PS#005: Intro to Portfolio Construction (Part 2)

In Part 1 of “Intro to Portfolio Construction,” I laid out the high-level pieces that venture capitalists consider when building and launching a venture fund.

In Part 2, we’ll walk through an example. As a reminder, we’ll go through the following…

Fund details
Investing approach
Target returns

Let’s get started.

(1) Fund details

Fund Size: $50M
Management Fee: 2% fee or $1M per year
Carried Interest: 20%
Fund Organizational & Administrative Expenses: we’re going to leave this out for now as it’s not a critical component to building out the strategy

We’ll build out this exercise for a $50M fund investing at the early stage (i.e., Seed - Series B) with the Seed stage being the primary entry point.

We’ll assume a typical economic structure of “2 and 20” or a 2% management fee and 20% carry structure. This gives the fund $1M per year to run the day-to-day operations.

(2) Investing approach

Now, let’s cover our investing approach.

To start, we need a plan for our targeted number of portfolio companies and leveraging the $50M in capital…

Number of Company Investments: 10 portfolio companies
Fee & Expense Recycling: assume that we’ll recycle all the management fees into investments, investing the full $50M into portfolio companies

Individual Investment Details

Next, we need to outline our gross return targets for individual investments and target ownership percentage. For this, we will leverage the following chart:

In the chart, you’ll notice that we’ve defined…

the characteristics of a company at this stage,
the expected range for the round size,
our target ownership percentage,
our target return,
and the expected length of time for the investment (i.e., exit horizon)

All of these items will be important to consider when we plan out our average initial checks and reserve capital for each investment.

I’ve highlighted the seed stage since this will be the primary focus of the fund. However, we need to have the same set of criteria for early and growth stage investments in order to underwrite potential follow-on investments. We should be completely re-underwriting each investment we make into our portfolio companies, even follow-on investments.

The target returns and exit horizon identified equate to a +25% internal rate of return (IRR). These target returns provide a minimum threshold we need to meet our overall fund returns.

Capital Allocation & Pacing

Once we have those items defined, we’ll calculate the average initial check and reserve capital.

As I mentioned, we’re going to keep this simple and focus on the Seed stage for the initial entry point.

Average Initial Checks

Based on the size of our fund and the assumed round sizes, our fund will likely only be able to lead Series Seed rounds (or rounds of that size).

We’ve assumed an average initial check of $2M, which will account for 50% of the round on the higher side (assumes $1-4M Series Seed round sizes highlighted in the first chart). If we assume that most rounds will acquire ~20% of the company (in line with historical averages), $2M of a $4M round will allow us to hit our 10% ownership target.

With this information, you can assume that we will be focused on companies with a post-money valuation at or below $20M.

Reserve Capital

For the follow on rounds (Series A-B), we’d like to reserve enough capital to defend our initial position (i.e, investing our pro rata).

Based on the $3M of capital we’ve reserved for each portfolio company and the assumed future round sizes, we should be able to defend our ownership position through at least the next round of financing with some capital to spare for the next round.

If we assume early stage rounds are between $5-20M, we will likely need to reserve between $500k - $2M to defend our 10% ownership position. We’ve assumed $3M.

You’ll also notice that the average initial check of $2M plus the reserve capital of $3M = $5M in total capital invested per portfolio company. This is intentional. We don’t want any deal to account for more than 10% of the total fund size or $5M in capital invested.

Investment Pacing

Now that we have our initial and reserve capital allocated, we can focus on investment pacing.

In the pacing chart below, I’ve assumed the reserve capital is split over two rounds ($1.5M each) with each round occurring 12 months after the previous round.

This results in the $50M being invested across 27 transactions in 5 years.

(3) Target returns

While we underwrite to the returns outlined, the reality of the situation is often quite different.

Venture capital returns are driven by the power law, meaning that most of the funds returns will be the result of a few companies.

Take a look at the distribution below:

The chart above provides a broad representation of the venture power law at work. We’ve got 3 companies that went to zero, 3 companies that were able to return the capital invested, and 4 companies that provided a return on investment (ranging from a 2x to 20x).

We’re able to calculate the gross and net returns with the following calculations…

Gross Fund Returns = $200M / $50M = 4.0x

For gross returns, it’s a relatively simple calculation.

Net Fund Returns = ((($200M - $50M)*80%) + $50M))/$50M = 3.4x

For net returns, we need to account for the $50M fund to be paid back in full first and surpass the “carry hurdle,” which is a minimum rate of return. Assuming both of these are achieved, the GP is able to start receiving carried interest.

As you can see, portfolio companies 9 and 10 accounted for 75% of the returns. If we remove just one of those investments, the fund isn’t able to hit the 3x net returns expected by LPs.

This in a nutshell highlights the importance of underwriting companies that can at least meet if not surpass the return thresholds highlighted in (2) Investing Approach. We’re counting on a few of these companies to greatly exceed our expectations.

Disclaimers

A few disclaimers to highlight…

This is just one way to construct a portfolio. There are several different approaches that investors take in the market and I encourage you to learn about different fund styles.
The portfolio construction above contemplates investing to our concentration limit for every portfolio company. This often isn’t the case as some companies may not survive to the next round and/or may no longer be a worthwhile investment.
We’ve assumed investing in 10 portfolio companies, but this will often depend on the actual deployment of the initial and reserve capital. In reality, the fund may invest in more or less than the target portfolio companies.

I hope this provides a bit more clarity into the process of constructing a portfolio and thinking through capital allocation.