Venture capital firms often employ different investment models for portfolio construction to maximize returns and minimize risks. In this article, we will explore three of the main models – Focused, Dispersed, and Hybrid – and discuss their respective pros and cons. By understanding the characteristics of each model, managers can make more informed decisions about which model best suits their investment goals and preferences.
Focused Model
The Focused model is a high conviction investing approach where the venture capital firm makes a small number of thesis-related bets in companies the manager strongly believes in. For example, a venture capital firm might concentrate its investments in generative AI startups.
Focused Model Example
In the Focused model, a venture capital manager might concentrate investments in the generative AI space, believing that a small number of companies will have outsized returns. The manager would perform extensive due diligence to identify a few standout startups that exhibit strong growth potential and align with their investment thesis. This in-depth research and vetting process may involve deep dives into each company’s technology, team, and market potential. The venture capital manager would often join the board of directors, providing significant financial support and dedicated guidance. This hands-on approach allows the manager to actively collaborate with the startups, assisting them in achieving their goals and growing their businesses.
Focused Pros
- – Strong alignment with manager’s expertise, enabling better investment decisions
- – Enhanced support for portfolio companies due to fewer investments
- – Potential for higher returns from concentrated, conviction-driven bets
Focused Cons
- – Higher risk exposure due to lower diversification
- – Reduced adaptability to market shifts and changes
- – Dependence on the manager’s expertise, creating a potential single point of failure
Dispersed Model
The Dispersed model involves investing in a large number of companies within a specific industry or segment, with the belief that the selected industry will generate the best returns. For instance, a venture capital firm might invest in numerous Foodtech startups.
Dispersed Model Example
A venture capital manager following the Dispersed model might choose to invest in the Foodtech industry, anticipating that this sector will experience significant growth and generate many strong startups. The manager would cast a wide net, investing in a large number of companies across various segments within the Foodtech space, such as alternative proteins, food delivery platforms, and smart agriculture technologies. Due to the large number of investments, the manager would conduct relatively low diligence on individual companies, and the support provided to portfolio companies would be limited and often automated, such as through standardized resources and templates. This approach allows the venture capital manager to capture a broader range of market opportunities while mitigating the risk that any individual company failure would significantly impact the overall portfolio performance.
Dispersed Pros
- – Improved risk mitigation through greater diversification
- – Increased chances of capturing top performers in a given industry
- – Broader exposure to market trends and opportunities
Dispersed Cons
- – Limited time for the manager to provide support to individual companies
- – Increased likelihood of individual company failure
- – Dilution of expertise, potentially weakening investment decisions
Hybrid Model
The Hybrid model combines elements of both Focused and Dispersed models, investing in a medium number of companies with conviction within a targeted industry or segment. For example, a venture capital firm might invest in a select group of Deeptech startups.
Hybrid Model Example
In the Hybrid model, a venture capital manager might target the Deeptech sector, investing in a medium number of startups with conviction within this specific field. The manager would conduct a moderate level of due diligence, focusing on identifying companies that demonstrate high potential for growth and innovation, such as those working on quantum computing, advanced materials, or biotechnology. Portfolio construction for this model would involve selecting a curated group of companies that both represent the targeted industry and align with the manager’s areas of expertise and conviction. The manager would support the companies as needed, potentially joining their advisory boards or providing strategic guidance on an ad-hoc basis. This approach allows the venture capital manager to balance the benefits of diversification with the potential for higher returns through conviction-driven investments while offering tailored support to their portfolio companies.
Hybrid Pros
- – Balanced approach combining diversification and conviction-driven investments
- – Tailored support for portfolio companies, improving their chances of success
- – Exposure to high-performing startups within the targeted industry
Hybrid Cons
- – Moderate risk exposure compared to the Dispersed model
- – Potential for lower returns than the Focused model due to less concentrated bets
- – Requires the manager to maintain expertise in multiple areas, potentially stretching resources
Follow-on Investing
Follow-on reserves play a crucial role in venture capital investing, allowing firms to provide additional financial support to their portfolio companies as they progress and achieve specific milestones. In the Focused model, venture capital firms traditionally reserve around 50% of the fund for follow-on investments, as they have a strong conviction in their selected companies and aim to support their long-term growth. In contrast, the Dispersed model typically allocates 10% or less for follow-on investments, given its broader diversification strategy and lower level of direct involvement in each individual company. It is worth noting that new venture capital managers, particularly those with smaller fund sizes, often do not have capital to allocate significant reserves for follow-on investments.
Choosing the Right Model
When deciding which investment model to adopt, venture capital managers should consider several factors, such as:
- – Personal preferences and passion for a particular industry or segment
- – Ability to provide support and assistance to portfolio companies
- – The desired level of risk exposure and diversification
By evaluating these factors and reflecting on the type of work they want to engage in, venture capital managers can make more informed decisions on the most suitable investment model for their fund. Ultimately, the right choice will depend on the unique combination of a manager’s expertise, resources, and investment goals.