“Week 6 of VC School: Fund Level Portfolio Mangement” is part of a seven week series from the interns at Bowery Capital. The series will cover lessons learned and concepts covered during the weekly “VC School” meeting, a program taught by the Bowery Capital team designed to teach interns the fundamentals of the venture capital space. This summer, we want to open our doors and share these lessons with the broader community.
Fund Level Portfolio Management
Last week we covered deal execution by taking a deep dive into term sheets. This week, we moved into portfolio management and discussed capital allocation strategy, fund modeling, and fund returns. There are two ways to look at managing a portfolio of assets: portfolio management on a fund level and an individual investment level. This lesson covered fund level portfolio management and focused on understanding how we think about portfolio management while next week will focus on the individual investment level. One of the key takeaways from the discussion was that there is no one correct management strategy but there are better strategies based on different characteristics and goals of a fund. When crafting a capital allocation strategy its important to understand expected return multiples, holding periods, projected ownership percentage and dilution, fund size, and exit strategy. Understanding these different characteristics will help funds develop the proper portfolio management strategy. For example, small funds and large funds have very different paths to returning their funds and therefore have different portfolio management strategies. Below are some of the overall lessons from our discussion.
1. Power Laws. Venture capital has a power-law style of returns and not a bell curve style that is typical of more traditional public equity investments. A power-law distribution predicts that 80% of your investments will fail and 20% of your investments will power your returns. It can be difficult to swallow but to succeed as a venture investor its important to accept that 8/10 of your investments will fail.
2. Focus on Winners. Since VC is a power-law game what sets the best VC firms apart is bigger returns on winners and not less overall losers. Using a baseball analogy, what matters most in VC is slugging percentage not batting average. Given the importance of winners, you should not spend as much time on the companies that will not succeed as it relates to your portfolio. Too many firms spend too much time trying to “prune” their portfolio and sell underperforming companies when they should just pull the ripcord.
3. Understand the Different Levers. When determining what your fund size should be and your fund’s return potential its important to understand the impact of different levers. The most important factors that drive your fund size strategy is the initial investment amount, follow on investment amounts, projected ownership percentage, and portfolio company count.
4. Fund Size. As discussed earlier there are a wide array of different portfolio management strategies that support different fund sizes. There is a misnomer that making too many investments or too few investments will not result in the best in class returns. When developing a strategy its essential to run models and simulations yourself to understand the impact of your fund strategy and your anticipated return.
1. In Praise of Failure. This blog post from Benedict Evans discusses the power-laws of VC and explains the necessity of accepting the failure of a majority of your investments.
2. VC Portfolio Management Tips. In this article, Neal Hill of BDC Capital’s Fund of Funds shares some insightful tips on portfolio management.
3. Venture Capital Portfolio Strategy. Alex Graham provides a great deep dive into portfolio strategy explaining the importance of hitting big, finding winners, and focusing and following on winning investments.
If you liked “Week 6 of VC School: Fund Level Portfolio Management” and want to read more content from the Bowery Capital Team, check out other relevant posts from the Bowery Capital Blog.