Concentrated Or Bust? The Case for Late-Stage Diversification in VC (Part II)
Author: Luke Skertich
Editor extraordinaire: Jeff Weinstein
In this article we will demonstrate why, contrary to popular belief, diversified portfolio construction is optimal for late stage venture investing.
Public Power Law
“[Our] favorite holding period is forever” — Warren Buffet 
We start with dispersion, holding period, and growth. Dispersion is weaker in the public markets. But, the holding period is typically longer. Whereas a VC fund life is 10 years on average, we should look to 20+ year holding periods in the public markets to take full advantage on average weaker, compounding growth. In effect, from Pre-Seed to Series A to Series C to Public, companies slow down their growth rate over time and dispersion decreases too.
Diet Power Law In Public Markets
By definition, diversified portfolios can work at later stages. Using public markets as a comparable, the S&P 500 Index has gained 10–11% annually since its inception in 1926. Vanguard acted as a harbinger for what is now common knowledge, creating the world’s first index mutual fund in 1975 and bringing assets under management to trillions of dollars by 2019. Outside of seismic macro events that impacted performance globally, the index has performed exceedingly well. While its performance is not good enough for the risk profile of private investors, it proves better than active management.
From January 1994 to October 2018 — through both bull and bear markets — the passive S&P 500 Index outperformed every major hedge fund strategy by about 2.25% in annualized return. You may recall The Oracle of Omaha challenging the hedge fund industry in 2008: including fees, costs and expenses, an S&P 500 index fund would outperform a hand-picked portfolio of hedge funds over 10 years. Of course, the bet paid off given the risk of loss paired with fees, costs, and expenses that are inherent in an actively managed portfolio. You can see the returns, below:
Interestingly, hedge funds perform best when they can hedge… in a bear market, so call your favorite hedge fund manager if you have the stomach. The down years provide the most alpha. Though, as demonstrated in Figure 5, we see many more up years than down.
Furthermore, public markets are also impacted by fat tails. Remember the power law from private markets? For example, per 2019 data from nearly 62,000 global common stocks during the 1990 to 2018 period, “the best performing 811 firms (1.33% of total) accounted for all net global wealth creation”. In effect, a portfolio of stocks will end up with a few big winners.
The main takeaway here is that an index approach will win on a consistent basis when operating in the world of power law.
A large constraint for late stage investors is their time horizon. We don’t have the luxury to compound for as long as we’d like. The rare exception is if you’re an angel investor or family office and are not beholden to LP expectations and can hold forever. We’ve seen early signs of other firms taking advantage of this force of nature called compounding interest — take a look at Sequoia’s strategy.
“Moving forward, our LPs will invest into The Sequoia Fund, an open-ended liquid portfolio made up of public positions in a selection of our enduring companies.” 
The point they are driving at is their time horizon! Open-ended = compounding forever.
Fortunately for investors, they can take advantage of the fact that companies are scaling faster at the late stage than ever before and the underlying reasons behind this are not inflated by free capital over the past two years. Rather, it is because AWS, microservices, APIs, component libraries, and the underlying infrastructure sets up technology businesses for success. It both lowers the barrier to entry for new businesses and helps them to build at a much more rapid pace once they understand the core problems they want to solve. Long gone are the days of expensive, in-house servers, or the annoyance of having to build login yourself when zero customization is needed for your business case. Indeed, the use of component libraries and 3rd party tools for non-core functionality has been a Godsend to developers and investors alike.
What the tech industry has accomplished is truly incredible! Yes, the cost of capital is on the rise and market fear is a deafening crescendo across VCTwitterSphere but that is a more macro issue. Technology businesses will continue to be built, continue to thrive, and continue to grow at an ever more shocking pace.
Our Hypothesis: Diversified Investing Also Works At Late Stage
If we all agree that indexing is the dominant strategy to play the public markets and it is even more powerful in the early-stage private markets (the fat tails in the public markets lead to black swans, but they’re nowhere near as fat as the tails in venture capital ), why shouldn’t these dynamics hold true at the late stage?
The Data shows That Late Stage Does Follows A Power Law
As we discussed, AngelList’s research posits that due the power law distribution of venture returns, the expected median return of an early-stage portfolio rises as the number of investments made increases. However, the author finds that as companies mature, these dynamics weaken. The authors go on to reject “spray and pray” at the late stage, and instead preach ‘thoughtful and discerning’ participation.
