How to Succeed as a Portfolio Manager
Chip Hazard; General Partner, Flybridge
This post is Part 6 of a series on Chip’s Playbook of 4 Success Factors for Early-Stage Venture Investors. You can see Parts 1, 2, 3, 4, & 5 here:
Part 1: Introducing the 4 Success Factors
Part 2: The Power-Law of Venture Returns
Part 3: Identifying and Capitalizing on Macro Market Trends
Part 4: The “SSWISH” Cycle
Part 5: SSWISH — How to Win, Support, and Harvest Opportunities
The term portfolio manager brings to mind asset managers. Most early-stage venture capitalists cringe at the thought of being dispassionate financiers and allocators of capital, but being adept at managing a portfolio of companies and investments is critical to success. For a VC, what being a portfolio manager primarily means is two things:
One: The optimal number of portfolio companies to have in a fund.
Two: How to think about allocating capital in subsequent financings for individual portfolio companies.
Among early-stage investors, there are different schools of thought on both fronts.
Optimal Portfolio Size
One side argues for a large number of holdings in a given portfolio. This comes from a belief that there is a relatively high degree of randomness to actual returns, and therefore it is better to make the best decisions you can but with more shots on goal to account for the unpredictability.
The other side believes they can confidently pick outliers, and therefore having fewer larger positions in a fund will drive overall returns. The math on their thinking is that a 5% (20-company portfolio) position that returns 50x will return 2.5x the fund, whereas in a 100-company portfolio will return only 0.5x.
- Having seen the randomness factor at work, I am biased towards a larger portfolio than smaller, but going to extreme portfolio size feels like a dilution of effort and limits the ability of an outlier to actually have an impact. A portfolio of 40–50 holdings feels about right to me.
Making Follow-on Investments
The different poles are never to make follow-on investments or to always do pro-rata in any company that raises outside capital.
The no follow-on crowd worries about misaligned incentives with founders and signaling risks, whereas the always-follow-on crowd worries about dilution and maintaining ownership.
It strikes me that to not follow-on is a huge missed opportunity. There is no new company you can know as well as the ones already in your portfolio, and in a world where there are relatively fewer outliers, why wouldn’t you take advantage of better information to make high-conviction follow-on investments in a subset of companies in which you’ve already invested?
Yes, this conviction will be wrong at times, but the impact of being right is enormous. However, taken to the extreme, supporting all companies runs the risk of exposing too much capital to potential underperformers. While losses matter less than winners, large-dollar losers can have a significant negative impact on fund-level returns.
Again, the lack of conviction will be wrong at times, and companies from this group will outperform.
However, overall I would argue that thoughtful investors significantly skew the odds in their favor with well-reasoned follow-on decisions, and if you end up with twice the capital in wins than losses, a good fund will move into the top decile instead of turning a good fund into a mediocre or worse one.
The bottom line: to be a successful VC portfolio manager, you need a diversified portfolio and to lean into your winners strategically.
While there are different approaches, my take is to maintain a decent-size portfolio and to make follow-on investments in the most promising companies you’ve already backed.