Felipe Montealegre: Analyst of the Month

What is your story? What was your journey into investing and into crypto?

Like many people in the Artemis community, I had an entire past life in traditional investing before moving into crypto. I covered banks and insurance companies as an Investment Banking analyst and spent seven years in mid-market buyouts focused on healthcare and financial services. I was consistently working eighty hour weeks and didn’t know much about the industry until 2021, when the firm I was working at started looking at a few growth deals in the space. I picked up some of the basic industry reading as part of the deal process — Bitcoin Whitepaper, Vitalik’s essays, Balaji’s podcasts, you know the drill — and was completely captivated by the idea of creating a faster, cheaper, better financial system that could scale to the entire world. I started working on launching a fund with John within the year

How did your time in private equity at Baypine and JLL Partners shape your mental model when it comes to liquid token investing?

I spent seven years doing mid-market buyouts before moving into the space, and it profoundly impacts the way I invest. The time John and I spent in private equity has been the single most important determinant of our strategy. We take large positions in small cap tokens in underexplored parts of the market and work closely with management teams to add value. We value companies based on fundamentals and intrinsic value as defined by a discounted cash flow analysis. We like to hold to see our investment thesis play out over 1 - 3 years. We seek to avoid anything that could jeopardize the long-term success of our firm. We do not put on portfolio leverage; we do not time markets; we do not go short. We look for proprietary deals and manage a relatively concentrated book for ten to twenty positions. These are all widely respected and often cited ideas in the buyout industry.

We think of ourselves as capital allocators and attempt to add value to our markets. This means we look to fund undervalued tokens with exceptional teams building good projects in large markets. You can’t add any value by funding mediocre projects or allocating capital to tokens that are already appropriately valued (or even overvalued). We understand the real-world impact capital allocators have on resource markets and have respect for our profession. This is another idea from mid-market buyouts. You learn to see yourself as an active participant in an inefficient market. You can make the capital allocation mechanism a little bit better or worse depending on the quality of your work.

I could honestly continue listing the parallels for a long time. The one thing that I’ll add is that I do believe these are basic principles for long-term investing. You see the same principles when reading legendary investors like Warren Buffett and Joel Greenblatt. Investing in good companies at attractive valuations is a good way to build wealth for investors over a long career.

What lessons have you had from launching your own liquid token fund?

We have learned enough lessons for a small book so I’ll try to keep this to the more interesting and broadly applicable lessons.
- Flexibility. You need to be flexible when running a liquid strategy in the space. Starting a liquid fund in this space means entering a solution space that is mostly unexplored while investing in an industry that’s evolving at a violent pace. It’s quite different to investing in an established industry — e.g. you are starting with a complete solution if you open up a mid-market buyout shop. You may refine an investment thesis so you are uniquely good at, say, automating pharma and med device manufacturing businesses but, for the most part, you bring a full solution set from the industry to bear when building a firm and establishing best practices. That’s not where we are in this industry at all. There is no established method for building a liquid token fund yet and you must constantly explore the best solutions. You are solving a rugged landscape optimization problem and need to constantly do more of what works and less of what doesn’t in order to continue improving. We have refined our strategy over two years through significant exploration and iteration. Operationally, we have continuously evolved to make our fund increasingly safe and efficient. Today, we are very excited about both, and given how quickly the industry evolves, we are always seeking to optimize within critical parameters.
- Focus. This industry is filled with exciting investment opportunities — VC deals, airdrops, LP yields, points, infra narratives, etc. — and it’s easy to get distracted. We believe in the idea of investing within a circle of competence — a set of topics and companies that you know better than 98% of competing investors in the space. We are not smarter than 98% of investors in the space so we can only achieve this type of expertise through focus. Our circle of competence is comprised of good, cash-flowing businesses building the Internet Financial System. A circle of competence is a tool that works via-negativa. It is not valuable because it tells you where to focus, but is instead valuable because it tells you where not to focus. We don’t spend our limited resources on VC, infra, DePIN, structured products, fixed income, NFTs, or many legitimately exciting investment opportunities because of our principles around focus. We believe many investors will do well in these areas, but those are investors who are focused on those areas and know them better than anybody.
- Small is beautiful. A smaller fund allows you to invest in small and mid-cap opportunities that are not accessible to larger funds. This is a proven strategy in traditional markets. It helps you play in markets with less competition while benefitting from a strong network and circle of competence. In general, we think there is a competitive advantage to focusing on quality and returns over headcount and management fees.

