Among the marble columns of the former San Francisco Federal Reserve building, Doug Leone, veteran leader of Sequoia Capital, spoke to a group of more than 300 emerging VCs and limited partners this fall at the 6^th Annual MicroVC Summit hosted by Silicon Valley Bank (SVB) and Cendana Capital. Underscoring the importance of seed stage investing in a crowded venture ecosystem, he carefully spelled out his email address for the audience – twice. Sequoia is interested in partnering with these small VCs.

After all, someone in that room could find his next deal.

With $130.9 billion invested in 2018, US venture capital is at a record high, according to the latest Venture Monitor Report. This abundance of capital is allowing companies to stay private longer (the average time to exit is now 6.4 years). Traditional venture firms have fueled this change by investing larger sums of capital at later stages, sometimes using the very size of their funds as a differentiator. Funds raising at least $500 million accounted for 57.0% of all capital raised last year.  Sequoia recently launched an $8 billion global growth fund, the largest single fund in its history.

Today, there are many permutations of venture capital, from late stage mega-funds to seed investors filling the gap at the early stage. SVB currently tracks over 500, sub $100M, seed focused funds in the US.  These funds are managing over $26B in aggregate, and there are 81 first-time funds currently raising.  Sequoia itself has a seed fund, and has always been very active at the early stage; Airbnb and Stripe were both seed investments for the firm.

Deal sizes are also rising –median deal size at the seed stage has increased by 25% since 2017 to $7 million. Yet, the total number of VC deals has gone down. This is particularly true for early stage deals; deal count of first financings in the US has declined 23% between 2017 and 2018, resulting in heightened competition for the attention of founders. “It’s never been so horrific in terms of competition, but never better in terms of opportunities,” says Doug Leone. Many GPs and LPs surveyed at the MicroVC Summit told us that their top challenges are the overabundance of capital leading to increased competition for deals and higher valuations.

As traditional VCs fight for massive Series C and D rounds, seed investors are sourcing early stage deals. This provides a feeder system for Series A and later-stage focused funds. “The importance of early stage venture is increasing, as is the amount of capital invested,” says Aaron Gershenberg, Managing Partner and Founder of SVB Capital, who moderated the talk with Doug Leone at the Summit. “Seed investors are critical to the ecosystem. They can bring great startups to funds like Sequoia Capital that have 40-year track records of helping companies scale, creating massive wins.”

“The best deal flow is dark,” says Hunter Walk of Homebrew Capital, a panelist at the Summit. “I worry more about misses than losses – the deals that we don’t see.”

The seed round has become what the Series A was in the classic venture model, both in terms of financing amount and as often the first professional money into a startup. While startup companies have long been disrupting larger firms, we are now seeing disruption in the venture capital industry itself. “Venture has fundamentally evolved,” says Elad Gil, investor and author of the “High Growth Handbook”. “The capital markets have shifted dramatically. One could argue there is as much of a change in venture since the 1990s as in startups themselves,” he adds.

In a crowded market, VC’s must find new ways to stand out. “You don’t have to be everything to everyone,” says Hunter Walk. “You can see differentiation in where we invest, where we don’t and in how we operate the fund.” Some venture firms say they are looking to invest in new geographies they’ve never explored previously beyond hubs like Silicon Valley. Two-thirds of those surveyed at the Summit told us that they are likely to make investments outside the US in 2019.

Other funds are testing strategies focused on specific industries or technologies, often where they can leverage previous entrepreneurial experience of their partners. Interestingly, nearly the same number of limited partners surveyed at the MicroVC Summit are investing in life science and healthcare as in cryptocurrencies and blockchain. And 10 percent of LPs are investing in cannabis funds. This could be a sign of strategy drift as seed investors seek new ways to differentiate.

“Don’t get distracted by deals that don’t tie back to the core of your business,” says Kirsten Green of Forerunner Ventures, also speaking at the MicroVC Summit. “Put a stake in the ground for what you stand for, and build from there.”

Many VCs are turning up their marketing efforts to help stand out, hiring PR and content experts. “I don’t have time to look through the haystack to find needles; I need to build a magnet,” says Hunter Walk. But building a unique brand starts by asking why a firm should exist in the first place. “If you don’t know what you stand for, it doesn’t matter what your marketing plan looks like,” he adds.

Erik Rannala of Mucker Capital, another speaker at the event, advises seed investors to “endeavor to be what you wish to be seen as. Actions speak louder than words. It’s a reputation business.” In fact, when asked why they believed founders took their investments, most VCs at the Summit cited their reputation as the top reason (72 percent), followed by their unique technical expertise (40 percent), niche/sector investment area (30 percent) and track record (30 percent).

As funds seek to define their unique space in the ecosystem, true differentiation will come from how they help founders. “We view this as a service business – serving founders and LPs,” says Erik Rannala. “What founders think about us ends up being our brand in the market.”

Seed investors, in particular, often strive to provide hands-on advice to their portfolio startups. “It’s pretty simple really: actually be valuable so that word spreads, be an expert in something and promote that expertise, and know what you stand for,” says Elad Gil.

Building the right reputation is a long game. When describing the work of his firm that has led the industry for decades, Doug Leone intentionally doesn’t use the word investor. “Sequoia wants to be the long term business partner to terrific founders to build long term businesses. We listen to a lot of companies, but once every 5-6 months, you meet one that describes the future. Then, we spend 10-12 years going to war with them.”

