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Strategy insights Dissecting Web 3.0 for private markets investing: Misconceptions
June 21, 2023 | 10 min read
There is likely no sector more debated and polarizing with investors right now than cryptocurrency. But what is Web 3.0? What is it not? And why should private markets investors care?
Cryptocurrency, and the roller coaster ride its investors have endured, has been dominating headlines for the last several years. Beginning in August 2020, the digital token market saw a meteoric rise that lasted through much of 2021. Then, in 2022, the crypto market lost nearly two thirds of its market value, contracting by $2 trillion.1 Late last year, the FTX debacle materialized and investor confidence in the digital asset market was severely shaken. Despite what some have called another crypto winter, the digital token market is recalibrating and has rebounded back over $1 trillion in the first few months of 2023.2
Principal
Elliott is a member of the direct co-investment team specializing in disruptive digital technologies.
Yet crypto is actually only a small portion of Web 3.0, the name given to the decentralized ecosystem of users and developers building products and services utilizing blockchain technology. Much like the early days of the internet, blockchain technology is offering lower cost, more efficient, and more secure delivery of products and services by decentralizing commerce and removing the need for human intervention. Innovators and technology investors – including HarbourVest – remain enthusiastic about the many ways that Web 3.0 and its underlying engine, blockchain technology, are reimagining traditional analog business models and reshaping the delivery of a host of different products and services.
Read below to learn more about the current Web 3.0 landscape, the growing use cases leveraging blockchain technology, and how investors can begin optimizing the risk-adjusted returns of these disruptive technologies.
How a Blockchain Works
1
A transaction is requested
2
The transaction is broadcast to every party in the network
3
Those in the network approve the transaction as valid
4
The transaction is unified with other transactions as a block of data
5
The new block is added to the blockchain in a transparent and unalterable way
6
The transaction is complete
How a Blockchain Works
1A transaction is requested
2The transaction is broadcast to every party in the network
3Those in the network approve the transaction as valid
4The transaction is unified with other transactions as a block of data
5The new block is added to the blockchain in a transparent and unalterable way
6The transaction is completed
Misconception 1
Web 3.0 is all about digital tokens or cryptocurrency
Reality:
While cryptocurrencies have captured the limelight, Web 3.0 is an umbrella term often used to describe the growing number of companies making up the dynamic and diverse network of users and developers building products and services utilizing blockchain technology and digital tokens. While the rise in tokens over the last several years is a proxy for the broader innovation in the ecosystem and the exponential growth in users of Web 3.0, the token simply serves as a medium of exchange or representation of digital ownership in the blockchain protocol.
The fundamental innovation of Web 3.0 revolves around blockchain technology, which provides an instrumental upgrade to existing centralized digital ledger technology. Public blockchains leverage cryptography, distributed systems, and digitally native tokens to enable the exchange of goods and services without the need to place trust in a third-party or centralized intermediary. Blockchain systems can seem complex, but they are simply networks of digital tokens and underlying users. The network is powered by a decentralized group of computers running shared software that is programmed with algorithmic rules that govern the ecosystem. In short, mathematics and computer code replace humans as the arbiter of governance for a community of individuals, assets, or products and services. Advantages potentially include the lowering of costs to operate via the removal of third parties and better protection of user data via cryptography.
As the asset class matures, blockchain technology applications are extending their reach and disrupting current delivery structures in areas ranging from healthcare and supply chain logistics to banking and capital markets, or gaming, sports, and art. Traditional companies like IBM, Apple, or JP Morgan, along with technology innovators like Coinbase, Open Sea, or Anchorage Digital, are exploring applications of blockchain technology across a variety of different industries. Despite the pronounced volatility during 2022, institutional adoption remained strong with several large players continuing to launch blockchain initiatives.
Institutional adoption persists during 2022’s bear market
Entity
Market Validation
Entity and Market Validation
Fidelity
April 2022: Allows clients to invest in Bitcoin through their 401(k) accounts
November 2022: Launches retail crypto accounts, enabling trading and custody of Ethereum and Bitcoin.
BlackRock
June 2022: BlackRock’s Aladdin partnered with Coinbase to provide institutional clients with direct access to crypto, an access point that could potentially help usher trillions into the asset class in the coming years.
J.P. Morgan
September 2022: Executes first decentralized finance trade using public blockchain and launches Coin Systems, a new payment rail to support domestic and cross-border payments enabling clients to make programmable real-time, multi-currency payments using multi-bank shared ledgers.
BNY Mellon
October 2022: Launched crypto custody platform to safeguard assets for institutional investors. Touching more than 20% of the world’s investable assets, BNY Mellon could use Bitcoin to scale financial services cost-effectively.
