The artificial intelligence (AI) industry is at a crossroads. A new player, DeepSeek, has emerged from China, challenging Silicon Valley’s long-held assumptions about the importance of scale in AI development. Meanwhile, the private equity (PE) and venture capital (VC) markets are experiencing signs of recovery, mainly fuelled by AI-driven companies. But as investment soars, are we witnessing a technological revolution or the next speculative bubble?

The DeepSeek Paradigm: Efficiency vs Scale

For years, Silicon Valley’s leading tech companies have adhered to the “scale law,” which suggests that increasing computational power and dataset size yields ever-more-capable AI systems. OpenAI’s GPT-4 epitomised this approach, costing $1 billion to train. However, DeepSeek has upended this notion by achieving competitive results at just $56 million in training costs—a fraction of the budget.

DeepSeek’s success challenges the belief that bigger is always better, raising questions about the sustainability of Silicon Valley’s scale-driven strategies. Nvidia’s shares plunged 11% following the announcement, a stark reminder of how disruptive this revelation could be for companies reliant on the traditional model of AI development.

Microsoft CEO Satya Nadella has drawn attention to the “Jevons paradox” in AI, where improved efficiency might drive higher demand and consumption, potentially negating the environmental benefits of smaller-scale AI systems. While DeepSeek’s efficiency is groundbreaking, whether it can dethrone Silicon Valley's scale-based approaches remains to be seen.

AI and the Private Market Boom

Parallel to the DeepSeek debate, the private markets are grappling with their AI-driven transformation. In 2024, PE and VC investments increased 5% year-on-year to $56 billion, with AI companies outpacing their non-AI counterparts. According to Forge Global, AI-driven firms delivered an average return of 213% over the past year, dwarfing returns in other sectors.

However, this meteoric rise raises concerns about speculative bubbles. AI startups are trading at a mere -2% discount to their last funding rounds, compared to a -28% average discount for non-AI firms. The stark valuation disparity suggests investors are betting on AI’s future potential rather than current fundamentals—a hallmark of speculative enthusiasm.

Howard Marks of Oaktree Capital recently cautioned investors to remain vigilant, citing the risk of overvaluation in his “On Bubble Watch” memo. While impressive, the PE/VC rebound is characterised by a shift away from speculative growth investments towards structured financing, such as private credit transactions, which rose 256% to $10.8 billion.

Balancing Innovation and Bubble Risks

While AI’s transformative potential is undeniable, its rapid ascent mirrors previous speculative cycles in tech. The private equity and venture capital markets, real estate, and even public equities show signs of overenthusiasm. Late-stage AI startups, for instance, are commanding valuations more reflective of hype than financial performance.

Other sectors are not immune. Industrial real estate remains resilient, but residential markets face affordability pressures, and city-centre office spaces are declining. Meanwhile, US equity markets are dominated by AI-driven firms, further concentrating risk in a handful of companies.

Lessons from History: Avoiding the Bubble Trap

To navigate these speculative waters, investors should heed the following principles, as outlined by Howard Marks:

• Focus on Fundamentals

Avoid investments driven solely by hype or momentum—Prioritise businesses with substantial revenue, profitability, and cash flow metrics.

• Diversify Across Asset Classes

AI is promising, but diversification across industries and geographies can reduce exposure to speculative corrections.

• Be Wary of Crowded Trades

When too many investors chase a sector, returns often normalise. History has shown that markets are correct when speculation outpaces reality.

• Maintain Liquidity for Opportunities

Keeping cash reserves allows investors to capitalise on undervalued assets when markets adjust.

• Exercise Patience in Overheated Markets

Sometimes, the best investments are made by waiting for the right conditions rather than rushing into inflated assets.

Conclusion: The Road Ahead

DeepSeek’s emergence and the explosive growth of AI in private markets present opportunities and challenges. The efficiency-driven approach championed by DeepSeek has the potential to democratise AI development, while the success of AI transactions underscores the sector’s commercial promise. Yet the risks of overvaluation and speculative bubbles cannot be ignored.

As we move into 2025, the investment landscape will be shaped by the tension between innovation and exuberance. The challenge for investors is to balance optimism with realism—grounding decisions in fundamentals rather than hype. In doing so, they can confidently navigate this transformative era, avoiding the pitfalls of speculative excess. 

Have a great week!

This article is based on content from Investors Chronicle, 7-13 February 2025, and insights from Oaktree Capital.