The limitations of portfolio management in venture capital
In any field of investing — whether it’s hedge funds, real estate, or venture capital — the hunt for new deals is without a doubt the most thrilling part of the game. But portfolio management is often where the best investors set themselves apart from others that fail to generate alpha. In public markets with daily liquidity, it’s easier to make ongoing, high resolution decisions about portfolio management. In a seed venture capital fund, like the one I manage, the opportunities to invest are infrequent, unpredictable, and impossible to unwind. In a field like this one, the inherent tradeoffs in portfolio management are even more stark than they are in other fields of investment. A good VC should have, at the very least, awareness of these tradeoffs. The very best have insight and conviction on these matters. In this post, I’d like to work through the way I think about these common tradeoffs.
Tradeoff between diversification and leading deals
Mike Maples of Floodgate famously said “your fund size is your strategy.” When it comes to portfolio management, your fund size also dictates many of the choices you have to make as a managing partner. In a small seed fund with assets under $50 million, one of the biggest tradeoffs you have to make is the tradeoff between leading deals and building a diversified portfolio.
To be a lead investor, you typically have to write a check that’s a meaningful chunk of the round. There are also more expectations of the lead investor, especially when it comes to bridge rounds, reserves, and the signals you send to other investors with your decisions. Social pressure and a greater sensitivity to sunk costs may compel a lead investor to continue investing in a startup longer than they otherwise would. A lead investor manages this kind of risk in a portfolio by making careful decisions about when to extend a startup’s runway and by how much, exercising oversight of spending as a board member, and having separate reserve allocations for bridge rounds and for next round pro rata.
The expectations on a following investor, who might have invested $500k in a $3 million seed round, are much less. Following investors write fewer bridge checks and they get fewer opportunities to exercise pro rata rights in their winners. They often mitigate this risk by investing in far more startups than a firm that leads deals, overweighting diversification at the expense of board room influence and access in later rounds. Due to these factors, investors that lead rounds exclusively will have portfolios that look entirely different from investors that follow other firms’ lead exclusively.
Like many firms, Stage VP leads some of our investments, and we follow other investors in others. We think about the expectations on us as lead investors very differently from the way we think about the expectations on us when we are not the lead. Despite that distinction, whether we lead or follow, we always look to deploy more capital into our companies as they grow.
Tradeoff between exercising pro rata rights and decreasing marginal returns on later dollars
Investors often have the right to a pro rata share of any future funding round. Some early stage venture funds choose to disclaim that right, diluting alongside founders. Others view the pro rata rights as inherently valuable, and they structure their funds or their opportunity funds to capture that value. Every fund manager needs to decide when they will stop taking their pro rata in their main fund, as funds all have finite lives and limited partners expect cash to come back to them at some point. Funds also have inherent tradeoffs between risk and return that can conflict with the risk profile of a later stage investment. A seed fund, which is in the business of finding startups that can return 100x, probably should not invest in the Series E round of one of their portfolio companies at $5 billion valuation, all things being equal.
Stage VP prefers to deploy the bulk of our reserves into our portfolio companies no later than at Series A. Our policy allows us to set aside reserves for both bridge rounds and third party priced rounds. It also keeps our cost basis between the average price of a seed round and Series A round, which feels right for an early stage fund.
Tradeoff between using reserves for bridge rounds, and for pro rata
When a venture fund tells you that it reserves capital for future investment in its portfolio companies, it’s not telling you enough to understand how it really thinks. You need to ask the venture fund how it deploys reserves in between priced rounds. At the seed stage, where some startups find product-market fit instantly, and some startups take years to do the same thing, the question is particularly acute. Will a venture firm support a startup during this phase? How much runway will they provide? Will the capital be tranched?
For the VC, every dollar spent on a bridge round is a dollar that could have been spent instead in the priced round of another portfolio company, this one led by a high profile, brand name firm. The former is a hard check to write, full of questions and doubt. The latter is an easy one, with equal parts enthusiasm, confidence, and congratulations. Making these decisions well gets especially complicated because the fewer bridge checks you write, the more money you have for the startups that don’t need a bridge round. But the more bridge checks you write, the more startups in your portfolio that will find their way to the next round and eventual success, increasing the optionality in your fund. The price of the option you’re purchasing in this case is the second guessing you’ll face for throwing good money after bad in startups that fail to succeed even after their runways have been extended several times.
We believe that having distinct pools of capital available for different kinds of reserve use can help bring clarity to decisions like this. We also believe that a policy of testing the same hypothesis only one additional time before demanding either new evidence or new leverage in the form of new third party investors is a good defense against chasing conviction straight to the grave.
Tradeoff between DPI & IRR
In the Old Testament, Joshua commands the Israelites to choose their gods wisely, because they cannot serve the gods of their ancestors and the Hebrew God simultaneously. While the stakes are lower in investing than they were during forty years in the desert, the choices are still stark. A PE or VC investor can choose to orient towards dollars to paid in capital (DPI) or towards an internal rate of return (IRR). The former will favor longer hold times, and more uncertainty along the way. The latter will favor shorter hold times, and risk reduction at the cost of total returns.
Our firm believes that managers in each asset class should emphasize the portfolio management strategies that distinguish their asset class from any other. Early stage venture capital is inherently illiquid and risky, and thus better for managers aligned towards DPI. Communicating this orientation upfront is critical, because limited partners will still call you every few months after year one asking about upcoming exits. Even though they will still call, they should be able to lip sync the liturgy you recite back at them.
Tradeoff between recycling management fees and returning capital to LPs early
Within the choice to maximize either DPI or IRR is a special case unique to VC firms around early exits and management fees. Most limited partnership agreements allow VCs to recycle management fees, bringing the net dollars invested into the portfolio as close to, and in some cases higher than, the gross dollars invested into the fund by limited partners. Of course, recycling trades off a potentially higher multiple on invested capital against the certainty of returning capital to investors early, which can help with the internal rate of return calculation, and with building confidence among early investors in the fund. Opinions on the matter differ by fund size, geography, stage, and firm age. As mentioned a moment ago, our firm has chosen to maximize DPI and as such we welcome the opportunity to recycle management fees. We do have limits on the amount of capital and the period of time in which we can do so, so that our investors have clear expectations about our decisions in cases like this.
The tradeoff between high resolution decisions and conviction
In a very small venture fund, like our Fund II, our follow on decisions were mostly binary. We either had the conviction to extend a startup’s runway, or we didn’t. The startups either had enough traction to attract a Series A investor, and then we either had the opportunity to exercise our pro rata rights in that round or we didn’t. There was little opportunity to make position sizing decisions beyond the simple yes/no choice of committing reserves. As such, the largest positions in our Fund II are approximately two times the size of our smallest positions, a result one would expect from a binary process.
The larger size of our more recent fund should allow us to make more nuanced decisions. Now, a runway extension need not consume the total reserve pool available for each company. If we’re right about that and we make good choices, the ratio of capital deployed into our largest positions divided by our smallest positions should be larger.
In conclusion
Portfolio management is a subject of endless debate, and endless explication, because there are no right answers. The debates are as esoteric as those in a Talmudic seminary for a reason. Since the controversy will never be resolved, the only thing we all can do is to seek alignment. Limited partners should seek general partners whose views they share, and startup founders should seek venture capital firms whose policies are in line with the startup’s needs. Choose your gods wisely.