How can diversifying your venture capital portfolio reduce economic downturn impacts?

Based on the data, it seems diversification is important at fund & company level… Between 1986-2018, VC FoF Vencap backed 259 funds w/ 11,350 underlying companies: ? These were funds raised by some of the best firms in the industry. ? ??Including realised & unrealised investments, here is what shook out: ? ? 6,000 (53%) companies are valued at less than cost (< 1x) ? (*2,500 are complete write offs) ? ? 2,157 companies (19%) returned between 1-2x ? ? 1,183 companies (16%) returned between 2-5x ? ? 1,342 companies (12%) returned at least 5x. ? ? 614 companies (5%) returned 10x+ ? ? Just 1.1% of companies (121) were “Fund Returners” ? It is the fund returners that drive the majority of performance. The Pareto Principle in all its glory.

The power law in venture capital basically says that if you invest in 10 companies, only 1 has a decent probability of doing really well, 2 will make a little bit of money, and you’ll be lucky to get anything back on the other 7. The problem is it’s exceedingly difficult to pick the winners. There are a few icons we know of who have picked consistent winners investing over and over in great companies that absolutely crush it. But because most transactions are private, we don’t usually see the list from those same people of all the companies they picked that didn’t crush it. Diversification is required to participate in venture capitals power law. But please see my additional post on other considerations to help balance this out.

Diversifying your venture capital (VC) portfolio is a crucial strategy to mitigate the impact of economic downturns, especially for early-stage investments. By allocating your investments across various sectors, stages, geographies, and startup types, you spread risk and enhance portfolio resilience. Not only that, it leverages the power law - with more than 50 companies in the portfolio, we statistically have a 15% likelihood of a 5x return without doing any of our value add. Venture capital is a delicate dance between precision and diversification. While 'spray and pray' may cast a wide net, strategic diversification is the artistry of planting seeds in fertile ground, nurturing them, reaping a bountiful harvest of innovation + returns.

Diversification is like having a well-balanced financial toolbox. By investing in a range of startups with diverse characteristics, you're essentially spreading your risk. This strategic approach is about both, minimizing the chance of losing big and optimizing potential gains. Different investments respond differently to various market conditions, and diversifying your portfolio ensures that you can benefit from the upsides while protecting yourself from the downsides. Diversification is about building a resilient and adaptive investment strategy in an ever-changing market landscape.

Diversifying a venture capital portfolio is a strategic approach to mitigate the impacts of economic downturns. By spreading investments across various sectors, geographical regions, and stages of company growth, investors can buffer against market volatilities. Different industries react differently to economic shifts; while some may struggle, others might thrive or remain stable. Geographic diversification also cushions against region-specific economic setbacks. Additionally, balancing investments in early-stage startups with more established companies can provide a mix of high-risk, high-reward opportunities and more stable returns.

Diversification has its own benefits but at the same time Funds which are not sector agnostic won’t be able to pick up companies from different sectors. Additionally, funds that only invests in early stage can’t pick up companies from Series B or late stage. These factors make it difficult for many sectoral Venture Funds to incorporate diversification as a strategy vs. Angel investors or sector agnostic funds. One way to have some diversification would be to pick up companies which have products that focusses on different regions or different TGs. Another way would be to have both product as well as services companies within the portfolio rather than just one.

Um dos grandes desafios de diversifica??o é no momento da realiza??o dos follow ons. Uma vez que há um interesse em alocar mais recursos nos investimentos que veem demonstrado melhores perspectivas. Considerando que o ciclo de investimento é muito mais longo que alguns ciclos de mercado, é bem possível (especialmente em mercados emergentes como no Brasil) que você fa?a um investimento em um determinado setor e este setor entre em crise e “sai da crise” enquanto ainda detém o ativo. Dessa maneira, a diversifica??o de mercados possibilitam uma mitiga??o de risco interessante, mas eu sempre procurei diversificar mercados mas com solu??es similares. Isso me ajudou a aprofundar nas dinamicas do modelo de negócio sem me concentrar.

Um dos grandes desafios de diversifica??o é no momento da realiza??o dos follow ons. Uma vez que há um interesse em alocar mais recursos nos investimentos que veem demonstrado melhores perspectivas. Considerando que o ciclo de investimento é muito mais longo que alguns ciclos de mercado, é bem possível (especialmente em mercados emergentes como no Brasil) que você fa?a um investimento em um determinado setor e este setor entre em crise e “sai da crise” enquanto ainda detém o ativo. Dessa maneira, a diversifica??o de mercados possibilitam uma mitiga??o de risco interessante, mas eu sempre procurei diversificar mercados mas com solu??es similares. Isso me ajudou a aprofundar nas dinamicas do modelo de negócio sem me concentrar.

