From the Lumikai Desk: Macro-economic Observations, Gaming & Web3
12 months ago it became clear to us that our worldview was different from that of others.
In January 2022, we decided to document our concerns in an internal memo to our portfolio companies in the wake of the frothiness, cheap liquidity, and excessive risk-taking in global markets. In this memo, we detailed certain leading indicators of unsustainable growth across asset classes, especially private markets and new markets such as crypto. Much of what we expected is coming true now, and as the music slows down, we felt it’s a good time to make this note public.
From the Lumikai Desk:
2022 has opened with a tumultuous month, and everyone has their eye on the global public markets correction. Below we share some insights/research. Hopefully, as you project your capital needs for the year ahead this will assist your decision making and financial planning.
The Big Picture
A macro-economic correction is inevitable in our reckoning. The top 5 developed economies now have a combined fiscal deficit of $7 trillion i.e. 12% of GDP. Governments across the world have been spending money indiscriminately without concern and consequence. At the same time, we have for the first time in the last 50 years, seen inflation increase to 5.8% in OECD economies with sovereign interest rates close to 0%. This has been very kind on borrowers in the Western markets. This has meant that across the world people/households have been largely leveraged and that capital has been following into public equities, alternative assets (e.g. venture capital, PE, hedge funds) and newer assets (like cryptocurrencies, NFT’s, Web 3.0) in the search for high-yield.
This is evidenced by the highest margin debt to GDP in history of the US i.e. 4.5% (previously in tech crash and the real estate bubble it was 3%). To put this number in perspective, it is important to understand this number. Margin debt is essentially what people borrow to invest in the stock market. US market capitalisation is now 125% of US GDP (it was 200% of GDP in July ‘21). The current mismatch between equity market cap and GDP is the highest and longest lasting of the last 50 years.
This implies that the rallies of the last 2 years have been driven by free cash provided by governments and levered individuals who have taken on borrowings to invest in risky assets. A lot of this new FII capital (also evidenced by the emergence of new hedge funds, rapid PE fund raises and emergence of new micro VC’s) has now also been directed to the India market which explains the liquidity rush and all-time highs of the Sensex. However, needless to say — the Indian markets are the most expensive markets in the world i.e. trading at an average of 26x price to earnings. While the above data can each be individually rationalised, we believe that the market is in the last stage of a “vampire rally” before an inevitable correction.
Why Should You Care?
At the moment there has been no high-profile mascot of a crash which could push markets into sell-off and panic, so there is still time to plan capital conservation strategies. In ’99 it was the implosion of Pets.com and ’08 it was the Lehman crash which finally led to the big capital freeze. However, prior to ’08 there were already enough signs of problems e.g. Bear Stearns and Northern Rock in ’07. Similarly, the malaise is showing. In 2021, there was a hedge fund which quietly imploded- Archegos and lost $30Bn in 2 days. Oil is trading at $100/barrel, ethereum money markets have seen record liquidations and 75% of the 137 SPAC deals last year have dipped below their listed price.
Market sentiments can change very quickly when a lot of trouble starts getting announced together. That being said, private markets lag public markets usually by 6–8 months. Also, the last 2 years of easy liquidity has meant that venture capital funds are sitting on enormous dry powder which may not curtail private funding.
But if LP public portfolios start getting hit, then venture capital and private equity in turn will pursue more conservative strategies. Risk appetites will reduce and there is typically a return towards value, unit economics, second time /experienced founders, familiar and low cash burn businesses, and profitable growth alongside less desire for experimental ideas. We anticipate valuations will start being impacted in a downward trend.
Gaming/Interactive Media Is Counter-Cyclical
Traditionally, in our experience gaming has proven to be counter cyclical in times of market downturns. Large strategics are typically extremely cash rich (with little or no debt) and as such the sector rarely faces liquidity issues. In fact, we foresee that the current wave of M&A consolidation is likely to continue.
In addition, for the first time in the history of games investing, there are 30+ dedicated global gaming funds with ample dry powder and a keen eye on India, hence even if domestic capital on gaming dries up, exceptional teams with sound metrics will always be in favor.
Also, while absolute valuations do decline when markets turn, typically gaming companies i.e. content companies which are revenue generating tend to thrive due to games providing a higher value to price proposition.
So if you are a games/ original IP developer with revenue, then we recommend doubling down on your games, building genre focus, tweaking performance marketing to focus on profitable unit economics and creating a steady pipeline of new games.
If you are in the process of developing games and content or original IP and are not revenue generating, then our advice is to budget for an 18–24 month runway. If that’s not the case, then its a good time to start thinking of accelerating capital raises as investor appetite for funding content which is not monetising or showing exceptional early retention metrics may prove to be difficult when risk appetites shrink.
For platforms, some of you are well capitalised and this a good time to plan out product roadmaps, managing cash burns and focusing on capital efficiency. Typically, if valuations start trending downwards, there will be overall pressure to grow into priced valuations without excessive cash burn. Monetisation plans could be accelerated.
Bottom line — if you are in the midst of raising a round, optimise for capital and not valuations and close rounds faster. If you are not looking to raise, then budget cashflow to survive 18–24 months or alternately accelerate funding conversations. Some of you are very fortunate to be well capitalised because there is no better time to focus on building and creating a product fortress. The silver lining in a down cycle is the talent wars may abate as there will be inevitable company lay-offs and often high caliber talent can be easier to attract and retain.
