Winning in 2025 - Trophy or Trade-off?

The new year has started with the most optimism we have seen for a while as we settle into the post-pandemic era while looking to the US and the Trump administration's focus on relaxing roadblocks in the regulatory environment in which the market should see a greater upshoot in US M&A and IPO activity. Even sprinkling in some potential unpredictability with Trump, the markets have so far responded by hitting new heights, until DeepSeek’s R1 rocked the market (more on that later). In Australia, we look to the US for guidance juxtaposed against our local dynamics with an upcoming election, macro conditions and changes to our regulatory framework. Inflation data reviewed by the RBA in 2024 prompted it indicate that if the data continued to point in the right direction, it would “be appropriate to begin relaxing the degree of monetary policy tightness.” A more friendly rate environment would certainly spur more deal making, fundraising, growth initiatives and exit activity.

Exits continues to be a focus

Managers of capital are expected to remain highly focused on returning capital to investors as many fund vintages approach end of (extended) life as more normalised market conditions return. Well intentioned but without a constructive market, exits has been a challenge. This has also been a handbrake for fundraising in general but should ease as more exits materialise. Australian founders are also well alive to the fact that their investors are also requiring a liquidity solution and there has been more active thinking around how to mature the cap table but balanced against the need for growth capital.

What has changed is more of a meeting of minds with portfolio companies and market expectations. Further, there is also a more willingness to deal. I have witnessed this in the portfolio I manage where there has been increased inbound M&A and strategic interest in the last few months resulting in more concrete discussions. Notably, merger reform expects to see the ACCC scrutinise mergers if combined Australian turnover exceeds $200 million and if the acquired business or assets meet certain thresholds: $50 million in Australian turnover or $250 million in global transaction value. At such "low" thresholds, this may slow down M&A activity and add an administrative burden.

DeepSeek and digging deep for innovation

The revelation that DeepSeek’s R1 model cost US$6m to train compared to OpenAI's cost of US$100m for ChatGPT created a storm in the US equity markets, wiping off nearly US$600bn in the market cap of Nvidia (a record) and 3% off the Nasdaq in one day. Why such a drastic drop off? If these cost estimates are accurate, this would mean the market’s expectation for the demand for high performance chips are off the mark. A corollary of this is that increased efficiency could actually stimulate more mainstream adoption of AI, not necessarily reducing demand in high performance semiconductors.

What other lessons can we learn from this?

1. Don't dismiss unforeseen competition and courage to take on an incumbent

A leader may have a large moat or even be tempted to rest on its laurels but competition begets more competition. Irrespective of whether DeepSeek's actually cost (a lot) more than estimated, this has definitely spurred a re-think of what it means to win and how to win. A key lesson is for founders to remain nimble and respond to competition and continuously innovate to maintain or extend its lead. Even with a capital moat (openAI raised US$6.6bn at a US$157bn valuation to be larger than all VC-backed IPOs) and what looked like an insurmountable lead, DeepSeek's founder had the courage to start a competitor in 2023. Its R1 open-sourced model emerged to be highly efficient and purportedly costs a lot less.

2. Capital constraints can drive more innovative ways to solve a solution?

"Necessity is the mother of invention...Because they had to figure out work-arounds, they actually ended up building something a lot more efficient" Aravind Srinivas, CEO at Perplexity

It is unlikely the market will return anytime soon to the heady unconstrained flow of capital as we witnessed in 2020/2021. In this new world, many cash burning companies have become significantly more efficient with the dearth of capital and managed to grow AND become profitable. At the same time, there are many quality private companies that have reached cashflow break even but are in the 'middle' zone where they won't attract venture capital (not enough headline growth) nor private equity (not enough EBITDA) and it is these companies that could do well with some growth capital to drive it to the next milestone whether that be a larger growth round, sale or even IPO. This presents an opportunity for private growth capital or debt to fill the gap. I also expect these resilient founders to eke ways to grow in what is still a pretty tight funding market for companies now in AI. Pitchbook data estimates that 1/3 of global deal value went to AI/ML companies

3. Watch portfolio concentration!

Nvidia has been a major winner in many portfolios (institutional and retail) but diversity in portfolio construction is important. Similarly, this applies to OpenAI with its key VC backers. While too early to call, the implications of DeepSeek's news, active private (and public) managers need to be mindful of portfolio concentration which can also happen when a portfolio company more than meets expectations and shoots the lights out. Accordingly, I expect to see more opportunistic secondary activity with private managers de-risking their portfolio while continue to compound growth in their winners. This is balanced against the trade-off of fund maturity constraints and 'leaving too much on the table.'

?