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Herd mentality is alive and well as VCs chase AI craze

Despite a significantly different investment environment from 2021, herd mentality is still very much a part of venture strategies. One example: The chase for AI as the next big thing.

Last month, a story popped up on my news aggregator about a four-week-old startup yet to develop its first product that has raised over $100 million in venture funding. At first I dismissed the story thinking that it was old news.

But upon closer inspection, I was surprised to see that Mistral AI‘s funding announcement was not from June 2021, when markets were hot, but from midyear 2023.

AI startups have seemingly defied the overall decline in VC funding of the past 18 months, collectively raising $15.5 billion this year, according to PitchBook data. Even when you exclude OpenAI‘s $10 billion round, the sector’s VC funding in 2023 has surpassed last year’s total and is well over halfway to 2021’s peak of $9.1 billion. On top of that, deal pace has remained steady and median post-money valuation is up 109.8% from last year.

While VCs have become more cautious with the downturn, the eagerness of some investors to plow capital into very early stage AI startups suggests that some of the exuberance of 2021 remains.

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At about the same time as Mistral AI’s announcement, reports said a three-month-old AI startup founded by former Salesforce co-CEO Bret Taylor and ex-Google executive Clay Bavor raised its first funding round at a valuation of over $100 million. A week later, Inflection grabbed $1.3 billion despite only being a year old. It’s now worth $4 billion.

While one could argue the scale of AI opportunity justifies the hype, this recent investment activity suggests that a sort of herd mentality has taken hold.

“In 2021 we saw [herd mentality] across the tech industry but right now we’re still seeing it in isolated pockets like AI,” said Hussein Kanji, partner at Hoxton Ventures. “This is just the nature of venture and I think just generally the financial markets. When something gets hot, there’s a massive push to be involved.”

Missing out is the big risk

For an asset class where it takes many years to see the real outcome of an investment, potentially missing out on the next big wave of innovation carries a lot of risk. So when a big leap like a generative AI comes along, it’s safer to follow the herd.

At the same time, investing in an area off the beaten track when everybody else is doing something else is risky—if it goes well you’re a genius, if it doesn’t you might just lose your job.

Kanji adds that temptation to jump on hot trends is particularly strong with less-experienced investors who seek validation from industry peers. Even if you make the wrong call, the music won’t catch up with you for a few years. As a more junior VC member, being part of a deal that includes a big-name VC firm offers validation and is often rewarded by partners.

Living in isolation is difficult in the world of VC where so much deal sourcing relies on networks. Investors constantly need to have their ears to the ground to find the best opportunities, and with that it’s almost a given that they’ll be influenced by their sources.

This psychology remains even in a downturn. In fact, it may be even more pronounced now that the venture landscape has become more uncertain.

“I would guess that the herd mentality is stronger in a downturn than it is in the uptrend,” Leila Zegna, founding partner of Kindred Capital, said. “To act outside of the herd and be truly authentic takes a certain degree of psychological safety and I think that’s lacking today. When the returns you thought you had vanish and you’re questioning whether you’re any good at [VC], putting your fist on the table to advocate for something that others don’t see is a tough ask.”

Global VC deal count reached 635 in H1, according to PitchBook data, a 30.1% fall from the same period last year. While real constraints have slowed the pace of dealmaking including the lack of liquidity and fundraising challenges, TempoCap venture partner Pierre Suhrcke believes that being contrarian now would actually mean writing checks rather than taking a wait-and-see approach.

“Now is the best time to invest and yet VCs are hiding,” he said. “It’s another form of herd mentality where everyone is focusing on their portfolio companies, etc., and not looking for new deals.”

Following the hype is not always a winning strategy, especially when overcrowding leads to inflated valuations.

Leading the herd is key

But like it or not, every investor eventually needs the herd.

Being contrarian can be great, but a single investor cannot build a unicorn alone. Follow-on funding is needed to grow a startup, and that can’t happen if you’re the only firm that believes in the business or the sector. This is particularly true for pre-seed investors who are making their bets at least as much on people as on business ideas that may still be in their infancy.

For those who get in early, having other investors come in after you and push up valuations and funding will likely lead to some good outcomes. An influx of capital into one sector also helps to push forward new technology, as well as increase the number of startups and talent in that area.

The real question is whether the hype around generative AI is typical VC froth from investors who haven’t learned their lesson from the last hype cycle, or if there is something more here.

“I think today’s herd is smarter (than in 2021),” Concept Ventures founding partner Reece Chowdhry said. “Investors are very well aware of the current market dynamics of defensibility. There are lots of companies that aren’t being funded even in generative AI, and investors are really looking for those category-defining businesses.”

And unlike other previously hyped sectors, such a rapid grocery delivery, AI is backed up by truly innovative technology and solid metrics.

So while hype persists in the VC market and almost certainly always will, it appears that investors have learned lessons from 2021’s exuberant atmosphere. It’s often okay to follow the herd, as long as you don’t do it blindly.

Featured image by Mara Potter/PitchBook News

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