The Performance Paradox in Venture Capital

Three statements that highlight a contradiction in venture capital strategy:

• There's a ~0.5–2.5% chance that a venture backed company, at seed, will produce a unicorn outcome.

According to Ilya Strebulaev: 0.5%

According to AngelList: 2.5%

According to: CB Insights : 1.28%

• Most VCs are willing to admit they really can't predict which of their investments will be a winner.

"After the deployment period for 20VC Fund I, I did an analysis of portfolio. I predicted the top 5. Three years later, not one of the top 5 is as predicted. The true value from seed is always the messy middle."

(source: Harry Stebbings , Founder of 20VC )

• We can follow the common wisdom that you need at least one unicorn (or greater) outcome for decent fund returns.

"I looked at our top 20 funds by TVPI. What's the common theme amongst the 3x net funds in our portfolio? 85% of them had at least one company that could return the fund."

(source: "Franchise Funds: Metrics To Be Extraordinary with Jessica Archibald ", OpenLP Podcast)

If we verge towards generous and assume a 2% hit rate (you don't necessarily need a unicorn to return a smaller fund), the conclusion should be that seed managers should probably target at least 50 investments, to optimise for at least one unicorn.

However, the 'rule of thumb' (surprising lack of data here) for a right-sized seed portfolio seems to be 25-30 investments per fund.

Essentially, GPs seem inclined to trade the risk of a lower hit percentage (less diversification) for more ownership (less dilution) in order to hit an outlier fund multiple (>5x) even when it jeopardises the baseline returns (>3x) which support raising future funds.

What explains this?

Signalling

If you try to sell LPs on a properly diversified portfolio, you may be signalling an inability to pick, and they may interpret your strategy as offering weaker returns.

"A slow and steady 'venture is a numbers game' pitch is much less emotionally compelling than 'I am a rock star who can consistently beat the odds.' And GPs need an emotionally appealing pitch to get funded."

(source: "The Pervasive, Head-Scratching, Risk-Exploding Problem With Venture Capital", by Kamal Hassan of Loyal VC, Monisha Varadan and Claudia Zeisberger of INSEAD)

It's far easier to sell them on the idea that you have an asymmetric edge which allows you to find success more easily, and take more concentrated positions.

Pattern Matching Success

If you want to be a top performer, you might be tempted to emulate the practices of legendary firms. e.g. Union Square Ventures seems to target 20-25 investments per fund.

This has some obvious errors built in. You don't have the brand to get the "best founders" (pick your definition of "best founder") queuing up at your door. More importantly, you don't yet have the experience and perspective to properly manage a process and achieve above-odds success.

At the very least, you haven't yet proven that ability — and offering it to LPs is a failure of your fiduciary duty.

Less Work / "More Value-Add"

A cheap point, but a true one. 50 companies is more to manage, even if you're generally not a lead investor or taking an active role as an advisor.

The other side to that, if you tell LPs that you have some brilliant operator wisdom to help guide your portfolio founders, it's easier to make that case in relation to 20 investments than it is for 50+.

Here's why all of this is a problem:

At 50 investments, with a 2% unicorn hit rate, venture capital is (just about) a portfolio strategy. Your actual probability of landing a unicorn is 63.5% (not 100%, sadly), which is a decent margin over a coin-toss.

Importantly: you're able to run a decent process, manage risk reasonably well, optimised for the realities of venture. As such, you can more comfortably back potential outliers, outside of the consensus.

"Returns in venture capital are distributed according to a Power Law with the lion’s share of returns earned from a small number of investments. The data demonstrate this distribution to be true across the industry and even within firms. In short, VCs cannot reliably pick winners. They can, however, construct portfolios that consistently generate great returns."

(source: "Picking Winners is a Myth", by Clint Korver of Ulu Ventures )

From 49 investments and lower (34 is where your odds become worse than a coin-toss) you are increasingly forced to focus on 'picking', not portfolio strategy.

A strategy of picking makes sense in PE, where there's a ~60% chance of success from an individual investment.