What are the differences between how the equity markets work today and the liquid token market?

US equity markets are relatively efficiency and well understood while liquid token markets are inefficient and poorly understood. The inefficiency is one of the reasons we love the token markets. You can find good opportunities by working hard and doing extensive diligence.
There are many structural reasons for this market inefficiency. There are hundreds of small cap tokens and the underlying technology is evolving quicker than most people realize. There is more data and public information on small projects than any one fund could properly digest. Take our recent investment in Lyra as an example. We have underwritten the onchain options market three times in the last eighteen months and found the market to be completely different each time. The market was comprised of Option AMMs on Ethereum Mainnet in mid-2022 and is now made up of custom rollup chain orderbooks that settle on Celestia. That’s like seeing the advertising industry go from newspaper to search in eighteen months.
Currently, there are hundreds of small and midcap tokens for early-stage businesses growing under the backdrop of Cambrian technological evolution and dramatic price volatility. Meanwhile, there are only a handful of fundamental funds to process all of this information into thoughtful predictions and investments.

You publish research memos in the open like your pieces on Lyra, Metaplex, Houdini Swap and Unibot. What advantages have you found from sharing fundamental research out in the open? I saw you posted an active model on Lyra — how do you think about that?

We appreciate the open source culture of the industry and believe it has many advantages over the traditional model of keeping all research within the confines of the investment firm.

Publishing research allows you to test ideas against believable adversaries. Ideas and predictions benefit from feedback and counterarguments. The Investment Committee process is meant to subject an idea to critique, so why not expand the set of believable adversaries by one or two orders of magnitude by posting research and inviting people to disagree?

We also believe that a culture of open source research leads to more intelligent markets and better resource allocation. There is a powerful process of natural selection in the marketplace of ideas — i.e. best ideas are repeated and survive and worst ideas are removed from circulation — but this is an active process that requires applied intelligence, honesty, and effort. Good research helps to move this process forward.

There are a few practical considerations as well. Posting research helps us build our industry presence, support portfolio companies, and even source new deals. We also find it exciting and rewarding to share our work with our colleagues. We have all spent too many hours pouring our heart into presentations and models that are saved on a OneDrive and never seen again.

Any lessons / post-mortem on the Houdini Swap investment? 

Yes. The investment has gone well and highlights our underwriting approach, so I can give you the full case study. However, this is an active hold for us so we believe there is a lot more to come for this team.

Business Overview. Houdini Swap allows users to send private transactions within and between blockchains. There are many onchain actors that need this service. Investors don’t want their strategies and transactions to be fully public. DAOs that pay engineers onchain through USDC don’t want all employees and contractors to be able to see how much other employees and contractors are being paid. There are more and more legitimate use cases for privacy as the Internet Financial System grows. Houdini Swap also serves as a bridge, allowing users to trade between tokens from various blockchains. The current landscape of bridges is cumbersome and prone to exploits and Houdini Swap offers a pragmatic solution for people transferring value across chains.

We believe compliant privacy technology is essential to the development of the Internet Financial System. Importantly, Houdini Swap works with OFAC-compliant exchange partners that monitor for sanctioned entities, providing both privacy and compliance. This sets Houdini Swap apart from many competitors who adopt a cypherpunk philosophy and do not comply with applicable privacy and compliance requirements.

Sourcing & Deal Process. We sourced Houdini Swap through one of the project’s early backers. We had built a relationship with this incubator over many years and they suggested we meet with Houdini Swap based on our strategy and investment criteria. We purchased Houdini Swap tokens through an OTC deal directly from the protocol treasury and negotiated with the protocol’s team. This is a common deal structure for us as it allows us to invest a substantial amount of capital in a small cap token without moving market price.

Our diligence questions revolved primarily around the market, team, quality of earnings, and compliance. On the market, we were able to verify the need for compliant privacy applications by honest participants. We closed this deal soon after Tornado Swap had been closed down and verified that Houdini Swap could 50x revenue by estimating Tornado’s compliant volumes. We typically prefer to invest in challengers that can grow substantially without having to forecast market growth. We did a fair amount of work around Houdini Swap’s token and confirmed the mechanism by which the team was taking 50bp fees from each transaction and using them to buy back tokens on the open market. We diligenced Houdini Swap’s quality of earnings to come up with a run-rate high quality cash flow estimate of $840,000 per year at the moment of our transaction. Finally, we did extensive work on the team and Houdini Swap’s compliance with applicable laws, including multiple conversations with lawyers and an in person meeting with the management team. We were able to complete this process over the course of ~14 days.

