"Few investors demand diversified funds, so GPs don’t offer them. A slow and steady 'venture is a numbers game' pitch is much less emotionally compelling than 'I am a rock star who can consistently beat the odds.' And GPs need an emotionally appealing pitch to get funded."
📄 Quote from: The Pervasive, Head-Scratching, Risk-Exploding Problem With Venture Capital, by Kamal Hassan, Monisha Varadan and Claudia Zeisberger
Despite what you may hear elsewhere, for early stage investing, large portfolios (~100 investments) outperform small portfolios (~30 investments).
The goal for pre-seed or seed GPs is to invest in a large enough number of companies to maximise the chance of finding outliers (about 2% for ~50x, 5% for ~15x according to data from Dave McClure). This implies a minimum of 100 investments, with an upper-limit realistically determined by the number of good opportunities you can find.
From that point, once you have built a sufficiently diversified portfolio, you can consider a strategy to deploy remaining funds into follow-on rounds for best looking companies as "call options". Evaluate these opportunities as you would any other investment.
Many VCs (and LPs, for that matter) understand the logic of concentrating into winners, but not the first step of building an appropriately sized portfolio. Why? Probably because the former amplifies risk, while the latter reduces it — playing into the principal-agent problem in VC and the "power law" smokescreen.
It also happens to be a lot easier to manage a small portfolio.
I've spoken to LPs that say they prefer small portfolio strategies because concentrating into winners is more likely to produce >10x returns. In a world where only the top 5% return >3x, it makes ZERO sense to optimise for that level of risk. Especially when you are allocating other people's capital (pension funds, MFOs, sovereigns, etc).
It's not at all clear that concentrated portfolios are more likely to deliver extreme outlier returns. Take Mucker Capital, which has raised 3 funds (avg $50M) and delivered ~30x returns to LPs from nearly 200 investments.
Essentially:
• If you believe that "picking" is the superpower of great investors, why wouldn't they pursue a strategy that allows them to make more picks?
• If outliers drive the vast majority of returns in venture capital, shouldn't you favour portfolio strategies that are optimised for finding outliers?
LPs should be looking for venture firms that have a carefully considered portfolio strategy based on solid theory — not in managers that just swing for the fences every time and call it power law investing.
This is yet another symptom of the crazy amplification of volatility in venture, a product of the deeply misaligned incentives which are becoming more widely discussed at last.
Sources in the reply below.
