How to Build a Best-in-Class Venture Portfolio | AWM Insights #157
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Episode Summary
Constructing a well-diversified portfolio is very similar to building a well-rounded baseball team.
Assets must be distributed between current players and prospects to field a strong lineup while also investing in the future to fill any foreseeable gaps and improve key positions.
Venture Capital aligns closely with the logic of investing in prospects. The benefit is deferred, but if done correctly, there may be outsized returns and general production relative to the initial investment outlay.
This must be carried out systematically and diligently to maintain the balance between the present and the future and optimize short and intermediate-term competitiveness while also reaching for a brighter future.
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Episode Highlights:
0:00 Intro
0:45 How do we build out and structure our Venture Fund
3:16 Why it makes sense to diversify across stages?
5:13 How do we determine what funds and fund managers we invest with?
7:53 How does our dynamic and consistent approach give us more quality at-bats?
9:25 How fund size impacts the investment process and returns?
10:46 What expected returns and outcomes are we targeting?
12:40 Text us!
+ Read the Transcript
Brandon Averill (00:05): All right, Justin, we're back for another one. And we're going to continue down the cycle here talking about the private markets. We've started 30,000 foot level really talking about why you would want to be invested in the private market space and specifically venture capital. We've kind of gone down the chain here and we've gotten all the way to this point of for clients listening talking a little bit about how do we actually come up with the portfolio. So we've talked about wanting to be persistently in the market. We want a very diversified approach.
(00:39): We think that that makes sense over time. But when we start to get to the nuts and bolts, I would love to just unpack a little bit. Year in and year out, we make an allocation. So when we start the year, we start the year with a certain amount of money. How do we look at actually building out that year's portfolio from number of positions that should be in there, maybe even as you think through different types of funds that we're going to include to get that diversification. So let's start with, hey, we got a certain dollar amount. Where do you even start with starting to construct the portfolio?
Justin Dyer (01:15): Well, we start high level. How much do we want in early stage exposure? How much do we want later stage? Do we reserve anything for directs? Those are checks written directly to a company, colloquially called directs in the business, I guess. So that's really the starting place. And where we land there is, and we touched on this, a emphasis on the earlier stage, specifically seed stage investing. The big reason there is it has the high expected return within the asset class overall. Venture as a large asset class in aggregate has the high expected returns.
(01:56): When you slice and dice that by stage, you start to see, oh, well the seed part of it has even higher expected returns. There's trade-offs to that as everyone can probably guess that risk and return are related. So we want to emphasize there, but we're not putting our entire stack of chips in, if you will. So what that actually looks like in principle, and this is reassess each and every year, but speaking for 2023 here, 60 to 70% of our vehicle will be in early stage. Again, that's going to be seed focus, but getting a little granular here, there will be some pre-seed checks within that.
(02:37): Small, those are just small checks by nature, but there will be some exposure on that really early side of the spectrum. But then also on the series A side of things, you put it all together, the early stage focus will be largely seed exposure on average. Again, that's by design. We want to get that exposure to the highest expected returns, but we want to do so in a thoughtful, diversified way. So we're going to hold roughly 10 to 12 different positions in venture funds with that general focus to get that broad diversification. So that's where we start.
Brandon Averill (03:19): I think that makes a lot of sense and maybe an analogy for those listening because this should be pretty familiar, but it's a lot like sports and we'll choose baseball. When you think about a seed position, we're thinking about the draft and we're looking at it and saying, hey, you know what, we're willing to take a chance early. We think there's projection here. But we all know that in the baseball draft, even first rounders, only 50% become meaningful-
Justin Dyer (03:44): That's right.
Brandon Averill (03:45): ... At that point. So we want to build our farm system, we want to build for the future because we also know that if we pay a seed stage, a draft pick a few million dollars, they may provide 10x the value throughout their career. And so we're kind of getting in cheaply at that point potentially. Whereas you go along the cycle, we still want to invest in our players that have performed to a certain extent. So we're willing to put maybe at a lower valuation, but we want some money in those pre-arb type players. And then at the end of the day, you get to the end of free agency and that's where you start to have to pay public or actual value-
Justin Dyer (04:29): Fair market value.
Brandon Averill (04:29): ... Fair market value. And so we don't want our venture portfolio to be paying fair market value at some stage. So really kind of think about it, you guys listening, in that way. We're investing along the spectrum of things. And then you just reference pre-seed that's your later round draft pick. We all know him. Mike Piazza, he was 62nd round. We still want to take shots there. There might be some reason for it. Very minimal positions, very low signing bonuses, but you may have an outsized return. We've all been pretty familiar with those players that have had success.
(05:06): So I think as you start, as we talk about these terms and everything, think about it in a language that you know, think about it in sports because there's a lot of side by side to that. Well, so you build out this portfolio, you want 10 to 12 funds. A question I often get is we start to put money in for the year is, okay, what are the 10 to 12 funds? So maybe talk through your process there. Do we know the funds when we actually start? How do we determine them? When do we know, etc.
Justin Dyer (05:39): So it depends, I guess, is the answer, which is an answer everyone hates, me included. But it truly does, and this is the nature of private markets, not just venture specifically. When we're in the market to deploy, doesn't necessarily always line up with our top picks. So the funds we've built relationships with that we really like, they've proven themselves, etc., they might not be raising a fund this year. Typically, a venture capital and private equity manager will raise a new fund every two to three years. That's certainly changing a little bit in the marketplace.
