The most important piece which defines VC fund economics, or to be honest, any fund economics, is the portfolio construction. In this piece, I am going to cover portfolio construction from the lens of early-stage VC or impact fund.
The portfolio construction is the strategic and optimal way to think about the entire portfolio of ventures that a VC fund is going to invest in.
The nine critical pieces of portfolio construction are:
Portfolio Strategy, i.e., the fund needs to define: concentrated portfolio vs. diversified portfolio. The fund needs to rationalize whichever approach it takes because that is going to determine the return expectations and success rate in terms of exits. In many cases, it also leads to GP-LP friction, as many GPs like to over-diversify.
Stage of the venture, it's essential to define which stage of the enterprise a fund wants to invest. The stage of the venture further defines the following parameters:
i) ticket size of the initial investment
ii) how much ownership a fund is looking in a deal, i.e., pre-money valuation
Reserve allocation, it is super important to define the reserve allocations, which can be static or dynamic, i.e., changes with the health of a venture and overall portfolio health.
Risks, it is crucial that a fund has identified business, sector, and impact risks investing in a particular geography, industry, and investment thesis.
Fund structure, i.e., is it a closed-ended fund or evergreen fund? Because the portfolio and liquidation strategy changes entirely. Also, some LPs prefer closed-ended as they want to see rigor and hustle in fund managers to close the fund in 24 months.
Liquidation strategy, i.e., is fund looking for early acquisitions of the portfolio ventures or taking them to IPO. It gives a visual picture of the kind of returns a fund expects to make over its lifetime.
Co-investment, is co-investment with the LPs or the opportunity fund leads to a conflict of interest, or is it essential for the fund portfolio to scale and grow? Many LPs separate their fund of funds and direct investments to avoid any conflict of interest. E.g., Sapphire Venture Partners.
Recycling, it's an essential strategy and involves to have buying-in from LPs, as the fund re-invest any of its liquid cash during the fund period. As seen, recycling helps funds to perform better over a long period.
Portfolio management, is it low-touch, high-touch, or medium-touch? i.e., how much time a fund and fund managers are spending time with the portfolio venture. Also, it describes what kind of portfolio ventures gets more time and support, high performing ones, or not-so-good performing ones.
Portfolio Construction drives fund economics:
If you are planning to start a VC fund or already running a fund, please do ponder about some of these pieces as portfolio construction is not static, it is dynamic, it changes every year, depending upon the health of the portfolio.
If you are a first-time fund or running your fund-I, it's high time start focusing on your DPI and DPI is dependent upon the liquidation strategy and exits. Even moderate distributions is a huge plus, as it gives a signal to the LPs that GPs know how to exit. That's why LP says, showing some DPI is vital for first-time fund managers, before going to raise Fund-II.
Today's portfolio construction of the VC fund essentially defines the VC fund economics in the future. Here are three key metrics on which VC Funds gets measured and evaluated by LPs:
TVPI: Total Value to Paid In capital multiple: "Quick example, let's say a VC has a $100M fund. If they have called 50% of the capital ($50M), returned $20M to their investors from exits, and the remaining portfolio is worth $55M, then TVPI = ($20 + $55) / $50 = 1.5."
DPI: Distributions to Paid-in Capital multiple: "This is how much money a VC fund has sent back to LPs divided by the amount of money the LP has paid into the fund."
IRR: Internal Rate of Return: As well all know, it's kind of a fake number at the initial stages of the fund - since most or none of the private stock is not liquid.
I am continuously looking for first-time funds and first-time fund managers, that are looking to create their first-time impact funds with an edge or a differentiated value proposition in emerging economies. If you are building one, please do write to me. I would love to learn more from you and would be happy to help in any way.
Occasionally, he blogs about the responsible investing, tech for good, venture capital, investment thesis, conscious capitalism, collaborative consumption, community, and humane lifestyle.