This is inherently hard for VCs only focussing on one niche / sector. Instead, you might want to diversify by region or stage instead. We solved the issue in not only for core automotive, but also robotics and enterprise SaaS for a wider spread and application areas.

Balance "Hot" and "Stable" Sectors - Complement investments in highly funded industries like FinTech with more resilient but underfunded sectors like Education Technology. Also important to note that this changes for each geography. I.e in Vietnam, education is more highly funded than other SEA markets

Early-stage investments, such as seed and Series A rounds, typically carry higher risks but also offer the potential for higher returns. These investments are more susceptible to economic downturns due to their early stage of development and reliance on external funding. However, by balancing these riskier investments with later-stage companies, you can mitigate some of the impact of economic downturns. Later-stage investments, such as Series C and beyond, tend to be more stable and less affected by economic fluctuations. By including later-stage companies in your portfolio, you can offset some of the volatility associated with early-stage investments.

By investing across different regions, venture capitalists can tap into unique ecosystems, talent pools, and market dynamics, thereby increasing the potential for high returns while reducing exposure to any single market's volatility. This approach also fosters resilience against economic downturns, as downturns in one region may be offset by growth in others. However, it's crucial for venture capitalists to conduct thorough due diligence and build strong networks in each target geography to effectively navigate local nuances and capitalize on emerging opportunities.

Though diversifying across multiple sector help balance the impact of volatility and reduce poor performance in any sector, but the complexity of managing a portfolio is that more research on every sector is high needed. While in any market downturns, the sector may correlate, which may reduce the effect of correlations across diversify portfolio.

One of the best ways of diversifying your VC portfolio is by investing through fund structures. For examply, at Eoniq.fund our investors invest in a diversified portfolio of 50 startups from different sectors and at slightly different stages (we only invest at pre-seed and seed stages, but having invested across multiple years, we now have startups from pre-seed to series A+ within the portfolio). Whether this be a supplement to investing directly in startups, or vice versa, this provides a large degree of diversification. Indeed if our investors then decide to double down by directly investing in some of the startups within the portfolio (something that we encourage) they get the best of both worlds. The same goes for most funds of course!

Although the Power Law is the generally accepted method of winning at venture capital, part of the beauty of being in VC is there is a limited supply of information. VC is not like the public markets where it’s very difficult to generate alpha due to the amount of information readily available in the market. In VC, alpha is generated by the investor’s ability to cut through the noise of risk factors associated with a decidedly little known business. I’m convinced that those VC investors with a strong thesis and a better approach to risk management can get away from the power law and diversification and generate more alpha. What if instead of 1 out of 10 companies crushing it, you could land 3 out of 6? Imagine the difference!

Diversifying my venture capital portfolio is crucial to mitigating the impact of economic downturns. By strategically investing in sectors known for resilience, such as healthcare and education, I aim to create a balanced portfolio that can weather market fluctuations. Additionally, focusing on sunrise sectors that emphasize domestic consumption provides an opportunity for sustained growth, further shielding my investments from external economic pressures.

Some sectors, like healthcare, may be less affected by downturns compared to others like luxury goods or travel. Secondly, spread investments across different geographical regions. Economic downturns may impact regions. Also, i like to invest in a mix of large, established companies and smaller, growth-oriented firms. Large companies often have more resources to weather downturns, while smaller companies might offer higher growth potential. Lastly perform a regular Portfolio Review and adjust your portfolio to align with current economic conditions and future forecasts. Perhaps keep a portion of your portfolio in more liquid assets. This can provide flexibility to make changes as needed during a downturn.

Vintage year diversification is also important. We at Cardumen Capital, do this by deploying in three years. It is done purposefully to try, to some extent, to catch several cycles. This helped us in 2021. Some funds aggressiveky deployed in 2021 and due to the overall bubble will likely be more affected. It is a delicate balance. On the one hand deploying fast means that your startuos will have more time to mature (in a constrained fund duration scenario) but you will not diversify by vintage and you will likely do worse due diligence.

In the Why Diversify? section above I shared the core of our funds diversification matrix (sector, stage, geography). The full matrix, however, includes diversity by both race and gender. Aperture VC considers these additional factors to be important for the same reasons we diversify in general: to optimize overall portfolio returns to our LPs. The academic research shows unequivocally that diverse management teams - including female led teams- regularly outperform all white/ all male teams. My personal experience as serial founder and investor with 25 years experience in early stage technology has also proven out this principle in the real world. It’s worth considering why so many funds in Silicon Valley don’t have the same perspective?