Much has been written about the FTX fallout and Sequoia's subsequent write down in their Global Growth Fund (GGF) III. For individual investors, there is much uncertainty around how the crypto landscape will change and how that affects their investment decisions. However, there has been commentary around Sequoia's involvement.
From the individual investor's perspective, it would have been hard to get exposure to Sequoia's GGF as, according to this CNBC article, the minimum investment was $250m. Based on this, it would seem any lessons learned would apply only to large institutional investors. However, there are many lessons that individual investors can take in as well.
Let's start by looking at what a Venture Capital fund is and how this fits into the investment landscape.
A Venture Capital invests in early stage growth companies. Historically, VC was the domain of private wealthy individuals who would help new and innovative companies become profitable. However, over the past few decades, funds were created to pool greater sums from institutions and family offices who wanted to outsource the allocation and management of VC investments. In particular, the dot com and tech booms have led to a huge influx of fund inflows. VC funds fall within the Alternatives asset class bucket. It differs to Private Equity in that the latter usually invests in mature firms, whereas VC looks to invest in ideas at the ground level such that the firm creates a viable proposition for a likely exit to another corporation or indeed a PE fund itself.
Because of the risky nature of each investment, VC funds have to be on top of what they perceive to be future growth industries, manage the risk of their investments appropriately and ensure there is a viable exit plan to monetize. In particular, they have to accept that some if not most of their investments will fail but they will be able to be up overall because of a few large outperformers. The law of averages would dictate that it would be best to invest in many firms to increase the odds of a few home runs. However, that needs to be balanced against the size of the fund, the size of any individual investment and the ability to run proper due diligence on all.
Sequoia's Global Growth Fund (GGF) III raised $8bn in 2018 and its position in FTX was not in its top 10 holdings and represented less than 3% of the committed capital of the funds. After the events earlier this month, Sequoia wrote down their $150mm FTX investment in the GGF III fund to $0.
So what can individual investors learn from this?
The first rule of investing is to preserve your capital. To do that, you need to ensure that you don't over-allocate to any individual position, especially if that position is volatile.
Looking at Sequoia's GGF III fund, they invested less than 3% of their committed capital to their FTX investment. If you consider the fund has made ~20% in realized gain and ~70% in unrealized gain, it would appear Sequoia's original 3% allocation to FTX was correctly position sized.
Ray Dalio stresses the importance of diversification as he believes risk adjusted returns can be improved significantly, especially when coupled with uncorrelated assets.
Bear in mind, Sequoia is a VC firm and as such, is looking at innovative growth companies within the Technology sector. However, even with that narrow confine, they still attempt to diversify across sub-sectors and various stages of company growth. For example, according to this article on Growth list, Sequoia invests across the software, internet, mobile, enterprise software and IT sectors and they also make investments ranging from seed stage, early stage and growth stage sectors.
As for the number of investments, this analysis from the CFA, suggests the sweet spot for stocks before diversification benefits are lost, seems to be around 15-20 individual stock positions within a portfolio. According to Pitchbook, the GGF III fund seems to be close to that number at 14 investments.
As an individual investor, it pays to consider not just the number of investments, but also the region, sector and of course asset classes that you invest your portfolio across.
When faced with an inevitable loss, rather than defend their position, Sequoia sought to come clean and message all their LPs about the investment, give context to the size of the loss versus their overall gains in the fund ($150mm loss versus $1.7bn of realized gains), delete a previous blog about FTX's founder and move on.
As an individual investor, one of the hardest lessons to learn is to not get emotional about losses. Many good investment portfolios become bad over time because investors hold onto losses and don't let their winners ride out. There is plenty written about the psychology around this but in short, when faced with a loss, cut it and move on.
In Sequoia's letter to their LPs, they said that in 2021 when they made their investment, FTX had generated approximately $1bn in revenue and $250m in operating income.
However, when looking at a company, you should always look beyond the headline revenue statements and examine their full financial profile. In particular, as the Balance Sheet leaked by the Financial Times shows, FTX had only $900m in liquid assets against $9bn in liabilities. This proved to be FTX's ultimate undoing.
If you are doing your own investment analysis as an individual investor, it's important to look at the full financial picture of a particular company.
Investing is a hard discipline to master and even when you outsource to fund managers, they can make mistakes. Nevertheless, in the context of a well publicised bad trade, there are both positives and negatives which an individual investor can take away.
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