Magma Partners Q2 2023 Investor Letter

August 1, 2023

February 23, 2021

We send quarterly investor letters to our LPs about what we're seeing in the Latin America startup market. We share edited versions with our portfolio. We’ve decided to share a further edited version publicly.


Magma LPs,

Hope you had a great Q2. In this letter, we’ll cover:

Lots of pain in the startup market, but some potential first signs of improvement

  • The VC market is potentially 33%-50% through its reset. Scarce capital, efficiency over growth, still 6-12 more months of resetting.
  • First potential good news with low inflation, surging NASDAQ up ~40%, but lots of risk in the system.

You can lead a horse to water, but you can’t make it drink

Some founders still think they’re getting “screwed by the market,” that the 2020/2021 bubble was normal, rather than adapting to current market conditions.

Bad VC advice: “Show me the incentives and I'll show you the outcomes”

Some founders are getting bad advice from VCs and board members, we’ll explore the incentives and some of the reasons why

Characteristics have replaced Character

Many VCs have mistakenly used founder characteristics like where they went to university, where they worked, or pure storytelling, instead of using real founder character like grit, honesty, traction, etc.

Q2 2023 State of Latin American Startups: Lots of pain, maybe a bottom starting to form

Many of the 2020/2021 investors who were new to Latin America deployed huge quantities of capital extremely quickly, putting money into startups that were grossly overvalued, including some that never had a business model that made sense and likely never will. Other startups have real businesses with good unit economics, but were priced 10-50x higher than they probably should have been.

Unlike public markets, which have small daily ups and downs during a downturn, a private market reset is like a slow motion car crash. You can see that a car might crash for 6-18 months before it actually hits the wall. The startup finally crashes when it runs out of fuel and needs to raise a new round in non-bubble market conditions.

This slow motion reset is happening now. It’s hitting companies that didn’t find product-market fit fast enough or have bad unit economics. It’s even hitting startups with great business models, but are still burning too much money. Our estimate is that we’re only 33-50% through this slow motion car crash. 

There are still many companies that have not needed to raise new capital yet and don’t have a business model that makes sense, or are still burning too much money. They will come to market in the next 6-12 months and get repriced at today’s non-bubble valuations.

On the other hand, there’s a hint of a bottom forming because:

  • The NASDAQ is up ~40% from the bottom
  • Inflation seems to be coming down in most of the world’s major economies
  • US interest rates seem to have stabilized
  • More people are thinking there could be a soft landing, although there’s warning signs in China and with US personal, real estate and corporate debt

Even with this good news, it’s going to take longer to find a real bottom and then start a recovery. There’s also additional storm clouds on the horizon of the global economy that could make this recovery slower, or not appear at all. The rebound from the bottom will take even longer in Latin America than the US because:

  1. Private market valuations and capital deployment take awhile to adapt to new market conditions
  2. Many of Latin America’s biggest startups haven’t reset yet, postponing fundraising until 2024

Those that couldn’t cut burn or were overconfident about their raise are having to raise money now at what might be close to the bottom, others will come to market in the next 6-12 months.

  1. Once startup valuations reset, VC portfolio valuations reset, which resets LP valuations

This whole process takes a few quarters to work through the system.

US venture capitalist Fred Wilson correctly called the top of the market. He is now calling the beginning of the end of the reset. He believes that the startup ecosystem will start to see improvements in “the next couple quarters.” 

Latin America will likely lag the US startup recovery by another “couple” quarters, making the first real chance of a Latin American recovery to be in 4-6 quarters, or the 2nd half of 2024. The big US money likely won’t come back until funds with PTSD from bad bubble investments work through the reset and get conviction back to start deploying in Latin America again.

“Riding out the storm” vs. today’s market is closer to normal market conditions

When we talk about a recovery, we are not talking about going to the 2020/2021 bubble valuations, the pace of investment or increased company formation. We’re likely going back to more normal historical public market multiples, and 3-4 year VC fund deployment cycles rather than bubble-boosted 1-2 year cycles. At the end of the reset, everyone will agree with us again that entry point valuations actually matter.

We have consistently written that current market conditions are much closer to “normal” and that the 2020/2021 Zero Interest Rate Policy (ZIRP) induced bubble was an anomaly.

