Riffs and Reveals

The opinions expressed in this article are the author’s own and do not reflect the views of any affiliated entity. Nothing contained herein should be construed as investment advice.

Intro

Ted Seides is a former allocator who hosts the popular Capital Allocators podcast. He started his career at the Yale Investments Office under the late David Swensen and went on to found a successful fund of hedge funds (FOF) business called Protege Partners.

Capital Allocators features Mr. Seides interviewing a range of investment professionals, most of whom allocate to third-party investment managers on behalf of large institutions and family offices.

A longtime listener of the show, its appeal has waned for me over the years. This is mostly due to a focus on incumbents that I believe perpetuates legacy thinking at the expense of originality (which partially inspired my last post). The show is nonetheless a worthwhile listen for allocators and those marketing to them.

A recent episode featured a reunion of allocator friends who gathered to “Riff on Investing”. In addition to Mr. Seides, the group included Brett Barth of BBR Partners, Jon Harris of Alternative Investment Management, Casey Whalen of Truvvo Partners, and Meredith Jenkins of Trinity Wall Street.

This was a fun conversation that made for a good listen. I was especially interested to hear Mr. Seides begin the discussion by asking the group’s thoughts on crypto. The ensuing conversation served as motivation for this post, as it revealed flawed thinking on the digital asset class among a group of otherwise thoughtful and sophisticated allocators.

Crypto as Bitcoin

Mr. Barth was first to opine, stating that he was “agnostic” on crypto and thinks of it “as a commodity like gold”. This was an unsurprising place for the conversation to start and set the stage for what would follow.

Thinking of crypto collectively as a commodity demonstrates a simplistic view of digital assets as a monolithic entity. Mr. Barth is likely referencing only bitcoin here (the default setting for most), which the CFTC technically classifies as a commodity and which many refer to as digital gold.

Given its pioneering status and hold on the public consciousness, bitcoin is often used as a proxy for the digital asset ecosystem. Since bitcoin is a cryptocurrency itself, the term “crypto” took hold as a generic catchall for the space. While a convenient term, it ignores the variety of coins comprising the digital asset panoply.

While there are thousands of digital assets in existence, only a small handful are technically considered cryptocurrencies (i.e., those seeking to perform a store of value function or serve as a medium of exchange). The overwhelming majority — both in existence as well as forthcoming — make no effort to be cryptocurrencies and therefore bear little resemblance to bitcoin.

Mr. Seides was asking for the group’s view on an asset class comprised of thousands of tokens/coins and Mr. Barth answered with cursory thoughts on just one of them. This is like asking for one’s view on technology stocks and getting a high-level assessment of Apple’s Mac business.

Besides, treating bitcoin as a commodity is itself incomplete. Bitcoin is a unique animal in that it possesses attributes of a currency, commodity, and out-of-the-money equity option. My guess is that the CFTC treats it as a commodity for regulatory remit purposes rather than because the classification is definitionally consistent.

Valuation Conundrum

Mr. Barth went on to state that he has “a very hard time investing in something where the only investment case is that someone will pay more in the future than you do today”.

This is a commonly dismissive take on crypto. Conventional wisdom seems to suggest that speculation should not be one’s primary use case when investing, that there must be some marginal utility derived from an instrument beyond just price action.

But speculation is the base impulse with most risk-taking, not just crypto. It involves the purchase of an asset with hopes that it will appreciate in value over one’s holding period. Outside of pure yield plays, this defines virtually every investment ever made.

Your favorite equity fund manager owns Google stock because they think it will be worth more in the future. The analysis underpinning that assessment might feel more traditionally robust, but the general objective remains the same: To one day sell that asset for more than its purchase price.

Ms. Whalen picked up where Mr. Barth left off by referring to crypto as a collective that she views in a similar manner as gold, “where you can’t underpin an actual value to it”. She goes on to state that “you can’t really use it as a currency” and seems to lament an inability to control its supply.

Similar to Mr. Barth, she appears to conflate bitcoin with the broader crypto complex, again excluding the vast majority of digital assets that share little in common with bitcoin and whose supply is often not constrained. I’d also be curious to learn why an ability to inflate/deflate an asset is necessarily a benefit.

There are myriad ways to value assets, traditional and otherwise. Bottom-up stock-pickers tend to be cash flow-oriented while macro traders analyze fund flows and interest rate differentials.

