The RISK-EXPLODING Problem with Venture Capital - How to De-Risk VC Portfolios | Claudia Zeisberger

Summary

Claudia Zeisberg, a professor at INSEAD, discusses the risk and potential de-risking strategies in venture capital investing. She highlights that most VC investments fail, but a few high-performing ones can significantly boost returns. Zeisberg suggests that diversification across at least 100 startups can mitigate risks and improve returns, drawing parallels with public equity portfolios. She also mentions funds like Y Combinator that provide exposure to a large number of startups, making VC a more palatable asset class.

Takeaways

• 📈 Venture capital (VC) investing is inherently risky, with seven out of ten portfolio companies typically losing money.
• 🌐 The dispersion of returns in VC is significantly wider than in public equity, meaning the difference between top and bottom quartile funds is substantial.
• 🐉 A few successful 'unicorn' exits are responsible for the majority of the cash returned to investors in the VC industry.
• 💡 VC funds expect the majority of companies to fail, with only a small percentage delivering high returns to offset the losses.
• 🎯 The target internal rate of return (IRR) for investors in VC is typically between 15 to 25 percent.
• 🧩 Diversification is key in VC to de-risk investments, but achieving it is more complex due to the high failure rate of startups.
• 🔢 The ideal number of startups for a diversified VC portfolio is between 100 and 500, much higher than the number in a typical VC fund.
• 📊 Public equity portfolios can be diversified with 20 to 70 stocks, but VC requires a much larger number due to the higher mortality rate of startups.
• 📚 A study by Correlation Ventures showed that out of 20,000 investments, only 1 in 250 returned over 50x, highlighting the importance of a broad portfolio.
• 🌟 Successful VC funds, like Y Combinator, achieve high diversification by investing in a large number of startups, creating a quasi-index of the early-stage VC industry.
• 🚀 To de-risk VC investment, LPs should aim for exposure to a large number of startups, which can be achieved through funds that follow a large-scale investment model.

Q & A

What is the primary focus of Claudia Zeisberg's lecture?

Claudia Zeisberg's lecture primarily focuses on the risks associated with venture capital investing and the strategies that Chief Investment Officers (CIOs) can employ to mitigate these risks.

What is the general return profile for venture capital investments?

The general return profile for venture capital investments is characterized by a power distribution, where a few investments generate the majority of the returns, and the majority of portfolio companies are loss-making, returning less than the money invested.

How many portfolio companies in venture capital typically fail?

In venture capital, seven out of ten portfolio companies are typically loss-making, meaning they return less than the money invested, and the majority of these seven will need to be written off.

What is the impact of a few exits or unicorns in private equity investments?

A few exits or unicorns in private equity investments are responsible for significantly higher returns, often 20 or 10 times more, for the total cash returned to investors.

What is the target internal rate of return (IRR) for investors when they allocate to venture capital?

The target internal rate of return (IRR) for investors when they allocate to venture capital is typically anywhere from 15 to 25 percent.

Why do institutional investors and family offices allocate to venture capital despite its risk profile?

Institutional investors and family offices allocate to venture capital due to its potential for high returns, despite the risks, as it can offer substantial returns that significantly impact overall portfolio performance.

What is the dispersion of returns in venture capital compared to public equity?

The dispersion of returns in venture capital is significantly wider than in public equity, meaning the difference between top-performing and bottom-performing funds is substantial.

What is the recommended minimum number of startups a venture capital fund should have to ensure diversification?

To ensure diversification, a venture capital fund should ideally have exposure to at least 100 startups, and to achieve full benefits, the target should be 500 investments.

What does the study by Correlation Ventures suggest about the returns of 20,000 investments?

The study by Correlation Ventures suggests that 65% of the 20,000 investments are loss-making, returning between 0 and 1x, and only 1 in 250 investments is likely to return over 50x, potentially becoming a unicorn.

How does the dispersion of returns change when the number of startups in a portfolio increases to 500?

When the number of startups in a portfolio increases to 500, the dispersion of returns tightens to a range of 10 to 17 percent, making the returns more similar to those of a public equity portfolio.

What is the model that Y Combinator uses to achieve exposure to a large number of startups?

Y Combinator's model involves accepting around 150 startups twice a year into their accelerator program, resulting in exposure to approximately 300 startups annually, which is significantly more than most VC funds.