While we agree with AngelList’s analysis of the data, we disagree with their conclusions. A weaker power law is still a power law, and as long as a power law still exists at the late stage, diversification improves returns. In fact, with an estimated α of 2 from Series B to pre-IPO investments, the optimal portfolio construction for late stage venture remains north of 100 companies. Additionally, we are seeing tectonic shifts in the tech industry that are leading to larger exits, increased prevalence of unicorns and longer holding periods: all of these trends only serve to increase the late-stage power law. Indeed, using an updated data set, Othman demonstrates that late-stage venture capital resembles early-stage venture more than public market investing. Late-stage investments do not follow the same price diffusion pattern as stocks, but rather have much more extreme outcomes. With a trend towards volatility, we must then study dispersion (the range of possible outcomes) and holding period (how long we compound growth for).
Taking advantage of dispersion means investing in a basket sizable enough to capture outliers. Assuming you have a pre-existing stable of startup investments, you are not drawing from a ‘blind pool’ of companies anymore. Instead, think of this as drawing cards from a stacked deck when you continue to double down.
My backtesting claim is that one should do a full pro rata investment whenever one of your companies does an up rounds led by a smart VC. — Peter Thiel 
Coincidentally, this claim is supported by AngelList data in a ‘momentum’ world where past performance is a positive indicator of future results. They found the highest mean return came from always following on in uprounds.
Therefore, with asymmetric information as an advantage, the optimal strategy is to invest in the top 10% of your existing portfolio and lean into new deals that you absolutely love given your unique access. This goes back to what we talked about earlier: if you see 100+ credible new deals per week and have 700+ active portfolio companies like FJ Labs, you have the ability to capture the benefits of dispersion.
Because companies have begun to stay private longer, the late-stage asset class will trend toward α ≤ 2 as you extend your holding period, allowing for winners to compound. This can be accomplished in two ways:
- You hold the original asset
- You recycle capital
Option one is straightforward. This is our bucket of big winners. Option two is more nuanced. You can choose not to distribute early exits (typically within the first 3 years of the fund life) and re-deploy that capital into new investments. Alternatively, you can sell secondaries in well-performing assets that you feel are overvalued — while holding onto some schmuck insurance — and re-deploy the capital, effectively increasing the duration of compounding.
Into The Crystal Ball
We believe the venture opportunity set will only continue to increase as the industry continues to grow and expand quickly across the world. Global venture activity in 2021 was 20x 2001 levels. Regardless of bubble conditions, this is impressive! There are now enough companies to create a large basket of 10x+ potential companies, which was not possible in the early 2000s.
In fact, for the first time ever, more venture capital flowed to startups outside the United States in 2021 than within it. While Silicon Valley syndicated deals on AngelList increased 77% over the last five years, emerging markets have started to break out, with EM opportunities increasing 144% on the platform over the last five years. We’re seeing early signs of regional tech ecosystems developing all over the World. LATAM now boasts 34+ unicorns , India 100+ , SEA 23+ , and MENA 5 .
Why does this matter?
Ecosystems develop with money being returned to early stage founders. Take, for example, Rappi’s Sebastian Mejia & Simón Borrero driving incredible impact across LATAM or Spinny’s Niraj Singh and Paytm’s Vijay Shekhar Sharma in India. Outcomes in emerging markets accelerate the number of flywheel founders and enable entrepreneurs in the company to leverage their experience in rapidly growing tech companies to go out on their own. Long term, this means more credible startups to invest in which further drives the advantages taken against dispersion.
Yes, the recent ‘reset’ will knock some of the Unicorns off their illustrious pedestal, but we are confident that the global venture ecosystem will return from this down market larger and stronger than ever.
Embracing “Spray & Pray” At A Later Stage
In sum, we know that the larger the portfolio, the higher our floor will be for returns. Angel investing is a proven commodity at the early stage. Data supports angel investing as the optimal strategy at the late stage too. We’ve seen examples in public markets of a large, diversified portfolio achieving better performance than active management. Pragmatically, we have conviction that founders want unique value additive investors (say, marketplace expertise) on their cap tables and that discerning capital deployment at scale benefits both LPs and GPs.
Here is the optimal strategy:
- Index to every credible deal at the early stage (the bigger the basket, the better)
- Utilize your asymmetric information advantage to invest in the top 10% of your portfolio at the late stage & add in your favorite late stage companies you have access to
- Take advantage of mis-pricing by selling secondaries + hold onto schmuck insurance
- Recycle that capital to compound further
- Continue backing your breakout winners
- Compound, compound, compound
- Re-invest into the ecosystem
We’ve proven consistency and discipline is key with our own data and look forward to changing the narrative about portfolio concentration for many funds to come!
 Quote, Warren Buffet