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When a venture fund deploys capital into startups, those startups become part of the fund’s investment portfolio. Fund managers (also known as “general partners” or “GPs”) seek to build a portfolio that aligns with the fund’s investment thesis and maximizes the potential return for the fund’s investors (also known as “limited partners” or “LPs”). The process of determining the number and size of checks to write and then tracking the actual investments over the lifetime of the fund is known as portfolio construction and management—and it’s a core skill in the world of investing, especially venture capital.
In this guide, we’ll provide an overview of the main components of portfolio construction and management, and how venture fund managers can use AngelList Projector to design their optimal fund strategy and track how their fund is pacing against that strategy.
Portfolio construction is the art of designing an investment strategy to inform investment decisions. This includes determining the number of checks you plan to write, your average check size, how you allocate capital across rounds and follow-ons, and more.
Portfolio construction can be viewed as the primary job of the fund manager. All other tasks (generating deal flow, pitching founders, helping startups post-investment) are ultimately in service of constructing and supporting the ideal portfolio.
Portfolio construction incorporates a handful of key criteria related to investment strategy, which we’ll explore in greater detail later in the article:
Of course, these criteria are themselves dependent on a variety of factors that may be out of the GP’s control, such as how much capital a GP can raise from LPs, how much deal flow a GP sees, how many deals a GP can earn allocation in, how much allocation a GP is offered, and how much time a GP has to perform due diligence.
That’s why we say portfolio construction is more art than science. Portfolio construction is similar to a personal budget or financial plan in that it’s not necessarily perfect, but it can provide guardrails around how to make smarter investment decisions.
Portfolio construction modeling takes your expected number of checks, investment amounts, and other information about your fund strategy and combines it with market data and assumptions to make a projection as to how your fund may perform.
For instance, if you know you’re going to write 20 $100k checks into seed-stage companies, a model can use historical data about the market (round sizes, graduation rates, exit valuations, dilution) to make an educated guess about how many of your companies will exit and at what valuation. This feeds into an overall projection of how much your fund may return based on those assumptions.
The power law nature of venture returns (which we explore at length here) makes modeling out venture returns more challenging than models that rely on the law of averages. Additionally, changes in the market over time can make historic assumptions quickly irrelevant when analyzing future performance (this is why some VCs broadly index the market, as more investments reduces the range of outcomes—which can also reduce max distributions to paid-in capital [DPI]).
AngelList Projector solves for both these limitations. To better account for the power law nature of these returns, Projector can perform hundreds of Monte Carlo simulations (i.e., a mathematical technique used to estimate the possible outcomes of an uncertain event) and produce the percentiles of possible outcomes, rather than a less accurate absolute outcome. Additionally, Projector is powered by AngelList platform data, which updates monthly, allowing users to closely follow shifts in the broader market.
Portfolio construction matters because, if done well, it can maximize a GP’s advantages and empower better decision making. For example, if a GP is well-networked in the early stage startup ecosystem, they can use a portfolio construction model and identify that they are most likely to have success writing X number of checks around Y size. On the other hand, if a GP has the cache to lead rounds in the later-stage, their portfolio construction model may lead them to write fewer, larger checks.
Portfolio construction can also help a GP market themselves to institutional investors. These types of investors typically want to see a detailed investment strategy before investing in a fund. Not having these details figured out can make it difficult to raise from more experienced or institutional LPs.
Additionally, portfolio construction can enable a GP to make smarter follow-on and subsequent investment decisions. Two funds investing into the same companies at the same time can have very different outcomes depending on their investment strategy. A GP’s ownership stake, follow-on approach, and capital recycling policy all have a significant impact on a fund’s returns.
For example, say you invest in a startup’s seed round and it goes on to be a big winner for your portfolio (i.e., raises a subsequent round at a steep valuation markup). Should you invest in this startup’s next round to maintain your ownership and increase your returns in the event of a positive exit? In this situation, some GPs like to follow on while others don’t. The argument against following on is the opportunity cost of doubling down on an investment instead of using the funds for another potential big winner (smaller funds typically don’t reserve capital for follow-ons because they want to ensure they take enough shots on goal). A pre-determined portfolio construction plan should provide guidance on what’s best for your fund and LPs in this situation.
Given venture investments are risky and illiquid and LPs generally don’t see a return on their investment for 7-10 years, “good” venture returns often need to be significantly higher than what an investor would see from more liquid public markets.
It is generally agreed that venture funds should have an internal rate of return (IRR) of 20% or more. For a typical venture fund that keeps significant reserves for follow-ons, this would equate to a DPI of 2.5x over the fund’s ten-year lifespan (using the rule-of-thumb that a fund’s effective duration is ordinarily about half its calendar age).
Note that Projector can calculate your fund metrics for you, including IRR. For more venture fund performance modeling tools, GPs can also try our VC Fund Performance Calculator.