MSCI
Goldman Sachs
November 2022: MSCI, Goldman Sachs, and CoinMetrics are jointly launching a new digital assets data system to provide institutional investors a standardized overview of digital asset performance based on their use cases.
Meta
November 2022: Meta and Instagram announce a partnership with Arweave to use the protocol to permanently store digital collectable data on the blockchain. Meta also announced the reveal and development of an end-to-end toolkit allowing Instagram users to mint non-fungible tokens on the Polygon (MATIC) blockchain and sell them on social media.
Source: HarbourVest, based on 2022 public company press releases.
Read more about companies that are disrupting the status quo:
Strike is leveraging blockchain technology to disrupt and re-think the existing business model for mobile payment providers.
Dynamic is leveraging blockchain technology to reimagine and strengthen the security of digital wallets.
A reference to a specific company does not constitute a recommendation to invest nor an indication that HarbourVest funds or accounts hold any specific company.
Misconception 2
Aside from speculation, there is no use for blockchains
Reality:
Web 3.0 and blockchain technology may seem a bit complex and esoteric, even speculative from an investment perspective, however, the technology driving the innovation simply represents the continuation of several decades of secular technological trends, including faster and cheaper computing power, the digitization of information, and network economies.
Web 3.0 represents the third iteration and the monetization of internet-based protocols. Web 1.0 (roughly 1990 to 2005) focused on open protocols that were decentralized and community governed. Web 1.0 has often been referred to as “read only” with users consuming analog content through a digital medium. Web 1.0 was revolutionary in that it provided an electronic platform that removed the geographical restrictions associated with brick-and-mortar businesses.
Web 2.0 (roughly 2005 to 2020) introduced the ability for users to create and share content, and the proliferation of mobile devices further expanded access to the internet. Web 2.0 was about siloed, centralized services run by corporations—largely on mobile devices—where the lion’s share of the value accrued to a handful of companies like YouTube, Apple, Twitter, and Facebook. The monetization model of Web 2.0 is based on selling advertisements and capitalizing on the large volume of users that leading platforms attract. Due to the network effect, Web 2.0 companies generally centralize overtime, with the economic value accruing to a handful of players that hold the majority of user data. Revenues often come at the expense of user privacy in the Web 2.0 environment.
In stark opposition to the Web 2.0 model, Web 3.0 reinvents the centralized business model using blockchain technology to better align network incentives and share the value more broadly among the users and the contributors to the platform. Web 3.0 is leveraging technological advancements to create a next generation structure where the builders and users can capture the majority, if not all, of the value that is created.
Blockchain technology has spawned three distinct segments of innovation, including:
Savings Revolution:
the dematerialization (replacement of physical records or certificates with a paperless computerized system) of physical stores of value via bitcoin and the Bitcoin blockchain
Financial Revolution:
the dematerialization of traditional financial services via decentralized finance and smart contracts being built on blockchains like Ethereum
Digital Network Revolution:
the dematerialization of centralized, corporate-owned platforms via interoperable, user-owned decentralized platforms, known as Web 3.0
As blockchain technology matures, and digitization by companies drives innovation, blockchain applications are extending their reach into a myriad of industries and sectors, including:
- Supply chain and logistics solutions for agriculture, auto, drug, or commodity supply chains
- Decentralized financing (DeFi) that is digitally replacing the functions of traditional banking, lending, and payment providers and services
- Non-fungible tokens (NFTs) that are distinct blockchain platforms established between a community of users for digitally trading and purchasing unique forms of digital value, like art, music, and digital content
- Infrastructure, and energy enterprise-wide process driven automation that adds efficiencies beyond human capacity with machine-driven technology
- Smart contracts supporting trading, lending, investing, or borrowing across capital markets
- Web 3.0 initiatives, including developers of enterprise applications supporting underlying decentralized ledger improvements, sematic web, machine learning and artificial intelligence
Web 3.0 Ecosystem
Enterprise
Development tools
Healthcare
Supply chains
Finance
DeFi
Institutional platforms & services
Insurance
Real estate
Trading & exchanges
Infrastructure
Data & analytics
Digital identity & privacy
Hardware
RegTech
Smart contracts & DOAs
Non Fungible Tokens (NFTs)
Art & collectibles
Gaming & entertainment
Trading platforms & exchanges
Metaverse
Misconception 3
Web 3.0 is too volatile to be included in an institutional allocator’s portfolio
Reality:
In addition to finding companies with strong business models and healthy cash flows, capital allocators today are faced with the difficult decision of determining how to participate in the potential outsized return opportunity of investing in disruptive digital technology. In particular, the track records of Web 3.0 firms are nascent, the industry itself is growing exponentially but still relatively immature, and the proliferation of firms and innovation remains immense.
