enture capital is an inherently risky business. It is notoriously difficult to generate strong returns on a portfolio of new or young firms that are often leveraging emerging technologies in dynamic, rapidly changing markets with uncertain outcomes. The failure rate is very high. In fact, according to the US Department of Labor, the survival rate of all small businesses after five years is approximately 50% and this declines to about 20% as more time passes. The rate is even lower for those enterprises that use the new and unproven technologies which venture capitalists specialize in financing. This is why sound portfolio management strategies are so essential to the maximization of venture capital investments.
What is Portfolio Management?
As defined herein, portfolio management is the process of making sound and intelligent investment decisions for clients—individuals and institutions—with the explicit goal of maximizing returns. We will focus on financial returns but the definition of good returns is expanding as ESG (environmental, social, and governance) factors become increasingly important to investors. In addition, a portfolio company is an entity into which a venture capital firm invests its money, expertise and time.
The goal of sound portfolio management is to manage the investments in portfolio companies in a manner that is in harmony with the investor’s goals, time horizon and appetite for risk. Metrics that are of particular importance are time weighted returns: a method of calculating investment return in which returns are compounded over subperiods and summed to result in an overall period return.
The rate of return for each subperiod is weighted and subsequently ranked according to duration relative to the whole. To further contextualize investments, good KPIs (key performance indicators) for specific industries that explain how well a company or collection of companies are doing is essential as different industries have distinct dynamics based upon how they are structured and the nature of competition.
The Challenge of Portfolio Management in Venture Capital
It is notoriously difficult to obtain consistent growth in venture capital portfolios. Critics of the industry note that venture capital investment returns have routinely underperformed relative to public markets and other alternative asset investments. Indeed, since 1997, according to a Correlation Ventures study of 21,640 venture financings from 2004-2013, 65% of venture deals have returned less than the capital invested into them; and those finding were further supported by a Horsley Bridge study of 7,000 investments from 1975-2014:
The data also demonstrates that it is exceedingly difficult--.07% to 2% probability--to invest in a unicorn or a company with a billion dollar valuation as according to Correlation Ventures, less than 5% of investments return 10x and only .04% have a 50x return while according to Horsley Bridge only 6% of deals return more than 10x.
Compounding and complicating matters is that successful venture capital returns are often characterized in just a few companies in a portfolio:
The majority of entire fund returns tend to come from single, outrageously successful grand slam investments as for the best funds, 90% of their returns come from just 20% of their investments. A few hits vastly outweigh the many misses in terms of the importance to the portfolio. To use a sporting analogy, venture capital is baseball not football. In football, mistakes and turnovers are often the most decisive factor in a victory. This is why teams that play smart, error free games often win. But in venture capital, since most baseball players fail—a 30% hit rate is considered to be a great success—maximizing your success with an extra base hit like a grand slam when you actually are fortunate enough to get a hit is essential.
Sound Strategies in Portfolio Management
Since home run investments—particularly grand slams—are so important to the success of a venture capital portfolio, it is therefore imperative to understand how to maximize the chances of hitting them. An argument that will be made here is that rather than diversifying risk by investing in many startups—and risking diluting your funds as a result—a good strategy is to invest in fewer companies and work harder to enhance their chances of success. This is akin to what angel investors do as they often have a more hands on and intimate relationship with their investments. Such a strategy would entail developing the capacity of the venture capital firm to provide more than just money but access to a deep ecosystem of support services which is the direction that the industry seems to be going in, particularly as it pertains to corporate venture capitalists.
Secondly, a good investment strategy is to prioritize investments in people more than investments in technology. Technology is sexy but in dynamic markets, it is ever changing. What does not change is the importance of having good people to execute on that technology and to transform the technology into a viable business.
As the noted venture capitalist Arthur Rock stated:
"Good ideas and good products are a dime a dozen. Good execution and good management—in a word, good people—are rare. …It’s the execution that’s really the important thing and you need really good people for that. Good people can change directions, but there are very, very few truly great people who can execute properly. …The biggest problem in starting high-tech businesses is the shortage of superior managers. There is too much money chasing too few good managers."
This wisdom is particularly salient as so many venture capitalists have been undone by investments in “fake it till you make it” endeavors such as Theranos and FTX. A deeper focus on the character of the individuals running the enterprise would have made for a much sounder investment decision.
Thirdly, since hitting a grand slam is so important, the total addressable market size of the startup should be immense. If the entrepreneur is fortunate enough to establish a successful beachhead in a market, will it be possible to expand vertically or horizontally into other large markets so as to increase profits geometrically? This is known as scaling and it is critical. Likewise, the focus needs to be on profits not just user growth which can be frequently obfuscated but rather on profits which usually requires economies of scale such that marginal costs decline as one adds users.
Declining marginal costs in large markets is how great profits are made. Moreover, the prospective entrepreneur must not just have figures about the absolute size of the targeted market but a deep understanding of its value chain, organization, competitive dynamics and success drivers which can often only be obtained through direct experience. This is why youth is frequently overrated in venture capital as such experience often takes time to accumulate.