When determining fund size, GPs consider many factors as there is no “right” size:
These inputs should inform an appropriate fund size.
There is no “right” number of investments to make. However, given the power law dynamics of venture capital, GPs may aim to take "more shots on goal" by investing in more startups to increase the chance of hitting an outlier investment that will drive a majority of their fund's returns. AngelList research indicates that majority of funds on the AngelList platform with at least 20 investments have a TVPI that’s greater than 1x.
Also note that many GPs balance their investment count with a desire to write large enough checks to purchase a meaningful equity stake in the portfolio company. Holding fund size constant, if a GP makes 100 investments, they’re more likely to find an outlier than if they only invest in 30 companies. However, the GP’s ownership stake in that outlier investment will be lower given the increased number of checks out of the fund, limiting the return potential.
As such, broadly indexing is generally considered a more “conservative” approach to venture investing. The more startups you invest in, the more likely you are to hit your target rate of return by picking an outlier. However, you’re also less likely to far exceed your target rate of return, as your ownership percentage in each company is lower. Conversely, if you invest big in fewer companies, one big winner can drive enormous returns. However, you also risk picking poorly and underperforming. In other words, the fewer investments you make, the higher the variance in results, but the higher your maximum return may be.
Again, there’s no “right” answer when it comes to deciding whether to follow-on. Reserving capital for follow-ons allows GPs to maintain a higher percentage of ownership in the company as it progresses though subsequent funding rounds. In other words, GPs are able to increase their upside if they pick the right companies to double down on. Many GPs reserve up to 50% of their fund for follow-on investments.
Reserving capital for follow-ons has its trade offs, though. Less capital will be available for initial checks, which reduces the number of shots on goal a fund has (which in turn reduces the likelihood of hitting on an outlier investment). Some smaller funds elect never to follow-on because it detracts from their ability to make meaningful initial investments into a diverse portfolio of companies. You can read additional AngelList research on this topic here.
Additionally, picking the “right” companies to follow-on can be tricky, which is why some GPs opt to never follow-on out of their fund. Instead, they spin up special purpose vehicles (SPVs) when they receive pro rata opportunities. However, SPV investing comes with its own pitfalls:
The state of the market also makes a difference in decisions to follow-on. Many GPs who started their funds during the venture market bull run of 2021 have opted not to follow on to their initial investments, as market valuations have fallen significantly.
Projector allows you to create a robust follow-on strategy for your fund, with controls to adjust your desired participation rate and check size (or target ownership percentage) for each subsequent round.
Fund recycling means taking exit proceeds from early fund successes (i.e., an exit in year 2) and re-investing them into the fund, instead of distributing the proceeds to LPs. A fund’s Limited Partnership Agreement (LPA) will specify what percentage, if any, of exit proceeds can be reinvested into the fund.
The benefit of recycling exit proceeds is that it allows GPs to increase the investable capital of the fund without raising additional capital from LPs. Many funds aim to recycle 20% capital for this reason.
However, recycling exit proceeds does come with risk, as the GP is reinvesting capital rather than returning it to LPs—and there’s no guarantee that reinvested capital will result in additional returns.
Projector will soon enable GPs to indicate their desired recycling rate and see the impact on their fund’s performance and cashflow.
Once a GP constructs their portfolio and starts deploying the fund’s capital, their primary job shifts to portfolio management. Portfolio management is the process of ensuring you’re tracking with your desired investment strategy by understanding, in real-time, your fund’s performance and projected performance (and adjusting your strategy accordingly over time).
Portfolio management typically seeks to answer two underlying questions:
Like portfolio construction, the purpose of portfolio management is to make smarter decisions and ensure LPs that they’re working with a sophisticated GP who’s queued into the performance of the fund.
In practice, portfolio management looks like maintaining a repository of actual investment data from your portfolio companies and cross-referencing it with real-time market data to model various scenarios for the outcome of your fund (e.g., best-case, worst-case, middle-case). GPs can then use this portfolio management information to keep LPs informed and manage expectations.
AngelList Projector can help streamline the portfolio management process. Using Projector, GPs can evaluate how their actual investing matches up with their plan, as well as project out how their fund might perform using their actual investments and investing strategy for the future.
In addition, GPs can create various projections for each company in their portfolio (bear case, bull case, etc) and attach probabilities. These probabilities are then integrated into the larger model to provide insight into how the fund may perform.
Knowing how to construct and manage a portfolio is a core competency for VCs. However, even the best fund managers are only as good as the data they’re working with. AngelList Projector solves for inadequate data and streamlines much of the portfolio construction and management process with scenario modeling, data visualizations, and more. To learn about Projector, visit our website. To learn more about other portfolio management software offered by AngelList, visit our website.
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