Portfolio construction & how to model your fund

One of the most important topics to study as a fund manager is portfolio construction. The model will determine your check size, volume of investments, and other factors that ultimately lead to returns (or lack-thereof if poorly constructed). Here’s Semil Shah on the importance of this topic:

“Portfolio Construction is what we, as GPs, are in the business to ultimately produce — it is our core job. The job involves other cool things, like hearing pitches, helping founders when we can, etc., etc… but at the end of the day, or at the end of the particular fund, what is built is a portfolio of (hopefully) uncorrelated assets.”

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In this post, we include the major drivers of portfolio construction, how they impact each other, and trade-offs to consider. You’ll also hear from experienced GPs on how to avoid common mistakes. Lastly, we’ve also included a Basic Venture Fund Model template you can use to forecast scenarios for your fund and better understand the levers at your disposal.

If you only have a few minutes, here are some key takeaways:

• Portfolio construction has trade-offs. A portfolio involves the calculus of several variables (more in the Drivers section). It’s important to understand how each one affects one another and the trade-offs.
• Pick a portfolio construction strategy that maximizes your edge. It’s important for fund managers to understand their strengths and pick a portfolio strategy that capitalizes on their advantages and considers their constraints. Your model might be dramatically different than another fund’s model.
• Assumptions are based on averages, but venture isn’t driven by averages. Ultimately, venture fund returns are driven by power laws which really limits a model’s ability to predict actual outcomes (more from Sam Gerstenzang on this here).
• Models should be optimized throughout a fund’s life cycle. As you’re starting out, your fund model will make key assumptions. Over time you may need to replace assumptions with real data. Portfolio construction isn’t a one-time activity; it’s continuous.

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Thanks to Abe Othman (AngelList Quant Fund), Ben Cashnocha (Village Global), Terrence Rohan (Otherwise Fund), Todd Goldberg (Todd and Rahul Angel Fund), and Semil Shah (Haystack) for contributing to this post. We’ve also included resources from Hadley Harris (Eniac Ventures), Taylor Davidson and Sam Gerstenzang linked below.

Strategies

First, let’s outline some of the major decisions to make when designing their strategy. The strategy chosen should lean into the fund manager’s strengths and will have a major impact on how they construct the portfolio. A model designed to lead rounds will look very different than a fund that writes smaller, follow-on checks.

Lead vs Follow

• Lead only: Funds that lead rounds, investing the largest check (sometimes covering the majority of a round) and setting terms
• Follow-on only: Funds that invest alongside (often) several others with a smaller check than the lead investor
• Mixed: Funds that lead and follow on depending on the company and round construction

Stage

• Early-stage funds: Funds that primarily invest in pre-seed and seed stage rounds (and might double down on their portfolio companies in future rounds)
• Series A funds: Funds that primarily invest in Series A rounds
• Growth funds: Funds that primarily invest in Series B rounds and beyond
• Multi-stage funds: Funds that write checks across stages

Diversification

• Diversified funds: Funds that invest in 40+ companies in each fund.
• Concentrated funds: Funds that invest in 20 or fewer companies in each fund, typically writing a lead check.

Drivers

These are the core drivers of the model. Like a math equation, changes to one influence the other variables and outcomes. We’ll first describe the inputs, the decisions that are within your control as a fund manager, followed by the outputs, the results informed by inputs and the fund’s performance.

Inputs

Fund size

The amount of capital committed to fund from LPs.

The larger the fund size, the more capital one needs to deploy, which affects the check size, reserves amount, and/or number of investments in each fund.

Increasing fund size requires the manager to have confidence that they will be able to effectively deploy larger checks and/or make a higher number of investments than a smaller fund.

Average check size

The average amount that will be invested in the first round of fundraising. This is independent from capital invested from reserves into portfolio companies in future rounds.

Increasing check size requires the manager to have confidence they can deploy that amount of capital in a single deal. For example, in early-stage it’s generally harder to fit $1M into a round than it is to invest $100K. Your check size might also affect the “bracket” of funds you’re competing with to invest. For example, lead investors can rarely invest together and meet their check size requirements.

Increasing the number of deals requires a high volume of deal flow to see enough companies to find those worth backing. It’s easier to invest in five good deals in a year than it is to do 20.

Number of investments

The number of companies you aim to invest in your fund. Lead funds tend to run a more concentrated portfolio strategy and follow-on funds tend to run a more diversified strategy.

