From Sabotage to Mastery: Investing Beyond the Hype Cycle

The Evolution of Institutional Digital Asset Returns

Institutional digital asset investment has been largely defined by two prevailing strategies, each contributing to the shape of market dynamics in their own way. The first involves maintaining market neutrality, leveraging yield from retail investors, while the second focuses on securing early-stage positions in projects with the goal of offloading tokens to retail investors at peak liquidity. While these strategies can generate impressive short-term returns, they are extractive in nature and have significantly affected the industry, creating market instability and ultimately leading to mutually assured destruction. 

The pendulum has swung too far, and now there is a contrarian opportunity to play the other side of these trades. Value-based, fundamental approaches target investments in projects that not only demonstrate clear product-market-fit for their use case but also trade at attractive value multiples. Many assets with these characteristics are trading at unsustainably low valuations to cash flow and future growth prospects. 

In the upcoming cycle, investors will need to transition to a fundamental strategy if they intend to own the strongest projects. The core primitives, and the industry at large, are no longer in the seed stage. 

A New Path to Liquidity

From 2017 to 2022, the digital asset industry embraced a new capital market for early stage blockchain companies to raise money. This has lent itself to pervasive adverse incentives and self-dealing across the industry. Let’s take a generic example to see how this typically plays out:

The typical Web3 journey often begins with a small team, buoyed by venture capital seed funding, working toward the development and launch of problem-solving software. In light of the minimal operational overhead and outsourced CapEx inherent in the Web3 model, the seed funding at this stage is modest.

Instead of opting for years of private VC investment culminating in an IPO, founders and VCs favor early token issuance – a logical choice given the potential short-term payout. With a liquid token, the thinking goes, projects can also incorporate new types of utility and financial participation into their product, often creating a powerful network flywheel when conditions are just right.

In practice, this has not panned out, and a protocol’s initial token issuance is commonly perceived by many market participants as the peak of the DAO's liquidity lifecycle. Once a token is liquid, many projects have already signed their users up for aggressive dilution via two avenues:

1. Pre-token distribution: issue ownership to large VCs and have them all cliff vest at the same time, eliminating any possibility of stable price and ecosystem bootstrapping
2. Ongoing “incentives” (read: constant equity issuance at dilutive prices) to subsidize unit economics/yields without any quantifiable increase in sticky user activity

Naturally, this leads to an unwind of the hype cycle. Institutional involvement tends to wane in the face of performance degradation, leaving the next step in the journey overlooked by most investors. 

“Incompetence, in the limit, is indistinguishable from sabotage” - Elon Musk

Original Sin

These outcomes are directly tied to embedded conflicts of interest between how institutional sponsors drive value and how decentralized networks evolve.

Market-neutral funds can take hedged positions in digital dollars (i.e. stablecoins) and in return receive equity-like incentives. These incentives escalated to unsustainable levels in the latest bull cycle, perpetuating unchecked token holder dilution. The beneficiaries? The funds that extracted low double-digit yields from liquidity-starved, equity-rich startups with lofty ambitions.

For early-stage VCs, they have managed to leverage retail exit liquidity to achieve VC-like returns in shorter time frames. Instead of permitting projects to compound capital, these funds are driven to manufacture hype, sell at peak liquidity, and move on to the next prospect. When these funds exit, many protocols are riddled with token debt and face severe headwinds. Even those that remain structurally intact are left for dead with scant “value bids” in the market to support ecosystem economics.

We would argue that too many VCs did not, and still do not, fully understand (or worse, care about) the distinction between creating value through liquidity arbitrage and compounding capital over the long term by investing in disruptive and profitable technology.

Since 2022, these two "trades" have only added fuel to the fire:

• Retail investors have lost money - giving regulators a stronger foothold to scrutinize the industry
• Institutional interest has dwindled - amidst countless tales of "ponzinomics" (dilutionary spirals) and "rug pulls" (VC supply shocks)
• Vaporware is rampant - the technology was never pivotal for these returns
• Liquidity is scarce - institutional liquidity providers took aggressive counterparty risk which has metastasized into material losses over the past 24 months

The Opportunity

It’s not all doom and gloom - many protocols exhibit strong revenue dynamics. While this economic value is typically held captive within the smart contracts at the start, most Web3 ecosystems convert their operations into a decentralized legal wrapper in order to safeguard members of the community while crucial decisions are made about the business. 

Industry-wide, many ecosystems have quietly reached "sufficient decentralization", enabling stakeholders to legally and compliantly optimize the protocol’s balance sheet and capital allocation. By definition, this generally plays out as large holders exit the ecosystem. This critical transformation has gone unnoticed amidst the ebb and flow of the industry hype cycle, obfuscating genuine fundamental progress to the untrained eye.

Looking at the broader picture, considering the amount of VC capital that poured into early-stage projects between 2019 and 2022, there are more assets reaching this stage of economic maturity than investors realize. Today, liquid investors can usher these projects into mature, self-sustaining businesses given institutional sponsors are MIA. 

The Road Ahead

Let's briefly take a step back to look at the current state of the digital asset market:

• Roughly 18 months into a technical bear market
• Total crypto market cap ~67% off of cycle highs
• Confidence and sentiment at lows
• Liquidity at lows

It is objectively true that given this mix of conditions, the 3-year expected returns in digital assets are at their highest. At this stage, a prudent investor would likely target assets tied to:

• High impact use cases
• Clear product-market-fit
• Dominant market positions
• Committed and capable teams
• Strong profitability
• Strong value capture

We are left with an abundance of opportunity In the wake of years of irresponsible behavior by market participants and a natural evolution of Web3 as an industry. This environment allows for a high degree of selectivity for discerning investors focused on fundamental excellence.

We are at the helm of this paradigm shift, guiding the trajectory of digital asset investing towards a future that is as stable as it is promising. This new epoch invites us to ponder not just the present value of select digital assets, but the immense potential they harbor for the future.