VC Portfolio: the Power Law Curve
Last week, I explained the quick math of VC returns in simple terms. You can see the link to the post here below:
Carlos Oliveira
Today, I want to focus on the "power law," the north star of VC's business model. What this means, in essence, is that 80% of investments will fail, and the other 20% will drive all the returns. It follows the Pareto principle very closely, and the difference is when you apply the principle repeatedly... Using the principle again to the top 20% of deals results in 4% of the deals producing 64% of all returns. Applying the 80-20 rule again to that 4% of deals, we get 0.8% of deals producing 51.2% of all returns.
Let's keep things simple: 1 in 20 deals may produce two-thirds of all returns, and 1 in 100 deals may return more than all combined deals.
A fantastic article from Angellist goes into technical data analysis on the topic.
Market conditions should set the strategy
Market conditions affect startup growth and success rates. In theory, if the market has a positive sentiment, then more sales, more revenue, and more growth. Otherwise, with a negative market sentiment, there will be fewer sales, less revenue, and less growth. These ups and downs will impact the potential for outsized returns on VC investments, as the market will amplify the success/failure of top-performing startups, enhancing the Power law effect.
When GPs decide to follow this strategy, they must adapt to market dynamics to leverage their investment strategies effectively. When interest rates are low, and capital is abundant, LPs are more risk-seeking (or risk-tolerant), which is the moment to enhance gains. The problem is that the days when money was cheap and central banks printed money were long. Now, cash is expensive for GPs, and LPs would rather keep their money at bay while the current storm passes.
I am very critical of this strategy in today's market conditions. In moments of pessimism, like 2022/2023, it's risky, and I wouldn't bet on a fund with this strategy for the upcoming years. It ignores fundamental facts and is dangerous in a more risky market like venture capital. Who knows what 2024 might bring if interest rates go down significantly? It might justify getting back to that approach. But I will leave that for a future piece.
The fund age will impact their returns
Typically, a VC fund ranges between 7 and 12 years in maturity, most commonly around 10 years. Imagine a startup fundraising from a fund that is 7 or 8 years old. What kind of pressure will the VC put on the founder for quicker returns? I've seen a founder being forced to exit just because of this.
On the contrary, a younger fund will be less pressured for short-term returns and be keen on helping follow-up rounds and supporting other fundraising, offering a different dynamic in their investment approach.
This means that depending on the maturity of the fund, a company will be more or less pressured to find a deal to be in the 20% level of return (or even the 0.8% that I mentioned above).
The performance of VC funds is the result of portfolio performance
A strong portfolio performance is key in attracting investments for future funds. LPs look at past performance as an indicator of a fund's ability to deliver returns. GPs must ensure they build a successful portfolio and have home-runs to enhance a VC firm's reputation and credibility.
Good portfolio performance elevates a VC fund's position in the competitive market. The ability to source and identify startups that will fit in that top percentile will impact the performance of their portfolio and, therefore, the final performance of the fund.
Well-performing funds have more resources to invest in high-potential startups. This allows them to capitalize on the power law by investing in ventures more likely to yield outsized returns.
Conclusion
For good reason, 90% of VCs follow the Power law strategy: build diversification and maximize potential returns. There are other strategies that I can explore at another time, some more risk-averse and others more risk-tolerant. I do think that, like in public markets and other types of funds, VCs should be able to adjust accordingly to the market conditions and what are the biggest risks.
You don't change your strategy when you are winning. But there is one thing you should be doing about your strategy when you are winning: prepare a strategy for when you start losing. But any financial market is a roller-coaster of emotions. Regardless of your approach, just be sure you are ready to ride it all along. Otherwise, it will teach you how to be humble!