(06:12): It was a little bit quicker than that in the 2020 to 2022 timeframe. Now it's slowing down a bit. People are having a harder time fundraising, which is great for us because we're always in the market. So to give some specifics and details, we do have a list of managers we've partnered with in the past that we like, that they've proven themselves and we want to partner with them again when they're going back to market. That may be this year, that may not be, and that's part of the systematic process that we are going to get exposure to them over time.
(06:43): But there's an element of that list that is either not raising or someone who's going to fall off. They didn't necessarily prove. Now they've changed their thesis, now they want to raise a gigantic fund or they're investing in series B all of a sudden then they fall off our list. They're not really fulfilling the reason why we hired them in the first place. And that's where just the constant kind of market participation, the networking, relationship building, etc., really comes in handy.
(07:15): And not only is it to replace a manager that may fall off, but it is also to say, well, are we constantly getting exposure to the best? So venture and private markets in general, it's an ever evolving very dynamic world. And so the 10 to 12 funds that we'll have exposure to, I'd say a good chunk of them are known, but there's close to 20 or let's call it 30 to 40% that's dynamic each and every year. And I might meet someone who I don't even know is fundraising right now, but I'll meet them in a couple months and we can then still make a commitment to them.
(07:53): The flexibility is nice, but it is also a challenge, I guess.
Brandon Averill (07:58): Yeah. And I think that's an important thing to hit on is this is why we spend so much time in this environment and doing the due diligence. I think we've referenced it before, but last year you reviewed north of a hundred different funds. Why we continue to go through that process and you go through year in and year out is because the market does evolve and you also have opportunities where seemingly unknown funds pop up. Maybe it's their first vintage, but you have to really get under the hood to see if that is really their first vintage.
(08:33): So there is a fund that we allocate to in this current fund, and when you look on the surface, it looks like it's her first fund. She's new to the entrance, but you unpack it a little bit and you see, oh, she actually had experience at Khosla and experience at Andreessen. And you start to see actually there is a lot of investing experience here that you can start to put together different things. So it's not always what it looks like on the surface. You have to actually dig under and then you also have to figure out were you really the investor on those opportunities at those previous funds.
(09:09): So I think I just bring this up because a lot of times when we even have clients that go up to the valley, get exposed to this, it seems easy. You understand who these funds are, but it is a constant process to really evaluate who we want to include on a year in year out basis.
Justin Dyer (09:30): It's never ending and it's exciting. It's, I use the word dynamic, you said constant, and it's true. And as funds are successful, they typically get this creep in size. And I think we've talked about large funds versus small funds, how smaller funds typically outperform. So that's another dynamic that we're always paying attention to in addition to new entrants into the marketplace. And it is ever-changing. I was at a conference actually yesterday and the topic of creative destruction came up quite a bit.
(10:07): And not only is venture as an asset class really playing and participating in that idea within the global or broader economy, but within venture itself, there's also a constant creative destruction of the incumbents kind of getting big. And that's not a bad thing in it in its own right. We do want some exposure to that, but they're not going to 10x a fund. If you're raising a billion dollars, it's going to be very, very difficult. But they have a very defined process and you're going to get a little bit more predictability, so we do want exposure there.
(10:38): So the new entrants do challenge them. It's where you can get higher expected returns, higher alpha, but you want to do it in a thoughtful way through our diligence, through really looking under the hood, all those things that you highlighted.
Brandon Averill (10:50): And I would say maybe we can wrap up with a quick comment on this, but you brought up expected returns, and that's something we give a lot of thought to. It's why we come up with the allocation to early stage, why we're willing to go slightly later stage. As you can imagine, as I referenced to earlier, your expected return of a little bit later stage probably comes down a little bit, but your timeframe's shorter. So there are all these trade-offs. So maybe just quickly, Justin, talk about when we put together this fund, are we targeting a range of expected outcome and that's a blend of what we put together?
(11:28): How do you think through liquidity and that type of stuff?
Justin Dyer (11:30): Yes. The short answer is it ends up being a range of what the sum of the parts are. So on the earlier stage side, you're expecting a much higher multiple on your invested capital there. It's going to be a longer timeframe to see that. So think roughly seven years, if you will, seven to 10 years maybe on the earlier stage side of things. And the multiple, there may be four to 6x on your money. The later stage, more established managers, you're going to probably cut that in half, two to three times, but it's going to be a shorter path to liquidity, and you have a little bit more confidence around that multiple, around that rate of return.
(12:14): You combine those two things together, we're expecting to outperform venture as a whole. We're not expecting to perform perfectly in line with-
Brandon Averill (12:23): Sure.
Justin Dyer (12:23): ... 100% seed exposure as you can imagine, because we're not allocating 100% there. But it gives us a good blend of higher expected returns with a shorter path to liquidity, which we like. We like money coming back so you can continue to invest it in future vintages or use it to support your priorities if you need to.
Brandon Averill (12:42): Well, that's great. Hopefully, this has been helpful for everybody listening. Just a little bit of a peak under the hood to how we actually think about constructing the portfolio. Hopefully, the theme you're taking away is we're very systematic, we're very thoughtful in our due diligence, very thorough. And when I say we, Justin and his team are pretty much heading this whole process up. But it gives us a lot of confidence that when we make these recommendations to you and we're building that multi-generational wealth, that this is an allocation we can all feel really good about.
(13:15): So, and until next time, own your wealth, make an impact, and always be a pro.