Council Post: VC Investment Strategies: Lean Into Risk To Find Alpha

By Tiana Laurence, Partner at Laurence Innovation, a pre-seed investment fund focused on early-stage tech companies in the 4IR verticals.

While access to information is crucial for venture capital (VC) funds to make better decisions on their investments, we’ve entered an era in which the widespread availability of information has become an impediment to finding alpha.

Alpha is defined as a better-than-expected risk-adjusted return and is the goal of all investors worth their salt. I would argue that venture is missing alpha if it follows traditional venture investment strategies that rely on domain expertise, investment social signaling and asset maturity as tools to cherry-pick the equity they are buying.

VCs, much like the stock pickers of the 1970s increasingly have access to the same information through platforms like Pitchbook, Crunchbase, LinkedIn and AngelList. They compete to gain allocation in “hot” companies and it’s far more difficult to find alpha in a saturated information environment, but there are strategies VCs can deploy to build more profitable and resilient portfolios than their competitors. 

One of the most effective ways to find alpha is to identify promising companies at an early stage of their development. Most VCs avoid this option for two reasons. Early stage companies are more likely to fail. It is at least three times as risky to go in early as an investor. The other reason is there is also no information on early stage companies. They often only have a great idea and maybe a prototype.

Many VCs are unwilling to invest resources in helping these companies improve their products, leverage new market segments, and make their teams more productive, but it can pay dividends, lowering the mortality rate of their investments and improving their internal rate of return (IRR).

VCs should also focus on building a large and diversified portfolio — and yes, diversity planning should also include diversity of founders, geography and industry. By working with many diverse companies at once, investors can simultaneously insulate themselves from risk and increase the chances that they’ll pick winning prospects. 

Build a large and diversified portfolio. 

We’re in the middle of the Fourth Industrial Revolution (4IR) — rapidly emerging technologies like artificial intelligence (AI), the Internet of Things (IoT), quantum computing and biotech are transforming the economy and our daily lives in ever more dramatic ways. Meanwhile, powerful and affordable technologies (such as software as a service platforms for internal communication and collaboration, customer experience management solutions, etc.) have substantially reduced the barriers to entry for founding and growing a company. 

These are all reasons VCs that build large and diversified portfolios have a better chance of capturing alpha than their counterparts. There are always trade-offs with investment strategies — for example, VCs that work with a larger number of companies cannot invest as much in each one (or provide the same amount of direct hands-on guidance).

However, investing in a bigger pool of companies also hedges against risk — there will inevitably be more failures, but the chances of success increase. When you balance the number of investments with the inherent risk of that asset class, it’s more probable that you will capture alpha. The key is finding the right balance, which means deciding what your risk tolerance is, carefully considering the market trends in the asset class you are investing in and making enough profitable investments to offset any costs you’ll incur from failed investments.

The most reliable way to make a large-volume investment strategy as sustainable and high yield as possible is to ensure that your portfolio is highly diversified. A study published in the Journal of Business Venturing notes that there is a “documented positive relationship between fund diversification … and performance in venture capital.” VCs should also expand their definition of “diversity.” Although it’s essential to develop a portfolio of companies that operate in various sectors and offer a wide range of products and services, it’s also crucial to focus on overlooked leadership teams — particularly those composed of women and people of color. 

Manage the risks of getting in early.

The nature of VC investing has to keep pace with developments in emerging markets, information availability in the sector, technological shifts and a vast range of other changes. According to a 2018 paper published by the National Bureau of Economic Research (NBER), the rise of early stage investing has been “driven by technological shocks that have substantially lowered the cost of starting new businesses, opening up a whole new range of investment opportunities that were not viable before but also necessitating new ways of financing them.”

There are clear risks associated with investing in early stage companies. Another NBER report found that early stage VCs are less likely to meet projections than their late stage counterparts. However, early stage VCs are also less likely to make due diligence a priority — 17% don’t use quantitative evaluation metrics for their investments (versus 9% of regular VCs). In comparison, 31% don’t forecast cash flows (versus 20% of regular VCs). 

When VCs balance an early stage investment strategy emphasizing due diligence, their chances of identifying cutting edge companies increase dramatically. This will ultimately lead to a more robust portfolio and higher returns over time. 

It’s time for VCs to adapt.

The VC investing landscape has shifted dramatically in recent years. We aren’t just witnessing an explosion of new technologies and companies as the 4IR picks up momentum — the VC industry has also become flooded with information, making it more difficult to find alpha with traditional investment strategies. This is why forward-looking VCs should get out in front of competitors by building their portfolios around promising and diverse companies in early stages of their development. 

Competition among VCs has never been more intense, especially now that many funds are relying on the same information supplied by universally accessible databases and other platforms. By looking beyond this conventional investment model, VCs can adapt to the new economy and increase the chances that they’ll partner with some of the most innovative companies in the country.