Five Years on the Sidelines of Venture Investing and Why We're Backing the Future of Tech, Differently.

The last time we made a new venture capital investment was late in 2019, five years ago, almost to the day. Five years. That's an eternity in the world of venture capital.

We didn't necessarily choose to sit it out. In fact, we used it as an opportunity to explore other areas of our business, building and testing alternate investment strategies. We've been active in M&A, we acquired an entire business, and dabbled in some new categories, however new venture investments, we didn’t touch.?

Sitting patiently on the sidelines of the venture ecosystem has been challenging, to say the least. The fear of missing out on the next big thing, the self-doubt, the continued analysis of potential opportunity cost, and the unavoidable loss of momentum in venture around personal and corporate brand building – it all weighed heavily. These past five years will certainly go down as some of the most emotionally and intellectually testing I've experienced.

You might ask, why did we do it??

Why press pause on new investments in an industry defined by momentum?

It wasn't a single decision, but rather a confluence of factors that led us to believe the traditional venture landscape had become fundamentally un-investable.

For us, 2019 was the turning point. That year we issued 3-5 term sheets for investment in promising fintech, SaaS, and marketplace companies. But each time, we were outbid, not by experienced VCs or industry veterans, but by relatively new players in the scene, players willing to bend the rules of the game. One instance saw us lose a deal to a big bank offering a convertible note with no valuation cap and no set conversion timeline. Another, an insurer offered more than $30 million for a pre-revenue company. Another, a SaaS business that rejected our ~8x revenue multiple for a deal that was double that. The market was, in a word, a mess.?

We learnt, sometimes viciously, how overly competitive and inflated the venture industry had become, and the negative impact that could have on the ecosystem and our ability to do great venture investing. Founders were swept up in a funding frenzy that none of us truly understood. I’d guess that we are all yet to experience the true cost of the capital being deployed the way it was during that period.?

Some of what we saw was unbelievable, irrational by any traditional investment managers’ metric. The only explanation was a "pay-to-play" approach (referring to the practice of accepting high valuations or unfavorable terms just to gain access to coveted deals, not the financing mechanism also called Pay-to-play) – a strategy that we fundamentally disagreed with as a path to building a long-term successful investment management business.

This period was marked by some concerning trends:

• Lacking sensitivity to entry valuation across almost all industry categories.
• Many cashed up emerging managers, and excessively cashed up top-tier funds with ample dry powder.
• A passing of the baton from retiring, seasoned venture investors, to younger less experienced up-and-comers.
• Increased noise and virtue signalling from VCs on LinkedIn, often overshadowing genuine insights and shared learning.
• An influx of hires into senior venture fund roles with no financial/investment background.
• Rapid promotions within venture funds, seemingly disconnected from tenure, exposure and/or experience.
• An escalation of preference share terms and aggressive power dynamics on company boards.

These are just a few observations. The list goes on.

Looking back at the data, it's clear we were witnessing the absolute peak of the Covid/ZIRP venture funding bubble, with record numbers of deals and funds raised – numbers we haven't seen since. There were also many alarming founder dynamics coming into play, a movement I’m still watching very closely.?

Amidst this turbulence, Rowan Grant and I began building our internal valuation benchmarking capability. We had two primary goals: first, to sanity-check our own valuation logic when analysing new opportunities, and second, to understand the implied bets that others were willing to make that we weren't. That data, over time, opened our eyes.?

The convergence of excessive capital flowing into venture capital as an asset class, coupled with retiring first generation Australian venture managers starting to pass the management/decision baton to a younger more inexperienced generation of managers that hadn't seen out the dot com and GFC periods' threw the industry into a tailspin. It felt like true risk-adjusted venture investing had become a lost art – everyone was simply paying to play and drinking the Kool-Aid.?

(As a side note, we're planning to open up our tech valuation index and modelling tool at some point soon to share some of these insights.)

The Importance of Valuations

One thing we learned very quickly in venture investing is that being first to the party doesn't guarantee you'll be the best dressed. If you’ve overpaid on valuation from day one, the roosters will come home to roost. If you embed egregious terms early on, you can be assured the next round of capital and its terms will trump yours. These things truly matter long-term. Building a portfolio on this foundation is a recipe for disaster, yet it's precisely what was happening, and to some extent still is, within certain verticals, across the industry.

The model of investing at any cost relies on the underlying invested company having truly breakout, runaway growth, and requires that it goes on to become a multi-billion dollar company. However, a brutal truth in Australia is that even if you get one of these in your portfolio, depending on how you've invested the rest of your funds' capital (i.e. the extent to which you follow-on into a winner), there is a good chance one breakout is not enough to provide overall outlier returns as a result of the dilution you’ve experienced along the way. This is because a typical venture round may dilute you anywhere from 10-30%, stack 4 or 5 of these on top of early investors and their ownership stake will only be a fraction of what it was from the outset.

We were lucky enough to have one major breakout company in our first fund, and the returns have only modestly exceeded the paid in capital value of that fund on paper. If we had invested irresponsibly with the rest of the capital we allocated in that fund, despite having that one major success story, our first fund would now only be sitting at ~1.25x TVPI. Not good enough. To really outperform against your vintage in venture capital, you need many winners and to reduce capital loss to near zero (that is unless you have a company like Canva that goes on to 30-40x from a $1bn valuation – which to be frank, rarely happens in Australia).

A New Path Forward (Introducing the Arbor Enduring Companies Fund)

In summary, the traditional venture capital model, with its lofty valuations, improbable exit expectations/reliance, increasingly complex capital tables, and extended exit timelines (something I will also write about soon), no longer made sense to us.?

It was extremely unlikely, given these factors, that a fund manager in Australia, deploying with a traditional venture strategy, could realistically produce an exceptional outcome with LP capital. We certainly weren’t going to be the ones to try it.?

So, we went back to basics. We built a new model, a new fund: the Arbor Enduring Companies Fund (AECF).?

AECF is an evergreen vehicle designed to take an unconventional approach to venture technology investing. We're backing founders building high growth private technology companies, albeit in some instances with lower growth than those on the venture flywheel (hence the funky tortoise unicorn graphic I generated for the post), and are focused on doing so more efficiently from day one - enabling founders to retain majority ownership of their business long-term. We're happy to take the patient pathway alongside these founders and build enduring business.

This isn't just a return to venture investing for us; it's a return to investment fundamentals. We're excited to re-enter the arena with a strategy that prioritises sustainable growth, sound valuations and long-term partnerships.

My next post will delve deeper into the Arbor Enduring Companies Fund, outlining our strategy, how we landed on it, and what we're aiming to achieve.

Stay tuned.

Note: If you're a wholesale/sophisticated investor and like the sound of our approach to venture capital investing, feel free to get in touch with Rowan Grant or myself directly on LinkedIn. I'd love to hear from you.

We're passionate about working with likeminded long-term private market investors that, like us, want to compound capital long-term in the best private technology companies in Australia.

Our website is arborcapital.co | LinkedIn Arbor Capital