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What is the Optimal VC Portfolio Construction?

Breaking down the math on VC portfolio construction.

Welcome to the 10X Capital newsletter.

We interview the world’s top Venture Capitalists and their Limited Partners.

📋 Today’s agenda:

  • What is the Optimal Portfolio Construction? 🤨

  • Lessons from Addepar’s $6 Trillion in Assets 💵

  • The Latest on YC’s Winter 2024 Batch 🖥️

And more! Let’s get started.

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Eric Poirier - CEO of Addepar on Lessons from $6 Trillion in Assets

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Eric Poirier CEO of Addepar on Lessons from $6 Trillion in Assets

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Contact Robert Regarding Film Fund: [email protected]

Apurva Mehta and Jack Altman on Sam Altman, CalPERS, and Liquidation Preferences

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The “Optimal” Portfolio Construction

Unlike traditional asset allocation, there is no single "optimal" portfolio construction in venture capital.

The most effective approach hinges on a fundamental question: what are you optimizing your portfolio for?

Chasing a single, high-flying outlier fund – the elusive 10x or even 20x return – may seem tempting, however, this strategy necessitates an extremely concentrated portfolio.

Concentrating a portfolio, however, is a dangerous strategy and one that is ill advised and is likely to lead to a underperforming fund.

The 3x Net Strategy: Building a Franchise 

A more prudent approach prioritizes building a portfolio with a high probability of delivering a consistent 3x net return (after fees). This return threshold ensures LP satisfaction while making sure that you remain in the game and are able to raise future funds.

The Institutional Investors’ Perspective

For institutional investors, venture capital typically represents a strategic allocation within their broader portfolio, ranging from 5% on the low end to 40% on the high end. Traditionally, large institutions target roughly an 8% overall return. A 3X net venture capital fund typically returns a 20%-25% IRR range which goes a long way in helping institutional investors achieve their target portfolio return.

Think of Portfolio Construction as a Simulation Game

An “optimal” portfolio construction is one that achieves its results the largest amount of times when simulated 1,000 times. In early stage venture the math can be simplified into the following question:

“How many portfolio companies do you need in order to achieve a single power law outcome?”

This is not a subjective question as much as it is a math question.

How should one think about portfolio construction?

Historical averages suggest that roughly 2% of early-stage companies breakout into $1B+ outcomes driving exponential returns for investors.

When it comes to your chances of capturing a breakout winner the most important variable you control is your portfolio size.

Here's where the math becomes crucial:

In order to calculate your chance of having a breakout winner in your portfolio, you need to take the odds of each company not being a breakout winner (98%) and take .98 to the exponential power of the size of the portfolio.

For example, 

  • With a 2% breakout rate and a 30-company portfolio, the math problem is 0.98^30=? which results in a 55% chance of not having a breakout company in your portfolio, otherwise known as a 45% chance of having a breakout company in your portfolio.  

When it comes to your career, a 50/50 coin flip is dangerous gamble.

The good news is that expanding your portfolio size improves your odds drastically.

By increasing the number of companies to 75, (1-.98^75) the chances of having a breakout company increases to 78%!

The Elusive Number

While historically 2% of seed companies have led to power law outcomes, there are investors such as Sequoia and Benchmark that have had breakout percentages closer to 5%.

For someone who has a 5% breakout average, a portfolio of only 30 companies can result in a 78% chance of investing into a power law outcome.

That being said, you are unlikely to be as talented as a Sequoia or Benchmark in picking winners so it is prudent to assume the market average of 2% (or lower) as the working number.

Unfortunately, when it comes to portfolio construction LP’s and VC’s are not 100% aligned. 

VC’s may want to optimize on delivering a 3X net but LP’s want to maximize on delivering the best possible return.  This is because LP’s may have 10+ funds in their portfolio making their odds of a breakout exponentially higher across their portfolio which leads LP’s to optimize on total returns vs. having a single fund return 3x net.

But this is a topic for another day.

Until then 🫡



Average Startup Valuations for Q1 2024


Reach out to Chris at [email protected].

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