In the area of investments aimed at sustainability and inclusion, the inevitable need for profit cannot be overlooked. Without profitability, the lifeline of any business grows tenuous. Even investments designed to foster a positive impact must have a reasonable margin between income and expenses, underpinned by a sound business strategy. This edition of my newsletter is a deep dive into venture capital investment strategies, a crucial compass for achieving desired goals and returns.
Venture capital is a dynamic and ever-evolving field, demanding constant adaptation from both seasoned investors and emerging managers. A skillful VC must nurture their start-up portfolios, enabling their growth and sustainability. Simultaneously, they must manage an effective exit strategy, all while ensuring the contentment of their Limited Partners with the investment returns. Striking this equilibrium is no small feat, as VCs find themselves at the intersection of divergent entities with often contrasting opinions on how to steer the ship.
In this article, I summarize findings from research and discourse in the industry, shedding light on various facets of venture capital.
The Right Investment Stage for VCs: A Strategic Perspective
For venture capitalists, the greatest returns typically stem from very early-stage investments, encompassing pre-seed and seed investments. If higher returns are the goal, investing in well-vetted seed ventures is the path to consider. However, those who prioritize risk mitigation over higher returns might find comfort in later-stage investments, such as Series A and beyond. It’s a trade-off, as later-stage investments are more secure but offer smaller returns.
There are several well-established investment strategies to weigh:
- Early-Stage Spread: Managing risk by dispersing investments in small ticket sizes across numerous early-stage startups, aiming to minimize losses through diversification and maximize large return by investing early.
- Late-Stage Focus: Opting for larger ticket sizes in later-stage ventures, with a focus on meticulous venture curation for a steady yet not extremely high return.
- Hybrid Approach – Small Ticket: Combining small ticket-size investment in early-stage start-ups with proven business models and later-stage opportunities. This approach aims to reduce the loss in relation to the amount of capital invested while maximizing venture curation.
- Hybrid Approach – Large Ticket : Diversify the risk by accommodating both early and later stages with larger ticket-size, thereby striking a risk balance.
In the dynamic landscape of venture capital, there is no definitive right or wrong approach. Venture capitalists must cultivate their preferred stage of investment, balancing profitability projection with their risk tolerance. Success stories in this space range from small pre-seed or seed funds outperforming larger funds to the reverse. Customized in-house formulas and frameworks are the key to success.
Some tips to bear in mind when participating in early-stage deals: VCs should consider several factors, including a strong management team (VCs see the management team as more important than business-related characteristics such as product or technology, Harvard Business Review), the qualities of the founders, a substantial market opportunity, innovative products, product-market fit, and competitive advantages.
Generalist vs. Specialist VCs: A Performance Analysis
The debate between generalist and specialist VCs remains an ongoing discussion. Pitchbook conducted an analysis of 1,306 VC funds with vintages between 2000 and 2020 to explore whether one of these types outperforms the other. They considered two metrics: median internal rate of return (IRR) and total value to paid-in capital (TVPI). The result did not reveal any significant disparities in performance between generalist and specialist funds.
However, specialist funds tend to excel in terms of TVPI due to their longer investment horizons, resulting in substantial investment appreciation over time, especially in sectors like biotech and deep tech. On the other hand, generalist funds from the 2015 to 2020 cohort exhibited better IRR performance. Their advantage lies in diversification, which enables them to manage risks more effectively and capture opportunities across various sectors. Consequently, this diversification leads to a more stable IRR, even when specific industries underperform, as they are not tethered to one sector.
Venture capital firms worldwide employ a variety of investment strategies. Some opt for a sector-specific focus, aiming to harness in-depth knowledge and efficiency to mitigate risks and secure lucrative deals. Others choose a broader approach, diversifying investments across multiple sectors to maximize the number of successful investments while mitigating the risk of overconcentration in one sector. The table below helps to compare the advantages and disadvantages of generalist vs. specialized VC funds (Medium):
The literature offers diverse perspectives on the significance of performance when comparing generalist and specialist venture capital firms:
- Specialized VC firms appears to be better in general (Gompers et al., 2009).
- Generalist VC firms demonstrate an aptitude for efficiently allocating capital across various industries (Stein, 1997).
- A finding in the literature reveals a U-shaped, non-linear relationship between the performance of VC firms and portfolio diversification. This indicates that VC firms benefit most from either low levels of diversification (specialist VC) or high levels of diversification (generalist VC). Moderate levels of diversification tend to yield the poorest results (Matusik and Fitza, 2012). This dynamic suggests that being either highly generalist or highly specialist holds more promise for success, while moderate levels of diversification may result in comparatively poorer returns.
Conclusion
Amid the ever-evolving and fiercely debated landscape of venture capital, the challenge persists for each VC to craft their unique recipe for success. VC firms must undertake a thorough self-assessment, weighing the costs and benefits of being generalist versus specialist, choosing the right investment stage, and clarifying their very objectives. This understanding paves the way for a clearer projection of a VC firm’s future direction and its investments.
Venture capital, with its expansive landscape, continues to captivate the continuous exploration of scholars and practitioners. While strategy analysis is significant, recognizing and remaining true to your core strengths is equally crucial. In many aspects of life, it’s not just about devising strategies solely to chase financial gains. Those who stay loyal to their core strengths and actively contribute to ecosystem value creation will naturally achieve the desired outcomes, including financial success.