Plenty of digital assets offer value accrual to tokenholders as a project’s user base increases. This allows for a form of valuation analysis that is similar to that found with legacy financial assets, particularly within certain sub-sectors like decentralized finance (DeFi). And since many digital assets can be lent for yield, rates can sometimes factor into one’s value assessment.

Venture Approved

Despite their collective skepticism on the space, there appears willingness amongst the group to gain exposure to crypto via venture investments. Mr. Barth claimed interest in “blockchain and DeFi” while reiterating his agnosticism towards bitcoin. This was followed by Mr. Harris noting that the opportunity is in the “toll booths, the picks and shovels”.

Mr. Harris appears to be the resident security expert and pointed to his investment in Chainalysis as an example of a crypto security play. I would not characterize Chainalysis as a security solution (it’s more of a blockchain forensic analytics business) nor is its business model akin to that of a toll collector (that would be the exchanges). But Mr. Harris is right to acknowledge the wisdom of having foundational exposure to a space that may have extraordinary growth potential.

Ms. Whalen then made her own case for venture capital wherein she characterized those practitioners as “critical, independent thinkers that can be intellectually honest”, which made for a good chuckle.

This is emblematic of the institutionalist approach to crypto. Viewed as an emerging technology that could be worth a lot or nothing, the venture bucket seems the obvious place to put it. But venture is an illiquid bet on an uncertain future that ignores the many opportunities afforded in the here and now. Focusing one’s crypto experience on the most binary and illiquid variety while ignoring the liquid side of the spectrum seems limiting to me.

Mr. Seides then put a question to the group about how they think through crypto and someone (either Mr. Harris or Mr. Barth — I couldn’t tell!) talked about speaking to all the end users, “whether it be in the financial services industry, looking at how governments are using it…who are going to be the people that need it and want it, and spend the time getting that sense”.

Unless this group is spending time in El Salvador, governments are not using blockchain or crypto in any meaningful way. In fact, they mostly complain about the new asset class. The traditional financial services industry is dabbling, but I wouldn’t rely on its view as a substantial participant. The real end users here are the retail punters, the traders, the arbitrageurs. We can only wonder how many of these people our allocator friends consulted in arriving at their respective views.

I appreciate the group’s broader skepticism of the digital asset class — there is admittedly plenty to critique — but I find that difficult to square with their willingness to engage with it in venture form. This is like saying you’re skeptical of retail equity trading but nonetheless happy to make early stage investments in Robinhood and Public. The success of those illiquid investments relies on the flourishing of the broader ecosystem. It’s unclear to me how one could be, say, unconvinced on social media but bullish on a Facebook equity round.

The reality is that most working use cases involve blockchain projects with tokens. Mr. Barth claims an interest in blockchain while being less sanguine on crypto (bitcoin), but it is the tradeable version of those projects that often brings them to life.

Ms. Whalen then spoke about how dipping one’s toes allows for learning through investing, how one is able to live and breathe an investment by witnessing the ups and downs. “By being invested in it, you then get greater conviction if there is a big dislocation, to go in big if that’s the right thing to do.”

I agree with this view but can’t help but wonder what form Ms. Whalen’s crypto exposure might take. Her earlier comments seemed to suggest that venture investing is the only version that makes sense for now. But living and breathing an investment is best done through liquid avenues (since venture takes years to play out) and capitalizing on a big dislocation suggests a more opportunistic, trading orientation.

Mr. Barth added that finding sharp-shooting managers who can serve as thought partners to educate you on the space is a great way to go. Here again I agree. But if this group is using managers to get educated on crypto, their treatment of it in this discussion is even more unfortunate.

In Closing

Mike Novogratz of Galaxy Digital recently lamented the flawed understanding of crypto among our political leaders and regulators. I believe a similar sentiment applies to our TradFi (traditional finance) colleagues, many of whom arrive at opinions on the space with only limited understanding of it.

This goes to show that we haven’t even scratched the surface when it comes to proper institutional engagement with crypto. Here’s hoping we can change that with continued education and engagement over time.

It’s fitting that the episode segued from crypto into a discussion about private equity, whose treatment Ms. Whalen complained often lacks nuance. We certainly could’ve used similar nuance for the crypto portion too!