Seeking Alpha: Thesis Driven v. Thematic Investing

As noted last week, Investment Filters establish boundary conditions for investment. Investment Filters conserve energy both for investors and entrepreneurs by quickly eliminating over 90% of investment opportunities.

But Investment Filters say little about where or how funds actually invest. Seed stage funds focus on Founder Fit. Growth stage funds focus on Product Market Fit and are metrics driven investors. Both strategies enable investors to deploy capital across many sectors that meet common investment criteria.

As the venture industry has matured, many firms have taken a more targeted approach to investing. Two popular focused approaches are thematic investing and thesis driven investing. Thematic and thesis driven investing are sometimes used interchangeably, but they are different disciplines requiring varied skillsets and fund management approaches.

Thematic Investing

Thematic investing involves investing in specific industries or technology areas. Examples include artificial intelligence, generative AI, marketplaces, digital health, fintech, social media or robotics.

Thematic investing has several advantages:

· Thematic investing is readily understood as many firms across the financial industry have industry practices. With this approach, partners specialize in specific market segments and develop a portfolio of investments within that sector. NGP Capital and other large, distributed funds use thematic investing to coordinate activity and leverage insights across regions.

· Investments within themes share common characteristics. Pattern recognition and synergies across investments are readily identifiable.

· Networks form around industries and themes. Deep industry networks augment deal sourcing, due diligence, recruiting executive talent, securing partnerships and funding for portfolio companies, and exit strategy.

· Sector expertise established by thematic investing is readily appreciated by entrepreneurs or other investors. Prior investment success unlocks virtuous cycles enabling investors to win contested future deals in the sector.

Yet thematic investing raises three challenges for fund managers:

· If narrowly defined, thematic investing produces portfolio concentration that increases systemic risk. Fund performance is more volatile when a fund has portfolio concentration in sectors that run hot or cold. Portfolio risk is particularly high when thematic investing chases after hot sectors.

· Running multiple investment themes may silo fund activity. As teams develop deeper expertise within their themes, communicating insights to other thematic teams becomes more difficult.

· Thematic investing may cause investors to overlook new, high potential venture opportunities, which rarely fit within previously defined themes.

Thesis Driven Investing

When funds describe their rationale for an investment, they often articulate an investment thesis supporting a startup and sector. Thesis driven investing extends this approach to a fund level commitment for a family of prospective investments.

Thesis-driven investors commit all or a large portion of a fund to investments that support a foundational idea or set of core beliefs about how trends or technologies will play out in the market. This thesis guides their investment decisions, focusing on specific trends they believe will yield high returns.

Fund managers use thesis driven investing as a strategy to generate alpha — investment returns that consistently exceed venture vintage benchmarks. Thesis-driven investing may produce superior returns for distinctive insights that are timely, widely applicable and yield a new class are high potential startups. But that is a high bar and thesis-driven investing underperforms if the insight is off on any one of those dimensions. In Superforecasting, Tetlock and Gardner concluded from a thirty year study that the best performers were generalists guided solely by the data without preconceived points of view.

Nonetheless, several highly successful investors have used thesis-driven investing effectively. In the 1990s, Vinod Khosla bet against telco incumbents investing in several successful networking startups including Juniper Networks, Cerent and Siara. Andreesen Horowitz has prospered on the view that “software is eating the world.” NEA has successfully invested across dozens of verticals leveraging its thesis on the digitization of traditional industries. Union Square Ventures was an early proponent of web services. Sam Dogen’s heartland real estate investment thesis in 2016 proved prescient with the onset of COVID but for different reasons than he had originally surmised.

Thesis driven investing may apply horizontally across many different industries as the examples of NEA and Andreesen Horowitz illustrate. Broadly applicable investment theses reduce portfolio concentration risk of thematic investing but requires judgment to discern relevant boundaries and resist overstretching the thesis.

Thematic and Thesis Driven Investing: Complementary Strategies

It should now be evident that thematic and thesis driven investing are different practices.

Thematic and thesis driven investing, though different, are complementary and can be deployed by funds concurrently. Both strategies attempt to differentiate firms in a competitive market by developing expertise, investment insight, and added value through pattern recognition.

Thematic investing helps build tight networks and gather intelligence that yields insights prerequisite for thesis-driven investing. Investment theses reinforce the open mindedness needed to exploit new opportunities that emerge beyond the narrow confines of thematic investing.

Thesis-driven investing yields alpha only if insights are meaningful, timely and distinctive. Thesis-driven insights may be short lived as they rarely remain proprietary or undiscovered for long. When proprietary advantage from an investment thesis dissipates, thematic investing sustains networks and expertise required for the next insight.

At NGP Capital, thematic and thesis driven investing have been complementary strategies for the past two decades. One example is our local services investment thesis that emerged from our mobility theme. With the advent of the smartphone in 2007, my insight that location is to smartphones as search is to the Internet led to several early-stage investments in startups that subsequently became unicorns, including Lime, Waze, Moovit, Ganji, UCWeb, Deliveroo and GetYourGuide.

Over the past twenty years, our best investments have from thematic investments that leverage thesis driven insights that are timely, distinctive, and apply across a broader range of investments.

Related Concepts

Investment Filters set boundary conditions and describe a not-to-do list for investments. Investment Criteria establish the characteristics sought in potential investments. Thematic and Thesis Driven Investing goes a step further and defines where and how to hunt for potential investments.

The Consensus Contrarian Matrix reminds investors that alpha derives from contrarian investing. It is easy to be contrarian and wrong in highly competitive markets. Thematic investing is a way to establish a Circle of Competence over time. Thesis-driven investing requires expertise that yields timely, contrarian insights. But Superforecasting reminds us that metrics ultimately matter more than a firmly held point of view.