Epistula #15: The Risks We Choose
Downside is unavoidable. Knowing what risk we want, is how we manage it.
Concentrated early-stage portfolios are the hallmark of Deciens’ approach to venture capital. We invest in roughly half to a third as many companies as our similarly sized peers. It's seemingly one of the most idiosyncratic and controversial things we do. Almost every LP, existing or prospective, asks us about it.
While I've been surprised at how much pushback this approach generates, I don’t dismiss the anxiety it brings. We take these concerns as seriously as LPs do, and I want to provide a single clear, unified picture of where the risks in a concentrated portfolio actually lie and how we think about managing them.
Risk Management: More Than a Platitude
Risk management is one of those late 20th-century platitudes. Who doesn’t want to manage risk? The idea of unmanaged risks conjures up images of runaway trains on their way to calamitous fates. Or, possibly, in the eyes of some LPs who look at our concentrated portfolio, foolishness. But all investors must take risks, understand them, mitigate them, and ultimately transform them into returns for clients — without risk, there is no reward. And as professional investors, this obligation goes a step further; we must calibrate the risk we take with the goals we have agreed on with our clients.
Every institutional venture investor operates under the same basic constraint: a fund has a fixed amount of investable capital, and how a venture capitalist allocates that capital is one of the major determinants of a fund’s performance. In practice, that generally means deciding how many companies to back, the percentage of each company to own up front, and how much capital to hold in reserve for follow-on investments. This is known as “portfolio construction,” and differing portfolio constructions yield very different outcomes. How Deciens constructs funds and their underlying portfolios is simply a byproduct of how we’ve chosen to balance these three variables.
What We Mean by "Risk"
Most of the time, when people say “risk,” they mean downside risk. In plain English, what are the chances that we will lose part or all of the capital we initially invested in a company, plus any additional capital we might have invested over the lifetime of our partnership with said company? There are other dimensions to how we think about risk, but since downside risk is the one everyone asks about, that’s what I want to focus on here.
Some downside risk is unavoidable. We want to support entrepreneurs in trying bold things, and some of those things will, invariably, fail. The question isn’t whether we can eliminate downside risk. We can’t and wouldn’t want to. Rather, the question is whether we manage the downside risk well at every stage of the investment lifecycle, including before the first dollar even goes into a particular investment.
Pre-Investment: Managing Risk Before the First Dollar
Our approach to risk management starts long before we commit capital. This is why our mean time from first meeting to a term sheet is over eight months and getting longer with each fund.
Finding the Right Markets
When considering an investment, we obviously look for markets large enough to support venture-style outcomes. But even more than that, is the market in the midst of changes or poised to change given the right catalysts? Small and/or static industries that are unlikely to evolve are generally not compelling places to build venture-backed businesses. Fortunately, the world of financial services, our domain, is filled with numerous very large, highly profitable, dynamic sub-markets.
We also want to find markets that allow for monopolistic or oligopolistic market structures at the steady state, with correspondingly deep moats and strong barriers to entry. This is the set-up that allows the winners to generate outsized profits and compound their equity at very high rates of return for years on end. Conversely, we actively avoid markets that invite intense competition, as that destroys profits. Finally, we are very aware that some markets within financial services can, at times, seem attractive because of the macro backdrop, but the specific circumstances that make these markets appear attractive are likely ephemeral. We want to find the markets that are actually attractive based on their long-term fundamentals.
Finding the Right Founders
As we have written about previously, we have strongly held views on the types of founders we want to work with. So we take our time, often over a year, getting to know founders in various contexts and really learning their stories. If all goes well, we will be partners with these founders for decades, so actually getting to know them seems, at the very least, prudent. In some cases we bring the person onto Deciens’ payroll for a period of time, as we do with the entrepreneur-in-residence program and other incubations. This lets us spend time with potential collaborators multiple days a week, for a year or more, before we put the first dollar of LP capital at risk. If done well, it can rapidly accelerate a business’ trajectory once it is launched.
Due Diligence and Finding the Right Amount of Risk
Once we find an exciting market and team, we doreal, material due diligence. Dozens of calls, pulling in multiple experts, numerous on- and off-list references, etc. Very old-school, shoe-leather due diligence, commensurate with starting a substantive business relationship. This seems to be very different from most other early-stage funds where their due diligence, if they can call it that, appears to be nothing more than a cursory pass.
This level of due diligence allows us to be flexible about the risk profile we’re taking on — the shape and size of risk in any given investment. We want to understand the risks we're underwriting, both to have a plan to mitigate them and to avoid being overly concentrated in certain types of risk within each fund’s portfolio. Macro risk is one example. We want a strong understanding of the macro exposure each company brings, so we’re never overly exposed to any particular type of macro risk.