As the history of innovation demonstrates, identifying investment opportunities that materialize from nascent and emerging technologies can be incredibly difficult — and blockchain technology is no different. The real challenge for potential Web 3.0 investors is deciphering where the opportunities and risks reside in today’s tighter economic conditions and positioning a portfolio to take advantage of these opportunities in a risk-adjusted manner.
While risk tolerance and portfolio construction are at the core of an investor’s underlying objectives, we think the distinct characteristics of investing in Web 3.0 via a diversified venture capital portfolio can potentially help drive more robust overall portfolio outcomes. Chart 1 below demonstrates that historically US venture funds investing in digital disruption, like Web 2.0 and Web 3.0, have generated returns similar to, or in excess of, the venture asset class overall. Chart 2 shows private equity portfolios that combine buyout and venture have regularly outperformed 100% buyout portfolios and the MSCI World index.
Chart 1
Source: Burgiss, data as of 12/31/2022. US Venture – IT Funds includes only funds that invested 50%+ of capital in portfolio companies classified as in the Information Technology sector using GIC classification standards. All performance in USD.
Chart 2
Sources: Burgiss, MSCI, data as of 12/31/2022. All performance in USD.
For illustrative purposes only. Past performance is not a reliable indicator of future results.
The takeaway for investors
Economic growth occurs whenever people take resources and rearrange them in ways that make them more valuable. Web 3.0 is reimagining the delivery of goods and services and harnessing monetary energy to more efficiently generate, store, and transmit value.
Given the early state of Web 3.0, the winners have yet to be definitively determined, and that presents an opportunity for investors to drive meaningful outperformance and alpha generation. While lower than the torrid pace of the last several years, the Web 3.0 ecosystem remains active logging an estimated $20 to $30 billion in new private capital during 2022.3 Aggregate deal value of emerging technologies (including Web 3.0) accounted for 11.6% of all seed- and early-stage venture capital investment in 2022 — a notch higher than the historical average of 10%.4 Consumer adoption and developer activity have also continued to show progress with active developers across the Web 3.0 environment increasing more than 60% in the last three years, and active addresses doubling over the last two years to hit an all-time high of 15 million in March 2023.5 Total Web 3.0 AUM is now estimated at $94 billion, with the bulk amassed in the last 3 years.6 Bottom line: we think Web 3.0 is here to stay.
Similar to the “S” shaped path of earlier technology innovations, there is sure to be a continuing shake out of winners and losers. And a stronger regulatory framework will help support more measured growth. But innovative applications of blockchain technology continue expanding across a wide variety of market verticals and it is reinventing how goods and services are purchased and delivered. As long-term technology investors, HarbourVest believes that diversification across leading Web 3.0 managers has the potential to mitigate concentration risks during bouts of market volatility while preserving the upside of investing in the earliest stages of technology innovation.
Would you like to discuss Web 3.0 opportunities?
1 Source: https://coinmarketcap.com/charts/
2 Source: https://coinmarketcap.com data as of 3/2/2023.
3 Bain & Company, Web3 Remains Highly Relevant for Private Equity, 2/27/2023.
4 PitchBook, Q4 Emerging Tech Indicator, 3/1/2023.
5 https://a16zcrypto.com/content/article/state-of-crypto-report-2023/
6 Bain & Company, Web3 Remains Highly Relevant for Private Equity, 2/27/2023.
Diversification does not ensure a profit or protect against a loss.
This material is solely for informational purposes and should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy securities or adopt any investment strategy. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication, are not definitive investment advice, and should not be relied upon as such. This material has been developed internally and/or obtained from sources believed to be reliable; however, HarbourVest does not guarantee the accuracy, adequacy or completeness of such information. There is no assurance that any events or projections will occur, and outcomes may be significantly different than the opinions shown here. This information, including any projections concerning financial market performance, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.
The MSCI AC World Index (ACWI) is designed to measure the performance of publicly-traded large and mid-capitalization equity securities in global developed and emerging markets. The MSCI ACWI Index is maintained by Morgan Stanley Capital International (“MSCI”) and has historically captured approximately 85% coverage of the free float-adjusted market capitalization of its publicly-traded global equity opportunity set.
Private Equity Index Data: Unless otherwise indicated, all private equity fund benchmark data reflects the fees, carried interest, and other expenses of the funds included in the benchmark. Burgiss (unless otherwise noted) is the source and owner of any private equity index data contained or reflected in this material and all trademarks and copyrights related thereto.
