Playing the concentrated VC game
Last year was a watermark year for the VC industry, most of the funds hit their highest ever deal volumes in 12 months. Our normal run-rate of 5–6 deals per year did lead to some introspection and soul-searching; but at the end of it, we are more sure than ever that we want to play the concentrated VC game…
Stay with me as I explain the thought process.
It is undeniable that the Power Law of returns applies to venture capital. Meaning, only a small percentage of investments will be responsible for a majority of venture capital returns. A study by Quartz supported this law, revealing that the top 14 VCs were investors in 93 unicorns that collectively represented 2.6% of their deals.
In Peter Thiel’s words, “the biggest secret in venture capital is that the best investment in a successful company equals or outperforms the entire rest of the fund combined.”
Clearly, it is important to have multi-baggers in one’s portfolio. Every VC looks for that winner that will return abnormal multiples.
However, I believe there isn’t a one-size-fits-all portfolio construction approach to ensure that the Power Law applies to your returns. Portfolio construction can either be “diversified” (or what is somewhat derogatively called the ‘Spray and Pray’ approach) (45+ companies with less than 5% ownership) or the “concentrated portfolio” approach (less than 20 companies with 10+% ownership) or an in-between approach (20 to 45 companies with 5–10% ownership).
Here are key reasons we believe that a concentrated portfolio rather than ‘diversified’ may be the way to go:
- Historical data shows that the benefits of diversification (large portfolio) tail off pretty hard. In other words, returns drop sharply with increase in portfolio size. Here’s an illustration to portray this:
The above table from a survey conducted by Blue Future Partners shows that a portfolio constituting 100 companies theoretically has a 99% probability of returning the capital and 57% probability of returning 2x — which is almost twice the probability of a portfolio having only 10 companies. However, we must determine the level of diversification the portfolio should have for lowering risk as well as protecting the chances of significant outperformance. Let us consider 5x return as the benchmark. If we look at the portfolio of 20 companies, it has a 9% probability of exceeding the benchmark. But, in order to only double this probability, one would need to invest in 1,000+ companies. This implies that the possibility of surpassing any benchmark may rise with portfolio size, but only marginally.
2. Help and mentoring at early stages can have a significant impact on the company’s chances of success. Given that VCs are unable to figure out which of the portfolio companies would be a winner, it makes sense to work with a smaller portfolio and offer the same level of mentoring across companies to increase their chances of success. Perhaps, the key lies in achieving a balance between the possibility of beating a certain benchmark and the number of companies a VC can actually offer support to, at a given point in time.
3. Survey shows that top funds have a portfolio of less than 30 companies
The above table portrays how different VCs may have diverse investment strategies. It can also be seen that the first 3 quartiles of fund managers prefer to invest in fewer than 30 companies. “30” can be a sweet spot for most managers, beyond which it is perceived as difficult to assess, select, and support companies.
4. Ultimately, skin in the game is what drives returns In a concentrated portfolio with larger equity positions, one maybe be able to achieve returns even with a “dragon ( loosely interpreted as a $500M to $800M valuation range)” without the need to make a “unicorn.” A fund manager building a concentrated portfolio would need much less to exit, given that they tend to have more sizeable ownership. A fund manager building a diversified portfolio, will need unicorns to make his return, as they tend to get significantly diluted. The importance of maintaining sizable ownership at exit is an oft-quoted, but significantly neglected during portfolio construction
5. The enterprise-tech vs. consumer tech perspective. It is well-established that returns in an enterprise-tech fund are driven by a cohort of exits, while in a consumer tech fund are driven by that one “mega” exit. For a largely consumer-tech fund, the key to generating returns will be finding that one multi-bagger, therefore it is reasonable to be invested in a wider portfolio. As an enterprise-tech investor, we expect a third of my portfolio to generate some returns. More sensible then to invest on fewer higher conviction bets, and follow on in subsequent rounds
While there is no set rule for VC investing, we are doubling down on concentrated portfolios, given that smaller portfolios allow us to work with portfolio in a meaningful manner and hopefully, meaningful exits as well
Arali Ventures is a pre-seed, seed-stage VC from India, investing in entrepreneurs building enterprise-tech solutions for the world. We help shape their journeys through product-market-fit and beyond and scale the offerings to greater heights.
Keep circling back to read our perspectives on enterprise-tech, our portfolio, seed-stage investing in India.