It does not make sense in venture capital, unless you are able to repeatedly and reliably demonstrate an ability to exceed the usual hit rate. VC is a portfolio discipline.

At 15 investments (26.1% hit probability across the portfolio), you are so exposed to the consequence of each pick that you are forced to seek the comfort of irrationality, like overconfidence and confirmation bias. Alternatively, you'll join the herd on a 'safe' consensus theme, sure to generate good markups.

Neither of these tends to end well, and at risk of repeating my earlier post: this is why venture capital has such poor aggregate returns, weak persistence, and high churn.

Doesn't concentration drive returns?

A common rebuttal to this case for diversification is that it might limit your chance of being a bottom top quartile manager, but it does so by jeapordising your chance at hitting top quartile.

This is not true.

Portfolio modelling and historical data suggests that larger portfolios (to a point) are more likely to outperform. For example, Dave McClure's analysis showed, of portfolios of 15, 30 and 100 companies, the latter was the only top quartile outcome.

"We believe the current VC fund industry average portfolio construction is inherently & critically flawed, and undersized by a factor of 2–5X. We believe a more rational # of investments is ~50–100 companies for later-stage funds, and at least ~100–200 companies for early-stage funds."

(source: "99 VC Problems But A Batch Ain’t One: Why Portfolio Size Matters For Returns")

A larger portfolio, with less concentration, might make it less likely that you land a top 5% fund outcome, but it makes it much more likely that you'll do well enough to survive and raise again.

Indeed, we can model two different portfolio approaches to simulate this:

Fund sizes:

Both start with $50 m; $40 m is investable (typical 2 % / 20 %)

Portfolio construction:

• Diversified: 100 × $0.4 m

• Concentrated: 20 × $2 m

Ownership after dilution:

• Diversified: 2.46 % (Starting at 3%)

• Concentrated: 10 % (Starting at 12%)

(This scenario is using LP data from BFP, which indicates that concentrated funds typically have a higher entry price. There is some interesting circular logic here, as a concentrated firm could target lower entry prices, or whether (for the reasons given above) you need diversification to drive the average entry price down.)

Exit distribution:

Discrete power‑law flavoured mix used in academic VC return papers:

• 70 % fail (0), 20 % $50 m, 7 % $200 m, 2.5 % $500 m, 0.4 % $1 bn, 0.1 % $2 bn

Metric tracked:

• (MOIC) at the fund level

The outcomes are as followed (displayed in the chart above):

Mean fund multiple:

• Diversified: 2.6x

• Concentrated: 2.1x

Median fund multiple:

• Diversified: 2.5 x

• Concentrated: 1.9 x

Chance of ≥ 1x (capital‑preserving):

• Diversified: ≈ 99.7 %

• Concentrated: 81.9 %

Chance of ≥ 2x:

• Diversified: 77 %

• Concentrated: 47 %

Chance of ≥ 3x:

• Diversified: ×27 %

• Concentrated: 22 %

95th‑percentile outcome:

• Diversified: 4.0x

• Concentrated: 4.8 x

As expected, the diversified fund beats the concentrated fund on all outcomes except the 95th-percentile.

Importantly, it's significantly more likely to deliver >2x and >3x, which means the GPs are able to raise a successor fund — offering the chance to learn and refine. There is no room for error with a more concentrated fund. Failure is a hard landing.

A track record of consistent >3x funds is probably also more valuable to LPs than a one-off 8x fund followed by performance all over the map. You'll be a better partner to them, and a more reliable partner for your portfolio founders.

In conclusion, even if you believe picking is your unique strength as an investor, why not give yourself 50+ opportunities to pick? There's nothing stopping you choosing a dozen rockstar outcomes, if you are so enabled.

The concentration problem drives a huge amount of underperformance, and is largely why ~50% of funds struggle to deliver 1x back to LPs today. Or the ~75% that struggle to deliver 2x.

The extent of underperformance is much bigger component of venture capital's sickness than the razor-thin tail of outperformance.

(This post is in some ways a sequel to my previous post on portfolio strategy: "Your fund size is your strategy" — and strategy beats luck 9 times out of 10)