VC Asset Bubble History: Why does every new coin seem to be reset to zero?

Original title: "The Great Crypto VC Bubble: Why Every New Token Trends to Zero (Part 1)"

Author: 0xLouisT

Compiled by: Deep Tide TechFlow

Altcoins are losing blood continuously – why? Is it because of high FDV or CEX's listing strategy? Should Binance and Coinbase directly use TWAP (time-weighted average price) to invest their funds into new altcoins? The real culprit is not new – it all goes back to the crypto venture capital bubble in 2021.

In this article, I will analyze how we have come to this point. In the following articles, I will explore the impact of this phenomenon on projects, mobile markets, possible future trends, and provide some suggestions for entrepreneurs in the current environment.

ICO Frenzy (2017-2018)

The crypto industry is essentially a highly liquid industry—projects can issue tokens at any time, which can represent anything, no matter what stage it is. Before 2017, most trading activities took place in the open market, and anyone could buy tokens directly through a centralized exchange.

Then, the ICO (initial token issuance) bubble arrived: an era of crazy speculation that was soon exploited by fraudsters. It ends like all bubbles: litigation, fraud, and regulatory crackdowns. The U.S. Securities and Exchange Commission (SEC) intervention has made ICO almost illegal. To avoid the U.S. judicial system, the founders had to find other ways to raise funds.

Venture Capital Crazy (2021-2022)

As retail investors were forced to withdraw, the founders turned to institutional investors. From 2018 to 2020, the crypto venture capital sector grew and grew—some companies were pure venture capital institutions, others hedge funds, allocating a small portion of their asset management scale (AUM) to venture capital bets. At the time, investing in altcoins was a reverse operation—many thought that these tokens would eventually return to zero.

Then, 2021 is here. The bull market has caused the portfolio of venture capital investors (at least on the books) to soar rapidly. By April, many funds had already achieved 20 or even 100 times return. Crypto VCs suddenly look like "money printing machines". Limited partners (LPs) flocked to the next wave. Venture capital institutions are raising new funds, which are 10 times or even 100 times the size of the previous one, and they are sure to replicate these amazing returns.

Source: Galaxy Research

In addition, there are some psychological reasons why VCs are so attractive to LPs, which I analyzed in detail in a previous article: The real reason why VCs outweigh liquidity in crypto arena

Hangover Period (2022-2024): Dilemma and Transformation of Crypto Venture

Capital

Then, 2022 followed one after another: Luna collapse, 3AC (Three Arrow Capital) bankruptcy, FTX collapsed - billions of dollars in book returns disappeared overnight.

Contrary to popular belief, most venture capital investors do not cash out at market highs. They, like everyone else, have experienced a downward decline in the market crash. And now, they face two major problems:

1. Disappointed Limited Partners (LPs) : LPs who once cheered for 100 times of return are now demanding to withdraw as soon as possible, putting pressure on the fund, forcing them to reduce risks and lock in returns in advance.

2. Excessive funds : There are a lot of unused venture capital funds in the market, but high-quality projects are in short supply. In order to meet investment thresholds and pave the way for the next round of financing, many funds choose to invest their funds in economically unreasonable projects rather than return capital to LPs.

Today, most crypto venture capitalists are in a dilemma: they cannot raise new funds and hold a bunch of low-quality projects destined to develop according to the "high FDV zero" script. Under pressure from LP, these venture capitalists have changed from supporters of long-term vision to chasers who exit in the short term. They frequently sell large VC-backed tokens (such as alternatives to L1, L2 and infrastructure tokens), and their high valuations are driven up by themselves.

In other words, the incentive mechanism and time frame of crypto venture capital have changed significantly:

• 2020 : Venture capital is a reverse thinker, with a shortage of funds and focusing on long-term development.

• 2024 : Venture capital becomes crowded, overcapacity, and even short-sighted.

I think venture capital funds will perform mostly lower than expected in 2021-2023. Venture capital's returns follow a power-law distribution, with a few winners making up for the majority of losers. But due to forced early sell-off, this model will be broken, resulting in weakening of overall performance.

If you want to know more about average VC returns, I have written a related article before.

It is not difficult to understand why more and more founders and communities are skeptical about venture capital. Venture capital’s incentive mechanisms and timetables are inconsistent with founders’ goals, and this misalignment is driving the shift in the following trends:

1. Community-driven financing : Projects tend to raise funds through community power rather than relying on venture capital.

2. Long-term support liquidity : Compared with venture capital, liquidity funds are gradually becoming the main force in supporting tokens for a long time.

Assessing liquidity/VC cycle

Tracking capital flows between venture capital and the liquid market is crucial. I use an indicator to evaluate the status of the venture capital market. Although it is not perfect, it is very valuable for reference.

I assume that VCs will deploy 70% of their funds linearly over three years – this seems to be the trend for most VCs.

VC 3y linear deployment visualization

Based on the venture capital funding data provided by @glxyresearch , I apply a weighted sum model and combine the deployment rate over 16 quarters to estimate the remaining dry powder in the system. In the fourth quarter of 2022, approximately $48 billion in venture capital has not been deployed. However, as a new round of fundraising has stalled, that number has been at least halved and continues to decline.

VC Unstart Fund Visual Chart

Next, I compare the remaining venture capital every quarter with TOTAL2 (the part of the total market capitalization of the crypto market excludes Bitcoin). Since venture capital is often investing in altcoins, TOTAL2 is the best proxy metric. If venture capital is too much relative to TOTAL2, the market will not be able to absorb future token generation events (TGEs). Normalizing these data can reveal the cyclical characteristics of the liquidity/VC ratio.

Crypto Venture Capital and Liquid Market: Cyclical Laws and Future

Outlook

Generally, when in the "VC euphoria" range, the risk-adjusted returns in the liquid market tend to be better than venture capital. The "VC capitulation" range is more complicated - it may mean that venture capital is giving up, and it may also indicate that liquid markets are overheating.

Like all markets, crypto venture capital and liquid markets follow cyclical laws. The surplus capital accumulated in 2021/2022 is rapidly exhausted, making it even more difficult for founders to raise funds. Meanwhile, capital-depleted venture capital institutions have become more picky in deals and terms.

I will stop writing here, and the next article will explore in-depth the impact of this phenomenon on the mobile market.

Summarize

1. Venture capital funds have performed poorly in recent years, and venture capital institutions are turning to short-term sell-offs to return capital to LPs. Many well-known crypto venture capital firms may not survive in the coming years.

2. The misalignment between venture capital institutions and founders is driving founders to turn to other financing channels.

3. The excessive supply of venture capital has led to unreasonable resource allocation, which I will analyze in detail in subsequent articles.

To be continued...