PS#004: Intro to Portfolio Construction (Part 1)
Today, I’m going to discuss portfolio construction.
So far, I’ve talked a lot about individual deal processes and best practices. Alongside those individual processes, it’s important to understand how deals fit into a broader fund strategy.
This is a really important topic for General Partners (“GP”) to understand when starting a venture fund. Almost every institutional Limited Partner (“LP”) will be digging into this as a part of their diligence process.
And why is that?
Well…
Portfolio construction impacts every aspect of a venture fund from expenses to returns.
Portfolio construction is essentially budgeting or forecast planning for a venture fund.
In this process, venture capitalists will plan out their investments, reserve capital, expenses, salaries, number of investments, potential returns, etc.
This is a complex topic. To better understand it and make it easier to digest, I’m going to cover portfolio construction in two parts. Today we’ll cover part 1.
For part 1, we’ll walkthrough the high-level pieces of portfolio construction:
Fund details
Investing approach
Target returns
In the second part, we’ll walk through a more detailed example.
So for today and part 1, I’ll provide the key terms and explanation for how to think about it.
Let’s break this down piece by piece…
(1) Fund details.
Key Terms
Fund Size – the amount of capital committed to the fund
Management Fee – the yearly fee taken from the committed capital to run the day-to-day operations of the fund, such as salaries, insurance, travel, etc. (typically 2% yearly fee over the 10-year life of the fund)
Carried Interest – the percentage of investment profits the GP receives after LPs are paid back in full (usually 20%)
Fund Organizational & Administrative Expenses – in addition to the day-to-day operations, GPs need to pay for legal fund set up costs, fundraising expenses, financial statements, tax preparation services, etc. which is usually allocated to LPs on a pro rata basis
Commentary
This is the starting point of our portfolio construction. The fund size determines how much we will receive in management fees and how much ultimately needs to be paid back to LPs.
The management fees in particular will determine one of the most critical components for you and them – hiring. Most GPs will anchor themselves towards the carry (or the upside) and take on more modest salaries. This allows those funds to hire pre-partner resources to help administer the fund and make investments. The amount of management fees will ultimately dictate how many resources they can hire and at what roles.
(2) Investing approach.
Key Terms
Number of Company Investments – the number of companies you’re targeting for the portfolio
Initial Check Size – the initial investment in a company
Target Ownership Percentage – the ownership percentage VC firms target to acquire in a company with their initial investment
Gross Returns – an investment's return before any fund-level expenses or deductions
Follow-on Reserves – the percentage of the fund that will be reserved to make follow-on investments in their portfolio companies
Fee & Expense Recycling – recycling the management fees and fund expenses as investments once the fund receives distributions from other investments to reach a level where the full capital committed is invested
Commentary
Modeling out the number of investments in your portfolio is a critical step in this process.
How many portfolio companies are you targeting? Is this a more concentrated portfolio of 10-15 investments or a much more diversified portfolio of 50+ investments?
This will help determine the initial check size (or investment) that you’re able to put into companies and the amount of capital you’re able to reserve.
The target ownership percentage combined with initial check size will also help determine where and how you’d like to invest. If you can only invest $1M for the initial investment, but would like to own more than 10% of the company, you’ll need to make investments in rounds and companies valued below a $10M post-money valuation.
The target ownership percentage, initial check size, and valuation restrictions will determine the stage at which to invest and the gross returns to target at each stage. We’ll dive into these details in Part 2 of Portfolio Construction.
Follow-on reserves is a VC concept that differentiates itself from typical private equity. When a PE firm purchases a company, they are usually buying the majority of the company and not looking for additional investment. On the other hand, VC firms are minority investors in companies that are consistently raising additional capital, which brings additional dilution. This will change their ownership percentage over time, unlike most private equity investments.
To solve this issue, most VC firms will hold a percentage of the fund as reserves for their portfolio companies. This capital is used to defend their ownership position in their best performing companies by investing their pro rata.
However, if a company is struggling, the reserve capital can be used to help extend runway and get the company back on track. In this case, it is still an effort to defend the capital that is at risk from the initial investment.
Finally, GPs will often recycle distributions from earlier investments to reinvest into new investments. This offers more opportunities for them to find 10x, 100x, etc. investments that will return the fund and then some.
If you’d like to learn more about managing dilution over the life of an investment, I discuss this in detail in my course How to be a VC Associate.
(3) Target returns.
Key Terms
Target Net Returns – the targeted amount of capital the fund looks to return to LPs
Target Gross Fund Returns – return is reflective of an fund's return needed to meet
Commentary
The target net returns and gross fund returns are the ultimate goals of a venture fund.
LPs invest across the spectrum of asset classes, including public companies, real estate, private equity, venture capital, debt structures, etc. Since venture capital is a riskier asset class compared to most of these investments, LPs expect net cash-on-cash multiples (“CoC”) of +3x and an internal rate of return (“IRR”) of +25%.
Venture capital funds need to hit these returns in order to continue raising capital. If they don’t, LPs will invest their money elsewhere.
GPs will look at the target gross fund returns required (which includes all the capital returned to a fund) to meet the net return thresholds identified above. This will give them a sense of how much capital will be paid to LPs and how much will be paid to them as carried interest.
Portfolio construction creates an overarching decision framework for venture capital funds.
As you may have noticed, portfolio construction is all about helping VCs make decisions.
From the capital requirements of the daily operations to the fund’s investing approach, this is all about how to structure the fund’s future-oriented decisions.
Today, we’ve covered the high-level aspects of portfolio construction, including fund details, investing approach, and target returns.
In part 2, we will walk through what this looks like in more detail.