Valuation. We made our initial investment in Houdini Swap at a fully diluted valuation of $7M on run-rate cash flows of $840,000 per year. This implies an entry multiple of 8.3x for a business that had grow monthly volumes from <1M to over $11M over the course of a year. This is exactly the type of investment we like to make: (i) good team building an important product in a large market with (ii) strong existing cash flows to support its valuation and (iii) impressive growth metrics that suggest continued future growth. Today, Houdini Swap is seeing over $30M of monthly volumes and earnings over $2M of annual cash flows.

Value add. Our strategy with portfolio companies is to meet regularly and be a resource. We set up weekly calls and try to supplement the management team however they want us to help. The HoudiniSwap / xBlock team is excellent and has continued to impress us. Since we have worked together, they have transitioned their business to become a privacy infrastructure business instead of just a front-end exchange (transition to xBlock). They have consistently improved swap infrastructure, re-written and improved compliance policies and procedures, rebranded HoudiniSwap and xBlock, and are about to launch a new token with very compelling tokenomics. We are very excited to continue to support this team as they execute on their roadmap.

What do you think most investors get wrong about digital assets?

I would say there are relatively too many players focused on short-term games in a long-term industry. There is so much focus on narratives, cycles, flows, market timing, and minute-by-minute candles. There are certainly many ways to earn good returns and these strategies exist in most markets, but I do believe the long-term approach to this market is under-competed and wide open for anybody who wants to come in. Specifically on the liquid token side as the liquidity can be very distracting.

Our fundamental thesis on the industry is that we are moving from a world where less than <1 basis point of global financial activity happens on blockchains to a world where the vast majority of global financial activity happens on blockchains. It’s not only us — many people in the industry believe this. So what’s the right strategy in that type of setup? We think long-term. Build a good reputation, avoid ruin scenarios, carve out a unique circle of competence, focus on fundamentals, and cultivate lasting relationships.

We had a good conversation on stablecoins and why you believe they can be a breakout application. Would you mind recounting that reasoning? 

Yes, I believe the USD stablecoin opportunity is one for the history books. Look at money supply growth around the world from 1970-2020 and you will that anybody who saved in local currency outside of the US, Europe, and Japan was diluted at a pace of >15% per year. The reality is that most people do not want to save in local currency, but opening a US bank account is cumbersome and prohibitively expensive for the vast majority of people in the world while holding local currency is easy. Stablecoins change this dynamic because you can self-custody USD on your phone.

We expect stablecoin market cap to grow into the trillions in this coming decade. It won’t be a straight line and there are many issues to work through before we can get there. The US needs to pass a comprehensive stablecoin bill, and it will because exporting the US dollar is and has always been treated as a political good, and blockchains need to continue scaling to handle this level of throughput. We will need a few adoption catalysts to increase the number of people who know how to self custody assets and use PKI infrastructure (e.g. using wallets and signing transactions). This will all take a little bit of time but it’s like chipping away at a dam. There will be some moment — maybe Apple and X integrate USDC — and then it’s off to the races.

The stablecoin thesis is a bit like the original BTC thesis but you don’t need to predict changing consumer preferences. There are billions of people in the world who desperately want to hold savings in USD but don’t have a way to do it. Our prediction is that this tacit demand will be met by the market now that the technology is there.

How have you been able to use Artemis in your fundamental research? 

We use Artemis constantly. We often use Artemis to peak at core blockchain metrics — active addresses, transactions, fees — and how they have been trending relative to peers. This feature helped us deploy additional capital into the Solana ecosystem last year. 

We are also constantly refreshing our view of the Perps and DEX sectors using Artemis data. These are two of the most important and competitive sectors in the market, and they are both constantly changing. You can see these changes in real time through real time metrics on traders and volumes.

Artemis has the best stablecoin dashboards that allow you to see the market breakout between stablecoins (e.g. USDC vs. USDT) and between ecosystems. This dashboard has been receiving some good publicity as Solana has grown to become the largest stablecoin ecosystem by transfers.

We spoke about market inefficiency earlier and how it impacts resource allocation. The market would be lost without good data providers like Artemis to help fundamental funds understand data in real time.

You can find or reach out to Felipe on Twitter or LinkedIn
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