Management fees

The fees fund managers receive to pay themselves and fund operating expenses.

The higher the management fees, the less capital fund managers have to deploy. Most managers charge 2% of amount raised annually over the 10-year life of the fund, equating to 20% total. If the capital isn’t required for operations, it might be wiser for a fund manager to lower fees so there’s more capital to invest and multiply. For example, a $20M fund taking 10% total management fees vs. 20% will have another $2M to invest, potentially increasing overall returns for themselves and LPs if the fund is successful.

Fund expenses

Fund expenses are typically used for back office, admin, and legal costs associated with operating the fund. This is often charged to LPs.

Carry (also called “carried interest”)

Percentage of profits the GP and other members that assist in operating the fund receive after investors are paid back in full. 20% carry is most common but can vary and sometimes ratchet up based on performance of the fund. For example, some managers take 25% carry for returns beyond 3x DPI.

Reserves percentage

The percentage of the fund reserved for follow-on investments into portfolio companies. Fund managers can use reserves to maintain or increase ownership as the company raises subsequent funding. Most early-stage fund managers incorporate a reserves strategy into their fund model.

The higher the reserves percentage, the larger the fund size needs to be to accommodate follow-on investments. For example, if you’re planning to deploy $10M into initial checks and want 100% reserves, you need to raise (or in part recycle) $20M. The higher the reserves, the less capital you have to invest in new companies.

While there’s conflicting advice on reserves strategy, it’s important to acknowledge that the ownership secured in the first check in earlier rounds is generally much larger than the ownership purchased in the future for potential fund returners.

Recycling percentage

The percentage of management fees and returns re-invested as investments.

Sometimes a portfolio company exits within a short amount of time (e.g. one year after the fund’s close). Depending on the LPA, the fund manager may be able to use those funds to invest in another company, recycling the proceeds. If invested well, this will increase the fund’s overall returns.

Outputs

Capital returned

The total capital returned from liquidity events.

Multiple on Invested Capital (MOIC)

MOIC is calculated by a portfolio’s (total value) / (initial Investment).

Distribution to Paid-In Capital (DPI)

DPI is the ratio of capital returned over capital deployed. For many LPs, DPI is what they care about the most as it’s the multiple they receive on their initial investment.

Internal Rate of Return (IRR)

The rate of return that sets a portfolio's net present value to zero. It represents the annual growth that your portfolio is expected to generate.

Unlike MOIC and DPI, IRR is heavily influenced by the speed of deployment. All things being equal, a fund that deploys and returns capital to LPs in 5 years will have a higher IRR than a fund that takes 10 years to deliver the same results.

Note that we excluded IRR from our Basic Venture Capital Model 101 to simplify the template and make it more accessible, but it remains an important consideration.

Assumptions

Outcomes at exit

To model fund returns, you’ll need to make assumptions about the exit valuation of fund outcomes. One way to approach this is to set exit valuations by size (e.g. returns at $0, $10M, $100M, $500M, $1B, $5B).

Conversion rate

With exit assumptions set, you need to be realistic about the probability of those events at different stages. It’s reasonable to assume later stage investments have a higher likelihood of exiting for $1B than earlier stage investments.

Dilution at exit

Many fund manager underestimate the affects of dilution but it’s critical to model. Generally, the earlier the investment, the more dilution one should expect at exit. An aggressive follow-on strategy and securing pro rata in all investments will help minimize dilution.

Common portfolio construction mistakes

As we mentioned in an earlier post, there are many ways to invest, from angel investing to scouting for another firm. They all have similar challenges but managing a fund introduces portfolio construction demands that even experienced investors may not have experience producing.

Here’s some advice on how to avoid first-time fund manager mistakes, although we acknowledge that there are varying opinions on this topic with even the most experienced GPs.

Keep portfolio construction standard  

I would not innovate on portfolio construction unless it is an essential part of your strategy. This means keeping portfolio construction simple and standard.  

LPs are accustomed to buying a "standard product" - i.e. 30 to maybe 50 companies portfolio, with a clear stage focus - and if you keep your portfolio construction simple like this it adds efficiency to the fundraising process.  

For Fund I, you also don't need to worry much about reserves; the main value in the first check. LPs understand this. They are also comfortable you building in more systematic pro rata in future funds.

