Question: How do VCs mitigate risk in their investment portfolios? Are VCs simply looking to diversify the type and stage of companies in which they invest, or do they employ other financial hedging strategies?
I’m not aware of VCs using classic financial hedging strategies. In many cases, they are prohibited from doing this by their LP agreements and/or investment documents in the companies when they make an investment. While I’m sure there are some folks that do this, I don’t believe it’s prevalent.
The primary ways VCs mitigate risk are (1) time diversification, (2) stage diversification, (3), sector diversification, (4) pro-rata or over pro-rata investing over time, and (5) number of investments in the portfolio.
1. Time diversification: Most VC funds are committed over a three to five year period. The commitment period for most funds is five years – by spreading out the commitments over a three to five year period, a fund gets time diversity and theoretically smooths out some of the macro cycles. Most VCs who have been investing since the mid-1990′s understand this well as many funds raised in 1999 and 2000 were fully committed in one year. As a result, the funds were invested during the rapid rise and peak of the Internet bubble, resulting in horrible performance for 1999 vintage funds due to their lack of time diversity. The firms that committed their 1999 over a three year period vs. a one year period ended up making a number of investments as the bubble burst, including many that ultimately ended up being successful.
2. Stage diversification: Some funds have an early stage and late stage investing approach. The VC industry went through a phase post 2000 where there was a shift in some early stage firms to mid and later stage investing as well as a phase in the late 1990′s where early stage firms created growth funds to augment their early stage strategy. Today most of the firms that did this have settled on an integrated early / late stage approach within a single fund. Recently, many larger firms who had drifted away from seed stage investing have created new seed programs.
3. Sector diversification: Historically, a number of VC firms had broad sector diversification, investing in software and life sciences companies out of the same fund. With the rise of clean tech investing in the mid-2000′s, many software oriented VC firms started clean tech practices. This ebbs and flows.
4. Pro-rata or greater: Most firms reserve the right to invest their “pro-rata” ownership in future rounds, allowing them to keep their percentage ownership in the company. This is both a downside and upside strategy. More recently, some firms have started aggressively buying additional ownership in their winning companies.
5. Number of investments in the portfolio: There is conventional wisdom that each fund should have 25 – 30 companies (or “names”) in each fund. Recently, some firms have taken a more extreme approach with upwards of 50 or more companies in each fund. Regardless, if you are playing for big wins, making sure you have enough investments in each fund is important.
There are other diversification approaches like geography (e.g. investing in the US, China, and Israel), but these tend to be limited to a few very large firms.