How VC Funds Should Approach Portfolio Construction

The last few decades have seen the venture capital (VC) sector emerge as a key source of success for countless high-growth startups. The barriers to entry to participate in these high-stakes investment activities are eroding and we are beginning to see more private investors entering the VC space. 

Despite increasing awareness amongst the investor community and the general public on the startup and VC ecosystem, emerging investors often find themselves at sea when it comes to constructing their VC investment portfolio.  

For emerging investors, it would also be useful to understand the context of the following advice, as the VC segment is undergoing a cyclical change.  

Over the last 14 years, VCs have been following a playbook, which was designed for a zero-interest rate scenario. Thus a fair amount of liquidity had been injected into the ecosystem. Now that the global economy is facing high inflation rates and increased interest rates, there is bound to be some slowdown in the markets. This will have an impact on the macro scenario and the playbook in use so far for VCs would need partial tweaking. 

In this context, here’s a look at the major contributing factors for venture portfolio construction. Let’s examine the various trade-off implications for early investors that are likely to impact their returns.

Establishing The VC Fund Size

Given the new global scenario, emerging investors starting out a fundraise should target slightly conservative VC fund sizes. Starting with a very large fund could immediately cause challenges, given the volatile market situation. 

There’s likely to be a slowdown in M&A (mergers and acquisitions) and IPO activity, which will further reduce liquidity, thus conservative funds will be safer bets, especially for first-time investors.

Plan The Number Of Total Company Investments

For portfolio constructs, 20-30 investments are a fair number. This has been a standard convention and is unlikely to change. 

This is because a diversified investment approach ensures out of the several investments, there are at least one or two solid companies, that will carry you forward. 

Capital Allocation Between New Investments Vs Reserves 

Another factor to consider is pre-deciding the average amount to be invested in early rounds of fundraising, and allocating and reserving follow-up investment percentages into the fund’s top-performing companies.  

Thus far, it was fine to invest a fair sum in round one and keep the same amount pro rata. However, in the new economic scenario, the next rounds can take longer to fund, so it is advisable for managers to reserve some capital for bridge rounds. This will allow them to support good companies if they are not able to raise subsequent funds immediately. 

Creating A Niche

The VC market is a highly competitive space and thus it is paramount to conduct thorough research on what should be your niche. The kind of companies you would like to invest in and the kind of people that you would want to associate yourself with. 

Partner with VC research firms to dig deep into the investments you are considering. A noteworthy point about niche funds is that they help open corporate LPs (Limited Partnerships), especially for AI, and fintech sector investments. 

This could prove to be a good strategy in the upcoming milieu, as there will be less investor money available but corporate money will be available for funds to get LPs. Hence for instance, in a fintech fund, banks and insurance companies would want to become LPs. 

LPs

Another interesting development in this space is that there is a lot of interest from family offices, ultra HNIs and corporates towards becoming LPs. Many corporates are turning into LPs in their first fund. A lot of startup founders and partners in VC and PE firms are also becoming LPs to other first-time fund managers.

More Collaborative Approach

Given the unpredictability of markets, a more collaborative approach towards investing would be advisable. 

In the past, investing alone had fewer risks but today, fund managers need to collaborate with each other and invest together in order to be able to support the company for longer, in case of delays in the next round. 

Harmonise Between Growth And Sustainability 

Another important factor to bear in mind for new investors is to maintain the right balance between growth and sustainability. This harmony is something they must understand, or they will end up burning cash or being overly cautious, risking missing out on investing in good companies in the mix.

Certain intangible factors also need to be considered when constructing a venture capital portfolio. If any of these is not modelled or strategised properly, early investors are in danger of impacting their performance. It is important to remind yourself that creating a new VC fund is a high-risk venture right from the word go. If too much time is invested in ensuring perfection then it might turn into a case of missed opportunities.

When planning the number of investments, investors should refrain from overcrowding the portfolio. While diversifying the portfolio might spread out the risk, it is also key to realise that each investment has bespoke requirements, and managing all at once could prove challenging, especially during the initial stages. 

It is better to focus on a few and ensure that management is not compromised. Be sure to put yourself in the driver’s seat and micro-manage all the details, at least in the early stages. 

As evident, various aspects need to be considered when building a VC portfolio, not just to evaluate investments but also to define the investment strategy. If any of these are not modelled properly, early investors would be at risk of impacting their performance. Of these, what they give more or less weightage to, or choose to invest their time and resources in will help construct their customised venture capital portfolios.  

Note: We at Inc42 take our ethics very seriously. More information about it can be found here.