— Terrence Rohan (Otherwise Fund)

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Have enough “shots on goal” in early-stage

“The most common mistake I see here for new seed managers is having too few portfolio companies. For example, I meet many pre-seed funds that are targeting 15–18 portfolio companies in their fund. This sounds reasonable but in practice is not a good idea. Even at a solid conversion rate of 60% between preseed → seed, seed → A and A → B, that fund ends up with a post series B portfolio of 3 companies. I hope it goes without saying that very few institutional LP’s would sign up for a B focused fund whose strategy was to only invest in 3 companies. In practice we think you want in the neighborhood of 20–25 post series A or 10–12 series B companies.

Given venture returns generally follow a distribution similar to the power law this gives you a good number of ‘shots on goal’ for exits that can be fund returners. From there you can work your way back to the stage where you plan to enter using an estimated conversion rate.”

— Hadley Harris (Eniac Ventures) in Seed Fund Portfolio Construction for Dummies

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Have a target ownership

“The classic mistake here is new managers pick an amount like $250K or $750K when they should be pegging initial checks to a target ownership. At the end of the day, the percentage you own of a portfolio company when it exits is what’s important, not the amount you put in. Pick a target ownership percentage you’ll try to stay close to. Then based on the average terms you project investing at, approximate the average allocation you’ll need to invest to buy that ownership.”

— Hadley Harris (Eniac Ventures) in Seed Fund Portfolio Construction for Dummies‍

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“Given your fund size, determine what your target check size range/ownership is and stick to it. I think it's ok to have some investments that fall outside of that, but understand how those atypical checks fit into your fund's model. You can have a fund with many great logos, but too little ownership in them might still yield average returns.” 

— Todd Goldberg (Todd and Rahul Angel Fund)

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Great angel investments might not be great fund investments

"All of the attributes you might look for matter — team, traction, market, etc — but entry price and check size/ownership matter too. This is especially true given the power law nature of outcomes (I.e only a few companies will drive the majority of your returns) and that you only have so many shots on goal. You can always try to invest more in follow-on rounds via the fund, but that capital might be better used on seeding a new company.”

— Todd Goldberg (Todd and Rahul Angel Fund)

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Consider the ratio between entry ownership and fund size

"I believe it’s always good hygiene to ask “What’s the ratio between our entry ownership target and our fund size? The bigger the fund size, the more ownership you need. And ownership in good companies is hard to earn.

– Semil Shah (Haystack)

Venture Fund Models

“Basic Venture Fund Model” Template

Here’s a Basic Venture Fund Model template you can use to understand how variables in your fund model interact and their influence on outcomes.

To play with the model, duplicate in Google Docs (File > Make a Copy) and input your fund details and assumptions. As with all models, we recommend you spend time understanding how the major drivers work (see above) before trusting its outputs.

Before you dive in, here’s what is important to know:

• We’ve designed the model to be easy to understand and use for modeling different scenarios. There are more sophisticated models for venture funds online that include IRR, sensitivity analysis, and more complex techniques, but they tend to be harder to use for most people.
• The model can be used for funds investing across various stages (early-stage, series A+ and later-stage follow-ons) as well as funds investing in a single stage (simply leave cells not relevant for your stage empty).
• Venture returns are driven by outliers. While we recommend using a model to understand the levers and potential outcomes in different scenarios, we recognize how real outcomes can vary heavily with a single breakout investment.
  

This fund model has four sections:

• Fund Inputs: Input your fund variables such as fund size, expenses, etc.
• Investment Inputs: Input your investment variables such as average check size, average valuation, and assumed valuation for each stage you invest in.
• Outcome Assumptions: Input your exit valuation and outlier frequency assumptions for various outcomes (loss, save, medium exit, unicorn and super-unicorn).
• Outcomes by Stage: Output of the fund’s returns by stage based on the inputted assumptions.
  

More fund model templates

If you want to go deeper and explore other models, see:

• Open Source Venture Model (V1) by Sam Gerstenzang
• Portfolio Construction for Dummies by Hadley Harris (Eniac Ventures)
• How to model a Venture Capital Fund by Taylor Davidson (OpenVC)

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If you’re a fund manager, thinking of starting a fund, or just curious, subscribe to Signature Block if you haven’t already. If you think this might be useful for others, share on Twitter. Lastly, let us know what topic you’d like us to cover in the next edition.

Until next time,

Ryan and Vedika :)