To Concentrate or Diversify
One of the most important decisions that an early stage venture investor makes is determining the target number companies their fund will invest in. This decision heavily influences how a VC will allocate their two most valuable resources: capital and time.
On one end of the spectrum are VCs who invest in a large number of companies to ensure their fund doesn’t miss out on the next big thing. These highly diversified investors cast a wide net with the goal of having enough coverage to ensure participation in the breakout companies. The rationale here is straightforward — if you managed a $30m fund and invested $100k in the seed round of Uber and $100k in each of 299 other companies, you would end up with a fund performing in the top decile even if all 299 other companies went to zero. Each additional investment your fund makes only increases the odds that you will catch the next Uber.
At the other end of the spectrum are VCs who invest in a small number of companies. These highly concentrated investors aim to limit the number of investments so they can focus on making successful companies out of the ones they choose to back. This is a more active approach to investing, as these investors provide more concentrated support after they invest. The investment rationale is that more concentrated time actually increases the likelihood of an investment actually becoming a breakout success.
Each type of investor recognizes that only a small percentage of their investments will be responsible for the bulk of their fund’s returns. Each type thinks the other misses the point on how to make sure those top performing investments get included in the portfolio.
The diversified fund manager assumes, at the earliest stages, it’s nearly impossible to identify what is going to be the next big breakout success. This is because many of the events which lead to the success or failure of a company are outside the founder’s control, let alone the investor’s influence. They believe an investor can be helpful in certain places, but even their best efforts will not meaningfully enhance the outcome for a top performer. So rather than allocating time trying to improve a 40x return to say 42x, investors should focus their time on ensuring that a 40x is included in their portfolio in the first place.
The highly concentrated fund manager believes, at the earliest stages, their experience and perspective can help the company avoid common pitfalls and capture opportunities that would otherwise go overlooked. They think each additional company added to the portfolio only increases the likelihood they aren’t paying enough attention to the others, which leads to companies making avoidable mistakes. As a result, what would have been a 40x return for a given company ends up being a 0x because the investor’s negligence.
In practice, most investors don’t sit at either extreme of the diversified/concentrated spectrum. Diversified fund managers won’t invest in every pitch they see, nor do concentrated fund managers have a portfolio of one. But if an investor wants to have a thoughtful strategy they generally do have to pick a side. It represents their philosophy on how they believe venture funds generate returns. As Fred Wilson of USV put it, “You have to either choose to be active and concentrated or passive and diversified. Either model works, but I think you need to be one or the other. It’s not really possible to be both.”
With that said, I’ve chosen my side, but I’ll save it for my next post. You can follow me here on Medium or on Twitter to make sure you catch it.