2.2 VC Portfolio Construction
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Building for Success: Understanding VC Portfolio Construction
Venture Capital (VC) investing involves deploying capital into high-risk, high-potential startups. But how does a VC fund decide where and how much to invest across different companies? This strategic planning process is known as Portfolio Construction. It's the blueprint a fund uses to allocate its capital over time, aiming to maximize returns while managing the inherent risks of early-stage investing.
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A well-defined portfolio construction strategy is fundamental to a VC fund's success and is tightly linked to its overall investment thesis, fund size, and team expertise.
Core Goals of VC Portfolio Construction
The primary objectives guiding how a VC portfolio is built include:
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Achieving Target Returns: VC funds aim for significant returns (often targeting 3x+ the fund size) to compensate LPs for the high risk and long lock-up periods. This often relies on identifying and backing a few "home run" investments (the Power Law effect).
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Managing Risk: While VC is inherently risky, construction strategies use diversification and staged investing to mitigate potential losses from failed investments.
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Optimizing Capital Deployment: Ensuring capital is available for initial investments and also follow-on rounds in the most promising companies.
Key Elements of Portfolio Construction Strategy
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Number of Investments (Portfolio Size):
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How many companies will the fund invest in?
This depends on fund size, stage focus, and GP capacity.
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Trade-offs: Too few investments increase concentration risk (high impact if one fails). Too many can dilute GP focus and support for each company, potentially requiring a larger fund.
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Typical Range: Early-stage funds often target 15-30 core investments.
02
Initial Investment Size and Timing
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How much capital does the fund initially invest in a company?
This depends on the company's stage (seed vs. Series A vs. later), the fund's size, the desired ownership percentage, and the specific deal dynamics.
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How quickly does the fund deploy its capital into new companies?
Typically, initial investments are concentrated in the first few years (e.g., years 1-4) of the fund's multi-year "Investment Period."
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Diversification
Diversification beyond multiple investments may or may not be occur across:
Stage: Investing in a mix of pre-seed, seed, Series A, etc.
Sector/Industry: Targeting different verticals (e.g., FinTech, HealthTech, SaaS, ClimateTech).
Geography: Investing across different regions or countries.
Lead vs. Non-Lead: Balancing deals where the fund leads the round versus participating alongside other investors.​
While diversification may reduce risk, over-diversification can lead to thesis drift and strain the GP's ability to provide meaningful support, especially if the fund lacks focus.
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04
Follow-on Investment Strategy & Reserves:
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A Follow On Reserve is where funds intentionally reserve a portion of capital (from 10-70%+) for future investment rounds in their existing, most promising portfolio companies to maximize returns from winners and maintain ownership.
Common Portfolio Construction Approaches
While utilizing the elements above, as identified by emerging fund thought leader VC Labs, VC funds often adopt an overarching strategic approach for constructing their portfolio. Three common approaches emerge:
The Concentrated Approach:
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Characteristics: This involves a portfolio with fewer investments (e.g., under 15-20), larger initial check sizes, aiming for higher ownership and deploying significant follow-on capital per company. GPs typically have deep conviction in each investment and provide substantial support.
Rationale: Aims for a higher "hit rate" and maximizes the impact of winners. Relies heavily on the GP's ability to select and support the right companies.
Trade-offs: Higher risk due to less diversification; poor performance in a few core holdings can severely impact the fund.
The Broad-Based Approach:
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Characteristics: This approach features a larger number of investments (e.g., over 30-40), smaller initial check sizes, potentially lower initial ownership targets. GP involvement per company might be less intensive.
Rationale: Maximizes the chances of capturing outlier returns predicted by the Power Law through wider diversification. Spreads risk broadly.
Trade-offs: Risk of being spread too thin, potentially lower impact on individual company outcomes, may require extremely efficient deal sourcing and selection. Follow-on strategy might be more selective or rely on later funds.
The Balanced Approach:
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Characteristics: Attempts to blend the Concentrated and Broad-Based strategies, often involving a medium number of initial investments (e.g., 20-30). Might involve different tiers of conviction or start somewhat dispersed and become more focused via follow-on capital allocation.
Rationale: Seeks to mitigate risks through reasonable diversification while still allowing for meaningful capital deployment and support in higher-conviction investments.
Trade-offs: Requires careful balancing and clear criteria for allocating follow-on capital and GP time.
The choice of approach depends on the fund manager's philosophy, fund size, team capacity, market focus, and risk tolerance.
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Continue to our next section -> The Waterfall of Distributions
For Further Reading:
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A VC's Guide To Portfolio Construction​
This GoingVC article defines portfolio construction as the blueprint for VC success, outlining key elements like deal flow, stage focus, and investment timeline. It covers best practices (thesis-driven approach, reviews, data usage), common mistakes (over-concentration, neglecting reserves, chasing trends), and offers a step-by-step framework for building a portfolio.​
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https://www.goingvc.com/post/a-vcs-guide-to-portfolio-construction
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Understanding VC Fund Portfolio Construction
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Rundit provides a comprehensive overview of the steps involved in building a VC portfolio. It details defining the fund strategy (thesis, stage, geography, size), determining allocation (number of investments, initial vs. follow-on reserves, check size), diversification methods, sourcing/selection, monitoring, and exit planning. ​
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https://rundit.com/blog/what-is-vc-fund-portfolio-construction/
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Portfolio Construction in VC: Strategies for Smarter Investing
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VC Stack defines portfolio construction and details the key levers GPs optimize: number of investments (portfolio size), diversification strategies (sector, geography, stage, model), capital allocation per investment (tiered models, barbell approach), reserves for follow-on investments (typically 50-70%, dynamic management), and ownership targets. It also mentions emerging trends like quantitative modeling and data-driven reserves. ​
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https://www.vcstack.io/blog/portfolio-construction-in-vc
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​The Basics of Venture Capital Portfolio Construction and Management
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AngelList distinguishes between portfolio construction (designing the investment strategy) and portfolio management (tracking against the strategy). It explains construction involves key criteria like fund size, number of investments, check size/ownership, follow-on strategy, and capital recycling, explaining how these elements shape investment decisions and fund returns, influenced by the power law. ​
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https://www.angellist.com/learn/portfolio-construction
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Portfolio construction & how to model your fund
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Signature Block emphasizes the importance of portfolio construction models for fund managers. It discusses trade-offs, aligning strategy with a manager's edge, and key model drivers including diversification (concentrated vs. diversified), average check size, number of deals, management fees, follow-on reserves, dilution, and exit multiples. ​
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https://www.signatureblock.co/articles/portfolio-construction
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