Author: Steve Shu

Two posts (here and here) over at Jeff Nolan’s site (regarding a speculated hedge investment holding by TCV) prompted me to write a more general post on venture capital portfolios.

To set some groundwork, I think about investments in two ways: 1) individual investment and 2) portfolios of investments.

From a typical entrepreneur’s vantage point, the entrepreneur seems to be mostly sensitized to the former aspect of investment theory. How so? Early-stage entrepreneurs tend to be more schooled in answering VC questions about prospective investments in their company in isolation of the rest of the world. The "investment-in-isolation" perspective tends to address three base areas that concern VCs:

1. what the makeup of the company management team is
2. whether the company can clearly articulate who the customer is and why they will buy
3. how the growth rates and potential will justify venture capital.

On the other hand, one core aspect of portfolio theory basically goes along the lines of this: one cannot look at an investment in isolation. Any investment in a particular security needs to be looked at in the context of other investments. An example commonly used in business school is the concept of house insurance. This type of insurance is basically a near-perfect hedge investment. That is, the value of one investment (e.g., the insurance) only goes up if the other one goes down (e.g., the house burns down). Some business schools also introduce the concepts of vector analysis and hedging where underlying factors are not necessarily so orthogonal in their outcomes (as is the case of the simple house insurance case).

Other aspects of portfolio theory include minimizing idiosyncratic risk through diversification (much like index funds do by investing in a large number of investments which VC funds cannot do to the same extent).

Blogs by venture capitalists have done a good job to date of shedding light on things like the mechanics of terms sheets, how individual investments are evaluated, how board relationships work, where innovative sales models are going, etc., but I have seen very little to date on how portfolio theory ties in from various angles. This is not to say that portfolio theory does not apply – perhaps it has just not been addressed widely, it is less transparent, or it is not as sexy. Business schools tend to characterize venture capital firms as never investing in competitive firms (overlapping investments for both legal and portfolio reasons) and never facilitating operational measures that intensify idiosyncratic risk. Synergies between venture portfolio companies tends to be a subject that is not addressed in business schools.

Two areas where this affects the entrepreneur are:

• in practice, entrepreneurs have unclear guidance (only anecdotal information) on whether to approach venture capital firms that hold competitive offerings (whether to create buzz, to seek financing, or to seek M&A)
• some entrepreneurs use portfolio company connections to make connections with the VCs that have provided funding (to exploit synergistic opportunities or to take advantages of brokered introductions) – where traction is actually obtained is more or less anecdotal.

In any case, it is my impression that many entrepreneurs are less sensitive to venture capitalists’ needs as investors and as portfolio fund managers. Some entrepreneurs tend to look at VCs as either vulture capitalists or white knights only.

As a final digression, I find it interesting that in TCV’s note in Jeff’s second post, that TCV made mention of board participation in one company and absence of board participation in the other. I suppose this was intended to highlight that TCV has no conflict of interest at the Board-level as far as synergies go (whether existing or not) between the portfolio companies.

Update (3/15/05): I missed this post from Silicon Beat on the Technology Crossover Ventures (TCV) subject.

Update (3/18/05): More updates on the TCV thing. Is the story getting worse?

Steve Shu