Hunter Walk closed his talk at the MicroVC Summit by showing that he has the logo for his own firm, Homebrew, forever tattooed on his arm. Luckily, he hasn’t had to use it to win any deals yet.

Commenting on short-term market movements is usually a futile task. One should focus on longer-term macro trends.

Since 2018 was the first significant yearly stock market loss since the Financial Crisis in 2008, and December 2018 was the worst December stock market performance since the Great Depression of 1929, I felt compelled to comment on current market gyrations and provide an outlook for 2019 and beyond.

Back to Normal:

2018 proved to be a difficult one for the market, with S&P 500 down 6.2 percent, which is only the second yearly loss in a decade. December proved quite painful, with the index down by 9 percent

To put this into a larger perspective, the S&P 500 had been going straight up since bottoming in March 2009. There has been 10 years of gains and close to 180 percent return, with very little downside volatility. Clearly, the market needed a breather.

The gains were greatly supported by the Federal Reserve’s zero interest rate policy (ZIRP) and quantitative easing (QE), which were put in place to supply money and liquidity to the financial markets and avert another crisis. There is much debate about whether the Fed and other central banks kept monetary policy too loose for much longer than needed, creating an overextended position in riskier asset classes.

During 2018, the Fed raised interest rates four times and began to shrink its balance sheet. As a result, the fuel that the stock market enjoyed from QE and easy monetary policy was no longer a tailwind, but a headwind. Individual company fundamentals will be increasingly more important than perhaps at any other time in the past 10 years as the Fed normalizes monetary policy.

As a result, volatility is rising again. By historical measures, volatility has been unusually low for many years due to extremely accommodative monetary policies. However, as the chart below shows, recently higher volatility levels are not extreme by historical standards— if anything, the “extreme” was the low-volatility period we had been experiencing in recent years.

Volatility Index (VIX) – Source: Yahoo Finance

What is causing this renewed bout of volatility?

• Normalization of Monetary Policy – As the Fed normalizes interest rates and overall monetary policy, it will continue to add fuel to the volatility fire. Usually the early cycle of rate hikes is positive for the market, as it shows confidence that the overall economy is strengthening. However, as rates continue to rise, they eventually become a headwind to stock prices because higher rates means lower present value of discounted cash flows, which negatively impacts stock prices.
• Uncertain policies coming from Washington – From trade wars to border disputes, the market is spooked by the unpredictable behavior coming from Washington. The political uncertainty has definitely been a contributing factor to overall market volatility. Trade policy uncertainty is now starting to negatively impact corporate earnings and business outlooks despite the tailwinds from tax cuts. The market hates uncertainty and short-term volatility will continue to be elevated so long as these issues remain unresolved.
• Paradox of Growth – We could very well experience a tug-of-war between a volatile stock market and an economy that continues to experience strong growth. As the economic slack created by the Financial Crisis continues to be filled and as the economy reaches full employment, the potential risk of wage inflation increases. Unlike other periods in history, inflation has remained subdued due to continued strong productivity growth, the exportation of cheaper labor abroad, technology advancements and efficiency gains. The Fed has a dual role of maintaining full employment and controlling inflation and is just now getting back to a more neutral monetary policy after years of QE. All of these factors lead to higher economic and market uncertainty and increased volatility.

What does this mean?

Our outlook for 2019 is positive for the economy. Consumers and businesses remain buoyant and over time, the markets will grow in line with overall economic activity. A lot of the recent volatility is due to lower growth concerns, but so far, we have not seen evidence of this in the U.S. economic data, which remains robust. China has been slowing for quite some time, but at some point in 2019 we could see their government try to stimulate their economy once again.

We are negative on bonds, as we expect long-term interest rates to resume an upward trend like we saw earlier in 2018. As rates continue to rise, the headwinds for bond investors will be significant. We have an entire generation of bond investors that have never had to deal with a bear market in bonds. This would be particularly difficult for prices of longer-duration bonds, and especially bond mutual funds and bond ETFs, which do not have maturity dates that provide some clarity on the return of capital to their investors. Shorter-duration and hedged fixed-income strategies will make a lot more sense in a rising rate environment since parts of the yield curve could remain flat or inverted for some time if the Fed continues to raise short-term interest rates.

The good news is that the plumbing of the economy is working well, with few signs of the excesses or irresponsible lending that occurred before the Financial Crisis. As we have seen, debt market crises are much harder to successfully resolve compared to bear markets in stocks.

In short, we see the current bout of stock market volatility as primarily an adjustment to a normalization of monetary policy, which is a result of a new phase of economic growth; and secondarily, a reaction to a number of other short-term political uncertainties that are likely to be clarified in the coming months. With the normalization of monetary policy, we are effectively removing the “training wheels” the Fed put in place during the Financial Crisis. Honestly, it is a welcomed sign.

How to take advantage?

This type of environment is quite positive for illiquid asset classes, as managers tend to have a longer-term view and are sheltered from day-to-day movements. I do worry about some large IPOs (particularly in the tech space) that are scheduled to come to market. If volatility persists, we could see delays in some key offerings.

As extreme volatility quiets down and the markets return to normal, underlying fundamentals will dictate performance again — welcomed news indeed. Additionally, we remain quite positive on venture development, as demand for early-stage funding continues at an all-time high and the opportunity to identify disruptive technologies within research institutions is an untapped opportunity.

Future performance will require skill rather than indexing. Stock/company/technology selection will matter again. Underlying fundamentals will rule again. Alpha generation will be back in the vocabulary of investors.