macro the company is
Multi stage funds with capital need to deploy
Getting in early on a company is effectively an option for a multi stage fund so ownership is important but the dollar amounts and valuations are manageable

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US Pre-seed Dollars Invested

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Source: PitchBook as of June 30, 2023

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US Pre-seed Pre-money Valuations

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Source: PitchBook as of June 30, 2023

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One prediction made by Jason Shuman at Primary Ventures is that multistage firms will have to start to focus more on their larger holdings given that financial runways will runout for larger companies in 2024. I believe there is some truth in this but I don’t think it will impact pricing or appetite too dramatically.

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The below chart also highlights the slowdown in step ups from Seed to A over the last few quarters. The chart is more representative of the general market not New Industrial Base startups as I’m seeing portfolio companies with good graduation rates and valuation step ups in the 2.5x - 3x range.

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Median Early-stage Valuation Step Up

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Source: PitchBook as of June 30, 2023

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IPOs are Happening

Headlines were made with Klaviyo, Arm, and Instacart all going public in September. Although all three are currently trading below their initial pricing, this is a huge win in my book. In particular, this shows that late stage private companies have the governance, infrastructure, and health to go public.

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My expectation is that the back half of next year should see a boom in IPOs as the last thing remaining, and arguably the most important, is a confidence in price floors. The only thing holding up a larger volume of IPOs are pricing which remains in flux as the Fed keeps rates steady and the possibility of another raise in the face of stickier than expected inflation impacting public markets. My bet is that the Fed will have to lower rates mid next year (more on this below).

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Narrative Shift in Silicon Valley to Support Global Resiliency

There has been a huge narrative shift in Silicon Valley with regards to investing in defense companies and their suppliers. Now is the time to invest and innovate in order for the US and its allies to maintain a global lead. Palmer Lucky said in 2012, "You can't just be equal with people if you want to lead the discussion.”.

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We have to lead the discussion it’s our duty to support that cause. I choose to support via investing in companies that allow us to push this agenda in order for the moral good to prevail.

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This cause is best pursued by investing in “real tech” - Delian said it best in this clip below:

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Source: LK-99 with Varda on This Week in Startups

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Small Early Stage Specialist Funds Have the Upper Hand

A trend that we’ll continue to see more is a flight to smaller, earlier stage, specialist funds. We’re not only seeing this with individual managers but also large multi-stage funds who are trying to stand out by specializing and getting more ownership earlier on with smaller checks. As mentioned above, multi stage funds will have to focus more on their largest holdings but the flow of talent with a background on the earliest stages of investing is a trend I don’t foresee slowing down combined with the opportunity to get in early will keep the flow of dollars sustained.

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The trend will be further underlined in future vintages that take advantage of the historical performance outlined below.

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Performance of VC funds under $250M by Vintage Cohort and Style (TVPI and IRR)

For the record - Commodity Capital has a TVPI of 2.70 and a Gross IRR of 37.35%

Source: PitchBook data as of Dec. 31, 2022

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Source: PitchBook data as of Dec. 31, 2022

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Macro - Soft Landing Still in the Cards

A contrarian take but we still have the ability to pull off a soft landing. This is due to a mix of a downward trend in inflation, strong consumer balance sheets, and a tried playbook on how to deal with failing regional banks should that happen due to a debt cliff in commercial real estate.

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Inflations Downward Trend

CPI, excluding Food and Energy

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Source: Bloomberg as of Sep. 28, 2023

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The chart above shows two months of sustained downward inflation - this trend should continue or be sustained due to the Fed’s very strong stance on higher rates and a hawkish comments by the Fed. Although pricing for food has been removed from the chart above we’re still seeing only a 0.1% increase in food-at-home from July 2023 to August 2023 with a YoY increase of 3%. According to the USDA,

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“Year-over-year price increases continued to slow for all food and for food at home. Food-at-home prices were 3.0 percent higher in August 2023 compared to August 2022, the lowest year-over-year increase since August 2021. Year-over-year price growth slowed across 10 food-at-home categories, and prices declined for 6 food-at-home categories between July and August 2023.”(Source: USDA - Food Price Outlook 2023 - 2024)

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Higher Rates for Now

The Fed recently announced that they plan to keep rates higher for now with the potential for another small hike in the near future should there be any unexpected increases in inflation. Combine this with a restrictive policy in place and the lag with which the Fed bases their decisions off of we should see a sustained downward path on CPI.

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Given the above and the level where rates are at, should we see a significant down turn the Fed has plenty of room to drop rates to get things back on track - this is one reason I believe a soft landing is still in the cards.

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Strong Consumer Balance Sheets

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The chart below shows consumer balance sheets have never been stronger - this is die to sustained job growth even though in tech it felt like the world was ending/ended it’s important to step outside the bubble for a more holistic view. A strong consumer balance sheet is critical to the soft landing outcome.

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Household Balance Sheets

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Source: Board of Governors Federal Reserve System as of Sep. 28, 2023

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Dis-inversion of the Yield Curve

Historically, we’ve seen a quick dis-inversion of the yield curve just before we enter a recessionary period. Don’t forget, a recession is two quarters of negative growth not a financial crisis - the point of outlining this is that it’s not the end of the world if we see growth go negative for a short period of time.

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Spread of 10-year Over 2-year Treasury Yield

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Source: Bloomberg Sep. 28, 2023

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Given consumer balance sheets are healthy, inflation is on a downward trend, rates have plenty of room to drop, and policy can get loose fast just as we saw in 2020 - I believe we have the ability to successfully land the plane during what feels like an awaiting storm.

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Reminder: Everything is Important from the Macro to the Micro

The reason it’s important to stay on top of the macro as a Seed / Pre-seed stage fund is because both VC’s and startups are impacted by the type of macro environment we’re in - so it’s always best to be prepared for the downside and ready to take advantage of the upside. Macro trends impact everything from fundraising, to customers, to suppliers.

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