Metaverse, NFT’s & Web 3
The extreme hype and noise around metaverse is on top of all our minds and this deserved a special mention. Our perspective is that digital identities need to become “worth more” than our physical identities for the metaverse to become a reality.
When there is no clarity on what the Metaverse means (is it virtual concerts with digital influencers, is it an interoperable set network of 3D worlds, is it communication tools like Discord or Zoom, is it persistent, massively multi-player concurrent games, is it large parcels of virtual land or is it VR/AR led etc) and with each large corporate building it’s own version of Metaverse, it has now become a free for all interpretation of who can promote the most Web3 propaganda.
As investors, we are cognisant that the past is not an indicator of the future. However, we wouldn’t be doing our jobs if we didn’t perhaps share some of our own experiences. This current hype cycle around Web 3.0 is eerily reminiscent of the VR gold rush from 2014–2016.
Large corporates got on the VR bus — FB & Social VR; Google with Daydream ; HTC Vive, Microsoft Hololens. There was unprecedented VC interest in VR peaking in 2016 seeing $4.5Bn being pumped across 1,179 deals. There were many front runners for the VR race — Magic Leap, Blippar, Daqri, Leap Motion, NextVR, MindMaze, Jaunt, Zspace, Meta, Lumus, Survios,Tangible Play etc commanding hefty valuations and raising large quantums of money. Many companies pivoted and rushed to add VR offerings to their original visions and the number of VR companies grow 40% in 2016 and 75% of the World’s Most Valuable brands announced VR projects.
However, multiple problems with the technology e.g. high price point, UI/UX complexities (design/weight of headset, motion sickness), lack of true gaming content, inconvenience of use and just general lack of user adoption, apart from early evangelists, made the VR dream fade quite quickly. This also left behind a graveyard of start-ups who couldn’t scale beyond the initial hype (including many of the multi-billion start-ups named above).
We find similar problems with the talks around Metaverse and NFT’s usage. The sad reality is that only 1% of NFTs sell for more than $1,500, > and 75% sell for $15 or less. The majority of these pieces don’t even sell. Creator led NFT’s have proven to be a dud with Tiktok NFT’s failing to even get off the ground. Projects like Sandbox have been populated with few users (30K MAU’s) and Decentraland (300K MAU’s) but are commanding hefty valuations. Similarly, P2E mechanics have yet to be proven out in the event of deflationary economies where now Axie Infinity earnings for scholars, on average have dipped below the minimum wage in Philippines as more users join. We also note that there are extreme financial barriers to entry — average buy-in to play P2E games ranges from $300-$500 making access difficult and structural barriers to play — there are 6 steps required to actually play an P2E game. P2E users are still largely crypto enthusiasts and mass market adoption is yet to be proven out.
In addition, NFT and game skin interoperability are incredibly hard to administer practically as technical challenges around cross-game asset compatibility are much steeper than most people realize due to different code bases, functions, game mechanics, aesthetics, narrative across games.
Most importantly, digital assets and digital IP’s are a 40 year old phenomena in gaming and you don’t need blockchain tech to solve problems that NFT’s say they will. Even NFT usage is fairly centralised, in October ’21 GMV of all NFT traded was $10.9B, with ~$9.3B coming from Opensea alone, across a small set of buyers.
Fun fact, Opensea has managed to capture ~85% of the GMV market share, with Cryptopunk being the only other exchange with any meaningful volume. So, ironically when the company itself comes out and states that 80% of NFT’s that are created for free are fraud or spam, then it’s worth listening to.
As avid gamers, while we are excited with the technological possibilities of Web 3, crypto and blockchain, we feel the hype needs to settle, the true believers needed to be weeded out from the speculators and the genuine use cases still need to be proven out (apart from pure novelty and bragging rights).
In times like this when capital is free and every other company is raising large rounds of funding on the mere mention of Web 3/NFT-it’s easy to get swept away with the noise.
Thus, we advise a word of caution when pursuing any Web3 strategies especially if it’s not core to your team skill set, expertise, original vision and thesis.
If you feel you have capital for experimentation, then we suggest maintaining strict budgets, focused management bandwidth and set criteria for user uptake and PMF before diverting complete attention to Web3 or undertaking pivots. Instead, we suggest that it maybe the right time to look at building the right internal culture, encourage product focus and smart, speedy execution towards your original visions without distractions.
Alongside the above, we keenly keep an eye on the evolving crypto regulation on the India market. The impact of the current taxation of 30% on crypto assets is too soon to call. However, the digital rupee is an interesting development which we will continue to track.
Conclusion
The above may read like a pessimistic world view. And we sincerely hope to be wrong. We do wish that the next 24 months will be like the last 24 months. We do hope the world never hits a bottom and capital continues to flow free. If that does happen, it will augur well for all of us.
We continue to remain optimistic on the future of India and long-term growth potential of the games and interactive landscape. We are honoured to partner alongside all of you for the next many years. However, we do feel that its best to prepare and face into some of these uncertainties in the near future head-on and focus on building long-term sustainable companies.
Some reference materials we found enjoyable -
1. https://naavik.co/business-breakdowns/axie-infinity
2. https://naavik.co/business-breakdowns/jan-2022-premium-sandbox
3. https://www.thetwentyminutevc.com/bill-gurley-michael-eisenberg/
4. https://moxie.org/2022/01/07/web3-first-impressions.html
5. https://www.profgalloway.com/web3/
6. https://onezero.medium.com/the-inevitability-of-trusted-third-parties-a51cbcffc4e2
7. https://investment-trusts.fidelity.co.uk/fidelity-asian-values/?p=0&c=10
