BFP #OpenLP Series — How we assess fund investments: (4) PORTFOLIO CONSTRUCTION
Having in previous articles in this series looked at performance metrics, we will now turn to other important aspects of our due diligence process. How a VC fund manager plans to construct their fund’s portfolio and allocates capital is a critical component of a fund’s strategy.
What is Portfolio Construction?
Portfolio construction broadly breaks down into (1) how many initial investments a fund makes, (2) what ownership stakes are targeted, if any, (3) what part of the fund’s investible capital is held in reserves and (4) how that remaining capital is allocated over time.
Some VCs build their strategies on quite concentrated portfolios, others optimize for optionality with a large number of initial investments, with a view of backing the winners in subsequent funding rounds.
Then, there are “buy-up” strategies (where the target stake at exit is bought over time) and “buy-and-defend” strategies (where the target ownership is sought with the first ticket and then pro-rata is defended in subsequent rounds). There are also ownership agnostic strategies, based on the argument that what matters is being invested in the best companies.
Why does portfolio construction matter? What are its limitations?
For some LPs portfolio construction is an important way of validating their target return for a fund investment. If an LP is looking for, say, a 2.5x cash on cash return on a $100mn VC fund, a certain number of outcomes and exit valuations are required to achieve this.
For example, returning a $100m fund just one time over (i.e. just to repay the capital) requires an exit at a $1bn valuation assuming an ownership stake of 10% at exit. Thus, to generate a 2.5x cash return on the fund level at least three such outcomes are necessary (taking fees into account).
Others might argue that such outcomes cannot be planned and optimize towards being invested in the fastest growing companies.
At Blue Future Partners we believe in thoughtful portfolio construction and more importantly, that ownership matters. Given most VC funds typically invest in one, two or three dozen companies, the statistical likelihood of hitting the number of large outcomes required to generate a certain return multiple can be a limiting factor. The smaller the ownership stake is at exit, the more large outcomes are required. Venture Capital really is a game of large outcomes, and a portfolio model needs to reflect that.
Blue Future Partners is currently conducting a survey into best practice in portfolio construction amongst VC funds. If you run a VC fund and would like to participate, please do so using the following link: https://www.surveymonkey.de/r/ZX6CS2M. Participants will receive the anonymised raw data alongside our full report on the survey results. Thanks!