In the world of venture capital (VC), portfolio size isn’t just a number—it’s a strategic decision that can significantly influence fund performance. Historically, VC funds have tended toward concentrated portfolios, often limited to fewer than 50 investments. While this approach may seem prudent, emerging evidence suggests that a diversified portfolio strategy can better capitalize on the unique dynamics of venture capital, where a small number of investments drive the majority of returns. This article explores the importance of portfolio size and why VC funds should embrace a broader investment scope.
The Case for Diversified Portfolios
Most venture capital firms fail to deliver consistently strong returns. Data indicates that nearly half of all VC funds fail to return their investors’ capital, and only a fraction outperform the public market. This lackluster performance is often attributed to overly concentrated portfolios. A typical fund might invest in 20-40 companies, a strategy that relies heavily on identifying a few exceptional winners—so-called unicorns—while absorbing losses from failed investments.
Yet, given the infrequent occurrence of unicorns (roughly 1-2% of startups), such concentration increases the risk of missing out on these high-value opportunities entirely. A more rational approach would be to expand portfolio size, particularly for early-stage funds where startup attrition rates are higher.
Understanding the Numbers: Unicorns, Centaurs, and Failures
- Unicorns: Startups valued at over $1 billion. These represent 1-2% of most portfolios and can generate returns of 50x or more.
- Centaurs: Startups valued at over $100 million. These account for 5-10% of portfolios and typically yield 10-20x returns.
- Failures: The majority of investments (50-80%) either fail outright or return less than 1x the invested capital.
Given these probabilities, portfolio size becomes critical. A fund investing in only 15-30 companies has a high likelihood of missing unicorns entirely. In contrast, funds with 100-200 investments stand a better chance of capturing multiple outliers, effectively mitigating the impact of failures.
The Power of Numbers
Dave McClure of 500 Startups argues that most VC funds are undersized by a factor of 2-5x. His experience investing in over 1,000 startups demonstrates the importance of volume:
- Highly Concentrated Portfolios (15-30 companies): High risk of missing unicorns.
- Moderately Concentrated Portfolios (50 companies): Greater probability of at least one big win.
- Highly Diversified Portfolios (100+ companies): Statistically safer, with a greater chance of capturing multiple unicorns or centaurs.
The reasoning is straightforward: if unicorns occur only 1-2% of the time, a larger portfolio increases the likelihood of discovering them. Early-stage funds, where failure rates are even higher, should aim for portfolios of at least 100-200 companies to improve their odds.
Addressing Skepticism: The Role of VC Involvement
One common argument against larger portfolios is that VCs must remain deeply involved in their investments, often through board seats or operational support. Critics claim this hands-on approach becomes unmanageable as portfolio size grows.
However, McClure counters that this belief may stem from outdated practices. Instead of direct involvement in every company, VCs can secure voting rights and focus their efforts on high-performing investments. This approach allows funds to scale their portfolios without sacrificing governance or strategic oversight.
The Risks of Concentration
By limiting portfolio size, funds gamble on their ability to consistently identify unicorns—a feat even top-performing firms struggle to achieve. Concentrated portfolios risk generating lackluster returns, failing to meet investor expectations, and ultimately jeopardizing the long-term viability of the fund.
As McClure notes, “Unless you think you’re going to pick unicorns at a rate of 5-10% instead of the 1-2% industry norm, you are essentially gambling with LP money by selecting a portfolio size of less than 50-100 companies.”
Embracing Diversification
For venture capital to thrive as an asset class, funds must adapt to the realities of startup investing. A diversified portfolio:
- Increases Statistical Odds: Captures more unicorns and centaurs, which drive overall returns.
- Reduces Risk: Mitigates the impact of failures, which dominate most portfolios.
- Enhances Scalability: Aligns with modern practices that prioritize voting rights over direct involvement.
Looking Ahead
The venture capital industry has long romanticized the image of the VC as a genius investor, capable of spotting the next big thing with unerring accuracy. However, the data tells a different story: success in VC is as much about strategy and portfolio design as it is about vision.
Expanding portfolio size offers a practical path forward, especially for early-stage funds navigating high attrition rates. By embracing a data-driven approach, VC firms can improve their chances of success and better serve their Limited Partners.
Acknowledgment
This article adapts insights from “99 VC Problems But A Batch Ain’t One” by Dave McClure, originally published on Medium under the 500 Hats blog. For the original piece, visit 500 Hats on Medium.
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