VC Fundamentals Part 4: Portfolio Construction & Management (with Jaclyn Hester & Lindel Eakman of Foundry Group)

Nov 30, 2020

Jaclyn Hester, a Partner at Foundry Group, and Lindel Eakman, also from Foundry, dive into the intricacies of venture capital portfolio construction and management. They discuss the importance of diversification versus concentrated investments, emphasizing the significance of risk mitigation and strategic decision-making. Key metrics like IRR and cash-on-cash multiples are explored, shedding light on what constitutes ‘good’ fund performance. The conversation also highlights the dynamics between VCs and founders, stressing the need for strong partnerships and open communication.

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INSIGHT

Net Returns in Venture Capital

Venture capital returns are judged by their net returns (3x), not gross.
This accounts for fees, carry, and fund expenses and is compared to other asset classes like private equity and public markets.

INSIGHT

IRR and Venture Fund Performance

Limited partners (LPs) are compensated based on Internal Rate of Return (IRR), which considers time.
A 3x net return is a reasonable proxy for a good IRR in venture capital, but macro factors like vintage year heavily influence it.

ADVICE

Aiming Above Median in VC

Don't invest in venture capital if you only expect median returns.
LPs must target above-median performance to justify the illiquidity and risk.

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We continue our VC Fundamentals series with Portfolio Construction & Management — how do you build and manage a fund's portfolio as a whole, beyond each individual portfolio company and investment decision? We brought in two of the very best people in the world to help us dissect this topic: Jaclyn Hester & Lindel Eakman of Foundry Group. Jaclyn and Lindel have been early and longtime LPs in some of the best venture funds in the world: USV, True, Spark — and of course Foundry — and now also sit on the GP side of the table at Foundry. Tune in for a master class on how the best VC managers think about generating and optimizing fund performance.

Sponsors:

Plaid: https://plaid.com

Topics Covered:

1. The bar for what "good" venture fund performance looks like in terms of returns:

Where venture sits on the spectrum of capital allocation options available to limited partners
The difference between "gross" and "net" fund returns and why IRR is still important
The distribution of returns across venture firms & funds — how many hit the performance bar — and the importance of diversification vintage years

2. Portfolio construction: how do you allocate the fund's capital across companies?

Why have a "portfolio" at all vs. loading up on a few high conviction investments — and what an LP's incentives are for diversification vs. a GP's
How to determine overall $ size you should target for a fund
Concentration vs diversification and the concepts of "shots on goal" and "groups" of high-potential companies within a portfolio
Fund reserves planning — are you "making your money at the buy", or able to buy up over time in your winners?

3. Balancing playing offense and defense:

The upside potential of "interstitial rounds"
Whether it's possible to save a company with more capital, and if pivots are a good idea

4. Time allocation vs capital allocation within a fund:

Understanding and managing your own cognitive biases
Why time & effort allocation across a portfolio rarely matches capital allocation (and shouldn't)
Why a firm's partnership dynamics are typically the most important driver of funds' outcomes

Links:

Foundry Group: https://www.foundrygroup.com
Seth Levine's post on skewed VC returns: https://www.sethlevine.com/archives/2020/10/vc-fund-returns-are-more-skewed-than-you-think.html
Fred Wilson's posts on losing money and portfolio outcome distributions: https://avc.com/2016/04/losing-money/and https://avc.com/2012/07/the-power-of-diversification/