Unfortunately, some founders and VCs still blame “bad market conditions” for their startup’s inability to raise money, or for having to raise at significantly lower valuations than they expected. These founders and VCs are anchoring expectations to bubble valuations or all time highs. Not the real, intrinsic underlying valuations that are based on the historical norms.

Those that did not adapt fast enough are paying the price. It is true startups that need to raise now are being harmed by market conditions. They’re likely raising with the market bumping along a potential bottom. But they also didn’t adapt and the market is punishing them for it. Current rounds might be ~20-50% cheaper than the “normal market” once we start to get a recovery, but it’s unlikely we’ll get back to bubbly rounds with 5-10x higher multiples than we’re seeing today .

As you’ve read in our LP letters, we have advised founders since 2020 that the market might turn, and that they should cut burn, extend runway and become more capital efficient in order to control their own destiny. But it can be extremely hard to change what “worked” (or seemed to work) for the past 15+ years during ZIRP to move to a brand new model. 

But you have to do it. Learn on the fly. Those that did are in a great position. Those that didn’t took extra dilution, or maybe didn’t even raise at all. Some are out of business or will be soon.

Bad founder and VC advice: “Show me the incentives and I’ll show you the outcomes”

As Charlie Munger, Warren Buffet’s longtime business partner, says, “show me the incentives and I’ll show you the outcomes.” Some founders made and continue to make suboptimal decisions because of their own misaligned incentives. 

Other times founders made decisions based on their VC-board member’s advice, even if that advice might not be completely aligned with what’s best for the company. Many VC incentives push founders to try to maximize for the largest potential terminal valuation, but an overall lower risk adjusted return for founders and investors by pushing startups to grow inefficiently. These VCs need $1B or $5B outcomes or they don’t return enough capital to LPs and likely go bust.

Some board members were not doing their jobs. They were inexperienced, lacked training, or didn't have the background to know how to give good advice. Others who should know better were asleep at the wheel. Sometimes founders only listened to the advice that they wanted to hear. If they could find a board member that would tell them they could avoid the hard choices, they took the path of least resistance.

It’s easy to give the advice some founders want to hear: ‘Don’t cut burn or employees too much, keep pushing, let’s get to $XM ARR and we’ll be able to raise our next round,” even if that raise is unlikely. Some board members mistook being “founder friendly” for telling founders what they wanted to hear. Telling founders what they want to hear is the exact opposite of founder friendly.

Other VCs were following their own self interest: they pushed startups to keep going, pedal to the metal, in hopes that the company would thread the needle and be a huge winner, or that the company would be doing well enough that the VC could invest more on market-depressed terms. Some VCs likely thought to themselves, “heads I win, tails you lose,” and acted accordingly.

We serve on startup boards across our portfolio that have a big mixture of experience, intelligence, and skill. It really matters who is on the board. Some board members are great, others are awful. More often than I’d like, we find ourselves fighting against the tide of bad VC or board member advice. And founders, especially less experienced founders, don’t know how to sift the good from the bad. This bad advice is still happening now.

This isn’t to say that Magma never gives bad advice. We do. But on balance, we have been ahead of the curve.

Broken Incentives: “Heads I Win, Tails You Lose”

There’s are three big broken VC incentives that feed into each other in a negative feedback loop:

  1. Increasing VC fund size = more management fee

Fund size has expanded exponentially during the bubble, driving higher management fees, which made returns less important to some VC’s personal compensation.

  1. Increasing VC fund size = VCs need bigger exits to return capital to LPs

Bigger funds need bigger exits. Even a $1B exit does not move the needle for most $500M+ funds.

  1. Go decacorn ($10B+ valuation), or go home

Large fund VCs push ever more risk into startups and potentially kill a $250m or even $1B exit in hopes of a low probability $10B exit that could end in $0 for the founder and early investors.

These misaligned incentives are driving many of the bad decisions we saw during the bubble and now again during the reset.

The Original Sin: Characteristics have replaced Character

Brain Koppleman, Billions co-creator, said on his podcast he had a clear view of what Billions would be about:

“We wanted a show…about the way in which characteristics stood in for character. How high IQ, verbal acuity, charm and power stood in for qualities of character. [People have] a fundamental misreading about what matters.”

