Late-Night Musings On Portfolio Construction
Without a doubt, the concept of “Portfolio Construction” was the most difficult VC fund management concept for me to get my arms around. To be clear before I write this, and before you read it, by no means do I mean to suggest that now I have that subject mastered — I am sure I will learn more just in the feedback generated by this post. However, as I’ve been talking to newer managers on their first or second funds, the topic is coming up so I thought I’d briefly share my two cents on what “Portfolio Construction” means to me, and in what context it matters.
Number 1, “Portfolio Construction” is what us, as GPs, are in the business to ultimately produce — it is our core job. The job involves other cool things, like hearing pitches, helping founders when we can, etc. etc… but at the end of the day, or at the end of the particular fund, what is built is a portfolio of (hopefully) uncorrelated assets. Each fund ideally owns a significant ownership percentage of each core company in the portfolio, including (obviously) the very best performing companies. So, at the risk of stating the obvious, it is a GP’s job to study this concept for as long as it takes to be highly conversant in it.
Number 2, Knowing “Portfolio Construction” as a concept is basically required to raise funds from institutional LPs. If a GP is talking to an LP and things progress toward a potential partnership, a sophisticated LP will chime in “Tell me about your portfolio construction.” The absolute worst response to this is some combination of “Geez, I don’t know what that means” and your hands flailing all over a messy Google Sheet. You can basically bet this will throw ice water on the deal. So, if you’ve read this post now, you do not have an excuse — don’t make the same mistake I did by not digging into it earlier!
Number 3, “Portfolio Construction” can be quite varied depending on asset class, investment stage, and fund size. For that reason, this post is specifically written for venture capital funds that are, say, below $200M (ie. not growth or mid-market funds). For early-stage funds, company ownership percentages are of critical importance given the sheer number of startups that are created monthly, and the high loss ratio these portfolios are bound to suffer as a result of today’s funnel of driving toward a classic institutional Series A investment or an accretive $100M+ exit. To quote Mike Maples’ famous line, “Your fund size is your strategy,” and applied to seed, there are unwritten rules of thumb for the check size one needs to deploy relative to fund size. The guideposts I use (which are imperfect, but…) are a $100M fund needs to own 15%+ of their best companies at exit to have a shot to return their fund; a $50M fund needs to own around 10% at exit; a $25M fund needs to own around 5%; and so forth.
Number 4, “Portfolio Construction” often requires sophisticated reserves management. There are many problems with this for newer managers. Again, I know from experience. Most new managers don’t even know what reserves are. By the time they figure out, they’ve been burned a few times. Ultimately, to boost ownership in the companies with where the GPs have the highest conviction, it either requires getting very high ownership upfront (which most people cannot do, and founders resist) or doubling-down on a smaller handful of companies in the basket. The danger for early stage GPs is that they may be forced to do so when they still have the least information about the performance of the company. To put this into practice, a $10M micro-fund which started off with some reserves may have to write initial checks of $100-250K to start (that’s a lot, and a good topic for another post), and then may have to pick 3-5 of those startups to really lever up into, perhaps even before a Series A round.
Number 5, “Portfolio Construction” for the GP could be broken down into other sub-categories, such as geography, stage, and sector. I’ve met early-stage managers who loosely try to have a mix of Bay Area and east coast startups in each portfolio; or they’ll allocate some percentage to seed versus Series A; or they’ll try not to have more than 2-3 businesses in a similar sector to mitigate any sector-specific risk they may be indirectly taking. I am sure there is no correct method here, but creating and imposing some loose guardrails here is helpful, I’ve found. This mix for Haystack is still evolving and changes with each vintage. (This is a good reminder to write on this, too — perhaps when we move from Fund 5 to Fund 6.)
Number 6, “Portfolio Construction” is critical to master because, as I wrote a few years ago, “Your Portfolio Is Your Path.” it’s worth re-reading this post quickly. The decisions we make today stick with us for many, many years. The relationships evolve, linger, strengthen, and fade away. Learning the concept of portfolio construction is one of the few things investors can do to impose some stylistic design on their path — so even while the path is mostly random, a GP can shape it a bit along these vectors. And if done well, it actually has a real shot of working out nicely for everyone involved.