We can also proactively change the risk posture of a given portfolio. For example, in Fund III, we have intentionally backed founders who want to go after the full addressable market of the sector they are focused on, rather than just the software layer. As a result, those companies can become profitable much earlier than a pure software company because they capture much more of the economics, which significantly reduces funding risk. In heady times such as these, that seems like a prudent adjustment.
Post-Investment: Staying Close When It Matters Most
Our disciplined approach does not stop once we invest in a company. If anything, it becomes more pronounced.
Every week, we spend substantial time with each company in our portfolio. This lets us granularly track what is and is not working and offer interventions when needed. It also lets us amplify momentum as soon as we see a company is breaking out.
This differs from many VC firms, which interact with their portfolio companies quarterly, at most. But start-ups operate in dog years, not human years. Everything and everyone can be totally different in a quarter. That’s why we prefer to have our finger on the pulse. And we can only do so because we have a small, concentrated portfolio.
We want to build companies that can weather shifting capital markets and economic environments, and we work intensively with founders to help them build this way. As we’ve shared in previous letters, companies should grow as fast as they can using their internally generated cash flow rather than external capital. Relying on external financing — what we call existential financing risk — is not aligned with anyone’s interests. Only once a company has achieved growth, profitability, and scale should we even begin to think about layering in growth capital.
This approach helps a higher percentage of companies escape the early stage and creates more optionality for long-term success. And it works. Our track record, our loss ratios, and especially our dollar-weighted loss ratios are consistently among the best in the industry. It also gives each of our funds multiple ways to win, rather than simply depending on a single company.
Mitigating Downside as a Third Co-Founder
We are fundamentally builders. By working hand in hand with entrepreneurs, acting as if Deciens is a third co-founder, we can fundamentally change the trajectory of our portfolio companies. Alongside our financial capital, we deploy substantial human capital across our portfolio companies, in support of our founders and in the service of our LPs, today and long into the future.
Our companies are not simply surviving. They are thriving — and with far less capital than their peers — thanks to this approach to portfolio support.
That closeness helps mitigate downside. If we can help companies get from point a to point b faster, and with higher probabilities of success, that reduces our downside. Our ability to deploy reserves to bridge companies, and to avoid the time and distraction of outstanding financings, has a similar impact, and is a key part of our capital deployment strategy.
A close working relationship also means we address problems as they happen, rather than having a quarter or two go by waiting for the next update. A lag like that can be fatal for an early-stage company. It means that when we do have to have tough conversations with founders, it is done from a place of influence. This influence means that founders will listen to our perspective at key inflection points, when it matters most.
Follow-On Investments: Managing Reinvestment Risk
The structure of venture capital investments allows us to allocate more dollars to a company after an initial investment. But that leads to a set of important questions, including:
What re-investment opportunities are the best, and can we access or manufacture them?
Are we putting good money after bad?
How do we know when to stop investing in a given company?
Managing reinvestment risk is one of the most critical parts of our process but is largely under-discussed.
A byproduct of our concentrated portfolio and engaged support model is that we get an intimate understanding of which companies within our portfolio are doing the best (and worst). We can then steer capital toward those where the incremental dollars will have the greatest return and impact, and away from those where they won't. This improves our reinvestment process and our overall return profile. Whether that capital is on the balance sheet in one of our funds or off-balance-sheet, requiring an SPV or co-investment, having a crystal clear view of what is happening is extremely powerful.
A secondary benefit of this approach is that we can proactively deploy capital on the basis of our relationships with companies, to the benefit of our companies and LPs. This is in stark contrast to the reactive posture typical in the venture capital industry. As my friend and mentor Ho Nam says, “Due diligence starts at the closing dinner.” If that's true, we stick around for breakfast, lunch, dinner, and dessert every day.
A Self-Reinforcing Loop
Finally, we see that these dynamics are self-reinforcing. We pick companies we know how to support. And having a strong view on the kinds of companies we can support helps us pick better. Our ability to reinvest in companies lets us meaningfully support across an investment’s lifecycle. This approach is at the heart of our confidence that the Deciens view of risk management is working.
By reducing the need for follow-on capital within any given company, we lower the financing risk embedded in each of our portfolios. By being more hands-on with each of our companies, we reduce downside risk. By being in a position to grow and maintain large ownership stakes, we ensure we can concentrate capital in breakout companies — which gives us many different ways to win within any given fund. The converse is also true: that same structure makes our system fault tolerant. We know we’re not perfect, so when we make a mistake, it isn’t fatal or existential, by design. The combination of these and other related strategies lowers our risk, across several dimensions relative to our VC risk management philosophies. We believe that it should also create superior returns, both on a risk-adjusted and non-risk-adjusted basis.
The fundamental optimization we work with is the idea that smaller funds with larger ownership need fewer dollars of aggregate value created to achieve the same goals, relative to larger funds with lower ownership, given the same exit multiples. For any given fund size, when the focus is primarily on delivering returns, greater concentration is a less risky investment.