He wanted to unmask this misunderstanding for the whole world to see. It’s not only a problem on Wall Street. It’s a problem in politics and even in venture capital. Characteristics are standing in for character.

Characteristics like where you went to university, what company you previously worked for, verbal acuity, charm and in some cases your gender, race or class, replaced character: moral fiber, vision, strength, execution, traction, metrics and more.

Characteristics over character explains a lot of what has happened over the past few years in VC, especially in Latin America.

Where you went to university or your last job meant much more than your underlying business metrics, if you had founder/market fit, or even knew how to do anything other than tell a good story. 

Huge top line revenue with broken unit economics got rewarded if the founder could tell a great story. Efficient, high net revenue companies solving real problems were left to fend for themselves. 

A US VC passed on an extremely high character underestimated founder with amazing traction, great unit economics, great growth recently because “the founder lacked ambition.” That VC was ignoring character and optimizing for characteristics.

Many founders optimize for characteristics over character too. They looked for quick, sugar-induced wins, to appeal to characteristic driven VCs, rather than building real businesses that solve problems and can make money some day.

They built complicated, wonky, unwieldy structures to be able to say in the press they “achieved unicorn status” rather than taking a lower valuation on a clean deal and focusing on building a real business. Founders were also looking at characteristics rather than character.

The VC ecosystem beatified companies that were lighting billions on fire. Founders followed the money and followed the ZIRP-induced, broken playbook. Founders saw VCs reward characteristics, not character. We saw a feedback loop of ends justify the means, terrible unit economics and sociopathic behavior feeding on itself that resulted in an ecosystem that lost its way.

Building great companies fell out of fashion. Raising the next round on an “up round” was in fashion. We hope that this reset starts to prefer character rather than characteristics. If it does, we’ll have a better, healthier ecosystem and we’ll be more likely to solve more Latin American problems using technology. We’ve been talking about character over characteristics for a long time and explain more in our Latin American Underestimated Founder Guide. We love investing in a scarce resource: founders with character.

A couple quarters of pain for inefficient companies, opportunities for investors

The next few quarters are shaping up to be extremely hard for companies that are burning too much money, no matter their stage. 

There are very few funds that are willing to write a check into a seed stage company that is burning like a Series A company. There’s even fewer that are willing to invest in a Series A company that is burning millions of dollars per month, even if that company is growing 2x per year or better. Most funds would rather see a company burn much less money and achieve lower growth, rather burn huge amounts of money to achieve inefficient higher growth.

Startups need to grow. That's why we invest in them. But they need to pair growth with great unit economics and a business that makes sense. Inefficient startups either don’t raise money or take excessive dilution. We expect to see more pay to play, multiple liquidation preferences and structured investment rounds between now and the end of the year.

We’re likely bouncing around the bottom now. Things will likely get better in the next 12-18 months. Getting better does not mean going back to the crazy bubble days of 2020/2021. It means more normal multiples, maybe 20-50% better than today at scale. At the same time, we are on the lookout for more macro uncertainty that could make the comeback even slower.

It also means that many VCs that do not return capital, or invested it into high valuation, growth at all costs companies, or don’t have a unique point of view, are likely to struggle over the next 2-3 years. Some will not raise new funds.

For VCs, It’s money (cash returns, DPI) over everything.

Our advice to founders is the same: control your own destiny, keep growing, but don’t push to grow faster if it means bad unit economics. If you have good numbers and want to top up your cash in the bank, think about testing the market in the Labor Day to Thanksgiving fundraising window (September to late November for the non US audience), and if you don’t get an offer you like, you can always come back to market in Q1/Q2 2024. Control your own destiny so you’re not forced to take a market-bottom priced deal.

If you can avoid raising until next year, you will likely have a better chance of getting a better valuation and for markets to be more open for business. But it might even take until Q3/Q4 2024, even if inflation stays down, interest rates stay more or less where they are, the stock market stays near all time highs and the US market conditions keep getting better. So many funds that deployed at Latin America bubble peaks are retrenching, even as true underlying fundamentals get better.

The companies that make it through this reset are well positioned to win for the long run. Latin America’s next generation of tech-enabled winners are being built right now.


Nathan, Pedro, Mak, Francisco and the Magma team