Resources

Investors’ Guide To Portfolio Construction In The Emerging Markets

Silicon Valley-Based South Park Commons Enters India In Collaboration With Binny Bansal
SUMMARY

Constructing a portfolio for a new VC fund is a complex process that involves a variety of factors 

From the size of the fund to the targeted net return, each element plays an important role in determining the fund's success

A well-thought-out portfolio construction strategy can give a fund a competitive edge and increase the likelihood of success

Inc42 Daily Brief

Stay Ahead With Daily News & Analysis on India’s Tech & Startup Economy

As investors in the volatile startup ecosystem, it’s important to have a strategic approach to portfolio construction. This involves carefully considering factors such as investment philosophy, risk tolerance, and market trends to build a diverse and cohesive portfolio that aligns with your goals. In this article, we’ll explore the key elements that an investor must consider in portfolio construction and highlight two commonly used VC fund strategies.

Key Factors Of Portfolio Construction

One of the first things to consider in portfolio construction is the investment philosophy. This includes factors such as your risk tolerance, investment goals, and sector focus. For example, some VC firms have a strong focus on early-stage technology companies, while others may concentrate on growth-stage businesses. It’s important to clearly set and also define your investment philosophy and make sure each investment is made accordingly.

Another important element of portfolio construction is asset allocation, or how you allocate your investments across different asset classes. This can include equities, bonds, and alternatives, and the right mix will depend on your risk tolerance and investment goals. Diversification is also key, as spreading your investments across a range of sectors, geographies, and market capitalisations can help mitigate risk and increase the chances of success. 

Risk management is another critical element of portfolio construction. It involves identifying, measuring, and mitigating potential risks in your portfolio. This can include factors such as market volatility, currency risk, and credit risk. A good risk management strategy can help you sleep better at night knowing that you’re better prepared for any potential downside.

Investment horizon, which means the length of time one plans to keep on investing, and tax considerations are also important in portfolio construction. 

Finally, it’s important to regularly monitor and review your portfolio to assess its performance and make necessary adjustments. This can help ensure that your portfolio remains aligned with your investment goals and that you’re taking advantage of new opportunities as they arise. These are a few general factors that investors must consider when constructing a portfolio. 

Key Factors For Emerging Investors For Seed-Fund Portfolio Construction

But, to understand how a portfolio is run, we must understand the different aspects of portfolio construction and also the inevitable impact they have on each other. So, now let’s get technical and understand the key contributing factors that emerging investors must consider for seed-fund portfolio construction. 

Fund Size

This is a straightforward one, it is simply the amount of capital committed to the fund. For example, a $100 fund would have a larger pool of resources to invest in companies compared to a $50 fund. The fund size will also impact the number of companies a fund can invest in and the average initial check size, as well as the level of follow-on reserves.

Management Fee & Carry Percentages

These are two key components of the economics of a fund. Management fees typically amount to 2% of the fund’s size per year over the 10-year life of the fund. This fee basically covers all overhead expenses for the management company. The carry percentage refers to the percentage of profits that the GP (General Partner) receives after investors have been paid back in full. This is typically set at 20%.

Fund Level Expenses

In addition to the management fees, there are other expenses that are deducted directly from the fund assets. These expenses include legal set-up costs, fundraising expenses, and other administrative, legal, and infrastructure costs. These costs can range from a few hundred thousand dollars to millions of dollars, depending on the fund.

Number Of  Total Company Investments 

This refers to the number of companies that a fund aims to invest in over its lifetime. Some funds follow a concentrated strategy and invest in a limited number of companies, typically between 12-15. Others take a more diversified approach and aim to invest in larger numbers, depending on their strategy and business plan.  

Average Initial Check Size 

This is the average amount that a fund will invest in the first round of fundraising for a company. The average size of initial check size/investments will definitely also have an impact on the percentage of average initial ownership.  

In some cases, the fund may choose to invest more in the top-performing companies, through follow-on investments. With the same example of a $100 fund, a $100 fund with an average initial check size of $2 would be able to invest in 50 companies in their first round.

Target Ownership From Initial Investment

This refers to the percentage of the company that a fund aims to acquire with its average initial check size.  

Follow-On Reserves 

This refers to the percentage of the fund that is reserved for follow-on investments in the best-performing companies. Funds have different strategies for a follow-on, some might reserve a certain percentage for follow-on from the time of initial investment and some aim at larger ownership and dedicate such a percentage of the amount for follow-up 

Fee And Expense Recycling

This refers to the reinvestment of fund expenses and management fees into companies. For example, a $100 fund with a 2% yearly management fee would incur $20 in total management fees over its lifetime. Some funds aim to reinvest the entire amount of these fees back into companies, investing up to $20 as companies exit and money is returned to the fund.

Targeted Net Return/Required Return Fund Capital 

This is one factor where, if the investor is investing $100 and expecting 3x returns, then the targeted net return will amount to $300.  This means the fund targets to return the $300 to its investors. 

Graduation Rate Assumptions 

The performance of the fund is also determined by the individual company dilution. One way to take this into account is to make assumptions about the percentage of total companies that will raise subsequent financing rounds and their size and pre-money valuations. 

Some funds may assume that of all the seed investments made, 50% will successfully raise a series A round and of those, 50% will go on to raise a series B round, 50% of those will raise a C round, and so on. This will give the fund an idea of how much dilution they can expect as a company grows.

In conclusion, constructing a portfolio for a new VC fund is a complex process that involves a variety of factors. From the size of the fund to the targeted net return, each element plays an important role in determining the fund’s success. It’s important for emerging investors to consider each of these elements and understand how they impact the overall portfolio construction strategy. A well-thought-out portfolio construction strategy can give a fund a competitive edge and increase the likelihood of success.

Now, let’s look at successful VC funds and their strategies. 

Spray And Pray

As startups progress through multiple rounds of funding, the number of follow-on investments by fund managers decreases significantly. This is because fund managers tend to only invest in the subsequent rounds of companies that show the most promise in their portfolio. This trend is observed in both the median and mean values, except for the first round, where investors who adopt a “spray and pray” strategy may heavily invest but limit their follow-on investments. 

As a result, fund managers may not fully exercise their pro-rata rights, which can lead to higher levels of dilution in their stakes. Despite this, follow-on investments tend to increase, indicating that fund managers tend to concentrate capital on their most promising investments. 

Overall, the decrease in investment following the first round and the increase in selective follow-on investments over time illustrate how fund managers prioritise capital allocation to their most promising investments and seek to maximise returns on their portfolios. This is the most common strategy VCs use for return maximisation. 

Unicorn V. Dragon

Usually, fund managers tend to have overly optimistic estimates of their ownership stakes at exit. This is particularly crucial because the exit value of a portfolio company has a significant impact on the overall fund’s returns. While fund managers may be attracted to investing in Unicorns, which are companies valued at over $1 Bn, the true key to generating outsized fund returns lies in identifying Dragons.

A Dragon is a portfolio company that, upon its exit, returns the entire fund at least 1x, regardless of the return multiple on the individual investment. Unlike Unicorns, a company doesn’t need to have a valuation over $1 Bn to be a Dragon. Instead, what’s important is that the fund manager owns a substantial stake in the company, allowing them to “have enough skin in the game.”

Ultimately, the level of ownership in a company will determine which exits are most impactful for generating returns. Fund managers should focus on identifying and investing in Dragons, as they have the potential to significantly contribute to the overall success of the fund and this is one strategy that VC funds are using.

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

Inc42 Daily Brief

Stay Ahead With Daily News & Analysis on India’s Tech & Startup Economy

Recommended Stories for You