The common notion is that to make money in venture capital, you must take on a lot of risk. After all, the dispersion of returns is far higher in VC than in other asset classes, which means that the risk of selecting a poorly performing investment is also higher.
The apparent instinct is to increase the size of the venture fund to reduce the risk of individual investments, but that’s not always the right move. Larger funds consistently underperform smaller ones, and established managers underperform emerging ones.
The trick is not to invest in larger funds but in many different funds across sectors, geographies, and stages. By investing in a wide variety of VC funds, you can offset the risk of any individual investment while still participating in the potential upside of the asset class.
More deals reduce risk dispersion
The main reason that investing in multiple VC funds reduces risk is that it leads to more investments, and more investments lead to lower dispersion of returns.
An Institutional Investor report simulated two VC portfolios: One with 15 investments and another with 500 investments. They found that the former yielded a median return of around 10 percent, with bottom-quartile funds losing money and the top-quartile funds experiencing large internal dispersion.
In contrast, the 500-deal fund experienced 10 to 17 percent returns, similar in size to that of public equity funds. But, with proper diversification, it’s possible to achieve a reasonably safe, predictable return profile in venture capital while outperforming public markets.
Similar to how Vanguard introduced the concept of index funds to reduce the risk of investing in stocks, you can also reduce your risk by reducing the number of bets you’re making on any particular VC fund. Today, index funds are a popular way to invest in stocks, like the S&P500 and Dow Jones Industrial Average, and there are ways to do the same with VC.
How many deals are needed?
Research finds that two-thirds of venture capital deals fail, meaning a VC’s ending portfolio size is one-third of its invested companies. Since classical portfolio theory suggests investing in 20-30 equities at once, with more recent research suggesting 40-70 investments, a well-diversified portfolio would include from 60 to 210 investments.
The problem is that very few VC funds have this many investments. The typical VC fund is concentrated in <20 to 40 deals, which is too small to provide the kind of diversification that would offset the risk of individual investments.
The solution, then, is to commit to many different VC funds. The problem with this, however, is that minimum investment sizes quickly add up, making it impossible for everyone but the most deep-pocketed investors to participate.
The better solution is to find a way to invest in many different VC funds without having to commit large sums of money. With Gridline, for example, you can deploy $100,000 across ten different funds, each making 30 investments. This gives you the diversification of 300 investments, equivalent to just $333 per investment.
With a portfolio like this, you can offset the risk of any individual investment while still participating in the potential upside of the asset class. And best of all, you can do it without committing large sums of money.
Institutional-Grade Due Diligence
Systematic vetting of funds can help ensure that you are more likely to select above-average managers. An experienced advisor and/or a platform like Gridline will run a comprehensive due diligence process that digs into granular details of the fund’s operations, legal structure, compensation structure, regulatory compliance, and reliance on third-party service providers.
Generating above-average, risk-adjusted returns in these markets comes from investing in a variety of diversified well-vetted top-tier fund managers.