Another vitally important portfolio management strategy is to target inclusion startups that have an unfair competitive advantage. This advantage can pertain to its product, intellectual property, business model, leadership and culture. Mediocrity is generally rampant. To successfully challenge entrenched competitors, a startup must excel in one or preferably more of these areas which is intrinsically quite difficult.
Leadership that can develop a culture which attracts and retains top product personnel is particularly rare. Indeed, an organization with a high turnover rate of these scarce but highly valuable employees is a serious red flag. Relatedly, the ability to not only build a great product that is protected behind a strong moat of intellectual property legislation; but also commercialized via an innovative business model can give a startup not just a first mover advantage but a fast moving advantage that it can leverage to gain traction in a market before other firms can react. This is business 101 but it is nonetheless applicable to the venture capital space.
Perhaps the hardest aspect of effective portfolio management is that so much of it relates to blind luck or fortuitous timing. For example, the COVID-19 lockdowns generated a rapid digital acceleration that enabled many companies such as Zoom and Doordash to achieve immense valuations. In the space of a couple of years, a decade’s worth of digital investments were made and the commercial real estate market has been fundamentally restructured to the detriment of companies such as WeWork and downtowns across the Northeast.
Startups that had a technology for sale that could contribute to this digital acceleration benefited handsomely while others lost. Another example of benefiting from good market timing is Airbnb. Initially, it had great difficulty in raising capital as the idea of having strangers rent out space in people’s homes did not resonate with investors. That changed with the recession of 2009 as the need to take on “side hustles” to survive made people much more willing to rent a room in their home for some extra money. Ultimately it is painful how little agency entrepreneurs and venture capitalists truly have as Idealab’s Bill Gross has estimated that timing accounts for 42% of the difference between their success and failure.
Follow On Investments
Since hitting a grand slam in venture capital is like finding a needle in a haystack, it is important to get the most out of such investments once they have been found. This is known as making a follow on investment and it is critical to the success of a venture capital portfolio. Just as it is foolish to continue to throw good money after bad, it is intelligent to continue to make further investments in a good firm.
Through a follow-on investment, a venture capitalist can maintain an ownership percentage without dilution which has implications regarding governance and return on investment at exit. There are also profound information advantages to follow on investments that can mitigate risk. A follow-on investment entails investment in a company that the venture capitalist typically has an established relationship with and understands deeply both financially and interpersonally.
This makes it easier to intervene to the benefit of the company. But being well positioned to make follow-on investments requires discipline. A venture capitalist must be careful not to deplete funds too rapidly so that at least 50% of the raised capital remains available for follow-on investments into successful startups. This is why it is recommended to invest in fewer firms and to give those firms not just access to financial resources but also all of the other forms of capital and professional resources that the venture capitalist has available.
An example of how even a top firm can fail to make a follow-on investment is Andreessen Horowitz’s (a16z) limited investment of only $250,000 in Instagram in 2010. While it is true that this investment netted the organization $78 million for a 312x return when Instagram was acquired for $1 billion by Facebook in 2012, this is a paltry sum compared to their $1.5 billion portfolio at the time. A follow on investment in Instagram would have netted a16z a far greater return.
Just as selecting a good team to invest in is essential to the success of the portfolio, it is also important for the organization to be well organized internally so that it can execute on its chosen portfolio strategy. Firstly, the investors at the venture capital firm need to have consensus on what their portfolio management strategy is. Institutional investors will want to know this and to see that a commitment to it is reflected in action.
They want to know what they are getting themselves into and what the venture capitalist is planning to do with their money. Yes, it is important to have the flexibility to adapt and shift as necessary in fast moving markets but that should still be consistent with a fundamental portfolio management strategy.
Having developed a consensus on a portfolio management strategy, there needs to be a codified decision making process within the venture capital firm to address disagreements over critical issues. There should be a well thought out process for who gets a vote, what they are allowed to vote on and who has the most authority and why. This is imperative as in venture capital partnerships there are liability considerations.
Due to these considerations, a recommended portfolio management strategy is to have a single partner in each portfolio (health, energy, etc.) whose responsibility is to focus only on the dynamics of that portfolio as a whole over 5 to 10 years. This can avoid the myopia and excessive focus on a single deal or transaction that can be so detrimental to overall returns.
Finally, data analytics is more important to sound portfolio management than ever before. Venture capital firms should invest in a robust infrastructure to put these tools in the hands of investors. The same goes for training investors in the nuances of data science. Nowadays, a good venture capitalist is as much a data scientist as an MBA and technologist. Data science is now a core competency of portfolio management as it makes it possible to more rapidly grasp the insights intrinsic to obtaining and maintaining competitive advantage.
The irony of venture capital is that as inherently risky as the asset class is, you win by doubling down on risk and swinging not for singles but for out of the ball park grand slams. As currently structured, the industry is oriented more for Aaron Judge than Derek Jeter even though the latter is clearly a better baseball player. This imperative to hit grand slams can be somewhat mitigated by the ability to use data science tools to more quickly identify trends and strategies such as follow-on investment that make it possible to get the most of a few successful investments. Still, realistically, luck and timing will likely remain the dominant factors in the success of a portfolio.
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