Crafting Early-Stage Venture Portfolios for Optimal Performance
By Consuelo Valverde and Vartan Indjeian
May 2024
Portfolio construction for early-stage venture capital can be a challenging task, especially when returns follow a power law distribution, where a small number of outliers drive most of the profits. Traditional portfolio construction — designed for asset classes with normally distributed returns — may not be effective in this context. Endurance28’s approach aims to increase the chances of consistently strong performance in our portfolios.
A key component of portfolio construction for VC portfolio managers is the question of capital reserves for follow-on investments. Irrespective of their size, stage or thesis, most funds typically earmark a specific portion of their capital for follow-on investments in existing portfolio companies. This is generally done to protect the investor’s ownership stake, and to provide sustained portfolio support.
Contrary to standard practice, Endurance28 does not set a predefined percentage of reserves for our portfolio companies. We use a Decision Analysis Framework to guide our investment strategy, assessing every investment opportunity individually — be it a new investment, or a follow-on in a subsequent round of funding for an existing portfolio company. This process enables us to focus on the possible returns for each individual investment, regardless of whether it’s for a follow-on investment in an existing company or an investment in a new venture.
Our strategy is consistent with the historical and intuitive reality that early-stage investments in successful companies yield higher returns than later rounds. And if we can identify investment opportunities that are more likely to provide outsized returns, it stands to reason that we would seek to maximize our investment in the earliest stage possible, instead of reserving a portion of the capital for later rounds, where the returns would naturally be smaller.
Our strategy is consistent with the historical and intuitive reality that early-stage investments in successful companies yield higher returns than later rounds.
This strategy also enables us to provide a much higher level of support for our portfolio companies. While other funds our size may not invest their full allocations because of their reserves strategy, we provide our full investment allocation from the beginning. This means we are offering a lot more capital to early-stage companies, enabling us to lead in a large portion of the rounds we participate in. Our early full commitment helps entrepreneurs focus on fueling rapid and robust growth from the outset, achieving significant milestones swiftly, and maximizing their potential for success.
The timing of investments also plays a critical factor in managing risk, since returns on venture capital investments can vary significantly from year to year, with some years being more profitable than others. An entire industry may perform exceptionally well one year, then struggle in another. Venture capital firms typically have a four-to-five-year investment window to deploy their funds, while some invest their funds much more quickly — sometimes within a year. At Endurance28, we aim for a time-diversified investment window of around three years to manage the variability in industry returns in any given year. This approach helps us to build a more robust and resilient portfolio that can generate stable returns over the long term, regardless of market fluctuations.
Portfolio construction follows a fund’s strategy and provides guidance for each investment decision. Context matters when crafting a portfolio. Strategy provides the foundational context to portfolio construction, and portfolio construction, in turn, provides context for each investment. By utilizing a firm’s investment strategy (which inherently leverages the areas where the firm has a competitive edge) in portfolio construction, investors can build a more resilient and successful portfolio. Endurance28’s strategic approach not only enhances the portfolio’s potential for higher returns, but also ensures investors have a sustainable investment strategy over the long term.