Epistula #7: Concentrated Conviction
The Deciens strategy that flies in the face of more shots on goal.
While fundraising, many of our conversations revolve around the same concern – the concentrated nature of our portfolio. We are often asked: “You must have super high conviction on the investments you make. How do you get there?” or “Would your model work with 20 companies? Don’t you think 10-15 is just too few?” or “How do you get comfortable with so few shots-on-goal?”
The Power-Law Distribution Dilemma
Many GPs and LPs point to venture capital’s power-law distribution of outcomes and assume a certain number of shots – in this context, start-ups invested in – are required to find a winner. But how does each additional portfolio company affect an investor’s expected returns? In a fixed-dollar portfolio, you both increase the chances of picking a winner and reduce your relative payout from any winners you have already chosen.
This is for two practical reasons:
Dollars. You must put fewer dollars into each company; therefore, you need more and/or larger winners to make up for your lower ownership.
Time. Investors are splitting their own and their network’s time across more companies.
In our view, the second is more pernicious – it reduces the likelihood an investor can impact a company, know whether following on is a good idea, or get a meaningful allocation if they want to deploy more capital.
Our Portfolio Size Sweet Spot
As we’ve refined our models, we came across a portfolio simulator by a European VC, Moonfire. It models venture portfolios and returns, using historical data to simulate nearly a trillion unique outcomes across two million portfolios.
When we load a Deciens-like strategy into this simulator – above-average decision quality, 200x-300x upper ROI bound, deal-specific ticket size (“passive” in the calculator), 50% reserves deployed in selected companies, and a sliding scale target fund return that prioritizes 10x (max) to 1x (min) in declining importance, with a bias to 5x and higher – it pops out optimal portfolio sizes of 10-20 companies. One of the most interesting factors is what you choose as the upper ROI limit of an investment during the lifetime of the fund.
Redefining Breakaway Winners
The vast majority of the “more shots-on-goal” crowd point to the most outlier of outliers (e.g., multi-thousand-multiple seed-to-exit outcomes of companies like Facebook, Uber, or Google). If there is a 2000x+ company out there and your strategy is to find it, then taking as many shots as possible is the way to go. And, sure enough, if you feed an “unlimited” or even 1000x ROI limit into the Moonfire calculator, it suggests optimal portfolio sizes in the 100s. This makes sense – simple math shows a single 1000x investment makes up for the dilution of 99 other equal-weighted losers and still delivers a 10x fund (before fees and carry).
However, the vast majority of companies that are considered breakaway winners are much smaller. Some of the best venture deals of the last decade, such as WhatsApp and Zoom, “only” returned seed investors 200-300x. If you recalibrate the simulator to those outcomes, much smaller portfolio sizes yield far better outcomes.
Our friends at Restive came to a similar conclusion on portfolio size and exits and shared two important insights: the impact of mergers and acquisitions and the fact that a tremendous amount of the value in public fintech comes post-IPO.
“As fintech specialist funds think about portfolio construction, they should not rely on multiple billion-dollar outcomes alone to drive returns. While funds and founders should be ambitious and shoot for big outcomes, fintech uniquely has a large M&A market.”
“...[V]alue accrue[s] to these companies over time. For example, both Intuit and Fiserv (two examples of “godfather” companies in fintech) took years of slow, steady growth before becoming the behemoths they are today.”
Active Management Over Passive Probability
The phrase “shots-on-goal” evokes a hailstorm of shots, with little you can do after you’ve taken each shot to impact it. You can’t redirect, speed up, or slow down a puck or ball after you’ve sent it on its way. As an investment strategy, “more shots-on-goal” is similarly passive (how will you keep tabs on, let alone add value to, dozens or hundreds of companies across numerous funds?) and probabilistic (done with the hope of increasing the “chances” of finding a winner) – and you’re far more likely to generate consistently mediocre performance. It makes sense if simply staying alive is your goal – and perhaps this may be the only way to deploy a multi-hundred-million-dollar seed fund in the 2-4 years most VCs hope to deploy it. But this is not Deciens' way.
Deciens’ Paradigm: Fewer, Bolder, More Significant Shots
We want our shots to actually be “on-goal” – building financial services companies of consequence – not merely shots as a goal itself. We take more time to diligence and way more time after we’ve made the investment to shepherd it along. It isn’t a few seconds on the ice or across the field; it’s years, maybe decades before we find out if the puck lands in the net.
This approach to VC is not for everyone. It requires a lot more active management – we need to decide where to spend our time, when to deploy capital proactively (and reactively), and when to get on a plane to work through sales pipeline spreadsheets, cash-flow forecasts, and product roadmaps.
We also recognize that for LPs, investing alongside us requires more careful underwriting, more political, social, and career risk, and more putting up with nerds trying to write about rap, sports, and restaurants to explain how we’ve refined our thinking. All of this is at a time when LPs have fewer liquid dollars to deploy, especially for venture capital, than in recent memory. But, in exchange, we offer a team genuinely vying for extraordinary returns by taking fewer, bolder, more significant shots and hustling like founders to score goals. And, as it turns out, this concentrated, actively managed approach is working.
Our Approach in Action
We started out looking to put 15 names into Fund 2 but decided to stop investing out of that fund because we were actively managing its return profile. In late 2022, multiple portfolio companies showed clear signs of being breakout winners. We could see these signs and have this level of conviction earlier than most because we were and are so involved with each company. At the same time, we believed that the challenging macro environment was showing signs that it would get worse and stay worse for longer than many suspected. Both factors led us to the same conclusion: hold more reserves and don’t dilute our holdings of the current crop of winners.
We can now help these companies ride out the current conditions. In doing so, we are actively building our ownership of extraordinary businesses at attractive multiples while continuing to prepare them for functioning capital markets in the coming years. Would we know enough about our companies to take such an unorthodox approach if we planned for 50 companies in the fund and had already invested in 36? I doubt it.
Deciens’ Fund 2 portfolio companies
How It’s Going
There are many stories of how this strategy of active involvement has led to attractive opportunities to deploy capital for our LPs. We share one further below on Pippin Title. As a whole, Fund 2 is maturing nicely. As of May 2024, two of 11 companies produced run-rate revenues above $7.5 million, four greater than $2 million, and two more will hit $1 million by the end of Q2, with still more finding their footing.
I think most conventional 30-50 investment 2020 vintage seed funds would love to have this many shots on goal.
Pippin Title: A Case Study
A great example of this strategy at work for Fund 2 is Pippin Title. Pippin provides technology-enabled title searches and was significantly bolstered by the mortgage and refinance boom, and faced significant headwinds when the cycle turned. The team was doing all of the right things, becoming more efficient and going upmarket to more stable customers, but they could not avoid the macro impact of rising mortgage rates. They were also exploring many alternative use cases for title search, but none had come to fruition. Towards the end of 2022 and the start of 2023, the company needed more capital. Deciens had a decision to make – should we fund the company to see them through the cycle or chalk up this investment to bad timing?
There were many willing investors, but no one was willing to lead the round or catalyze the investment. We leaned on our insight from working closely with the company to make the call – the incredible tenacity of the founders, the promising new business opportunities, and the latent upside in the residential business (they had experienced limited customer churn, just reduced volume per customer). We first supported them by putting forward a term sheet to lead a new financing with a small check to catalyze the round, and then quickly followed by increasing our check size when the new business opportunities became clearer. Revenues are now far beyond the peak during the boom and are continuing to grow at a record pace. Our closeness to the company and team meant we could make a great investment for our LPs, and the round was ultimately significantly oversubscribed, giving the company the capital it needed.
